Dual citizens of the US and another country (like Canada) have unique tax issues to grapple with. For starters, US tax law states that you have to report your worldwide income in your tax returns, regardless of which country you derive your income from. You must file a federal income tax return for any tax year in which your gross income is equal to or greater than the applicable exemption amount and standard deduction. See IRS Publication 501 (Exemptions, Standard Deduction, and Filing Information) for information on applicable exemption amounts and standard deductions.
But it does not mean you have to pay taxes in both countries. The foreign-earned income exclusion presently exempts US$92,900 of employment income from the country you reside in (i.e. the non-US country, like Canada). And after the application of the exclusion and the application of foreign tax credits, most American citizens living in another country pay no additional US income tax.
The problem is many dual citizens are unaware of this tax rule. They think that after they have paid taxes in their country of residence, they have no more tax obligations. Wrong. You still have to file your 1040 and in addition, a Report on Foreign Bank and Financial Account (FBAR) by April 15 every year if you are taxable. This has raised an uproar in recent years as many who were unaware of the requirements found themselves transgressing tax laws. This left them with little choice but to participate in the IRS Offshore Voluntary Disclosure Initiative (OVDI) which carries substantial penalties albeit that waives criminal prosecution.
If there is a good reason why you did not file your 1040 and FBAR, you will have to submit a signed and dated statement explaining why there is reasonable cause for failure to file.
Last year, the IRS announced a way for dual citizens to bring their tax obligations current. With effect from September 1, 2012, you can now file delinquent tax returns for the past three years plus FBARs for the past six years, which is less than the usual eight years’ amended returns and eight FBARs for OVDI participants. However, you must accompany your submission with the appropriate payment of back taxes and interests. You may not even be penalized if you owe little or no taxes.
Generally, if you owe less than $1,500 in tax due in each of the three years, you are considered “low risk” and will likely avoid penalties. But if you did some complicated tax planning or have substantial economic activity in the US while holding dual citizenship, you are not “low risk” and you might face an audit going back more than three years.