foreign earned income exclusion

As an ex-pat, one of your biggest tax concerns will surround the possibility of owing taxes to the U.S. for the money you earn in another country. Fortunately, the U.S. offers several tax benefits that you can use to reduce and/or eliminate any liability you may have. One of the most significant advantages available to you as someone earning money overseas is the Foreign Earned Income Exclusion via Form 2555. This advantage is available to most expats, except for U.S. government employees.

Do U.S. Citizens Pay Taxes on Foreign Income?

Unlike most other countries, the U.S. requires its citizens to report and pay taxes on all of the income they earn during the year. This includes income from other countries.

In other words, the U.S. taxes its citizens and resident aliens on their worldwide income regardless of where they live or work.

Some people living and working outside of the U.S. are unaware of this requirement. But lack of awareness will not excuse your tax liability or responsibility to file a return.

Fortunately, many people who earn income overseas can reduce the amount of tax they owe to the U.S. using certain available tax benefits. For example, the Foreign Earned Income Exclusion, Foreign Tax Credit, Foreign Housing Exclusion, and more.

What Is Foreign Earned Income Exclusion?

Qualifying individuals may be eligible to reduce their U.S. taxable income by claiming the foreign earned income exclusion, foreign housing exclusion and/or the foreign housing deduction.

The Foreign Earned Income Exclusion, or FEIE, is a tax benefit that allows you to exclude income earned in a foreign country from your taxable income for U.S. purposes. If you meet the requirements established by the Internal Revenue Service for a given tax year, you will be able to deduct some or all of the income you have earned outside of the United States during that tax year with form 2555. The limit on this deduction changes on an annual basis to reflect inflation. Qualifying for the overseas earned income exclusion typically means that you qualify for the Foreign Housing Exclusion.

Foreign Earned Income Exclusion versus Foreign Tax Credit

The Foreign Earned Income Exclusion and the Foreign Tax Credit are two of the most popular tax advantages. However, they are not the same.

The Foreign Earned Income Exclusion allows you to exclude a certain amount from your U.S. taxable income. It lowers the total amount of income on which tax will be calculated.

This benefit is claimed on the Form 2555. It applies to income earned for personal services (i.e. from employment or self-employment) in a foreign country.

The Foreign Tax Credit, on the other hand, reduces the tax you owe to the United States dollar-for-dollar based on the amount you have already paid to a foreign country.

It is important for expat taxpayers to remember that you cannot claim both of these benefits for the same income. For example, if you exclude all of your foreign earned income using the Foreign Earned Income Exclusion, you cannot use any taxes you paid on that excluded income to qualify for the Foreign Tax Credit. However, it is possible to claim both of these benefits by allocating a portion of your qualifying foreign income to each. An expat tax professional can help you determine the best way to use these tax benefits to your advantage

Can I Reduce My Taxes With The Foreign Earned Income Exclusion (Form 2555)?

Yes, it is possible. If you are a U.S. citizen or a resident alien of the United States and live abroad, you are subject to tax on your worldwide income and must file a U.S. return for all the tax years you are residing abroad. However, as a U.S. ex-pat you may be able to use the foreign earned income exclusion, form 2555, to reduce the taxes you owe or eliminate your taxable earned income altogether.

What Are the Requirements for Foreign Earned Income Exclusion?

To be eligible for the foreign income exclusion, an expatriate must meet all four of the following requirements:

  • Must have foreign earned income
  • Must have a tax home in a foreign country
  • Meet either the bona fide residence test or physical presence test
  • Make a valid election to exclude foreign earned income.

Foreign Earned Income

The foreign earned income exclusion is only available for wages, or self-employment income earned for services performed outside the U.S. Foreign “Earned” income includes salaries, wages, commissions, bonuses, self-employment income. The income must also be “foreign” income, meaning that the performance of services was physically in a foreign country.

It does not include:

  • Non-earned income or passive income such as investment income (interest, dividends, and capital gains), social security
  • Income earned as an employee of the U.S. government
  • Income for services performed in international waters
  • Self-employment taxes; while you can exclude your self-employment income, your self-employment income is subject to self-employment taxes (social security and medicare taxes) unless the services took place in a country with a U.S. totalization agreement.

