IRS Basic Rules for Excluding Earned Income from Your U.S. Tax Return
Foreign Earned Income Exclusion is prepared on IRS Form 2555. When a person is a U.S. Person or U.S. Citizen and is subject to U.S. Tax (but resides overseas), they may qualify for the Foreign Earned Income Exclusion (FEIE).
A person claims the Foreign Earned Income Exclusion by filing IRS Form 2555 and meeting the Physical Presence Test or Bona Fide Residence Test.
Common Issues we handle with the Foreign Earned Income Exclusion:
- What is the maximum exclusion amount?
- How long do I have to be Physically Present?
- What is the Physical Presence Test?
- What is the Bona-Fide Presence Test?
Key Terms & Definitions
This category of income involves income that is “earned,” which is typically from employment or self-employment. Other non-earned types of income are usually passive income “Interest, Dividends, Royalty and Capital Gains.”
Physical Presence Test
One of the Two Foreign Earned Income Exclusion tests in which a person can show they lived outside of the United States for at least 330-days in any 12 month period.
Bona-Fide Residence Test
One of the Two Foreign Earned Income Exclusion tests in which a person can show they lived outside of the United States as a Bona-Fide Resident of a Foreign Country(s).
Foreign Housing Exclusion
An additional exclusion in which a person may also receive an exclusion for a portion of foreign housing expenses.
Do U.S. Citizens Pay Taxes on Foreign Income?
Yes, U.S. Citizens pay tax on their worldwide income.
U.S. International Tax Basics
Under the concept of Citizen-Based Taxation, a person files taxes in the United States each year if they are considered a US person. It is important to note the distinction in the prior sentence: even though it is called Citizen-Based Taxation, it is not limited to U.S.Citizens; rather, it includes U.S. Persons and it involves worldwide income. In other words, a person who is considered a U.S. Person (even if they reside overseas) is subject to U.S. Tax on their Worldwide Income.
Foreign Earned Income Exclusion
Under certain circumstances a person can claim either one, the other, or sometimes both (and sometimes even for the same income) but not for the same actual earnings.
The following is a summary of how the process works when determining which mechanism you should choose, and whether you may qualify for both the Foreign Earned Income Exclusion and Foreign Tax Credit on the same income.
Foreign Earned Income Exclusion Background
The idea behind the Foreign Earned Income Exclusion is that under certain circumstances a person is able to exclude certain income from US taxes. It is a difficult burden to meet, but for the individuals who qualify, they may get to exclude upwards of $100,000 of earned income each year from the tax (that is per person, not per return — so if there are two individuals filing a joint return they may both qualify and take the exclusion). Moreover, they may also get to exclude a portion of their housing.
**When someone takes the exclusion, that does not mean they are exempted filing taxes. In other words, just because a person qualifies for the exclusion does not mean can get away without filing a return.
Time Expires for Claiming the Exclusion
When it comes to claiming the Foreign Earned Income Exclusion, it must be done timely. Therefore, if a person does not claim the exclusion properly in their return, it may be waived — which means they could not claim the exclusion for the current tax year at a future date. Although this is true, a person can typically apply for reasonable cause and submit a statement along with their tax return explaining why they may not have claimed it timely.
Moreover, if a person is applying for the Streamlined Offshore Voluntary Disclosure or traditional OVDP they are usually allowed to claim the exclusion. Therefore, even though the time has already passed for filing a return timely and/or claiming seclusion, they can claim the exclusion in either a late filed 1040 Return or Amended Return.
How to Qualify
In order to qualify for the exclusion, there are two alternative tests that a person must meet (they have to meet one test, but not the other). It is important to note that a person cannot flip-flop back-and-forth each year between 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.
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.
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.
Unreported Foreign Assets, Accounts and/or Income
If you have more than just foreign income that you have not filed with the IRS, you may consider entering one of the approved offshore voluntary disclosure programs.
Depending on how long you have lived outside the United States, in addition to the fact as to whether you can prove you are non-willful, you may qualify for a penalty waiver.
Why IRS Voluntary Disclosure?
With the introduction and enforcement of FATCA (Foreign Account Tax Compliance Act) and FATCA penalties, coupled by the renewed interest in the IRS issuing FBAR (Report of Foreign Bank and Financial Account Form aka FinCEN 114) penalties — which are both very steep – it is typically a better strategy to be proactive and get into compliance, than to play “defense.”
FBAR penalties alone can reach ~$12,500 per account, per year (adjusted inflation from $10,000). While this is the maximum penalty, the “recommended penalty” is still $12,500 per year (usually 3-6 years).
