If you’re working or living abroad, a.k.a. an expat, Form 2555 should be the IRS form you’re most familiar with. But, what is form 2555, and why should you familiarize yourself with it?
Also known as the form for the Foreign Earned Income Exclusion, Form 2555 is the document for expats who want to or are eligible to exclude their foreign earned income from taxes. As you fill out the form, you declare your different sources and types of income. Then, you attach it to your U.S. tax return.
Not all types of income are eligible for the Foreign Earned Income Exclusion (FEIE), though. Only earned income or income received from work or services “physically” performed in a foreign country are included in the FEIE. However, there are some exceptions, such as rent, capital gains, interests, dividends, and royalties.
Generally, it doesn’t matter where the payment was made or received; as long as you can prove that you earned these while living abroad, the Internal Revenue Service (IRS) can consider it part of FEIE. In addition, there are tests to determine if you qualify for FEIE: the Physical Presence Test and the Bona Fide Residence Test.
Before you go through these tests, you should first know the foreign income types you can and cannot claim on your Form 2555.
As the label suggests, this is the type of foreign income that you have earned for a service you have physically performed in another country.
If your salary, wage, or tip came from work physically performed outside of the U.S., it counts as foreign income. Even if you’re being paid by a U.S. company when you’re an expat, the IRS also considers your pay as foreign income. Basically, if you were paid for the personal services you performed while you’re on foreign soil, you can include it on your FEIE.
However, the IRS notes that you can’t include “amounts received for personal services provided to a corporation that represent a distribution of earnings and profits rather than reasonable compensation.”
Employers sometimes use sales commissions as incentives to sell certain services or goods. They pay you based on performance either on top of your salary or instead of a paycheck. Nevertheless, you can include this in your FEIE. Ensure that you coordinate with your employer about your taxes to avoid double taxation.
Another form of workplace incentive, bonuses are given to employees who do exceptional work. Examples include retention, signing, and referral bonuses. If you received any of these rewards for the tax year, you could include them in your FEIE. Other than cash, some companies provide stock or stock options as rewards, which also count as earned income.
On the other hand, there are these foreign income types that highly depend on certain factors before being determined as earned or unearned income and they fall under variable income.
4. Rents from foreign real estate
Rent is considered passive or unearned income because you aren’t working to receive this income. The same is true of investment income such as interest income and capital gains. Passive income isn’t eligible for the FEIE.
Royalties are considered passive income and not earned income for purposes of the foreign earned income exclusion.
Disclose Your Foreign Financial Assets
As an expat, you should take advantage of the FEIE as it can cover a lot of tax breaks, helping you save money and preventing double taxation. You just have to review which kinds of income you can and cannot claim on your Foreign Earned Income or Form 2555.
If you need any help in identifying if a particular type of income is foreign-earned or not, don’t hesitate to reach out to Tax Samaritan, a tax resolution partner that offers best-in-class service.