Digital Nomads are entrepreneurs who run location independent business. Many digital nomads travel outside the United States with their laptops. Although they have a presence in other countries, they rarely stay long enough in any country to become tax residents of those other countries. They typically conduct their businesses through non-U.S. (foreign) corporations and draw a salary from those foreign corporations. By drawing a salary from those foreign corporations, they ensure that their income is foreign and they they avoid paying U.S. self-employment taxes.
Now, let’s see how a U.S. citizen can avoid being subjected to income tax by ANY country while travelling the world. Here are the requirements for a U.S. citizen digital nomad to being taxed on any income in ANY country.
1. The Digital Nomad CANNOT have an abode in the United States.
2. The Digital Nomad CANNOT have any income earned from/in the United States (U.S. Source income).
3. The Digital Nomad must have a tax home outside the United States.
4. The Digital Nomad must avoid establishing tax residence in another nation or must avoid establishing tax residence in a country that has an income tax.
5. The Digital Nomad must have ONLY foreign earned income. The Digital Nomad will commonly incorporate a company outside the United States. That foreign corporation will carry on the business activity and then pay the U.S. citizen as an employee (ensuring that the income is foreign and can be excluded under the Foreign Earned Income Exclusion).
6. The Digital Nomad must spend enough days outside the United States to meet the physical presence test (approximately 330 days per year outside the USA).
7. The Digital Nomad must file a U.S. tax return in order to be eligible to take the Foreign Earned Income Exclusion.
8. Assuming that the Digital Nomad is being paid through his or her controlled foreign corporation, the Digital Nomad must file IRS Form 5471 to meet the reporting requirements mandated by Internal Revenue Code Sections 6038 and 6046.
9. The Digital Nomad must be aware of Mr. FBAR and the consequences of having signing authority over Foreign bank accounts and other specified financial assets. Mr. FBAR may have to be filed and Form 8398 may have to be filed. For a description of many of the forms that may be mandatory for Americans abroad see here.
Warning!!! Points 1 – 9 are a gross oversimplification. There are a number of technicalities and you are encouraged to read Internal Revenue Code 911 and to read the IRS interpretation of the Foreign Earned Income Exclusion.
The future of the Foreign Earned Income Exclusion (FEIE)
Both American Citizens Abroad (ACA) and Republicans Overseas have proposed changes in the way that Americans abroad are subjected to U.S. taxation. Both organizations have (for different reasons) proposed either abolishing the Foreign Earned Income Exclusion.
The American Citizens Abroad proposal
The FEIE would be abolished and citizenship taxation would continue. After five years, Americans abroad would be eligible to apply for residence based taxation. For American abroad who were NOT eligible to move to residence-based taxation, the repeal of the FEIE would/could be a major loss.
The Republicans Overseas proposal
Republicans Overseas proposes moving to a system of territorial taxation. Under a system of territorial taxation foreign income earned by Americans abroad would no longer be subject to U.S. taxation. Hence, the FEIE would be unnecessary.