THE FOREIGN EARNED INCOME EXCLUSION
U.S. citizens living in a foreign country are subject to the same U.S. income tax laws that apply to U.S. citizens living in the United States. This means that you are subject to U.S. tax on your worldwide income and are required to file a U.S. tax return each year. However, if you meet specified requirements as to residency or physical presence in a foreign country, you may elect to use the Foreign Earned Income Exclusion to exclude from gross income up to $101,300 of your foreign earnings. For most Americans who live abroad, this results in a significant reduction of their U.S. tax liability.
Residency and Physical Presence Requirements
You must meet one of the following two tests to qualify for the Foreign Earned Income Exclusion:
Physical Presence Test – You meet the Physical Presence Test if you are physically present in a foreign country or countries 330 full days during a period of 12 consecutive months. The 330 days do not have to be consecutive.
Bona Fide Residence Test – To meet the Bona Fide Residence test, you must be a bona fide resident or a foreign country for an uninterrupted period that includes an entire tax year (January 1 – December 31). Whether you are a bona fide resident of a foreign country is determined based on all relevant facts and circumstances, such as your intention with regard to the length and nature of your stay in the foreign country, physical presence, payment of tax to the foreign country, whether your family lives with you or stayed in the U.S., your income tax status in the foreign country, etc. As the taxpayer, you must provide strong proof to establish your bona fide residency to the satisfaction of the IRS.
In case you do not meet either the Physical Presence Test or the Bona Fide Residence Test by the filing deadline of June 15, you should file for an extension until October 15. If you still do not meet the requirements by the extended October 15 deadline, you can file IRS Form 2350 to ask for an additional extension, allowing you to file your federal income tax return when you qualify for the Foreign Earned Income Exclusion.
What Income can be Excluded?
If you qualify for the Foreign Earned Income Exclusion, you can exclude from your gross income up to $101,300 of your foreign earned income (2016 amount). The tax code defines foreign earned income as income from sources within a foreign country. For example, when otherwise qualifying for the Foreign Earned Income Exclusion, income earned during a 3-day business trip in the United States cannot be excluded. On the other hand, salary paid by a U.S. company into a U.S. bank account of an employee who qualifies for the Foreign Earned Income Exclusion can be excluded.
If you and your spouse both qualify for the Foreign Earned Income Exclusion, each can exclude up to $101,300. The maximum amount applies to each taxpayer separately. For example, if your foreign earned income exceeds $101,300, but your spouse’s foreign earned income does not use the full exclusion amount, you cannot use the part not used by your spouse to exclude more than $101,300.
If you are self-employed the exclusion amount is applied against gross receipts (i.e. gross income and not income after deduction of expenses (net income)).
Is Claiming the Foreign Earned Income Exclusion Always a Good Idea?
Claiming the Foreign Earned Income Exclusion may not always be beneficial – by not using the exclusion, but instead using foreign tax credits, your U.S. tax liability may be lower. The reason is that foreign tax paid on the foreign income which is excluded under the Foreign Earned Income Exclusion cannot be claimed as a foreign tax credit against your U.S. tax liability. Whether you should use the Foreign Earned Income Exclusion depends on the foreign tax rate.
Questions about the Foreign Earned Income Exclusion?
If you have any questions about the Foreign Earned Income Exclusion, please don’t hesitate to contact us. Our tax professionals can advise you on the Foreign Earned Income Exclusion and when preparing your tax return will make sure you will not pay more tax than required.