One of the common misconceptions of U.S. taxpayers is that if they earn less than the FEIE amount, no return is required. This is wrong!! In fact, only a qualifying individual with qualifying income may elect to exclude foreign earned income, and the qualifying exclusion applies only if the qualifying individual files a tax return and reports the income.
A U.S. citizen or a resident alien of the United States is taxed on their worldwide income both in the country of residence and in the United States. In an earlier article our tax analysts highlighted the two common ways: Foreign Tax Credit (FTC) and Foreign Earned Income Exclusion (FEIE) by which U.S. taxpayers residing abroad could avoid paying taxes twice on the same income.
In this article, we will discuss the ‘Foreign Earned Income Exclusion’ in detail to provide a better understanding of this tax relief measure provided by the U.S. Internal Revenue Service (IRS) to U.S. taxpayers living abroad.
Overview of Foreign Earned Income Exclusion (FEIE)
The Foreign Earned Income Exclusion (FEIE) allows non-resident U.S. citizens and greencard holders to exclude certain qualifying foreign-earned income from U.S. taxation. The exclusion amount is adjusted annually for inflation. For the 2016 tax year the exclusion amount is set at $101,300 per person. The foreign earned income exclusion is limited to the actual foreign earned income. This means that taxpayers earning less than the exclusion amount may fully deduct their income earned from services performed outside the U.S. Foreign housing expenses may also qualify for exclusion up to a certain limit.
Income Qualifying for Foreign Earned Income Exclusion (FEIE)
For U.S. citizen/resident employees, the income qualifying for FEIE would be: salaries, wages, commission received, bonus income, tip income, cost of living reimbursements, education allowances, familial allowances, and other allowances or reimbursements by the employer to ease the employee’s life in the foreign country. Furthermore, severance pay, sick leave pay, and vacation pay also qualify for this exclusion. In some cases, the employer may provide lodging, automobile and meals while the U.S. citizen employee is residing abroad, these non-cash payments also qualify for exemption provided they are included in income. The exemption amount is calculated based on the prevailing fair market value, such as rental value of the car, house, or cost of a meal in that place.
Likewise, self-employed individuals can exclude professional fees they receive for their services performed. If you are engaged in a trade or business (other than a corporation), and capital is a material income producing factor of that trade or business, then a reasonable allowance as compensation for the personal services you actually rendered while in a foreign country is considered foreign earned income, but this amount cannot exceed 30% of the net profits of the business.
It is not necessary that the income be received in a foreign country. Foreign income qualifies for FEIE even if it is received by the person while in the U.S. if it is received for the services rendered when the individual was physically outside the U.S.
Eligibility for FEIE
To claim the FEIE, the individual must have qualifying foreign-earned income, must have a tax home in a foreign country (outside the U.S.)., must fulfill the Bonafide Residence or Physical Presence Test, and must make a valid election.
Bona-fide Residence Test
To fulfill the bona-fide residence test, the individual must be a resident of a foreign/non U.S. country for an uninterrupted period that includes an entire tax year. Having said that, one simply does not fulfill the bona-fide presence test simply by living or working in the foreign country. The U.S. citizen or greencard holder must establish residential ties and become a tax resident of the foreign country. The number of days are not counted, therefore, the individual would be allowed to return to the U.S. for vacations or other personal reasons.
Physical Presence Test
To fulfill the physical presence test, the U.S. citizen or greencard holder has to be physically present in the foreign country for 330 days of a 12 month period. A full day is a period of 24 consecutive hours, beginning at midnight. The 330 days do not have to be consecutive nor do they need to fall entirely within the tax year as long as they fall within a period of 12 consecutive months. Unlike the bona fide residence test, this test does not depend on the kind of residence established, nor questions about any intention of returning or nature and purpose of stay.
Claiming FEIE
To claim the ‘Foreign Earned Income Exclusion’ (FEIE), the US citizen or greencard holder is required to file U.S. Tax Form 2555 or Form 2555-EZ along with their annual individual U.S. income tax return. Two separate elections should be made to exclude foreign earned income, and foreign housing expense/cost.
Taxpayers, should keep in mind that filing the U.S. income tax return with Form 2555 is mandatory to claim FEIE, regardless of whether the qualifying foreign earned-income is less than the exclusion limit. Failure to make a timely election could result in the claim being denied.
Also, note that the FEIE can be claimed only in the tax year for which the income is received, however, the limitation will be applied based on the year the income was earned. For example, Mr. Taxpayer earned $80,000 in 2016. He uses the FEIE to exclude this amount in 2016. During 2017, he returned to the U.S. and received a bonus of $25,000 which related to his services performed in 2016. Mr. Taxpayer would be entitled to claim the FEIE on this bonus on his 2017 return, however, he would only be entitled to use the remainder of the 2016 exclusion limit. As he claimed $80,000 of the $101,300 maximum limit in 2016, he would only be entitled to claim $21,300 in 2017.
If the FEIE qualifying period is less than a year, the maximum exclusion amount will be prorated.
Often both the taxpayer and their U.S. citizen or greencard holder spouse work in the foreign country. In this case, they have to individually file Form 2555 or Form 2555EZ to claim the Foreign Earned Income Exclusion (FEIE).
Although, each individual is entitled to claim up to the maximum exemption, the exemptions may not be combined. In other words, if one spouse is not fully utilizing the exemption, the unused amount may not be transferred to the other spouse. The IRS accepts a situation wherein one spouse files a Form 2555 and the other files a 2555-EZ.
Consequences of Claiming FEIE
Once a taxpayer chooses to exclude foreign earned income or housing amount, that choice remains in effect for that year and all later years unless the taxpayer requests to revoke it.
If a taxpayer chooses to exclude either foreign earned income or foreign housing costs, the Foreign Tax Credit (FTC) cannot be claimed for the taxes paid relating to the foreign earned income for which FEIE has been claimed, however the foreign tax credit may be claimed for the amount of foreign income which has not been excluded under the foreign earned income exclusion or the foreign housing exclusion.
In order to claim benefits, such as: child tax credit and/or the additional child tax credit, and the earned income tax credit (EITC) the excluded foreign earned income will be added back to compute the tax credit amount.
Dealing with cross-border tax situations can be complicated, it is best to consult a cross-border tax professional specializing in U.S. and the foreign country’s tax laws to help the U.S. taxpayer comply with the tax laws of both the countries in a tax-compliant manner.
AG TAX LLP CAN HELP
If you have any tax-related queries, need assistance with tax planning or filing your tax returns please contact us. Our team comprises of highly experienced tax professionals with extensive knowledge of US and Canadian tax laws as well as cross-border compliance.
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