Tax Home in a Foreign Country

Another requirement you must meet before you can qualify for the foreign income exclusion is having your tax home in a foreign country. Your tax home must be in a foreign country throughout the entire period you use to meet the foreign earned income exclusion physical presence or bona fide residence test requirements.

Defining “Tax Home”

According to the Internal Revenue Service, your “tax home” is the general area you conduct your business or employment. Your tax home is not necessarily the place where you maintain a residence.

The IRS does not consider you to have a tax home in a foreign country if you are maintaining your “abode” in the U.S. Even if you are earning money from overseas, in this case, you will not be able to claim the Foreign Earned Income Exclusion.

The IRS defines your “abode” as the place where you maintain your economic, family, and personal ties. Keep in mind that merely maintaining a dwelling in the United States will not disqualify you from this tax benefit. Likewise, being in the United States temporarily or having a spouse or dependents living in your dwelling in the United States will not be an automatic disqualification either. Nevertheless, these factors are a consideration and may impact qualification.

Determining your tax home location will often be dependent on whether you are working in a foreign country temporarily or indefinitely. In general, your work assignment is temporary if it is going to last for no longer than one year. However, if the assignment lasts for more than one year, the IRS will consider it indefinite.

If you determine that your work assignment does not qualify you to establish a tax home in a foreign country, and you are unable to claim the Foreign Earned Income Exclusion. In that case, you may still be able to deduct some of your other expenses, lodging, travel, and meals.

Serving In A Combat Zone

Suppose you serve in an area designated by the U.S. President by Executive Order as a combat zone for purposes of Section 112 in support of the U.S. Armed Forces. In that case, you can qualify as having a tax home in a foreign country. This is applicable even if you have an abode within the U.S.

Defining “Foreign Country”

The IRS defines a foreign country as a territory that is not under the United States’ government’s sovereignty. Thus, U.S. possessions like Guam and Puerto Rico will not qualify as foreign countries. However, other locations not under the U.S.’s control or ownership fall under the classification of “foreign countries.”

Not all overseas locations are a “foreign country.” For example, Antarctica, U.S. territories, international waters, and the air space above them fall under the classification as a “foreign country.”

Bona Fide Residence Test or Physical Presence Test

Perhaps one of the most complicated requirements facing expats is passing the bona fide residence test or physical presence test.

What Is the Bona Fide Residence Test?

The bona fide residence test requires you to become a bona fide resident of a foreign country for a period that includes an entire tax year. For the purposes of this test, “foreign country” is the same definition as it is with regard to the establishment of your tax home.

The IRS cautions taxpayers to remember that only traveling to and living inside another country for a year will not automatically make them bona fide residents. However, suppose you live and work in another country where you have established a residence and intend to remain for an extended or indefinite period. In that case, you are likely a bona fide resident.

Determinations of bona fide residence are on a case-by-case basis. The IRS decides if the taxpayer qualifies as a bona fide resident based on information provided on Form 2555. For this reason, it is crucial to consult an ex-pat tax professional if you are hoping to qualify for the overseas earned income exclusion or any other tax benefit using this test.

Special Cases that Prevent Bona Fide Residence

  1. Statements Made to Foreign Authorities. In some cases, taxpayers can avoid paying income taxes in foreign countries by making a statement to the government indicating that they are not a resident and therefore not subject to taxation. However, if you make such a statement and the country’s authorities decide that you are not a resident for income tax purposes, you will not pass the bona fide residence test. Likewise, if the foreign country authorities are still deliberating your case at the time of your tax filing, you won’t pass the bona fide residence test either.
  2. Treaties. Some income tax treaties between the U.S. and other countries may prevent you from passing the bona fide residence test. However, this will not happen automatically. To determine whether a given tax treaty prevents you from passing the bona fide residence test, you will need to consult the treaty provisions carefully.

Can You Be a Bona Fide Resident for Part of the Year?

Once you can pass the bona fide residence test for one or more entire tax years, the period for which you are a bona fide resident may extend into a portion of two additional tax years. Specifically, the IRS will consider you to be a bona fide resident when you establish the residence until the time you abandon it.

For example, if you established a bona fide residence in France on May 30, 2015, and you maintain your residence until July 31, 2017, the IRS will consider you a bona fide resident of France for all of 2016, as well as parts of 2015 and 2017.

Can You Leave the Country at All as a Bona Fide Resident?

