The article was first published in Global Tax Weekly, issue 156. Below is the full text of the second article in the series on US taxes for US persons living outside the US.
US Tax Compliance And Planning For US Executives, Entrepreneurs And Investors Living Outside The US – The Foreign Earned Income Exclusion
by Stephen Flott and Flott & Co.
This is the second article in a series of articles on key US tax compliance and planning issues that should be considered by US executives, entrepreneurs and investors living outside the United States. This second article provides an overview of the Foreign Earned Income Exclusion and Foreign Housing Exclusion.
US Persons1 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 USD100,8002 of foreign source earned income. There are several explanations for why US Persons living abroad are allowed this apparent windfall or tax break, some of which include:
- Encouraging American businesses abroad;
- The cost of living overseas is higher for American style amenities;
- US foreign tax credits do not allow offsets for foreign taxes when foreign governments rely on indirect taxes;
- US Persons living abroad do not derive the full benefit of public services financed through federal income taxation in the United States; and
- Tax incentives encourage US Persons to suffer the discomforts of living and working in less developed countries or ar
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.
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
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 United States.
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 12 consecutive month period that were included in the tax year where the FEIE is claimed. For example, where the 12 consecutive month period started October 16, 2014 and ended October 15, 2015, the FEIE amount of USD99,200 in 2014 will be prorated for the portion of the period that falls in tax year 2014 (October 16, 2014 – December 31, 2014).
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 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 United States, a US Person working for a foreign corporation is not subject to payroll tax on his or her earned income. In contrast, a US Person who is considered self-employed in a foreign country is subject to US self-employment taxes. The United States 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 he or she will have little to no foreign tax credits to offset US tax on his or her 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 his or her income, or to the US.
1The term “US Person” as used in these articles includes only US citizens. It should be noted that legal permanent residents (LPRs) and non-citizens who spend more than 182 days in the US during a tax year are US Persons for tax purposes. LPRs cease to be US Persons when they abandon their status. Non-citizens cease to be US Persons as soon as they spend fewer than 183 days in the US during a tax year. The calculation of days present in the US for purposes of determining the substantial presence test includes 1/6 of the days spent in the two years prior to the current tax year, 1/3 of the days spent in the year prior to the current tax year, and all of the days spent in the US during the current tax year. Effectively, non-citizens should not spend more than 122 days a year in the US during any three consecutive year period to avoid being a US Person for US tax purposes.
2USD100,800 is the Foreign Earned Income Exclusion for tax year 2015. The Foreign Earned Income Exclusion is annually indexed for inﬂation.