Foreign Income Exclusion (Expat Taxes & Excluding Foreign Income)
If you reside outside of United States and are considered a US Expat meets either the Physical Presence Test or Bona-Fide Residence Test, and can show that the foreign country is your tax home, you may qualify to exclude up $102,000 (adjusted for inflation) each year by using the Foreign Earned Income Exclusion on IRS Form 2555.
In addition, you may be able to exclude a portion of your housing (aka, “Housing Exclusion”).
And, If you are married and both of you live overseas, and qualify for FEIE you can each qualifyFor the exclusion (It is not limited per household).
Foreign Income Exclusion
Foreign Income Exclusion: For some individuals who reside outside of the United States, but are still subject to U.S. Tax, may qualify to have more than $100,000 excluded from their U.S. tax liability to the IRS.
The process is called “Foreign Earned Income Exclusion” or the acronym (FEIE) and it is claimed on IRS tax form 2555.
Common questions we receive about the Foreign Earned Income Exclusion:
- When do I file Form 2555?
- Is Form 2555 included with my tax return?
- How does the exclusion work?
- Can I use the Foreign Exclusion with the Foreign Tax Credit?
- What if I do not file the Form 2555 timely?
IRS Foreign Income Exclusion Basics
The IRS Foreign Earned Income Exclusion (FEIE) is one of the most commonly used forms of income tax reduction for individuals who have a US tax requirement, but live overseas.
Under certain circumstances, FEIE allows a person to “exclude” a portion of their income from U.S. Taxation – but, it does not mean the income is excluded from inclusion on the Tax Return.
In other words, you cannot just exclude the income from your tax return. Rather, you have to report the income and claim the exclusion, together.
How does FEIE Work?
In recent years, the law involving how the Foreign Earned Income Exclusion work has been modified, which unfortunately works against the taxpayer.
We receive numerous questions on issues involving the Foreign Earned Income Exclusion because oftentimes a person will not know they have this mechanism available to them until after the time to file a return has passed. Unfortunately, the IRS has the right to reject your request to apply the foreign earned income exclusion if you make a late request – unless you can show reasonable cause.
The following is a summary of 10 important questions we receive often regarding the Foreign Earned Income Exclusion:
What is the Physical Presence Test?
The Physical Presence Test is the first (and most common) of the two tests an individual must pass in order to qualify to use the Foreign Earned Income Exclusion. Essentially, it is a counting days test. In other words, a person must count the number of days they are outside of the United States in any given twelve-month period (it does not need to be January to December).
If during the 12-month period, as person can show that they he or she was outside of the United States (in one country or multiple countries) for at least 330-days, the person may qualify for the Physical Presence Test as long as you meet some additional other qualifications.
For example, you cannot switch back and forth each year between the Physical Presence Test and the other Bona-Fide Residence Test (see below). Also, if you have already revoked the exclusion on prior occasions and may limit your ability to use it again.
What is the Bona-Fide Resident Test?
The Bona-Fide Residence Test is a more difficult test to prove. That is because, a person must show that he or she is a Bona-Fide Resident of the other country (which is usually harder than just ‘counting days’). For example, under the Physical Presence Test, a person could be a full-fledged US citizen, with a home in the United States and a family that never visits them while they are working abroad. Still, as long as you can show that you have lived outside of the United States for at least 330 days you’ll qualify for the test.
For the Bona-Fide Residence Test, the IRS is aware that it is mainly used by people who do not qualify for the Physical Presence Test. As such, the IRS does not want individuals who were not Bona-Fide Residents of a foreign country, but failed the Physical Presence Test to try to qualify under the Bona-Fide Residence Test, solely because they did not otherwise qualify for the Physical Presence Test.
In order to be a Bona-Fide Residence Test you have to show that you are a part of the local fabric. For example, you shop at the local stores, you have a local drivers license, your children go to school in the location, you have your own housing. This is different than a U.S. Contractor for example that resides in company provided, and shops at stores intended for government contractors of the United States abroad, etc.
Typically, a non-US citizen or green card holder who resides in the United States but still firmly makes their home in a foreign country will qualify.
Can I Also Use the Foreign Tax Credit?