You can still be a bona fide resident of a foreign country for the Foreign Earned Income Exclusion purposes even if you leave the country at times during the year. However, it must always be clear that you have an intention to return to a foreign country without unreasonable delay. The IRS will review the circumstances to determine if any trips you have taken during the tax year will prevent you from passing the bona fide residence test and claiming the foreign income tax exclusion.

What Happens during Reassignment?

If your employer reassigns you to another post before you have met the bona fide residence test requirements for a given tax year, it may or may not affect your ability to pass the test.

In general, as long as you move directly from one post to the other outside the United States and meet all other requirements, you have a good chance of passing the bona fide residence test. However, if you return to the United States while waiting for reassignment, likely, you will not be able to pass the bona fide residence test.

What Is the Physical Presence Test?

The physical presence test requires you to be physically present in one or more foreign countries for a minimum of 330 full days during 12 consecutive months. Keep in mind that, although the 12-month period must be consecutive, the days themselves do not need to be consecutive. You can qualify for the Foreign Earned Income Exclusion using the physical presence test. This is the case whether you are a U.S. citizen or a resident alien.

Many expats find that this test is more straightforward to pass than the bona fide residence test. It only requires being present in a foreign country instead of establishing a specific type of residence or demonstrating your intentions.

Defining “Full Day”

The IRS defines a “full-day” as a period of 24 consecutive hours that begins at midnight. During this entire period, you must be physically present in a foreign country and/or passing over a foreign country. You cannot count any days in which you were present in a foreign country in violation of U.S. law.

You can still meet this requirement even if you travel back and forth to the U.S. multiple times. However, it is vital to plan accordingly to avoid spending too much time in the U.S.

Does it Matter Why I Was Abroad?

For the foreign earned income exclusion physical presence test, your reason for being outside of the U.S. and present in a foreign country is not relevant. Count all days you spent abroad, whether you were working, on vacation, or traveling for some other purpose.

How Do I Count Time Spent Traveling?

Time spent traveling may or may not count toward your 330-day total. For example, any time spent over international waters will not count toward your 330-day total. However, if you are traveling from one foreign country to another, your travel time can still be counted. So long as it lasts less than 24 hours. If your trip takes more than 24 hours, you will lose all days spent traveling. And the next full day you can count will be the first full day spent at your destination.

When traveling from the United States, passing over a foreign country can affect which days are countable. In general, if you pass over a foreign country before midnight on the day you leave the United States, you will be able to count the day after you left as your first full day abroad for this test.

What If Circumstances Out of My Control Prevent Me from Meeting Physical Presence Test Requirements?

Exceptions to the requirements of the foreign earned income exclusion physical presence test are not generally possible. If vacation, employer assignments, family emergencies, or illness prevent you from being physically present in a foreign country for enough full days to meet this test’s requirements, you won’t pass the test. You will not qualify for the foreign tax exclusion unless you can pass the bona fide residence test instead.

The only exceptions typically involve civil unrest, war, pandemic, and similar adverse conditions that make it impossible or unsafe to meet the physical presence test’s time requirements.

Make a Valid Election to Exclude Foreign Earned Income

Finally, to claim the Foreign Earned Income Exclusion, you must make a valid election. This means you must complete the appropriate sections of Form 2555 accurately. Then, submit it with your tax return to claim this benefit.

Completing Form 2555

Form 2555 is a requirement for each tax year you intend to claim the Foreign Earned Income Exclusion. You should complete this form and submit it to the IRS with Form 1040. Like Form 1040, Form 2555 is due on April 15 for most taxpayers.

To complete Part I of the form, you will need to list your address and the location of your tax home or tax homes, and the date of establishment. If you plan to use the bona fide residence test to qualify for the Foreign Earned Income Exclusion, you will need to complete Part II of the form. If you are planning to use the physical presence test, on the other hand, you will need to complete Part III. Both of these parts of the form require you to provide details to show you meet the specific test requirements you have chosen.

For Part IV of Form 2555, you will list all of the foreign earned income you received during the tax year. In Part V, you will calculate the total of your foreign earned income and indicate whether you are claiming the foreign housing exclusion or deduction. If you plan to claim a housing exclusion or deduction, you must complete Part VI. If not, you will skip to Part VII. The remainder of the form will guide you through the calculation of your Foreign Earned Income Exclusion for the year, as well as any housing exclusion you can claim.

