Avoiding the Earned Income Exclusion Trap

If you are a US person lucky (or smart) enough to live in a country that either has territorial based income tax or does not tax foreign investment income, you still might be caught in a conundrum. This just happened here in Uruguay last month when Uruguay imposed a personal income tax, but excluded foreign investment income from the new tax.


This created a tax conundrum for US persons:

  • Uruguay will not levy income tax on any foreign “unearned income” such as dividends, pensions, annuities, and other income from investments, however
  • the United States only excludes foreign earned income from US taxation of its non resident citizens, and then only the first US$80,000 per year per person-all other earned income and all unearned income is taxable, EVEN IF YOU NEVER LIVE IN THE US AGAIN!

The upshot was noted by one of our correspondents in this way:

Of course, if you take income as earnings…the USA will give you an exemption but then UY will require payment. If you take it as a dividend, UY will give you a break but then the USA will want their cut.

Fortunately, there is a way around this problem.
If you set up a limited liability company (LLC) and you are the sole owner, you can file IRS form 8832 and elect to have it considered a “disregarded entity” for US tax purposes. Have that company “earn” the money (and take advantage of the US earned income exclusion), and then have that same company pay you a dividend from outside UY so that it is tax-free investment income here.
There are other solutions, depending upon size, but this is the simplest.
Complete IRS rules for Non Resident Citizens can be found at:
http://www.irs.gov/publications/p54/index.html.
–The Navigator

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