U.S. citizens and resident aliens are taxed on their worldwide income. This can lead to double taxation when a U.S. citizen or resident alien works abroad and incurs foreign income taxes. The foreign tax credit can reduce U.S. tax so that the double tax impact is lessened. Another available tax provision that lessens the double tax bite is the foreign earned income exclusion.
IRC Sec. 911 provides U.S. citizens and resident aliens who work or have a business abroad to exclude a significant portion of their foreign earned income. For 2015, such individuals can exclude up to $100,800 of foreign earned income from their U.S. taxable income. Of course, they must still pay foreign income tax on this income, but the double taxation detriment has been greatly reduced.
Who Qualifies for the Foreign Earned Income Exclusion
To be eligible for the exclusion, an individual’s tax home must be in a foreign country. Generally, a tax home is the general area of the taxpayer’s main place of business or employment, regardless of where the family home is maintained.
There are two ways to establish a tax home in a foreign country:
- the bona fide residence test
- the physical presence test
The Bona Fide Residence Test
This test is based on the taxpayer’s intent in residing in a foreign country. The test is subjective and requires a taxpayer to satisfy the IRS that he/she has been a bona fide resident of a foreign country for an uninterrupted period of time that includes an entire year.
Factors the IRS will consider in determining the taxpayer’s intent to reside in the foreign country are:
- whether the taxpayer bought a home or entered into a long term lease in the foreign country
- the nature, extent, and reasons for temporary absences from the foreign home
- whether, and for how long, the taxpayer’s family has lived in the same foreign country
- whether the taxpayer has made a serious effort to become involved in the social life and culture of the foreign country
- whether the taxpayer maintains a home in the U.S., whether that home is rented out to others, and the taxpayer’s relationship to the renters
- whether the taxpayer has gone abroad with the intent to evade U.S. taxes
The Physical Presence Test
This test requires a taxpayer to be physically present in a foreign country for 330 full days during any 12 consecutive months. Unlike the bona fide residence test, the physical presence test is completely objective, requiring only the counting of qualifying days.
How the Exclusion is Calculated
The foreign earned income exclusion is computed on a daily basis. The total number of qualifying days under the bona fide residence test or the physical presence test are divided by the total number of days during the year.
This exclusion is limited to the amount of earned income in foreign countries. This requires taxpayers to allocate their work days or earned income between foreign qualifying work days and other work days (e.g., U.S. work days).
Example: Grover, a U.S. citizen, is a bona fide resident of Freedonia from May 1, 2013 through November 30, 2015 and has a salaried position in Freedonia during this period. Before and after this period, Grover has U.S. salary income.
Grover earns $90,000 in 2013 and $110,000 in 2014. These amounts are earned equally throughout the year.
The maximum foreign earned income exclusion in 2013 was $97,600 and was $99,200 in 2014.
For 2013, Grover’s maximum foreign earned income exclusion is $65,512 ($97,600 maximum foreign income exclusion times 245 days in Freedonia divided by 365 days in the year). For 2014, Grover’s maximum foreign earned income exclusion is $99,200 ($99,200 maximum foreign income exclusion times 365 days in Freedonia divided by 365 days in the year).
Grover’s actual foreign earned income exclusion is limited by his actual foreign earned income, which must be apportioned between foreign earned income and other income (e.g., U.S. income).
Assume there are 240 work days during the year. In 2013, Grover worked 161 work days in Freedonia and in 2014, Grover worked all 240 work days in Freedonia.
For 2013, Grover’s foreign earned income exclusion is the lesser of $65,512 or $65,473 ($97,600 salary times 161 work days in Freedonia divided by 240 work days during the year).
For 2014, Grover’s foreign earned income exclusion is the lesser of $99,200 or $110,000 ($110,000 salary times 240 work days in Freedonia divided by 240 work days during the year).
If Grover’s salary was not earned equally throughout the year, it would be more appropriate to apportion his salary based on where it was earned rather than on the number of days worked in each country.
A related income exclusion is for employer paid housing costs for a taxpayer in a foreign country. This is a topic for a future post.
To see how this applies to you, give us a call at 248-538-5331.
Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.