The United States (US) government assesses the wage of its nationals, occupant outsiders, and residential companies paying little mind to where the pay is earned. In like manner, alien outsiders and remote organizations are additionally saddled on pay that is adequately associated with an exchange or business led inside of the US. Most different nations do in like manner. Thus, a US citizen who procures cash in an outside nation brings about an expense risk to both the remote nation and to the United States. Since this twofold tax collection can be very grave, the US assessment code permits a citizen to assert the outside earned pay avoidance, a remote duty credit, or conclusions for outside costs.
The remote earned wage prohibition can reject just about $100,000 of salary earned in an outside nation from United States wage charges in addition to either an avoidance or a finding can be asserted for certain lodging expenses. Nonetheless, the pay avoidance, which is balanced for swelling, just applies to profit from work .
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 2011, then the maximum exclusion is $74,571 (= $92,900 × 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,
- Guam,
- Commonwealth of the Northern Mariana Islands,
- American Samoa,
- Johnston Island, or
- Antarctica.
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.
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 |
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