4 Types of IRS Offshore Voluntary Disclosure Programs
There are typically four types of IRS Offshore Voluntary Disclosure programs, and they include:
- Offshore Voluntary Disclosure Program (OVDP)
- Streamlined Domestic Offshore Procedures (SDOP)
- Streamlined Foreign Offshore Procedures (SFOP)
- Reasonable Cause (RC)
IRS Voluntary Disclosure of Offshore Accounts
Offshore Voluntary Disclosure Tax law is very complex. There are many aspects that go into any particular tax calculation, including the legal status, marital status, business status and residence status of the taxpayer.
When Do I Need to Use Voluntary Disclosure?
Voluntary Disclosure is for individuals, estates, and businesses who are out of compliance with the IRS and the Department of Treasury. What does that mean? It means that for one or more years, you were required to file a U.S. tax return, FBAR or other International Informational Return and you did not do so timely, then you are out of compliance.
Common Un-filed IRS International Tax Forms
Common un-filed international tax forms, include:
- 1040 (Tax Returns)
- Schedule B (Ownership or Signature Authority over Foreign Accounts)
- FBAR (FinCEN 114)
- FATCA (Form 8938)
- Form 3520 (Gift from Foreign Person)
- Form 5471 (Foreign Corporations)
- Form 8621 (Foreign Investments, aka PFIC)
- Form 8865 (Foreign Partnership)
If the IRS discovers that you are out of compliance, you may become subject to extensive fines and penalties – ranging from a warning letter all the way up to tax liens, tax levies, seizures, and criminal investigations. To combat this, you can take the proactive approach and submit to IRS Offshore Voluntary Disclosure.
Golding & Golding – Offshore Disclosure
At Golding & Golding, we limit our entire practice to offshore disclosure (IRS Voluntary Disclosure of Foreign and U.S. Assets). The term offshore disclosure is a bit of a misnomer, because the term “offshore” generally connotes visions of hiding money in secret places such as the Cayman Islands, Bahamas, Malta, or any other well-known tax haven jurisdiction – but that is not the case.
In fact, any money that is outside of the United States is considered to be offshore; the term offshore is not a bad word. In other words, merely because a person has money offshore (a.k.a. overseas or in a foreign country) does not mean that money is the result of ill-gotten gains or that the money is being “hidden.”
It just means it is not in the United States. Many of our clients have assets and bank accounts in their homeland countries and these are considered offshore assets and offshore bank accounts.
The Devil is in the Details…
If you do have money offshore, then it is very important to ensure that the money has been properly reported to the U.S. government. In addition, it is also very important to ensure that if you are earning any foreign income from that offshore money, that the earnings are being reported on your U.S. tax return.
It does not matter whether your money is in a country that does not tax a particular category of income (for example, many Asian countries do not tax passive income). It also does not matter if you are a dual citizen and/or if that money has already been taxed in the foreign country.
Rather, the default position is that if you are required to file a U.S. tax return and you meet the minimum threshold requirements for filing a U.S. tax return, then you have to include all of your foreign income. If you already paid foreign tax on the income, you may qualify for a Foreign Tax Credit. In addition, if the income is earned income – as opposed to passive income – and you meet either the Bona-Fide Resident Test or Physical-Presence Test, then you may qualify for an exclusion of that income; nevertheless, the money must be included on your tax return.
What if You Never Report the Money?
If you are in the unfortunate position of having foreign money or specified foreign assets that should have been reported to the U.S. government, but which you have not reported — then you are in a bit of a predicament, which you will need to resolve before it is too late.
As we have indicated numerous times on our website, there are very unscrupulous CPAs, Attorneys, Accountants, and Tax Representatives who would like nothing more than to get you to part with all of your money by scaring you into believing you are automatically going to be arrested, jailed, or deported because you have unreported money. While that is most likely not the case (depending on the facts and circumstances of your specific situation), you may be subject to extremely high fines and penalties.
Moreover, if you knowingly or willfully hid your foreign accounts, foreign money, and offshore assets overseas, then you may become subject to even higher fines and penalties…as well as a criminal investigation by the special agents of the IRS and/or DOJ (Department of Justice).
Getting into Compliance
There are five main methods people/businesses use to get into compliance. Four of these methods are perfectly legitimate as long as you meet the requirements for the particular mechanism of disclosure. The fifth alternative, which is called a Quiet Disclosure a.k.a. Silent Disclosure a.k.a. Soft Disclosure, is ill-advised as it is illegal and very well may result in criminal prosecution.