Yes. There is some confusion surrounding this issue, so we will try to shed some light for you. If Joe earned $100,000 from working abroad, and also paid 20% tax on the foreign income, he cannot use both the foreign earned income exclusion and the foreign tax credit on the same income.
Therefore, usually someone in Joe’s position would simply exclude the hundred thousand dollars of income instead of applying the foreign tax credit, so that he can carry credit forward for subsequent years.
Alternatively, if Joe earned $150,000 abroad, (if applicable) Joe would first us the ~ $101,000 Foreign Earned Income Exclusion on the first $101,000 he earned, and then for the remaining salary if Joe has any additional foreign tax credit remaining, he can apply that tax credit to the additional income.
No Double-Dipping FEIE/FTC
This is important. Let’s say Joe only paid $25,000 in foreign tax on his $150,000 worth of foreign income. Once Joe applies the foreign earned income exclusion, the foreign tax credit is also apportioned accordingly — so that the Foreign Tax Credit portion that would have otherwise been applied had the Foreign Earned Income Exclusion not been used is now “gone.”
In the above example, Joe’s $25,000 foreign taxes would probably be insufficient to have any tax credit left over after the Foreign Earned Income Exclusion is applied.
**Conversely, if Joe paid $60,000 in foreign taxes on his $150,000 for the income, even after apportionment Joe would still have foreign tax credit remaining so that he can apply the additional tax credit to the income that exceeds the maximum amount of the foreign earned income exclusion (which is around $101,700)
Foreign Housing Exclusion
Under certain circumstances, a person can use the Foreign Earned Income Exclusion for housing as well. One thing to keep in mind, is that if you own a home abroad than typically you can take the same deductions on your schedule A that you would otherwise take for home you owned in the United States – and it may be more beneficial than excluding housing (if that option was available to you).
If you do not fall into the latter category of owning a home (if you are renting), then you can usually use the housing exclusion, in addition to the FEIE. A few important pointers are about the housing exclusion is that first, the amount of the exclusion may vary depending on where you reside (whether it is an expensive area to live) such as London versus a less-expensive area.
In addition, the test for housing is a bit difficult — but it is typically applied like a sandwich. For example, the first layer of your housing is not excludable. So, in most situations it will mean that the first $15,000 that you pay for housing cannot be excluded. Therefore, if your foreign housing only came out to $15,000 in rent for the year, you may not be able to exclude it.
The next layer, inside the sandwich can be excluded. This usually comes out to also around $15,000. So, if you pay $30,000 for the year in rent, you can normally exclude $15,000 of the $30,000 for the foreign housing exclusion.
If you have any additional housing costs above and beyond the $30,000, you cannot exclude that portion either. Therefore, for example if you have $45,000 in foreign housing, you can typically exclude the middle $15,000, but not the first $15,000 or last $15,000.
Tax Rate on Non-Excluded income
Unfortunately, this rule has changed in recent years – to the dismay of taxpayer. In prior years, if a person applied the Foreign Earned Income Exclusion and still had remaining income above and beyond the exclusion, the remaining income would be taxed at the tax rate of the remaining income. For example, if Denise earned $110,000 and was able to exclude $100,000 of it with the foreign earned income exclusion, the remaining $10,000 would be taxed at her progressive tax rate as if she earned $10,000 in total.
Fast-forward to the present, and currently the state of the law is that Denise should be taxed on $10,000 worth of income at the tax rate as if she earned $110,000 – not as if she only earned $10,000 in total.
Foreign Earned Income Exclusion is individual to each Taxpayer. Therefore, when it comes to spouses, the Foreign Earned Income Exclusion is independent to each person and f two spouses are both working overseas and each one of them qualifies for the Foreign Earned Income Exclusion, then each one of them can apply the exclusion to their own income.
Typically, a person can claim the foreign earned income exclusion even if they file their tax return late, as long as it is filed within 1 year from the original due date of the return (determined without regard to any extensions).
Even if it is passed the one-year mark, a person can still apply for the reasonable cause exception either independently or through the IRS Offshore Voluntary Disclosure Programs to still apply the Foreign Earned Income eExclusion to tax returns that are being filed late pass the one year mark, or amending returns for years beyond the current year.
