Taxpat's US Tax Blog

How Do You Qualify for the Foreign Earned Income Exclusion?

United States citizens and resident aliens are taxed on their worldwide income, whether the person lives inside or outside of the United States. However, qualifying U.S. citizens and resident aliens who live and work abroad may be able to exclude from their income all or part of their foreign salary or wages, or amounts received as compensation for their personal services. In addition, they may also qualify to exclude or deduct certain foreign housing costs.

A common misconception that contributes to the international tax gap is that this potentially excludable foreign earned income is exempt income not reportable on a US tax return. In fact, only a qualifying individual with qualifying income may elect to exclude foreign earned income and this exclusion applies only if a tax return is filed and the income is reported.

General Rule

To qualify for the foreign earned income exclusion, a U.S. citizen or resident alien must:

• Have foreign earned income (income received for working in a foreign country),
• Have a tax home in a foreign country, and
• Meet either the bona fide residence test or the physical presence test

Exclusion Amounts and Limits

The foreign earned income exclusion amount is adjusted annually for inflation, starting with the 2006 tax year. For 2008, the maximum foreign earned income exclusion is up to $87,600 per qualifying person. If married and both individuals work abroad and both meet either the bona fide residence test or the physical presence test, each one can choose the foreign earned income exclusion. Together, they can exclude as much as $175,200 for the 2008 tax year.

In addition to the foreign earned income exclusion, qualifying individuals may also choose to exclude or deduct from their foreign earned income a foreign housing amount. Starting with the 2006 tax year, the amount of qualified housing expenses eligible for the housing exclusion and housing deduction is limited. The limitation on housing expenses is generally 30% of the maximum foreign earned income exclusion. For 2008, the housing amount limitation is $26,280 for the tax year. However, the limit will vary depending upon the location of the qualifying individual’s foreign tax home and the number of qualifying days in the tax year.

The foreign earned income exclusion is limited to the actual foreign earned income minus the foreign housing exclusion. Therefore, to exclude a foreign housing amount, the qualifying individual must first figure the foreign housing exclusion before determining the amount for the foreign earned income exclusion.

How to Claim the Exclusion

Since the foreign earned income exclusion is voluntary, qualifying individuals must choose to claim the exclusion. The foreign earned income exclusion and the foreign housing cost amount exclusion are claimed and figured using Form 2555 (pdf), which must be attached to Form 1040 (pdf). However, if only the foreign earned income exclusion is claimed, a shorter Form 2555-EZ (pdf) may be used instead.  Once the choice is made to exclude foreign earned income, that choice remains in effect for the year the election is made and all later years, unless revoked.

Other Rules

Not foreign earned income: Foreign earned income does not include the following amounts:

• Pay received as a military or civilian employee of the U.S. Government or any of its agencies
• Pay for services conducted in international waters (not a foreign country)
• Pay in specific combat zones, as designated by an Executive Order from the President, that is excludable from income
• Payments received after the end of the tax year following the year in which the services that earned the income were performed
• The value of meals and lodging that are excluded from income because it was furnished for the convenience of the employer
• Pension or annuity payments, including social security benefits

Self-employment income: A qualifying individual may claim the foreign earned income exclusion on foreign earned self-employment income.  The excluded amount will reduce the individual’s regular income tax, but will not reduce the individual’s self-employment tax.  Also, the foreign housing deduction – instead of a foreign housing exclusion – may be claimed.

Figuring the tax: Beginning with tax year 2006, a qualifying individual claiming the foreign earned income exclusion, the housing exclusion, or both, must figure the tax on the remaining non-excluded income using the tax rates that would have applied had the individual not claimed the exclusions.

Foreign tax credit or deduction: Once the foreign earned income exclusion is chosen, a foreign tax credit, or deduction for taxes, cannot be claimed on the income that can be excluded.  If a foreign tax credit or tax deduction is claimed for any of the foreign taxes on the excluded income, the foreign earned income exclusion may be considered revoked.

Earned income credit: Once the foreign earned income exclusion is claimed, the earned income credit cannot be claimed for that year.

Timing of election: Generally, a qualifying individual’s initial choice of the foreign earned income exclusion must be made with one of the following income tax returns:

• A return filed by the due date (including any extensions),
• A return amending a timely-filed return.  Amended returns generally must be filed by the later of 3 years after the filing date of the original return or 2 years after the tax is paid, or
• A return filed within 1 year from the original due date of the return (determined without regard to any extensions)

Revoking the exclusion: A qualifying individual can revoke an election to claim the foreign earned income exclusion for any year.  This is done by attaching a statement to the tax return revoking one or more previously made choices.  The statement must specify which choice(s) are being revoked, as the election to exclude foreign earned income and the election to exclude foreign housing amounts must be revoked separately.  If an election is revoked, and within 5 years the qualifying individual wishes to again choose the same exclusion, the individual must apply for approval by requesting a ruling from the IRS.