What Type of Income is Covered by the Foreign Earned Income Exclusion?

The Foreign Earned Income Exclusion applies to income you earn while performing services, either as an independent contractor or employee.

Examples of income that qualifies for exclusion using this tax advantage include professional fees, wages, and salary payments.

You can claim the foreign income exclusion even if you are self-employed. However, it is essential to remember that this tax advantage will not reduce your self-employment tax liability.

What Is Not Foreign Earned Income

Below are common types of income not considered “foreign earned income”:

  • Dividends, interest, capital gains, and alimony
  • Pension or annuity (including social security benefits)
  • Compensation paid to an employee by an employer, which is the U.S. government or any of its agencies or instrumentalities
  • Any portion of an amount paid by a corporation that represents a distribution of earnings and profits rather than a reasonable allowance as compensation for personal services rendered to the corporation (i.e., wages)

What Is the Foreign Earned Income Exclusion for 2020?

Each year, the IRS updates the amount of income you can exclude from your taxable income using the Foreign Earned Income Exclusion. The tax year 2020 foreign earned income exclusion is $107,600. Together, if two individuals are married, they can exclude as much as $215,200 for the 2020 tax year.

Any foreign income earned above this amount may be subject to taxes. However, you may be able to eliminate or reduce any taxes that result from the excess income using other tax advantages available—for example, the Foreign Tax Credit.

What About A Foreign Earned Income Exclusion Partial Year?

If you qualify for the foreign income tax exclusion for only part of the tax year, you can still claim a foreign earned income exclusion partial year. However, you will need to modify the way you calculate the excluded tax amount accordingly.

First, you must determine the number of days in the year for which you qualify. Qualifying days are days when you pass either the bona fide residence test or the physical presence test AND have your tax home in a foreign country. Once you have calculated this amount, you will need to adjust the limit to your Foreign Earned Income Exclusion based on the number of qualifying days in the year. Multiply the excludable amount of income based on the number of qualifying days divided by the total number of days in the year.

What Are the Most Common Problems Taxpayers Experience with the Foreign Earned Income Exclusion?

Determining whether you qualify for the Foreign Earned Income Exclusion, calculating the amount of the Foreign Earned Income Exclusion, filling out form 2555, and claiming this tax benefit is tricky. As a result, all taxpayers need to be aware of the most common issues. Some of the most frequent mistakes made include:

  1. Failing to realize that you still owe self-employment tax. The Foreign Earned Income Exclusion cannot be used to eliminate self-employment tax liability to the U.S. Even if you meet all of the foreign tax exclusion requirements and all of your money is earned overseas. You will still be responsible for paying these taxes. Failing to pay what you owe will result in penalties.
  2. Claiming the Foreign Earned Income Exclusion as a Government Employee. Suppose you are an employee of the United States Government and receive payment from the United States Government. In that case, you will not qualify to claim the Foreign Earned Income Exclusion even if you meet every requirement.
  3. Failing to calculate the Foreign Earned Income Exclusion correctly. Figuring the Foreign Earned Income Exclusion can be challenging. Especially, if you can only claim this benefit for a portion of the tax year. It is essential to be aware of what types of taxable income you can exclude. As well as the annual exclusion limit. You must also be sure to subtract the amount of your Foreign Housing Deduction.

Other Common Mistakes

  1. Claiming the wrong tax benefits: The Foreign Earned Income Exclusion is not the only tax benefit available to U.S. expats. For example, many expats also have the opportunity to claim the Foreign Tax Credit. However, the same income cannot be used for both tax benefits. For this reason, it is important to consider how each of these benefits would affect your tax bill. And allocate income in the best way possible. While many taxpayers will find that the Foreign Earned Income Exclusion minimizes their U.S. tax liability. Others will find that the Foreign Tax Credit saves them more money.
  2. Claiming the Foreign Tax Credit on Excluded Income. The Foreign Tax Credit (Form 1116) is not allowed for foreign income taxes paid on excluded income.
  3. Claiming Schedule C expenses on excluded income. A deduction on Schedule C is not permissible for any expense related to excluded income.
  4. Failing to consult a professional when necessary. Because the laws surrounding the Foreign Earned Income Exclusion are so complex, many ex-pats will need to work with a professional tax preparer to ensure that they can qualify for this tax benefit and that they are claiming it appropriately. Unfortunately, not all expats consult tax professionals. They may lead to inaccurate tax returns, overpaid or underpaid U.S. taxes, IRS penalties, and other negative consequences.

