Expat Tax Return – Understanding the $100,000 Earned Income Exclusion
- 1 Filing is Required To Exclude $100,000 (FEIE)
- 2 Foreign Earned Income Exclusion
- 3 How to Qualify
- 4 Must be Earned Income
- 5 How the Exclusion Works
- 6 Tax
- 7 Foreign Tax Credit
- 8 Foreign Housing
- 9 Married Filing Jointly – Double Exclusion
- 10 You Have to Claim the Exclusion
- 11 If you Don’t Claim the Exclusion…
- 12 Streamlined Offshore Disclosure (SFCP)
- 13 Want To Learn More About IRS Offshore Disclosure?
Filing is Required To Exclude $100,000 (FEIE)
When it comes to expatriates residing overseas, there is a lot of misunderstanding regarding tax responsibilities. Most importantly, if the Expat is still a U.S. person such as a U.S. Citizen or Legal Permanent Resident (or a Long-Term LPR who did not properly relinquish their “Green Card”) they still are required to file annual tax returns with the IRS.
One of the biggest sources of confusion is the issue involving individuals who earn less than $100,000 a year and believe they are not even required to file taxes because they may not owe any U.S. tax once the proper exclusions are applied; this is false, and if the individual does not claim the exclusion timely, they may lose it.
Foreign Earned Income Exclusion
There is a special rule for individuals who reside overseas and meet the qualifications of either being a bona fide resident of a foreign country or meet the physical presence test.
If a person can meet either one of these two tests, then they qualify to have up to ~$102,000 worth of earned income excluded from their taxes. In addition, they may also qualify to have a portion of their housing excluded as well.
How to Qualify
In order to qualify for the exclusion, there are two tests that a person can try and meet (they have to meet only one of the two tests). It is important to note that a person cannot flip-flop back-and-forth each year between the two tests.
Once they pick a test, they generally have to the same test for the next five years.
Must be Earned Income
In order to claim the foreign earned income exclusion, it must be earned income. In other words, it is income from employment or self-employment and not income generated from passive means such as investments, dividends, interest, or capital gains.
If you already paid tax abroad for income earned overseas, you may be able to claim the foreign tax credit for taxes you already paid (subject to any potential exclusion or HTKO – High Tax Kick Out)
Physical Presence Test (330 Days)
This is the easier of the two tests, and basically amounts to a “Counting Days” est. A person has to reside outside of the United States for 330 days in any 12 month period. It does not have to be January to December. Rather, it could be July to June (or any 12-month period) and the application of the exclusion is prorated between two individual tax years.
There are other requirements a person must meet, but the gist of it is living outside of the United States for at least 330 days. Depending on the facts and circumstances tuition, a person can file either a form 2555, or a 2555-EZ.
When a person does not qualify for the Physical Presence Test, they may qualify as a Bona-Fide Resident. Qualifying for the Bona-Fide Resident Test is difficult. The reason why is the IRS does not want individuals applying for the Bona-Fide Resident test solely because they cannot meet the 330 day requirement of the physical presence test.
Under the Bona-Fide Resident test rules, a person has to prove that they have immersed themselves into the local fabric so that they are a “Bona-Fide” Resident. In other words, working as a U.S. government contractor for nine months abroad and living in government provided housing is probably not going to work (Read: It will not work).
But, if a person can show they possibly live in local housing, have a local drivers license or other card, are members of the local clubs or organizations, shop at the local markets, have their children attend the local schools, etc. then they have a better chance of meeting the requirement.
Oftentimes, the type of person who will qualify as a Bona-Fide Resident is a foreign citizen who is in the United States for brief periods of time for employment or otherwise as either a Legal Permanent Resident and/or meets the requirements of the Substantial Presence and is therefore required to file a US tax return.
How the Exclusion Works
If you happen to meet exclusion requirements, one of the first questions is how does the process work. There is no need to get too technical for this summary, but we will provide you a basic summary using an example:
David works in Singapore and earns $175,000 USD annually. He also earns about $12,000 a year in passive income. David will first include all of his salary and income in his tax return.
Next, David will complete an IRS Form 2555. The form ask questions about whether David works for a U.S. Company or foreign company, when he first arrived abroad, and whether he wants to submit under the Physical Presence Test for Bona-Fide Residence Test.
Since David is a US citizen working on a project in Singapore, he is going to submit under the Physical Presence Test. For the tax year, David resided in Singapore for 345 days, only returning to the United States on two separate occasions for 10 days each.
On the form, David will identify his travel, as well as whether he was in the United States for business or not.
Since only about $100,000 of David’s income can be excluded, what happens to the other $75,000?