5 IRS Methods for Offshore Compliance
- Streamlined Domestic Offshore Procedures
- Streamlined Foreign Offshore Procedures
- Reasonable Cause
- Quiet Disclosure (Illegal)
We are going to provide a brief summary of each program below. We have also included links to the specific programs. If you are interested, we have also prepared very popular “FAQs from the Trenches” for FBAR, OVDP and Streamlined Disclosure reporting. Unlike the technical jargon of the IRS FAQs, our FAQs are based on the hundreds of different types of issues we have handled over the many years that we have been practicing international tax law and offshore disclosure in particular.
After reading this webpage, we hope you develop a basic understanding of each offshore disclosure alternative and how it may benefit you to get into compliance. We do not recommend attempting to disclose the information yourself as you may become subject to an IRS investigation insofar as you will have to answer questions directly to the IRS, which you can avoid with an attorney representative.
If you retain an attorney, then you will get the benefit of the attorney-client privilege which provides confidentiality between you and your representative. With a CPA, there is a relatively small privilege which does provide some comfort, but the privilege is nowhere near as strong as the confidentiality privilege you enjoy with an attorney.
Since you will be dealing with the Internal Revenue Service and they are not known to play nice or fair – it is in your best interest to obtain an experienced Offshore Disclosure Attorney.
OVDP is the Offshore Voluntary Disclosure Program — a program designed to facilitate taxpayer compliance with IRS, DOT, and DOJ International Tax Reporting and Compliance. It is generally reserved for individuals and businesses who were “Willful” (aka intentional) in their failure to comply with U.S. Government Laws and Regulations.
The Offshore Voluntary Disclosure Program is open to any US taxpayer who has offshore and foreign accounts and has not reported the financial information to the Internal Revenue Service (restrictions apply). There are some basic program requirements, with the main one being that the person/business who is applying under this amnesty program is not currently under IRS examination.
The reason is simple: OVDP is a voluntary program and if you are only entering because you are already under IRS examination, then technically, you are not voluntarily entering the program – rather, you are doing so under duress.
Any account that would have to be included on either the FBAR or 8938 form as well as additional income generating assets such as rental properties are accounts that qualify under OVDP. It should be noted that the requirements are different for the modified streamlined program, in which the taxpayer penalties are limited to only assets that are actually listed on either an FBAR or 8938 form; thus the value of a rental property would not be calculated into the penalty amount in a streamlined application, but it would be applicable in an OVDP submission.
An OVDP submission involves the failure of a taxpayer(s) to report foreign and overseas accounts such as: Foreign Bank Accounts, Foreign Financial Accounts, Foreign Retirement Accounts, Foreign Trading Accounts, Foreign Insurance, and Foreign Income, including 8938s, FBAR, Schedule B, 5741, 3520, and more.
What is Included in the Full OVDP Submission?
The full OVDP application includes:
- Eight (8) years of Amended Tax Return filings;
- Eight (8) Years of FBAR (Foreign Bank and Account Reporting Statements);
- Penalty Computation Worksheet; and
- Various OVDP specific documents in support of the application.
Under this program, the Internal Revenue Service wants to know all of the income that was generated under these accounts that were not properly reported previously. The way the taxpayer accomplishes this is by amending tax returns for eight years.
Generally, if the taxpayer has not previously reported his accounts, then there are common forms which were probably excluded from the prior year’s tax returns and include 8938 Forms, Schedule B forms, 3520 Forms, 5471 Forms, 8621 Forms, as well as proof of filing of FBARs (Foreign Bank and Financial Account Reports).
The taxpayer is required to pay the outstanding tax liability for the eight years within the disclosure period – as well as payment of interest along with another 20% penalty on that amount (for nonpayment of tax). To give you an example, let’s pick one tax year during the compliance period. If the taxpayer owed $20,000 in taxes for year 2014, then they would also have to include in the check the amount of $4,000 to cover the 20% penalty, as well as estimated interest (which is generally averaged at about 3% per year). This must be done for each year during the compliance period.
Then there is the “FBAR/8938” Penalty. The Penalty is 27.5% (or 50% if any of the foreign accounts are held at an IRS “Bad Bank”) on the highest year’s “annual aggregate total” of unreported accounts (accounts which were previously reported are not calculated into the penalty amount).
For OVDP, the annual aggregate total is determined by adding the “maximum value” of each unreported account for each year, in each of the last 8 years. To determine what the maximum value is, the taxpayer will add up the highest balances of all of their accounts for each year. In other words, for each tax year within the compliance period, the application will locate the highest balance for each account for each year, and total up the values to determine the maximum value for each year.
