Foreign Earned Income Exclusion & Foreign Tax Credit – Can I Use Both?
In general, the Foreign Earned Income Exclusion is the preferred method when the applicant works in a low-tax jurisdiction, since the Foreign Tax Credit in a low-tax jurisdiction will yield a less impressive Foreign Tax Credit.
With that said, can a person use both the Foreign Earned Income Exclusion and Foreign Tax Credit together on the same income, in the same year?
The answer is…it depends.
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 from filing taxes. In other words, just because a person qualifies for the exclusion does not mean can get away without filing a return. They still must file a tax return (timely or late with reasonable cause) and then claim the exclusion.
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” test. 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 can meet the 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.
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.
Passive Income Foreign Tax Credit
Under most circumstances, there is no crossover between the different buckets of foreign tax credit. For example, general income such as employment is one bucket, and passive income is a different bucket.
Is David wants to, he can submit a separate 1116 foreign tax credit form if he also paid foreign taxes paid for his passive income such as dividends, interest, or capital gain (although in Singapore this is usually excluded from Singaporean tax).
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.