Foreign Earned Income Exclusion
The United States (US) government taxes the income of its citizens, resident aliens, and domestic corporations regardless of where the income is earned. Likewise, nonresident aliens and foreign corporations are also taxed on income that is effectively connected to a trade or business conducted within the US. Most other countries do likewise. Hence, a US taxpayer who earns money in a foreign country incurs a tax liability to both the foreign country and to the United States. Since this double taxation can be quite onerous, the US tax code allows a taxpayer to claim the foreign earned income exclusion, a foreign tax credit, or deductions for foreign expenses.
The foreign earned income exclusion can exclude almost $100,000 of income earned in a foreign country from United States income taxes plus either an exclusion or a deduction can be claimed for certain housing costs. However, the income exclusion, which is adjusted for inflation, only applies to earnings from work, not to investment income — hence, the name foreign earned income:
To claim the exclusion, the taxpayer must have a tax home in the foreign country and must satisfy either the foreign residence or physical presence test. US government employees may not claim any exclusion for government pay earned abroad.
If foreign income is not excluded, then the taxpayer can either deduct the foreign tax paid or claim the foreign tax credit. Generally, the tax credit will yield greater tax savings. However, if the foreign income tax rate is high and the amount of foreign income to US income is small, then a deduction may be more advantageous. In any given tax year, the taxpayer must choose either to use the tax credit or take the deduction — it cannot do both in a single tax year. However, choosing to claim deductions will allow the taxpayer to carry back any unused credit from a future tax year.
The applicable tax year for foreign earned income is the year in which the income is earned, not when it is received. If gross income exceeds the filing threshold for the filing status of the taxpayer, a US income tax return must be filed even if the taxpayer owes no taxes on the income.
The exclusion is not automatic, but must be claimed on Form 2555, Foreign Earned Income, which is attached to Form 1040. The election for the housing cost exclusion is also claimed on Form 2555. Form 2555-EZ, Foreign Earned Income Exclusion can be used if the taxpayer has no self-employment income or does not claim the foreign housing exclusion or deduction, or any business or moving expenses, and if income is less than the foreign earned income exclusion.
An employer must withhold taxes from payments to employees, but an employee can file Form 673, Statement for Claiming Exemption from Withholding on Foreign Earned Income Eligible for the Exclusion(s) Provided by Section 911 with the US employer to claim the exemption from withholding on wages because of the expected foreign earned income exclusion or foreign housing exclusion. However, the taxpayer must certify, under penalty of perjury, that the taxpayer has a reasonable basis for believing that he will qualify under the foreign residence or physical presence test. Estimated foreign housing costs must also be certified.
If the foreign income exclusion is claimed, then the taxpayer may not claim any business deductions that are allocable to the excluded income — foreign taxes paid on the excluded income cannot be claimed either as a credit or a deduction, and neither traditional nor Roth IRA contributions can be based on the excluded income.
Any taxable income that is not subject to the earned income and housing exclusions will be taxed as though no exclusions have been claimed. Regular tax liability must be calculated on the Foreign Earned Income Tax Worksheet in the Form 1040 instructions and the AMT liability is calculated on the Foreign Earned Income Tax Worksheet in the Form 6251 instructions.
Generally, to maximize tax savings, the taxpayer will have to calculate taxes using the foreign exclusion and without the foreign exclusion but using the foreign tax credit and allowable deductions.
If the taxpayer chooses the exclusion, then that election remains in effect until the taxpayer specifically revokes it, after which the taxpayer cannot choose the exclusion again for 5 years without IRS consent. Foreign earned income exclusion and the housing income exclusion must be revoked separately by attaching a statement to the tax return. However, the IRS will generally allow a change in calculating foreign income if there's been a substantial change in the tax law of the foreign country, the taxpayer moves to a different country with different tax rates, or the taxpayer changes employers.
If the taxpayer claims the foreign tax credit or the housing credit, then the IRS will consider that to be a revocation of the election to claim the foreign earned income exclusion.
Foreign Earned Income
Foreign earned income is considered a compensation for personal services that were performed in the foreign country and the taxpayer meets either the foreign residence test or the physical presence test. Earned income does not include pensions or annuities, or any type of investment income, or other types of income that was not earned by providing services, such as gambling and alimony.
Foreign earned income does not include any earnings from countries subject to US government travel restrictions, or income earned in geographical areas outside of the jurisdiction of any particular country, such as Antarctica, international waters, or international airspace.
If the source of business income is only for personal services, then 100% of that income is considered earned income. However, if capital is also an income-producing factor, then the value of the personal services provided is considered earned income but the amount cannot exceed 30% of the taxpayer's share of the net profit. In calculating the 30% share, the net profit must be reduced by the 50% self-employment tax deduction. Profits earned by a passive partner are not considered earned income. If the business suffers losses, a reasonable allowance for personal services is considered earned income.
