How do U.S. Taxpayers Exclude Income Earned Abroad
Overseas Income Exclusion If you reside outside of the United States but still need to file a U.S. Tax Return, you may qualify for IRS Form 2555 (aka the Overseas Income Exclusion). The IRS Income Exclusion s one of the most commonly used forms of income tax reduction for individuals who have a US tax requirement, but live abroad.
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 the Exclusion Work?
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.
Foreign Tax Credit for the Same Income Source?
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.
Oftentimes, a person will have other issues involving the reporting of foreign income, including, FBAR, FATCA, etc. If you are out of compliance and considering getting into compliance, your best option may be entering one of the approved Offshore Voluntary Disclosure Programs.
Golding & Golding: About Our International Tax Law Firm
Golding & Golding specializes exclusively in international tax, and specifically IRS offshore disclosure.
We are the “go-to” firm for other Attorneys, CPAs, Enrolled Agents, Accountants, and Financial Professionals across the globe. Our attorneys have worked with thousands of clients on offshore disclosure matters, including FATCA & FBAR.
Each case is led by a Board-Certified Tax Law Specialist with 20 years of experience, and the entire matter (tax and legal) is handled by our team, in-house.
*Please beware of copycat tax and law firms misleading the public about their credentials and experience.
Less than 1% of Tax Attorneys Nationwide Are Certified Specialists
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How to Hire Experienced Offshore Counsel?
Generally, experienced attorneys in this field will have the following credentials/experience:
- Board Certified Tax Law Specialist credential
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