Other Items Of Importance

  1. Retirement Contributions. Income limitations for IRA and Roth IRA eligibility are determined based on excluded and un-excluded income. However, any income excluded on Form 2555 is not considered compensation for purposes of determining the amount that can be contributed to an IRA.
  2. Additional Child Tax Credit. A taxpayer does not qualify for the refundable Additional Child Tax Credit when the foreign earned income exclusion is claimed.
  3. Earned Income Credit. A taxpayer is not eligible for the Earned Income Credit when the foreign earned income exclusion is claimed.
  4. Foreign Earned Income Exclusion Audit. If you have a foreign income tax exclusion audit, this is a grave matter because a significant amount of income was excluded from taxation. The tax and penalty exposure can cost tens of thousands of dollars. If multiple years are audited (which is typically the case), the impact can be multiplied for each impacted year. Tax Samaritan focuses exclusively on expat taxes for Americans Abroad. If you have been audited for the foreign tax exclusion, there is no time to waste to address the issue urgently before it is too late.

Do I Need to Consult an Expat Tax Preparer?

Even if you understand the basics of the Foreign Earned Income Exclusion, it is still in your best interest to consult a professional ex-pat tax preparer. They have experience with this tax benefit and expat taxes in general. A professional ex-pat tax preparer will be able to review your case. Let you know whether you qualify to claim this benefit. Complete all of the required paperwork and make sure that the exclusion has been calculated and elected correctly.

Benefits Of A Professional Expat Tax Preparer

Some of the other benefits of hiring a professional expat tax preparer include:

  • Access to in-depth knowledge about expat taxes. Professional tax preparers who specialize in expat taxes will help with more than just the Foreign Earned Income Exclusion. They can help with every aspect of the preparation and filing process.
  • Minimal tax liability. A competent tax preparer will be able to help you minimize your liability for U.S. taxes. While still ensuring that you comply with all relevant laws.
  • Protection from penalties. Failing to meet the IRS requirements as an ex-pat can lead to harsh consequences. This includes interest, monetary penalties, and even legal charges. A professional expat tax preparer will help you avoid all of these negative consequences.
  • Representation in an audit. Even if you do everything right, you can still be subject to an IRS audit at any time. Complying with an audit is difficult for all taxpayers. But it can be even more overwhelming when you are an expat. Working with a tax preparer specializing in expat taxes ensures that you will have the support and assistance you need if there is an audit.
  • A chance to fix past problems. In some cases, ex-pats are out of compliance with the IRS because they were unaware of requirements. Or, otherwise neglected to file or pay taxes as they should have. An expat tax professional can help you resolve these matters with the IRS as quickly and cost-effectively as possible.
  • Peace of mind. Trying to keep up with all of your tax obligations as an expat can be overwhelming. With the help of an expat tax professional, however, you can meet all of your requirements. And rest easy knowing that you are in good standing with the IRS.

What’s New

COVID-19 Emergency Relief

Due to the global health emergency caused by COVID-19, the IRS has provided relief related to the time requirement necessary to meet either the bona fide residence test or physical presence test for purposes of claiming the foreign earned income exclusion.

The IRS is providing a waiver of the time requirements that allow a qualified individual to exclude foreign earned income and the housing cost amount from income.

If your tax home was in a foreign country, and you reasonably expected to meet either test (bona fide residence or physical presence test) during 2019 or 2020 but failed to do so, you may be entitled to the waiver.

If due to the COVID-19 emergency, you left:

  • China excluding Hong Kong and Macau, on or after December 1, 2019, but on or before July 15, 2020, or
  • Any other foreign country on or after February 1, 2020, but on or before July 15, 2020

You will qualify as having met the physical presence or bona fide residence test if you could establish a reasonable expectation that you would have met either test if it had not been for the COVID-19 pandemic.

The minimum time requirements for the bona fide residence test and physical presence tests will be waived if you qualify. You can claim the tax benefits on Form 2555, but only for the number of days, you were a bona fide resident of, or physically present in, the foreign country.

Tax Year 2020 Exclusion Amount

For tax year 2020, the maximum foreign earned income exclusion amount is $107,600.