international tax

How to Exclude Foreign Earned Income from U.S. Tax

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foreign earned income exclusionU.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.

Background

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.

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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.

Tax Changes in the New Trade Laws

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currencies-69522_1280On June 29, the President signed into law two major trade bills:  the Trade Preference Extension Act of 2015 and the Trade Priorities and Accountability Act of 2015.  These two trade laws made a handful of tax law changes, including the following:

$1,000 Child Tax Credit Limited for Certain Taxpayers with Foreign Earned Income

U.S. citizens and residents are taxed on their worldwide income.  Under existing law, taxpayers who meet certain residency or physical presence requirements within a foreign country and who have foreign earned income (wages, self-employment income) can exclude up to $100,800 of this income from U.S. taxation.  This provision is known as the foreign earned income exclusion.

Taxpayers can claim a $1,000 child tax credit for dependent children under age 17.  The child tax credit is refundable.  Under the new trade law, beginning in 2015, any taxpayer who takes advantage of the foreign earned income exclusion for a tax year cannot claim the refundable portion of the child tax credit.

Greater Exemptions from 10% Penalty on Qualified Plan Early Distributions

Qualified plan participants who separate from service after reaching age 55 can avoid the 10% penalty on early distributions.  The age requirement is lower for certain government pension plans for state or local police, firefighters or emergency personnel.  For these workers, the separation of service must occur after reaching age 50.

The trade law expands the category of eligible governmental workers who can qualify for the exemption from the 10% penalty after reaching age 50.  The expanded workers include federal law enforcement officers, customs and border protection officers, federal fire fighters, and air traffic controllers.  Additionally, the new trade law expands the types of plans from which distributions eligible for the exemption can be made.

Penalty Increases for Errors on Form 1099

The current tax law imposes a penalty on taxpayers who do not file correct informational returns (such as Form 1099) with the IRS.  There is a separate penalty on taxpayers who do not provide the payee with a correct copy of the informational return.

Under the new trade law, these penalties are increased.  For example, for an unintentional delinquency that is corrected within 30 days of the due date, the penalty is increased from $30 to $50 and the maximum penalty for any year for “small” taxpayers is increased from $75,000 to $175,000.

Health Coverage Tax Credit

 The Health Coverage Tax Credit is a federally funded tax credit that allows individuals to pay only a portion of their qualified health insurance.  This program was created in 2002 to help workers who were trade-affected.  The federal government pays a significant portion of these workers’ qualified health insurance.  This program expired at the end of 2013.

Under the new trade law, this program is retroactively reinstated for 2014 and is extended through 2019.

If you have questions on how this relief applies to you, give us a call at 248-538-5331.

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Foreign Accounts Must be Reported to IRS by June 30

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The IRS is cracking down on people who hide assets offshore in an attempt to evade paying taxes.  The IRS requires people with interests in fbarforeign financial accounts to report information on these accounts annually through what is known as an FBAR filing (FBAR refers to Reporting of Foreign Bank and Financial Accounts).  This form must be filed even if the income from the foreign accounts is already being reported on the income tax return.  There are substantial penalties for not filing the FBAR.

 Who is Required to File the FBAR?

 The requirement to file the FBAR is triggered when:

  • a United States person
  • has a financial interest in or signature authority over an account
  • that account is a foreign financial account
  • and the combined value of the account(s) exceed $10,000 at any time during the year

 What is a U.S. Person

 A United States person is a U.S. citizen (regardless of where they live), a U.S. resident (generally a Green Card holder or someone who has a substantial presence in the U.S.), and U.S. entities.  U.S. entities include any entity created or organized in the U.S. or under U.S. law such as a corporation, an LLC, or a trust.

 What is a Financial Interest?

 A person has a financial interest in an account when that person is the record owner or holds title directly to the account.  A person also has a filing requirement when someone else holds title for the benefit of that person.  There is also a filing requirement when a person owns an account indirectly, such as through a corporation.  Generally, the person would have to own more than 50% of the entity to be subject to the filing requirement.

 What is a Foreign Account?

 A foreign account means the physical location of the account is outside of the U.S.  The following locations are considered in the United States:

  • the states
  • the District of Columbia
  • U.S. territories and possessions
  • Indian lands

 Combining Accounts to Reach the $10,000 Filing Threshold

Financial assets include monetary and non-monetary accounts.  For example, gold bullion stored overseas would have to be valued and reported on the FBAR.  People are more familiar with monetary accounts such as bank, brokerage, investment accounts, insurance and annuity policy cash values, and mutual funds.  Real and personal property is usually not required to be reported.

To determine if the combined value exceeds $10,000, you must determine the highest value of each account during the year and combine these amounts.  If the sum exceeds $10,000, then an FBAR must be filed.  Accounts that you have a financial interest in are combined with accounts that you have signature authority over.  Accounts held directly are combined with accounts that are held indirectly (such as through a corporation).

 When Must the Form be Filed?

The form is due June 30 of each year.  The form must now be filed electronically.

 Penalties for Not Filing the FBAR:

 A person who is required to file an FBAR and fails to properly file may be subject to a civil penalty not to exceed $10,000 per violation.  If there is reasonable cause for the failure and the balance in the account is properly reported, no penalty will be imposed. A person who willfully fails to report an account or account identifying information may be subject to a civil monetary penalty equal to the greater of $100,000 or 50 percent of the balance in the account at the time of the violation. Willful violations may also be subject to criminal penalties

If you have any questions on how this applies to you, please feel free to give us a call.

 

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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.

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