We Specialize in IRS Voluntary Disclosure
We have successfully handled a diverse range of IRS Voluntary Disclosure cases. Whether it is a simple or complex case, safely getting clients into compliance is our passion, and we take it very seriously.
Unlike other attorneys who call themselves specialists but handle 10 different areas of tax law, purchase multiple domain names, and even practice outside of tax, we are absolutely dedicated to IRS Voluntary Disclosure.
No Case is Too Big; No Case is Too Small.
We represent all different types of clients. High net-worth investors (over $40 million), smaller cases ($100,000) and everything in-between.
We represent clients in over 60 countries and nationwide, with all different types of assets, including (each link takes you to a Golding & Golding free summary):
- Foreign Mutual Funds
- Foreign Life Insurance
- Fixing Quiet Disclosure
- Foreign Real Estate Income
- Foreign Real Estate Sales
- Foreign Earned Income Exclusion
- Subpart F Income
- Foreign Inheritance
- Foreign Pension
- Form 3520
- Form 5471
- Form 8621
- Form 8865
- Form 8938 (FATCA)
Who Decides to Enter IRS Voluntary Disclosure
All different types of people submit to IRS Voluntary Disclosure. We represent Attorneys, CPAs, Doctors, Investors, Engineers, Business Owners, Entrepreneurs, Professors, Athletes, Actors, Entry-Level staff, Students, and more.
You are not alone, and you are not the only one to find himself or herself in this situation.
…We even represent IRS Staff with getting into compliance.
Sean M. Golding, JD, LL.M., EA – Board Certified Tax Law Specialist
Our Managing Partner, Sean M. Golding, JD, LLM, EA is the only Attorney nationwide who has earned the Certified Tax Law Specialist credential and specializes in IRS Offshore Voluntary Disclosure and closely related matters.
In addition to earning the Certified Tax Law Certification, Sean also holds an LL.M. (Master’s in Tax Law) from the University of Denver and is also an Enrolled Agent (the highest credential awarded by the IRS.)
He is frequently called upon to lecture and write on issues involving IRS Voluntary Disclosure.
Less than 1% of Tax Attorneys Nationwide
Out of more than 200,000 practicing attorneys in California, less than 400 attorneys have achieved this Certified Tax Law Specialist designation.
The exam is widely regarded as one of (if not) the hardest tax exam given in the United States for practicing Attorneys. It is a designation earned by less than 1% of attorneys.
Our International Tax Lawyers represent hundreds of taxpayers annually in over 60 countries.
IRS Offshore Penalty List
The following is a list of potential IRS penalties for unreported and undisclosed foreign accounts and assets:
A Penalty for failing to file FBARs
United States citizens, residents and certain other persons must annually report their direct or indirect financial interest in, or signature authority (or other authority that is comparable to signature authority) over, a financial account that is maintained with a financial institution located in a foreign country if, for any calendar year, the aggregate value of all foreign financial accounts exceeded $10,000 at any time during the year. The civil penalty for willfully failing to file an FBAR can be as high as the greater of $100,000 or 50 percent of the total balance of the foreign financial account per violation. See 31 U.S.C. § 5321(a)(5). Non-willful violations that the IRS determines were not due to reasonable cause are subject to a $10,000 penalty per violation.
FATCA Form 8938
Beginning with the 2011 tax year, a penalty for failing to file Form 8938 reporting the taxpayer’s interest in certain foreign financial assets, including financial accounts, certain foreign securities, and interests in foreign entities, as required by IRC § 6038D. The penalty for failing to file each one of these information returns is $10,000, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return.
A Penalty for failing to file Form 3520
Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts. Taxpayers must also report various transactions involving foreign trusts, including creation of a foreign trust by a United States person, transfers of property from a United States person to a foreign trust and receipt of distributions from foreign trusts under IRC § 6048. This return also reports the receipt of gifts from foreign entities under IRC § 6039F. The penalty for failing to file each one of these information returns, or for filing an incomplete return, is the greater of $10,000 or 35 percent of the gross reportable amount, except for returns reporting gifts, where the penalty is five percent of the gift per month, up to a maximum penalty of 25 percent of the gift.
