Most tax preparers make a mistake with RSUs that cannot be fixed afterwards. And it is not their fault. It is just one of the many reasons you want someone specialized in this area preparing your U.S. tax return if you live in Israel and work in hi-tech.

Most accountants are preparing a normal U.S. tax return using the tax software's default settings, which backfires on the taxpayer if they are US citizens working in Israel. The worst part is that the IRS came out with a publication a few years back that blocks you from fixing the issue later.

By the time many people discover the issue, the most important decision may already be locked in.

Key Points

  • U.S. taxation of RSUs and Israeli taxation of RSUs often happen in different years.
  • This timing mismatch can create a double-tax problem.
  • The foreign tax credit does not automatically solve the issue.
  • One election on Form 1116 can have a major impact on the outcome.
  • That election generally must be made on a timely filed original return.
  • Amending a return later may not allow you to change that election.
  • There may still be carrybacks, carryforwards, or other planning opportunities, but they are not guaranteed.
  • Proper planning needs to happen when the RSUs vest, not when the shares are eventually sold.

One of the most frustrating conversations I have with new clients usually starts with them saying “I already paid U.S. tax on my RSUs when they vested. I just sold the shares and paid tax again in Israel. Can we amend the old U.S. return and fix it?”

They assume this is a reporting mistake. We amend the prior return, add the Israeli tax, and the double-tax problem disappears. Unfortunately, it often does not work that way.

The United States generally taxes RSUs when they vest and the shares are delivered. Israel may not tax those same shares until much later, often when they are sold through the Israeli trustee.

That creates a timing mismatch. The U.S. reports the RSU income in one year. Israel collects its tax in a future year. Sometimes it might be the case of RSUs vesting in December of the first year, and sold in January of the next. Then at least there is what you can do... in theory.

In theory, the foreign tax credit is supposed to prevent the same income from being taxed twice. In practice, the credit only works properly when the income and the related foreign tax can be connected within the U.S. foreign tax credit system.

That is where one small box on Form 1116 becomes incredibly important. Most individual taxpayers claim foreign tax credits using the paid method. That means the Israeli tax is reported for U.S. purposes in the year it was actually paid.

But Form 1116 also allows a taxpayer to elect the accrued method. Under that method, foreign tax can generally be associated with the year to which the foreign tax relates, even when the final payment happens later.

The problem is that this election must be made on a timely filed original return.

It cannot generally be added later through an amended return.

By the time someone comes to me after selling their RSUs, the U.S. return for the vesting year may have been filed earlier using the paid method. We now know exactly how much Israeli tax was paid, but we cannot simply go back and elect the accrued method for that old year.

There may still be foreign tax credit carrybacks, carryforwards, sourcing positions, or other possible relief. Every situation needs to be calculated separately. And sometimes, even if you elect the accrued method, it doesn't help. There are still other rules to qualify for accruing the taxes backwards. But the chance of being able to do it if you already filed a return with the paid method, is very slim.

The worst part about this whole thing is that most tax software defaults to using the paid method. That means that if your tax preparer is not specialized in cross-border issues like RSUs and similar issues, they won't know to turn off the default. At that point, the IRS still bars you from making any fixes.

This is why RSU planning for Americans in Israel cannot begin in the year the shares are sold. It needs to begin with the first U.S. return reporting vesting income. Your accountant should understand how the plan is taxed in both countries, when Israel is expected to collect its tax, how the income will be categorized and sourced, and whether filing using the paid or accrued method makes sense.

If you prepare U.S. tax returns, look into the accrued method on Form 1116, and review the requirements. It is separate and different from a similar election on Schedule C (business income) and other forms. Make sure you see if you are defaulting to paid and help your clients not fall for this trap.

If you need help with filing U.S. tax returns and calculating the best way forward with your RSUs, reach out to us at Y2J.