Kevin Matthews, CPA, PHR, MBA, MAcc
What an exciting time! That was the feeling I had when I stepped off of the plane after arriving at Narita Airport. I had just flown business blass (they did it business class back then) and then had a relaxing ride from Narita to Tokyo. We were greeted at the door of the hotel by a man all dressed up with a top hat, and he ushered us in. WOW!
Over the next few days, we would learn about what it took to survive and thrive as ambassadors of our nations to the country of Japan. In one of the seminars, it hit me… taxes. At first, I wasn’t worried as I had been filing my own taxes, but some of the people said it would be different in Japan. How hard could it be? Well, I found out really quick; it was hard.
Perhaps, it wasn’t so hard, but rather different. I used to file my taxes using a 1040-EZ form, but now I was told that I could no longer do that, because I was living in a foreign country. What was the difference? How is a U.S. citizen or permanent resident (or green card holder) taxed when living in Japan? Finally, how does the U.S. prevent “double taxation?” These topics will be discussed as we explore how the American JETs can keep compliant with the tax laws of their home country.
WARNING: This article is not intended to make you a tax expert. If you need assistance, please seek out the advice of a CPA, enrolled agent (EA; people who have passed a test with the IRS and have received a special status to represent people before the IRS) or a tax attorney. The information in this article is for general informational use only and should only be used after consideration of your specific situation.
WHAT’S THE DIFFERENCE?
First question: How is it different? We will discuss this more into the second and third sections, but be prepared for your taxes to get a little more complicated. First, you will have to complete additional forms and really consider your situation as you begin to decide how you will carry out your tax filings. Because of the additional forms, filing your taxes on your 1040-EZ or 1040-A will no longer work.
Second, you are going to have to separate your income into pools of foreign income (i.e. income in Japan) and domestic income (income from back in the U.S.). This is because only foreign income can be excluded or qualify for the foreign tax credit. Finally, as we will discuss in the third section, your tax-filing deadline is more than likely to be extended, because you are going to want to meet one of the residency tests, which will allow you to exclude your income.
WORLDWIDE INCOME?
The second question: How are U.S. citizens and permanent residents taxed? While the first answer which may come to mind is the “by the IRS,” this answer does not get to the point relating to your special situation. If you ask your French, U.K., or Irish colleagues about their tax requirements, they will likely tell you they filed a form with their home governments to say they are going to live abroad. This form stops them from being taxed in their home country, while they live overseas.
The U.S. (and some other countries) does not work in this manner; instead, the United States taxes your worldwide income. This means that a dollar you make in Japan is taxed in the U.S., just as much as a dollar made back in your hometown.
One might say, “Worldwide income? But that’s not fair!” In this case, Congress agrees and they offer some relief measures, which introduces the third section: How does the U.S. prevent double taxation? Being taxed once in Japan and then once again in the U.S. would not be a fair regiment, so Congress passed two sections to the tax law.
FOREIGN EARNED INCOME EXCLUSION AND THE FOREIGN TAX CREDIT
The first section they passed was section 911. Section 911, which is better known as the Foreign Earned Income Exclusion (FEIE), was passed back in 1951. Back then, there was no limit to the income, but over time, a limit was imposed, and it has changed over the years. In 1986, it was reduced to $70,000 of income. It was increased to $80,000 in 2002, and since 2005, it has been adjusted for inflation. Congress added a housing exclusion along the way to where we are today. For 2016, the FEIE is $101,300, which does not include the housing allowance amount. Since most JETs (at least when I was in the program) make less than that amount, the housing exclusion could raise this higher, but for our purposes, we will use the $101,300 number.
So how does someone qualify for the exclusion? There are two tests: The Bona Fide Residence Test and the Physical Presence Test. The Bona Fide Residence test requires that you live in a foreign country for an entire tax year (for all of us, that is January 1 – December 31) as a tax resident of that country. If you live in Japan and are subject to their tax scheme, then you will likely qualify for this test.