Source:  www.irs.gov

David Colvin is a CPA and CFP® based in Amsterdam, Netherlands since 1998. His niche focus is serving high-net-wealth individuals with cross-border tax and financial issues. He is also an advisor to Maxim Global Wealth Advisors, based in Amsterdam and Portland, Oregon.

Should you "revoke" the Foreign Earned Income Exclusion?

Based on the current US tax laws for expats, many taxpayers (mainly those in high tax countries) may be better off if they "revoke" one of the main benefits for expats, the Foreign Earned Income and Housing Exclusions.

Some background - the Foreign Earned Income and Housing Exclusions are not "optional".  If you don't want to claim the Foreign Earned Income and/or Housing Exclusions (after you have once claimed them on a prior tax return), you need to "revoke" them by attaching a statement to your tax return (see IRC Sec. 911(e)(2) for those of you who like to read the Internal Revenue Code).

Why the change now?  The Tax Increase Prevention and Reconciliation Act of 2005 (ironically) changed (by increasing) the way expats calculate the US tax on "non-excluded" income.  Prior to the 2006 tax year, expats would deduct the exclusions and then calculate the tax on the remaining income, so you got to use the lowest marginal tax rates.  As of 2006, you need to add back the exclusions before calculating tax, which means you generally "start" at a much higher marginal tax rate (the IRS calls this the "stacking rule"). 

Since Foreign Tax Credits are calculated based on average tax rates, but the income gets taxed at the higher "marginal" tax rates, you "lose out" when calculating you foreign tax credits  if you use the exclusion (and have sufficient foreign tax credits).

For example, a taxpayer in the Netherlands (without the 30% ruling) earning $200K might pay $75K in Dutch income tax.  If they use the exclusion, their US tax would be (roughly) based on $200K - $80K = $120K (less deductions and exemptions).  Let's say the "marginal" US tax rate is 30%, or $36K of tax before credits.  The tax after credits would be zero and the Foreign Tax Credit Carryover would be $9K ($75K Dutch tax paid less $30K allocated to excluded income less $36K used as a Foreign Tax Credit).

If the taxpayer did not claim the exclusion, the Dutch tax would remain the same, but the US tax would be based on $200K.  In this case the "average" tax rate might be (again very roughly) around 25%, or $50K (this is lower than the first example because you get to use the lower tax brackets to calculate the average rate).  After applying Foreign Tax Credits, the US tax would still be zero, but the Foreign Tax Credit Carryover would now be $25K ($75K less the $50K used as a Foreign Tax Credit).

Since "excess" tax credits carry over for 10 years, the taxpayer would be leaving $16K "on the table" by taking the exclusion (since the tax due in both cases is zero, but the carryover with the exclusion was $9K and without it was $25K).  In the event the taxpayer then moved back to the US (and continued to have foreign travel days), or to a no tax country such as Dubai, or a very low tax country such as many in Asia, they may have missed out on a huge benefit by unnecessarily using foreign tax credits. 

Sound complicated?  It is.  It turns out this decision is very complex for many taxpayers, not least because you need to know what you are doing for the next several years, because if you do choose to revoke the exclusion, you cannot claim it again until the sixth taxable year after the exclusion was revoked. 

Note:  If you have the "30% ruling" in the Netherlands, it probably doesn't make sense to revoke, but it doesn't hurt to do a quick analysis just in case (we currently do this analysis for all of our clients).

David Colvin is a CPA and CFP® based in Amsterdam, Netherlands since 1998. His niche focus is serving high-net-wealth individuals with cross-border tax and financial issues. He is also an advisor to Maxim Global Wealth Advisors, based in Amsterdam and Portland, Oregon.

Do you pay double tax if your income exceeds the Foreign Earned Income Exclusion?

I frequently get questions about what happens when your wages exceed the amount of the Foreign Earned Income Exclusion ($87,600 for 2008).  A common misconception is that you will then need to pay "double" tax - to the US and also to the Netherlands. 

This is incorrect.  The tax laws and tax treaties are specifically designed so that you only pay tax once on each item of income (either to the US or to the Netherlands).  If your wages exceed the exclusion amount, the remaining income is eligible for Foreign Tax Credits (to the extent that it was earned outside of the US).  What this means is that you are allowed to use the Dutch tax that you pay to offset the US tax on the same income.  As long as the Dutch taxes you paid are higher than the US taxes, you should not owe any additional US tax.

David Colvin is a CPA and CFP® based in Amsterdam, Netherlands since 1998. His niche focus is serving high-net-wealth individuals with cross-border tax and financial issues. He is also an advisor to Maxim Global Wealth Advisors, based in Amsterdam and Portland, Oregon.