Foreign Earned Income Exclusion

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Citizens of the United States are taxed on their worldwide income regardless of their residence or the source of the income. Accordingly, a U.S. citizen who lives and works abroad is subject to U.S. income tax on their worldwide income. However, certain provisions exist that allow for the exclusion from income for specified items. These items are:

  • A Foreign earned income exclusion of a fixed statutorily defined amount
  • A housing exclusion for housing expenses in excess of a statutorily calculated amount


Contents

Foreign Earned Income Exclusion - Overview

The foreign earned income exclusion allows a taxpayer to claim an exclusion from gross income of up to $80,000 for 2005. The exclusion is only allowed if you meet the following conditions:

Your tax home is in a foreign country AND

You have foreign earned income AND

You are a U.S. citizen or U.S. resident alien and pass the Physical Presence Test OR you are a U.S. citizen or a citizen or national of a country with whom the U.S. has a tax treaty in effect and pass the Bona Fide Resident Test.


Foreign Housing Exclusion and Deduction - Overview

In addition to the foreign income exclusion a taxpayer may also claim a housing exclusion or deduction. The exclusion or deduction is allowed if:

  • Your tax home is in a foreign country

AND

  • You qualify for the foreign earned income exclusion under the Bona Fide Residence or Physical Presence tests

An exclusion is given for amounts considered paid from employer-provided monies and a deduction is granted for amounts paid for with self-employed earnings.


Foreign Earned Income Exclusion - Details

In order to qualify for the exclusion, the taxpayer must meet 3 criteria. Here, we will examine in more detail the elements of those 3 criteria. The first criteria is that the taxpayer’s tax home be located in a foreign country. Generally speaking, your tax home is where your main place of business, employment or post of duty regardless of where you maintain your family home. Additionally, the location of an individual’s tax home is dependent on the nature of their foreign assignment. Temporary assignments generally do create a new main place of business unless the facts and circumstances surrounding the assignment indicate otherwise. Conversely, an assignment of indefinite period generally creates a new main place of business and thus a new tax home location.

Once the location of an individual’s tax home has been established, one must be sure to check the location of that person’s abode as a taxpayer can not have a foreign tax home when their abode is in the United States. A person’s abode has been variously defined as one’s home, habitation, residence, domicile or place of dwelling. It does NOT mean your principal place of business. Your abode is most often where you maintain your economic, family and personal ties.

The second criteria that must be met to claim the foreign earned income exclusion is to have foreign earned income. Foreign earned income is generally income you earn for services performed. This includes wages, salaries, commissions, bonuses, professional fees as well as the fair market value of non-cash income such as lodging and use of a car. Additionally, allowances and reimbursements such as cost of living allowances, overseas differentials and other similar reimbursements are considered earned income.

In addition to being earned income, the income must be considered foreign source. The source of earned income is generally the place where you perform the services for which you are receiving the income. Thus, income received for work done in the United States is not considered foreign source. For income received for work not specifically done in the United States, the amount of U.S. source income is usually allocated on a time basis via a ratio of days worked within the United States to the total number of days worked.

Lastly, the taxpayer must qualify under either the Bona Fide Residence Test or the Physical Presence test.

Under the Bona Fide Residence Test, the taxpayer must be a bona fide resident of a foreign country for an uninterrupted period that includes an entire tax year. The determination of bona fide residence is based on the facts and circumstances of each taxpayer. Several factors are taken into consideration such as your intention, the purpose of the trip, and the nature of trip. Other factors may also be considered based on the unique circumstances of that situation.

Once a taxpayer has established bona fide residence for an entire uninterrupted tax year, the bona fide residence period is extended back to the date on which you first established your residence and extends forward until the date you end your foreign residence.