A Penalty for failing to file Form 3520-A
Information Return of Foreign Trust With a U.S. Owner. Taxpayers must also report ownership interests in foreign trusts, by United States persons with various interests in and powers over those trusts under IRC § 6048(b). The penalty for failing to file each one of these information returns or for filing an incomplete return, is the greater of $10,000 or 5 percent of the gross value of trust assets determined to be owned by the United States person.
A Penalty for failing to file Form 5471
Information Return of U.S. Persons with Respect to Certain Foreign Corporations. Certain United States persons who are officers, directors or shareholders in certain foreign corporations (including International Business Corporations) are required to report information under IRC §§ 6035, 6038 and 6046. The penalty for failing to file each one of these information returns is $10,000, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return.
A Penalty for failing to file Form 5472
Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business. Taxpayers may be required to report transactions between a 25 percent foreign-owned domestic corporation or a foreign corporation engaged in a trade or business in the United States and a related party as required by IRC §§ 6038A and 6038C. The penalty for failing to file each one of these information returns, or to keep certain records regarding reportable transactions, is $10,000, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency.
A Penalty for failing to file Form 926
Return by a U.S. Transferor of Property to a Foreign Corporation. Taxpayers are required to report transfers of property to foreign corporations and other information under IRC § 6038B. The penalty for failing to file each one of these information returns is ten percent of the value of the property transferred, up to a maximum of $100,000 per return, with no limit if the failure to report the transfer was intentional.
A Penalty for failing to file Form 8865
Return of U.S. Persons With Respect to Certain Foreign Partnerships. United States persons with certain interests in foreign partnerships use this form to report interests in and transactions of the foreign partnerships, transfers of property to the foreign partnerships, and acquisitions, dispositions and changes in foreign partnership interests under IRC §§ 6038, 6038B, and 6046A. Penalties include $10,000 for failure to file each return, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return, and ten percent of the value of any transferred property that is not reported, subject to a $100,000 limit.
Fraud penalties imposed under IRC §§ 6651(f) or 6663
Where an underpayment of tax, or a failure to file a tax return, is due to fraud, the taxpayer is liable for penalties that, although calculated differently, essentially amount to 75 percent of the unpaid tax.
A Penalty for failing to file a tax return imposed under IRC § 6651(a)(1)
Generally, taxpayers are required to file income tax returns. If a taxpayer fails to do so, a penalty of 5 percent of the balance due, plus an additional 5 percent for each month or fraction thereof during which the failure continues may be imposed. The penalty shall not exceed 25 percent.
A Penalty for failing to pay the amount of tax shown on the return under IRC § 6651(a)(2)
If a taxpayer fails to pay the amount of tax shown on the return, he or she may be liable for a penalty of .5 percent of the amount of tax shown on the return, plus an additional .5 percent for each additional month or fraction thereof that the amount remains unpaid, not exceeding 25 percent.
An Accuracy-Related Penalty on underpayments imposed under IRC § 6662
Depending upon which component of the accuracy-related penalty is applicable, a taxpayer may be liable for a 20 percent or 40 percent penalty
Possible Criminal Charges related to tax matters include tax evasion (IRC § 7201)
Filing a false return (IRC § 7206(1)) and failure to file an income tax return (IRC § 7203). Willfully failing to file an FBAR and willfully filing a false FBAR are both violations that are subject to criminal penalties under 31 U.S.C. § 5322. Additional possible criminal charges include conspiracy to defraud the government with respect to claims (18 U.S.C. § 286) and conspiracy to commit offense or to defraud the United States (18 U.S.C. § 371).
A person convicted of tax evasion
Filing a false return subjects a person to a prison term of up to three years and a fine of up to $250,000. A person who fails to file a tax return is subject to a prison term of up to one year and a fine of up to $100,000. Failing to file an FBAR subjects a person to a prison term of up to ten years and criminal penalties of up to $500,000. A person convicted of conspiracy to defraud the government with respect to claims is subject to a prison term of up to not more than 10 years or a fine of up to $250,000. A person convicted of conspiracy to commit offense or to defraud the United States is subject to a prison term of not more than five years and a fine of up to $250,000.
What Should You Do?
Everyone makes mistakes. If at some point that you should have been reporting your foreign income, accounts, assets or investments the prudent and least costly (but most effective) method for getting compliance is through one of the approved IRS offshore voluntary disclosure program.