If a US partnership has a foreign branch, then the partnership agreement determines the tax status of the allocation of foreign earnings to partners living abroad as to whether it is considered foreign earned income. However, an allocation based primarily on tax savings may not be recognized by the IRS.
Compensation includes fringe benefits. Reimbursements from a nonaccountable plan or for moving expenses are generally taxable.
Earnings from copyrights are considered earned income, but not patents nor the leasing of oil and mineral lands. Rental income is generally not considered earned income, unless the taxpayer performs personal services, such as managing the rental.
If the taxpayer moves back to the United States, but remains with the same employer, then moving expenses are considered US sourced income, and, thus, cannot be excluded. However, if the taxpayer changes employers after returning to the US, but the old employer pays for the moving expenses, then that is considered foreign earned income for services rendered in the foreign country.
Foreign earned income that was earned in a prior tax year but was paid later does not qualify for the foreign income exclusion. However, it may be tax-free if the amount was less than the foreign income exclusion that was available in the previous year. Income that was earned in the previous year but paid in the next year can be excluded if the payment was within a normal payroll period of 16 days or less.
If foreign taxes are paid on foreign earned income that is tax-free within the United States, then no credit or deduction can be claimed, since there is no US tax liability for the income.
Requirements to Claim the Foreign Earned Income Exclusion
The requirements to claim the foreign earned income exclusion is that the taxpayer's tax home is in the foreign country and the taxpayer meets either the 1-year foreign residence test or the 330-day foreign physical presence test. If the taxpayer does not satisfy either time test to claim the foreign earned income exclusion or the housing exclusion or deduction by the due date of the return, but expects to do so, then the taxpayer can either file for an extension of time on Form 2350, Application for Extension of Time to File US Income Tax Return for US Citizens and Resident Aliens Abroad Who Expect to Qualify for Special Tax Treatment until she qualifies under the time test or she can file a return on the due date, reporting the income and paying the tax, then file for a refund when the time test is satisfied.
An additional qualification is that the taxpayer be either a US citizen or a resident entitled to tax treaty benefits who meets either the foreign residence or physical presence test in a foreign country. Tax treaties with foreign countries are generally designed to prevent double taxation. More information can be found in IRS Publications 54, Tax Guide for US Citizens and Resident Aliens Abroad and 901, US Tax Treaties.
If the taxpayer qualifies for the foreign residence or physical presence test for only part of the tax year, then the exclusion limit is reduced by the percentage equal to the qualifying time divided by the number of days in the year. So if a taxpayer satisfies the foreign or physical presence test for 293 days in 2015, then the maximum exclusion is $80,916 (= $100,800 × 293/365). If married, the spouses can each claim the foreign earned income exclusion and the foreign housing exclusion if both meet the foreign residence or physical presence test, even if their permanent home is in a community property state. However, they must each file a separate Form 2555, even if they file jointly.
The following are not considered foreign countries:
- Puerto Rico,
- Virgin Islands,
- Commonwealth of the Northern Mariana Islands,
- American Samoa,
- Johnston Island, or
Furthermore, income earned in international airspace or international waters is not considered income earned in a foreign country. That the foreign earned income exclusion does not apply to Antarctica or to international areas makes sense since there are no taxing authorities in those areas.
If the tax home is within the United States, then the taxpayer may claim the foreign tax credit and deduct living expenses while away from home if the assignment was temporary and was expected to last and actually did last for 1 year or less. A taxpayer with the tax home in the United States may not claim the foreign income exclusion but only the foreign tax credit and deduct living expenses while away from home.
The foreign earned income exclusion or the housing exclusion or deduction cannot be claimed if the taxpayer lives in a country, listed in Form 2555, that is subject to United States government imposed travel restrictions.
If the failure from satisfying the foreign residence or physical presence test was because of a war or civil unrest, then the exclusion can be claimed for the period in which the taxpayer was a resident or physically present. Foreign locations and the time periods to qualify for the waiver are listed in the Form 2555 instructions.
Foreign Residence Test
The foreign residence test is satisfied by a US citizen who is a bona fide resident of a foreign country for at least 1 full tax year. This also applies to a US resident alien who is a citizen of a country that has an income tax treaty with the US and meets the full-year foreign residence test. Business or vacation trips outside of the country, including to the United States, does not disqualify the taxpayer from satisfying the foreign residence test.
A bona fide resident of a foreign country is one who takes actions that would indicate an actual relocation to the country, including:
- bringing the family;
- buying a house or renting an apartment rather than going to a hotel room;
- having a permanent foreign address;
- joining clubs there;
- opening charge accounts and stores in the foreign country; and
- participating in foreign community activities.