Thereafter, the OVDP applicant selects the highest year’s value, and multiplies it by either 27.5%, or possibly 50% if any of the money was being held in what the IRS considers to be one of the “bad banks.” When a person is completing the penalty portion of the application, the two most important things are to breathe and remember that by entering the program, the applicant is seeking to avoid criminal prosecution!
2. Streamlined Domestic Offshore Disclosure
The Streamlined Domestic Offshore Disclosure Program is a highly cost-effective method of quickly getting you into IRS (Internal Revenue Service) or DOT (Department of Treasury) compliance.
What am I supposed to Report?
There are three main reporting aspects: (1) foreign account(s), (2) certain specified assets, and (3) foreign money. While the IRS or DOJ will most likely not be kicking in your door and arresting you on the spot for failing to report, there are significantly high penalties associated with failing to comply.
In fact, the US government has the right to penalize you upwards of $10,000 per unreported account, per year for a six-year period if you are non-willful. If you are determined to be willful, the penalties can reach 100% value of the foreign accounts, including many other fines and penalties… not the least being a criminal investigation.
Reporting Specified Foreign Assets – FATCA Form 8938
Not all foreign assets must be reported. With that said, a majority of assets do have to be reported on a form 8938. For example, if you have ownership of a foreign business interest or investment such as a limited liability share of a foreign corporation, it may not need to be reported on the FBAR but may need to be disclosed on an 8938.
The reason why you may get caught in the middle of whether it must be filed or not is due largely to the reporting thresholds of the 8938. For example, while the threshold requirements for the FBAR is when the foreign accounts exceed $10,000 in annual aggregate total – and is not impacted by marital status and country of residence – the same is not true of the 8938.
The threshold requirements for filing the 8938 will depend on whether you are married filing jointly or married filing separate/single, or whether you are considered a US resident or foreign resident.
Other Forms – Foreign Business
While the FBAR and Form 8938 are the two most common forms, please keep in mind that there are many other forms that may need to be filed based on your specific facts and circumstances. For example:
- If you are the Beneficiary of a foreign trust or receive a foreign gift, you may have to file Form 3520.
- If you are the Owner of a foreign trust, you will also have to file Form 3520-A.
- If you have certain Ownerships of a foreign corporation, you have to file Form 5471.
- And (regrettably) if you fall into the unfortunate category of owning foreign mutual funds or any other Passive Foreign Investment Companies then you will have to file Form 8621 and possibly be subject to significant tax liabilities in accordance with excess distributions.
Reporting Foreign Income
If you are considered a US tax resident (which normally means you are a US citizen, Legal Permanent Resident/Green-Card Holder or Foreign National subject to US tax under the substantial presence test), then you will be taxed on your worldwide Income.
It does not matter if you earned the money in a foreign country or if it is the type of income that is not taxed in the country of origin such as interest income in Asian countries. The fact of the matter is you are required to report this information on your US tax return and pay any differential in tax that might be due.
In other words, if you earn $100,000 USD in Japan and paid 25% tax ($25,000) in Japan, you would receive a $25,000 tax credit against your foreign earnings. Thus, if your US tax liability is less than $25,000, then you will receive a carryover to use in future years against foreign income (you do not get a refund and it cannot be used against US income). If you have to pay the exact same in the United States as you did in Japan, it would equal itself out. If you would owe more money in the United States than you paid in Japan on the earnings (a.k.a. you are in a higher tax bracket), then you have to pay the difference to the U.S. Government.
3. Streamlined Foreign Offshore Disclosure
What do you do if you reside outside of the United States and recently learned that you’re out of US tax compliance, have no idea what FATCA or FBAR means, and are under the misimpression that you are going to be arrested and hauled off to jail due to irresponsible blogging by inexperienced attorneys and accountants?
If you live overseas and qualify as a foreign resident (reside outside of the United States for at least 330 days in any one of the last three tax years or do not meet the Substantial Presence Test), you may be in for a pleasant surprise.
Even though you may be completely out of US tax and reporting compliance, you may qualify for a penalty waiver and ALL of your disclosure penalties would be waived. Thus, all you will have to do besides reporting and disclosing the information is pay any outstanding tax liability and interest, if any is due. (Your foreign tax credit may offset any US taxes and you may end up with zero penalty and zero tax liability.)
*Under the Streamlined Foreign, you also have to amend or file 3 years of tax returns (and 8938s if applicable) as well as 6 years of FBAR statements just as in the Streamlined Domestic program.
4. Reasonable Cause
Reasonable Cause is different than the above referenced programs. Reasonable Cause is not a “program.” Rather, it is an alternative to traditional Offshore Voluntary Disclosure, which should be considered on a case by case basis, taking the specific facts and circumstances into consideration.
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