Foreign Earnings Income Exclusion
As we have discussed US citizens, (resident alien included) must pay US federal income tax on their worldwide income. [For a detailed explanation of who all needs to file, check out our Substantial Presence video.] This becomes an issue if you earn income outside the US. In essence, you would be taxed by the foreign country where you earn your income and in the US. To combat this double taxation, the US implemented two exclusion/deduction, to lower your US federal income tax -- Foreign tax credit and the foreign earned income exclusion ("FEIE"). We will be covering the FEIE today.
What is the Foreign earned income exclusion?
In short, it is the amount of foreign income for which a US taxpayer does not have to pay US federal income tax (note I said "federal income tax"--you are still subjected to SE tax). For example, assume you work abroad, and you earned $105,900 in 2019. Although you have to pay US taxes on this amount, the US basically give you a pass on it through the FEIE. If you go above this amount, then you would have a US tax bill. However, the FEIE is limited and the taxpayer must meet various fact-driven standards in order to qualify.
To claim the foreign earned income exclusion, the foreign housing exclusion, or the foreign housing deduction, you must have (1) foreign earned income, (2) your tax home must be in a foreign country, and (3) you must be one of the following:
A U.S. citizen who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year,
A U.S. resident alien who is a citizen or national of a country with which the United States has an income tax treaty in effect and who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year, or
A U.S. citizen or a U.S. resident alien who is physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months. (note the disparity in days 330 to claim this exclusion, while only 183 days to meet the substantial presence test).
Let's go over the rules:
(1) Do you have foreign earned income?
This income that you "earned" outside of the US so it will not include foreign passive income. In other words, you must either be an employee and get a salary/wage or be self-employed and earn money in foreign country.
Other exclusions include:
Pay received as a military or civilian employee of the U.S. Government or any of its agencies
Pay for services conducted in international waters (not a foreign country)
Pay in specific combat zones, as designated by an Executive Order from the President, that is excludable from income
Payments received after the end of the tax year following the year in which the services that earned the income were performed
The value of meals and lodging that are excluded from income because it was furnished for the convenience of the employer
Pension or annuity payments, including social security benefits
In other words, services you provided as a United States government employee or under a Personal Service Agreement with a U.S. government agency will not count as foreign earned income.
(2) Is your tax home in a foreign country?
This is a major topic and we will be discussing this in our next blog. However, this is not what people typically think. Although there's a familial aspect to this analysis, your tax home is not so much where you live but more of where you work. As tax court cases has shown us, this is largely a fact-driven analysis.
(3) Are you a U.S. citizen?
As mentioned in our substantial presence video, if you are a resident alien (you hold a green card) or meet the number of days requirement, then you are taxed just like a US citizen for US tax purposes. Here is where the difference lies. If you are a citizen, you move onto the next question and if you meet that, you qualify for the FEIE. However, if you are a resident alien, you must qualify for the second part of this test, which has little to do with you. This test is based on the other country you are associated with. Is that country one in which the US has an existing tax treaty with. For example, assume Belle was born in France. When she received US green card, she is still considered a French citizen. If France has a tax treaty with the US (which it does) then she moves onto the next question. If not, her journey stops here, and she does not qualify for the FEIE.
For a list of existing tax treaties: https://www.irs.gov/pub/irs-utl/Tax_Treaty_Table_3.pdf
(4) Were you physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months?
If your answer is yes to this test and the prior ones, then congratulations, you qualify for the FEIE. Your next step is to figure out how much you would still owe the IRS for SE wages (if you are self-employed) or if your income exceed the FEIE amount. It is noteworthy to mention that even if you will owe no Federal income tax, you must still file a tax return. On the bright side, if you live abroad you are entitled to a later deadline. While the rest of us are struggling to meet the April 15th deadline and if extended the 10/15 deadline, your deadline is 6/15 or 10/15 should you extend. It is noteworthy to mention that although your tax returns are due by 6/15, any payments is still due 4/15.
(5) Were you a bona fide resident (BFR) of a foreign country or countries for an uninterrupted period that includes an entire tax year?
If you failed the 330 days, which is where most court cases are made up of, you are in murky territory my friend. Similar to the "tax home" question, a BFR is also fact-driven. And you do not automatically acquire bona fide resident status merely by living in a foreign country or countries for 1 year.
To qualify as a BFR, you must establish that you have a residence in a foreign country. Your bona fide residence is not necessarily the same as your domicile. Your domicile is your permanent home, the place to which you always return or intend to return.
You could have your domicile in Dallas, Texas, and a bona fide residence in Paris if you intend to return eventually to Dallas. The fact that you go to Paris does not automatically make Paris your bona fide residence. If you traveled to Paris as a tourist, or on a short business trip, and then return to the United States, you have not established bona fide residence in Paris. But if you go to Paris to work for an indefinite or extended period and you set up purchased or rented a flat there for yourself and your family, you probably have established a bona fide residence in a France, even though you intend to return eventually to the United States. Thus, while you are clearly not a resident of Paris in the first instance (going as a tourist). In the second (going for an indefinite work assignment), you are a resident because your stay in Paris appears to be permanent. If your residency is not as clearly defined as either of these illustrations, it may be more difficult to decide whether you have established a bona fide residence. If this is the case, check with a professional. Remember, anytime you litigate against the IRS, you are paying an attorney an hourly fee. Make sure your facts are clear from the start.
The other thing to note is the phrase "uninterrupted period that includes an entire tax year." This does not prevent you from leaving the country on short trips. However, it does require you to establish residency for an entire year. For most of us, this would be 1/1 - 12/31. It is also not uncommon to be a BFR for partial year(s) so long as you meet at least one full year (1/1-12/31). Please check with an advisor if you believe this to be your case.
What if you earn above the exclusion?
If you meet all four requirements, you will need to elect the FEIE on your tax return. If your income exceed the FEIE, then, you must figure the tax on the remaining non-excluded income using the tax rates that would have applied had you not claimed the exclusions.
"An individual’s tax on any foreign earned income above the exclusion amount and on any unearned income is computed as if the foreign earned income exclusion was not claimed. The individual's tax will be the excess of the tax that would be imposed if his or her taxable income were increased by the amount(s) excluded, and the tax that would be imposed if his or her taxable income were equal to the excluded amount(s). For this purpose, the excluded amount(s) will be reduced by the aggregate amount of any deductions or other exclusions otherwise disallowed." In other words, get professional help.
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