There is only one major thing: In order for you to qualify, you will have to wait to file your taxes until you have lived in Japan for an entire calendar year. For most taxpayers, this means you will not be able to file your 2016 tax returns until January of 2018! Yikes! If you go this route, you will have to extend your tax returns, not only by the standard six months, but you will also have to file a Form 2350 to ask the IRS for an extension through the beginning of 2018.
The easier test, and the one that I used when I was a JET, is the Physical Presence Test (PPT). The reason why it is more popular is because people qualify faster for the test. The way the test works is in order to qualify as a tax resident, you have to live outside of the U.S. for 330 days out of 365 days. Now, this sounds easy, but the 365-day factor confuses many people, because they think the 365-day term has to fall in the same calendar year, but it doesn’t!
Instead, your 365-day term when you arrive in Japan (or any foreign country where you want to use this rule) From your arrival date, count 365 days later, and as long as you have 330 days in Japan, you will qualify for this test and you can exclude your foreign income you earned in Japan (Japanese salaries). If you arrived in Japan in August 2016, you will likely be able to file your taxes in August of 2017, thus you can file them sooner and you will only have to request an extension through October 15, 2017, which is an automatic extension and can easily be filed using a Form 4868. The major trip up on the PPT is how many vacation days you spend in the U.S. You only have 35 days you can be there, so be wise about your use of them and track carefully.
The second section Congress passed was section 901, or better known as the Foreign Tax Credit. If you pay taxes in Japan (I am not a Japanese tax expert, but when I was in Japan, they excluded us from filing taxes for the first two years in Japan), you can earn a tax credit on the taxes you pay in Japan.
My experience has shown Japanese income taxes to be higher than U.S. taxes, so it could potentially be very valuable in removing your taxes on your foreign income in the U.S., but facts and circumstances are different for everyone. Before deciding on this course of action, it is recommended you seek council of a CPA, enrolled agent or a tax attorney.
Finally, there are many rules for people living abroad. A couple of those rules is as follows:
- People who are living abroad at the time of the tax return’s due date (April 15) are granted a special two-month extension automatically for filing and paying. If you pay after April 15th, but before the end of the extension (June 15), you will not pay penalties on your payment.
- If you open a bank account and have more than $10,000 in your foreign bank account, you will have a requirement to file a form FinCEN 114 to report the account. Your account will not be taxed, but must be reported and the penalties for not reporting are pretty stiff. If you have not filed a FinCEN 114 in the past and are now required to, please seek out the guidance of a CPA, EA or tax attorney, particularly one who specializes in international tax, because there are relief provisions, but you have to apply on your own in order to get them. Starting in 2016, these forms are due on April 15 along with the tax return and can be extended for six months.
- If you have purchased investments in Japan, please seek out the advice of a CPA, EA or tax attorney who specializes in international taxes as there might be additional reporting requirements.
I know that the information in this article is a lot, and the last thing I want to do is to worry you about your taxes. First and foremost, have fun in Japan. Being a JET in Chiba City was one of the most rewarding experiences in my life and I would not be where I am today without those experiences. I loved being in Japan and look forward to the day I can return there to visit the place where I experienced so much happiness.
Enjoy the moment. Enjoy the WOW! 20 years later looking back, as I am now, you will focus on the good times, provided that you take care of the tax returns as they require. If you have any questions, please feel free to contact either myself or the IRS office at the U.S. embassy. When I lived in Japan, they were very helpful in showing me what to do.
Kevin Matthews was an JET ALT from 1998-2000, stationed in Chiba City, where he taught in middle and elementary schools. His major was Asian Studies and he spent eight years learning the Japanese language. Upon his return, Kevin earned a Master’s in Business and Accounting and now owns his own practice (Beta Solutions CPA, LLC), where he focuses on business, payroll, and international taxes for U.S. citizens, permanent residents, and immigrants to the U.S. He has been preparing tax returns for over 12 years.