However, a taxpayer who does not qualify as a bona fide resident can still qualify under the physical presence test.
Physical Presence Test
To satisfy the physical presence test, the taxpayer must be present on foreign soil 330 days during a 12 consecutive month period. However, the days do not necessarily have to be consecutive. A full day is considered from midnight to midnight. The 330 day period can include time spent traveling between foreign countries while on vacation, since there is no requirement that the days were spent working; even working for the US government also counts. If the 330 day physical presence test is satisfied, then the taxpayer can claim an exclusion equal to the maximum foreign income exclusion multiplied by the number of days in the tax year when the foreign presence test was satisfied divided by the number of days in the tax year:
|Claimable Exclusion||=||Maximum Exclusion||×||Days of Physical Presence |
Days in Tax Year
Housing Cost Exclusion or Deduction
Employees can claim the housing exclusion while self-employed persons must claim a deduction for housing from taxable foreign earned income. The housing exclusion is figured before the foreign income exclusion, which is limited to the excess of the foreign earned income over the housing exclusion.
Maximum Foreign Earned Income Exclusion = Statutory Maximum Foreign Earned Income Exclusion – Housing Exclusion
So, if $15,000 is being claimed for the housing exclusion for 2015, then the maximum foreign earned income exclusion that can be claimed for earned income = $100,800 – $15,000 = $85,800.
The housing exclusion for employer-financed housing costs is the excess of reasonable housing expenses over a base housing amount, but the maximum housing exclusion can be no more than 16% of the maximum foreign earned income exclusion for that year. If the applicable period is less than 1 tax year, then the housing exclusion must be prorated by multiplying the housing exclusion that could be claimed for the year by the number of qualifying days divided by the number of days in the year:
|Prorated Housing Exclusion||=||Maximum Housing Exclusion||×||Number of Qualifying Days |
Number of Days in Year
However, the housing expenses that can be taken into account in calculating the base housing amount is limited to 30% of the maximum earned income exclusion, which must be prorated if necessary.
Reasonable housing expenses include rent, insurance, parking, furniture rentals, repairs, and utilities except telephone. Nonqualifying expenses include the purchase price of a home, home improvements, depreciation on the home, payments of mortgage principle, furniture, accessories, or domestic labor. If the taxpayer lives in a foreign country that is potentially dangerous, then the taxpayer may claim an exclusion for housing maintained elsewhere for his family. The IRS does increase the maximum limit for specific geographic locations with higher housing costs, but the taxpayer must actually reside within the geographic limits to qualify — nearby locations do not count.
Self-employed taxpayers may claim a deduction for housing costs that exceed the foreign earned income exclusion plus the housing exclusion, to the extent that it offsets taxable foreign earned income. If the taxpayer's taxable foreign earned income does not offset all of the eligible deductions, then the expenses can be carried forward to the next year to offset taxable foreign earned income for that year.
If the taxpayer is both self-employed and works as an employee during the same tax year, then the income is deductible to the extent that the taxpayer was self-employed during that part of the time in the foreign country for a given tax year. The proportion of expenses equal to the portion of time working as an employee is excludable.
The value of meals and lodging provided by an employer to employees located in a foreign country may be excluded from the income of the employees if:
- the lodging is necessary for the performance of services in a remote area lacking adequate housing;
- the lodging is close to where the services will be performed;
- the lodging is provided in a common non-public area that can accommodate at least 10 employees.
However, employees working for a US military contractor on a foreign military base do not qualify, since the lodging is not part of the employer's business premises.
Itemized deductions, such as medical expenses, real estate taxes and mortgage interest are deductible. Personal and dependency exemptions are also deductible. Business expenses attributed to excluded income are not deductible.
If the taxpayer earns more than the maximum foreign income exclusion amount, then a percentage of the deductions that can be deducted is proportional to the amount of taxable income divided by the total income:
|Percentage of Deductible Expenses||=||100||×||Non-Excluded Income|
So a taxpayer who excludes 80% of his income can deduct 20% of his expenses.
Reimbursed expenses do not have to be reported. However, if the reimbursement is less than the expenses, then the excess is deductible where the deduction is multiplied by the non-excluded income divided by total income.
Reimbursements from a nonaccountable plan, however, are treated as income, which must be added to income before the exclusion. Moving expenses are deductible if:
- the employer transfers the employee back to the US, or
- the employee:
- transferred to another job, or
If the move back was because of retirement, then the 39-week test for employees or the 78-week test for the self-employed does not have to be met.
Moving expenses of a spouse or dependent of a worker who has died in the foreign country are generally deductible if the move commences within 6 months of the worker's death. The general requirements for moving expenses must be met except for the time test. However, if the taxpayer moves to a foreign country and excludes her income, then moving expenses are not deductible.