Foreign Earned Income Exclusion

Christopher Klug – International Tax Attorney, Washington DC

foreign-earned-income-exclusion

 

US citizens and tax residents (“US Persons”) living and working abroad experience a different income tax environment than domestic US taxpayers.  US Persons living and working abroad are allowed under section 911 of the Internal Revenue Code an annual exclusion from income tax up to $101,300 in 2016 and increasing to $102,100 in 2017 of foreign source earned income.  There are several explanations as to why US Persons living abroad are allowed this apparent windfall or tax break, some of which include:

  1. Encourage American businesses abroad;
  2. The cost of living overseas is higher for American style amenities;
  3. US foreign tax credits do not allow offsets for foreign taxes when foreign governments rely on indirect taxes;
  4. US Persons living abroad do not derive the full benefit of public services financed through federal income taxation in the United States; and
  5. Tax incentives encourage US Persons to suffer the discomforts of living and working in less developed countries or areas.

Section 911 provides for an income tax exclusion, known as the Foreign Earned Income Exclusion (“FEIE”), and housing allowance for US Persons living abroad.  Under section 911, a qualified individual may elect to exclude foreign earned income from income and exempt the housing cost amount from taxation for any taxable year.  

Earned income includes compensation for personal services such as wages, salaries, tips, bonuses, and net earnings from self-employment earnings, as well as similar types of income.  Passive income such as interest, dividends, rental income, or retirement income is generally not considered earned income.  Also, income from foreign retirement accounts cannot be excluded under the FEIE.

In order to claim the FEIE and housing cost amount, the US Person’s tax home must be in a foreign country and qualify under one of the following requirements:

  • A US Person who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year;
  • A US Person who is physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months.

 

Tax Home is defined as the regular or principle place of business, employment, or post of duty, which is separate from the US Person’s family residence that may still be in the US.

For a US Person to qualify under the physical presence test, the 330 full days in a foreign country or countries can span into two tax years.  Where the 12 consecutive month period used to claim the FEIE spans into two tax years, the exclusion is prorated for the number of days of the consecutive 12 month period that were included in the tax year where the FEIE is claimed.  For example, where the consecutive 12 month period started October 16, 2016 and ended October 15, 2017, the FEIE amount of $101,300 in 2016 will be prorated for the portion of the period that falls in tax year 2016 (October 16, 2016 – December 31, 2016).  

The amount of foreign earned income excluded from a US Person’s gross income will be used for the purposes of determining the rate of income tax and alternative minimum tax that applies to his or her nonexcluded income.  A US Person’s tax on any foreign earned income above the FEIE amount, and on any unearned income, is computed as if the FEIE was not claimed.  The US Person’s tax will be the excess of the tax that would be imposed if his or her taxable income were increased by the amount excluded, and the tax that would be imposed if his or her taxable income were equal to the excluded amount.  

Once a US Person elects to exclude foreign earned income and/or housing costs, he or she cannot receive a foreign tax credit or deduction for taxes on income that was excluded under the FEIE or the housing cost amount.  It will be important for a US Person to determine whether he or she is in a better position receiving the FEIE, or receiving the foreign tax credit applicable to the foreign earned income.

Once a US Person elects the FEIE for a given year, the election remains in effect for that year and all future years, unless revoked.  Once the FEIE election is revoked, the US Person cannot elect the FEIE again for a five-year period without the approval of the IRS.

US Persons may also take the housing exclusion in addition to the FEIE.  To be eligible, the US Person must have paid or incurred housing expenses in the foreign country in addition to meeting the conditions required for the requirements to claim the FEIE.  Eligible housing expenses include rent, utilities, real and personal property insurance, rental of furniture and accessories, repairs, and residential parking.  Housing expenses do not include the costs of purchasing or making improvements to a house, mortgage interest and real estate taxes related to a house the US Person owns, purchased furniture, television costs, or domestic help.  The housing cost amount equals the excess of eligible expenses incurred for the US Person’s foreign housing over a stipulated base amount, which is then prorated for the number of qualifying days in the year.  

It is important to note that a second residence is not required for the US Person to claim the housing exclusion.  As there are many US Persons living abroad who have little or no connection to the US, the housing exclusion can be claimed as long as the residence is being rented and the other requirements are met.

It is important to note that while the FEIE and housing exclusion will reduce a US Person’s income subject to income tax, it will not reduce the US Person’s income subject to self-employment tax.  For example, by claiming the FEIE a US Person may have no earned income subject to US income tax, but owe self-employment taxes.  On another note, since foreign corporations are not subject to payroll taxes in the US, a US Person working for a foreign corporation is not subject to payroll tax on their earned income.  In contrast, a US Person who is considered self-employed in a foreign country is subject to US self-employment taxes.  The US has Totalization Agreements (Social Security Agreements) with certain nations that exempt those covered under the agreement from paying into two social security systems.  

A key consideration for a US Person living abroad will be to determine whether to elect the FEIE or use foreign tax credits to offset US tax on foreign source income.  A US Person who works in a low-tax jurisdiction will benefit from electing the FEIE since they will have little to no foreign tax credits to offset US tax on their earned income.  For US Persons with both foreign source income and US source income, the FEIE could be elected under the right circumstances to reduce their adjusted gross income below the standard/itemized deduction and personal/dependency exemption amounts to remove any US tax liability on their US source income.  

Whether the US person lives in a high or low tax jurisdiction, the US Person will pay the higher tax rate whether it is to the country in which the US Person lives or derives their income, or to the US.

 

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