How would I need to prove to the IRS I paid foreign taxes if I take the Foreign Earned Income Exclusion?

Question

I'm a US citizen (I have no other citizenships) who's been living in Ukraine for several years. I've passed the 330 days out of US test. I have a permanent Ukrainian residency permit, and I'm married to a local. In the past I've kept paying US taxes as if I was a full resident, but I've heard local Ukrainian taxes can be a better deal. I work remotely (and lead a local team) for a US company that withholds tax from the state I used to live in (I use a relative's address).

Can I claim the Foreign Earned Income Exclusion? When I figure out how to pay local tax here, what should I be prepared to show the IRS in case they ask?

Answer 1

You seem to be conflating two things.

1. The Foreign Earned Income (and Housing) Exclusion allows you to exclude from US tax the income you earn for services (typically, a job), optionally plus some employer-paid housing expenses, while you live in a foreign country and meet the bona-fide resident or 330-day test (as you do), up to a cap that was $102,100 for 2017; I'm not sure where to find the 2018 figure. It does not matter to the IRS whether this income was taxed by the other country. It usually does matter to that country, and you should certainly find out whether the relevant part of the Ukraine government thinks your income was and/or is taxable, but that's between you and Ukraine; IRS doesn't care -- unless you owe and pay foreign tax on nonexcluded income, see below.

   Since you are being paid by a US employer, to get them to stop withholding US tax you must provide them a signed statement that you qualify for FEIE, and the IRS provides form 673 for that purpose. (Unless your US employer is actually a US government agency, but in that case you should be getting guidance through official channels and not here.)

2. The Foreign Tax Credit or deduction allows you to either deduct or get a credit on your US tax if you owed and paid foreign income tax on income that is also subject to US tax. If you use the FEIE as above, the excluded income is not subject to US tax, so you don't get a credit or deduction for any foreign tax you paid on that income. (You also can't take deductions or credits that depend on earned income, like HSA and IRA contributions and EITC.) If you have earned income over the FEIE cap, and/or unearned income, you still have to compute US tax on those (and at the usually-higher marginal rates that would apply if the excluded income had not been excluded), but if you paid foreign tax on those parts of your income you can take the foreign tax credit or deduction for that tax against your US tax. Choosing the deduction is simpler but normally less valuable; the credit is limited to the US tax separately for several categories, which can be fairly complicated to compute, but if you use software it should do this for you.

   To substantiate the foreign tax credit or deduction, you should keep evidence of the payment(s), including date(s); normally a bank or credit-card statement or similar should be enough, but if you pay in cash for some reason be sure to get an official receipt. In addition you should be prepared to show that you owed the tax: if you have overpaid the foreign tax, you can't just choose to let the foreign country keep the extra and get a bigger credit (or deduction) from Uncle Sam; you can only take off US tax the foreign tax properly paid, and seek a refund of the overpayment from the foreign country. I don't know about Ukraine, but most systems have some kind of form either for you to tell them what you owe (with sufficient details to establish its correctness), or they tell you what you owe and/or already paid by withholding (ditto).

I suggest you spend a little time looking at https://www.irs.gov/individuals/international-taxpayers/taxpayers-living-abroad and the forms and publications linked on the relevant pages there, especially pub 54 Tax Guide for U.S. Citizens and Residents Abroad and pub 514 Foreign Tax Credit for Individuals. Few of the 2018 versions of documents are up on the website yet (most should be posted over the next 2-3 months) but AFAIK this area of tax law was not changed for individuals by TCJA, so looking at last year's should give you a good start if you don't want to wait.