Thanks to updated rules with the IRS, the additional $75,000 is taxed at David’s progressive tax rate (it used to be taxed at the rate that a $75,000 earner would be taxed at.)
In other words, in years past David would be taxed as if he’d only earn $75,000, which would put him in a much lower tax bracket. Fast-forward to the present, and David will pay tax on the remaining $75,000 just as if he earned $175,000. Stated another way, David will pay tax on the $75,000 remaining after the exclusion at the same tax rate he would’ve been paying as if he was paying full tax at the $175,000 progressive tax rate.
Foreign Tax Credit
Since David pays significant income tax on his earned income in Singapore, he may have some residual foreign tax credit he can use.
There is a formula that is used to determine if David can apply any remaining foreign tax credit to his tax liability. For example, if David paid $35,000 in income tax abroad, you would use the equation to determine which portion of that $35,000 is eliminated due to the fact that David used the foreign earned income exclusion (aka to avoid double-dipping the FTC and FEIE for the same earnings.)
If there is some credit remaining, David can file a form 1116 to claim the Foreign Tax Credit.
David pays rent for an apartment in Singapore. Therefore, David will also go through the process including the 2555 form with respect to his foreign residence. The test for housing is a bit odd, with a certain portion being immediately disallowed, followed by a portion of the rent payment which is excluded-up to a certain portion, and the remainder is then excluded again.
Think of it as a sandwich, wherein David can only exclude the middle portion. Usually, this comes out to about $15,000/annually give or take.
Married Filing Jointly – Double Exclusion
In terms of tax benefits, this is a gift from the IRS. In other words, the fact that two individuals who are filing Married Filing Jointly (MFJ) are each able to claim a separate $100,000+ exclusion on the same tax return is not typical of tax law. Generally, certain exclusions and credits are limited when individuals are married — to avoid a 200% credit or exclusion for married couples.
Luckily, at least as of the time of this article/blog posts, each spouse can take the full exclusion, so that a married couple can claim $203,4000 – along with foreign housing exclusion.
You Have to Claim the Exclusion
This is one of the biggest fallacies we deal with when individuals approach us and let us know that they want to enter the streamlined program, but that they never filed tax returns because “they didn’t have to.” That is incorrect; in order to claim the exclusion you must file the tax return in order to claim the exclusion
Example: a person earns $95,000 a year living overseas. Presuming that the person meets either the Physical Presence Test (PPT) or the Bona-Fide Resident Test (BFR) — along with a few other hurdles along the way — they will be entitled to exclude that $95,000 from their tax return, as long as they file the return.
If you Don’t Claim the Exclusion…
You may lose the exclusion. In other words, it is not the type of exclusion that “hangs on” or stays around for an infinite amount of time. Typically, a person has to use the exclusion in the current tax year and/or at least show Reasonable Cause if they are filing their taxes late and want to use it in a subsequent tax year — in order to show why they did not claim the exclusion timely.
It should also be noted, that the IRS is not very sympathetic, so if you do not use the exclusion timely, the IRS is not going to feel bad under most circumstances. There are numerous cases in which individuals who were formally in the military and then transition to civilian work in file the exclusion late – and it was denied by the IRS.
Streamlined Offshore Disclosure (SFCP)
In 2014, the Internal Revenue Service formalized the Streamlined Filing Compliance Procedures, which allow individuals to file or amend past returns, and disclose unreported foreign accounts and assets with minimal penalty.
For many expats, they may qualify for an offshoot of the program which is the Streamlined Foreign Offshore Procedures (SFOP). SFOP is a great program for individuals who are non-willful, because by qualifying as a foreign residents the IRS will waive all penalties.
Therefore, feasibly in the person earns less than $100,000 – or more than $100,000 and has sufficient foreign tax credit to offset any tax liability, the person can apply for the Streamlined Foreign Offshore Procedures and probably avoid all taxes and penalties (although depending on the value of the investments and income, there may be NIIT 3.8% Tax)
For individuals who do not qualify as non-willful, they can still get into compliance using the traditional OVDP (Offshore Voluntary Disclosure Program). The requirements and filings of the traditional OVDP are much more comprehensive – as is the penalty amount – but it nearly guarantees the avoidance of an audit/examination or criminal investigation.
Want To Learn More About IRS Offshore Disclosure?
At Golding & Golding, we limit our entire practice to IRS Offshore Voluntary Disclosure submissions. We have helped thousands of individuals, get into compliance, and we can help you too!
Sean holds a Master's in Tax Law from one of the top Tax LL.M. programs in the country at the University of Denver, and has also earned the prestigious Enrolled Agent credential. Mr. Golding is also a Board Certified Tax Law Specialist Attorney (A designation earned by Less than 1% of Attorneys nationwide.)