Alternatively, the taxpayer may qualify under the Physical Presence Test. The test is met if a taxpayer is physically present in a foreign country (or countries) for 330 full days in any 12 consecutive month period. The days of foreign presence are not required to be consecutive. The test is based only on the length of your trip(s) and not the taxpayer’s intent or purpose for the trip. An exception does exist that allows a taxpayer to meet this test if they were required to leave a country because of war or civil unrest.


Foreign Housing Exclusion and Deduction – Details

In addition to the foreign earned income exclusion, an exclusion or deduction is available for amounts spent on foreign housing costs. The foreign housing exclusion/deduction is available if a taxpayer’s tax home is in a foreign country and they qualify for the foreign earned income exclusion under the Bona Fide Residence or Physical Presence Tests.

Whether a taxpayer takes the housing exclusion or housing deduction depends on if amounts are considered to be received from an employer or from self-employment earnings. For a taxpayer who is employed, the foreign housing amounts paid are considered paid from employer amounts and they are eligible for the housing exclusion. Conversely, for self-employed individuals, foreign housing amounts are considered paid from self-employment income and they qualify for the housing deduction. For persons who have both types of income, a pro-ration calculation is used to calculate the respective amounts.

The calculation of the exclusion or deduction begins with your total housing expenses less a base amount. The base amount is a statutorily defined as 16% of the annual salary of a GS14, step 1, U.S. Government employee figured on a daily basis multiplied by the number of days in the year that you meet either of the two income exclusion qualifying tests.

Total housing expenses are reasonable amounts spent on the following:

  • Rent (also the fair market value of housing provided in kind by an employer)
  • Repairs
  • Utilities
  • Insurance

Housing expenses do NOT include:

  • Lavish or extravagant expenses (under the circumstances)
  • Deductible interest and/or taxes
  • Purchase cost of property
  • Domestic labor


Once total housing expenses and the “base amount” are computed, the actual deduction or exclusion is calculated via Form 2555 (or Form 2555-EZ). There are limits to the exclusion and the deduction. The exclusion is the lesser of a) the portion of housing expenses paid for with employer-provided amounts or b) the taxpayer’s foreign earned income. The limit on the deduction ensures the deduction can not be more than the taxpayer’s foreign earned income less the sum of a) the taxpayer’s foreign earned income exclusion and b) the taxpayer’s housing exclusion. Any excess deduction beyond the limit is allowed to be carried over to the following year. Should that carryover not be allowed in the subsequent year, it expires.


Reporting

The foreign earned income exclusion is reported on Form 2555 or 2555-EZ. A form must be filed each year the exclusion is elected. If the taxpayer will be claiming either the housing exclusion or deduction, Form 2555-EZ is prohibited.

The forms have 4 main areas, each of which details a different area of information. These areas are: 1) General taxpayer information, 2) Which test the taxpayer is using to qualify for the exclusion, 3) the calculation of foreign earned income and allowable exclusion and 4) the calculation of the housing exclusion and/or deduction.

Form 2555 and 2555-EZ must be attached to Form 1040 and may not be filed by separately.


Other Administrative Requirements

Normally, calendar year taxpayers file their income tax returns by April 15 of the following year. An automatic extension is granted to those taxpayers who have a tax home is outside the United States on April 15th. This extension is not granted to those who are merely traveling outside the U.S. on that date. No form is required to be filed but a statement should be attached to the return when filed indicating that the taxpayer was residing outside the United States on April 15.

For those taxpayers not residing outside the U.S. on April 15, Forms 4868 and 2688 are available and the same filing conditions exist for those forms as if the taxpayer were not filing Form 2555.

For those taxpayers who need even more time in order to claim the benefits of Form 2555, an extension request specifically for that situation exists. Form 2350 provides a mechanism for the taxpayer to request an extension of time until 30 days after the date on which the potential qualifying period ends.

Taxpayers electing the foreign earned income exclusion do not file their returns using the normal filing Service Center assignments. Instead, they file with the IRS Center, Philadelphia, PA 19255.

Source: IRS Publication 54

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