The US taxes its citizens and residents based on their worldwide income. A US citizen living abroad can elect to exclude a certain amount of foreign earned income on his or her US income tax return, if certain requirements are met. For 2013, the maximum foreign earned income exclusion (“FEIE”) amount is $97,600 per taxpayer (amount indexed for inflation each year). The FEIE is available only to exclude income from wages or self-employment income earned for services performed outside the US. The FEIE is claimed on IRS Form 2555.
In order to claim the FEIE, the individual’s tax home must be in a foreign country and qualify under one of the following requirements:
A US citizen who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year;
A US citizen who is physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months.
The amount of foreign earned income excluded from an individual’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. An individual’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 individual’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 taxpayer chooses to exclude foreign earned income, he or she cannot receive a foreign tax credit or deduction for taxes on income that was excluded under the FEIE. It will be important for an individual 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 taxpayer makes the choice to elect the FEIE for a given year, the election remains in effect for that year and all future years, unless revoked. Once an election is revoked, the individual cannot again elect the FEIE for a five year period without the approval of the IRS.
Even if an individual’s entire earned income is excluded by the FEIE, it still may be more beneficial for the individual to forego the FEIE and use the foreign tax credit. This will generally be the case if the foreign tax credit would eliminate all US income taxes attributable to the foreign earned income.
There are certain refundable US tax credits that the individual will not be entitled to if the FEIE is elected, but can receive if he or she instead uses the foreign tax credit to eliminate the US income tax associated with the foreign earned income. In a surprising result, an individual could claim the foreign tax credit, eliminating US income tax on all foreign earned income in a given year, while being entitled to claim certain refundable tax credits allowing the individual a refund from the US government for the tax year. In other words, under the right circumstances, instead of paying US income taxes, the individual is being paid by the US government to file his or her US income tax return for that year.