US citizens and green card holders are taxed on their worldwide income. Moreover, American expats living abroad are required to file US expat tax return and report their worldwide income whether they live in London or Honolulu. This fact comes as a surprise to many Americans living abroad because they file tax returns and pay income taxes in a foreign country.
Fortunately, there are several ways to avoid double taxation and to minimize US tax liability. Per Internal Revenue Code 911 American expats can utilize several exclusions as well as the foreign tax credit. Earlier we covered the rules to claim Foreign Housing Exclusion. Another exclusion is Foreign Earned Income Exclusion.
Foreign Earned Income Exclusion Basics
What is Foreign Earned Income Exclusion?
Foreign earned income exclusion is one of the tools to minimize expat tax liability. American expats living abroad can exclude from foreign earned income up to $97,600 in a tax year 2013. This amount is adjusted for inflation every year. The foreign income exclusion was $91,500 in 2010, $92,900 in 2011 and $95,600 in 2012.
What is Foreign Income Exclusion for Married Filing Jointly?
Each spouse can claim the same amount of foreign income exclusion even if they file Married Filing Jointly. However, each spouse must meet either the physical presence test or bona fide residence test to qualify for the exclusion.
What is Foreign Earned Income Exclusion and Self-Employment Tax?
Self-employed expats can claim the same amount of exclusion if they have foreign earned income and meet one of the tests: physical presence test or bona fide residence test.
Who can claim Foreign Earned Income Exclusion?
Many taxpayers assume that they can claim the foreign income exclusion because they live abroad. However, American expats must meet several tests to be eligible for this exclusion:
- Americans living abroad must have foreign earned income.
- Americans must have a tax home in a foreign country.
- US citizens must meet either a physical presence test or bona fide residence test.
What is Foreign Earned Income?
Foreign earned income is the income earned in a foreign country for the services performed. Salary is not the only type of foreign earned income. Moreover, various benefits are considered the foreign earned income too.
Foreign earned income includes the following:
- Salaries and Wages
- Professional fees
The following benefits are considered the foreign earned income too:
- Fair market value of lodging, meals and use of car provided by an employer
- Cost-of-living allowance
- Family allowance
- Overseas differential
- Reimbursement for education
- Home leave
- Reimbursement for moving
What is NOT Foreign Earned Income?
However, there are several types of income that are not considered the foreign earned income.
- Income earned as US Government employees
- Capital gains
- Social Security Benefits
- Gambling winnings
- Meals and lodging furnished for the convenience of the employer
- Employer’s contributions to a nonexempt employee trust or to a nonqualified annuity
Several types of income might be considered either earned or unearned.
Proper guidance of an expat tax CPA is required to review individual circumstances. These types of income include:
- Business profits from corporation, partnerships and proprietorships
- Stock options
- Some fringe benefits
- Scholarships and Fellowships
What is Tax Home in Foreign Country?
One of the requirements to claim the foreign income exclusion is to have a tax home in a foreign country during the period of bona fide residence or physical presence abroad. The foreign country territory is not only the land but also territorial waters as well as the seabed and subsoil of submarine areas. A foreign country must have an exclusive right to this land. Additionally, a foreign country is a country located outside of the United States and US possessions such as Puerto Rico, Guam, the Commonwealth of the Northern Mariana Islands, the U.S. Virgin Islands, or American Samoa. The international waters do not belong to any country so they do not count as a foreign territory.
Tax home is usually considered the place of employment, post of duty, or main place of business for self-employed American expats. American retirees in a foreign country usually do not work so they should consider as a tax home the place where they live.
Let’s review one example. US citizen moved to Madrid for work. His wife and children joined him in Madrid too. The children go to a local school and the wife is actively engaged in civic organizations in Madrid. In this case this American expat will be eligible to claim the foreign earned income exclusion because he has the foreign earned income, a tax home in a foreign country and he meets one of the tests: physical presence test or bona fide residence test.
What is Physical Presence Test?
To meet the physical presence test and to claim the foreign income exclusion, American expats must be physically present in a foreign country or countries for 330 full days during any period of 12 consecutive months.
Americans are not required to be present in a foreign country only for employment purposes. For example, an American expat can spend 1 month in Italy taking cooking classes. The number of days spent in Italy is included in 330-day requirement.
Also, it is not required that 330 days must be consecutive. For example, US expatriate moved to Dubai on January 1, 2013. He visited the USA from March 1 to March 8, 2013. Also, he was in New York on business from June 20 – July 1, 2013. This taxpayer meets the physical presence test because he spent 330 full days overseas.
What is Bona Fide Residence Test?
Bona fide residence test is quite confusing to many Americans moving abroad. In order to meet the bona fide residence test and to claim the foreign earned income exclusion, several requirements must be met:
First, Americans living abroad must be present in a foreign country for an uninterrupted period of one tax year. Second, a taxpayer must be a US citizen or green card holder of a foreign country that has an income tax treaty with the United States. Third, American expats must establish a tax home in a foreign country. Traveling from one country to another as a tourist does not qualify an American expat as a bona fide resident. Finally, American expats cannot make a statement to foreign authorities that they are not residents of that country.
Is it a requirement to file US expat tax return to claim the exclusion?
Foreign income exclusion is not granted automatically by the IRS. A taxpayer must file a US expat tax return to claim the foreign earned income exclusion.
Foreign earned income exclusion is one of the ways to minimize US expat taxes. American expats can claim foreign housing exclusion or deduction too if they qualify for the foreign income exclusion. Americans living abroad must seek help of international tax experts. Expat tax CPAs at Expattaxservices.com are pleased to assist with US expatriate tax preparation and various overseas tax issues.