U.S. citizens and resident aliens who live abroad are taxed on their worldwide income. But such taxpayers may qualify for the foreign earned income exclusion, which allows certain taxpayers to exclude up to $112,000 (in 2022) of their foreign earnings from income, as well as to exclude or deduct certain foreign housing costs. Note, however, that not all U.S. expats qualify to take advantage of the foreign earned income exclusion. In addition, business owners may be subject to other complications and taxpayers residing in countries that have tax treaties with the United States may have certain tax planning opportunities.
The Foreign Earned Income Exclusion: The Basic Requirements
To qualify for the foreign earned income exclusion, the taxpayer must have (i) foreign earned income, (ii) a tax home in a foreign country (the “tax home” test), and (iii) the taxpayer must be one of the following:
- A U.S. citizen who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year,
- A U.S. resident alien who is a citizen or national of a country with which the United States has an income tax treaty in effect and who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year, or
- A U.S. citizen or a U.S. resident alien who is physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months.
What is Foreign Earned Income?
For purposes of the foreign earned income exclusion, foreign earned income includes wages, salaries, professional fees, and other compensation received for personal services performed in a foreign country during the period that the taxpayer meets the tax home test and either the bona fide residence test or the physical presence test. It also includes noncash income (such as a home or car) for such items and allowances or reimbursements.
It does not, however, include amounts received from a corporation that represent a distribution of earnings and profits rather than reasonable compensation.
A qualifying individual may claim the foreign earned income exclusion on foreign earned self-employment income. The excluded amount reduces the applicable income tax but does not reduce the taxpayer’s self-employment tax. In addition, a self-employed individual may be eligible to claim the foreign housing deduction instead of a foreign housing exclusion.
What is Not Foreign Earned Income?
Foreign earned income does not include dividends, interest, capital gains, gambling winnings, alimony, social security benefits, pensions, or annuities. In addition, foreign earned income does not include the following amounts:
- Amounts paid by the U.S. Government or any of its agencies to an employee of the U.S. Government or any of its agencies;
- Pay for services conducted in international waters or airspace (not a foreign country);
- Payments received after the end of the tax year following the year in which the services that earned the income were performed;
- Pay otherwise excludible from income, such as the value of meals and lodging furnished for the convenience of an employer on their premises (and, in the case of lodging, as a condition of employment);
- Pension or annuity payments, including social security benefits;
- Pension and annuity income (including social security benefits and railroad retirement benefits treated as social security);
- Interest, ordinary dividends, capital gains, alimony, etc.;
- Amounts received after the end of the tax year following the tax year in which the taxpayer performed the services;
- Amounts included in gross income because of an employer’s contributions to a nonexempt employees’ trust or to a nonqualified annuity contract.
Distinguishing Between Earned and Unearned Income
Some types of income are not easily identified as earned or unearned income.
Income from a sole proprietorship or partnership
Income from a business in which capital investment is an important part of producing the income may be unearned income. With respect to a sole proprietor or partner whose personal services are also an important part of producing the income at issue, the portion of the income that represents the value of personal services is treated as earned income.
Capital a factor
If capital investment is an important part of producing income, the IRS maintains that no more than 30% of the taxpayer’s share of the net profits of the business can be treated as earned income.
If a taxpayer has no net profits, the portion of their gross profit that represents a reasonable allowance for personal services actually performed is considered earned income. Because such taxpayers do not have a net profit, the 30% limit does not apply.
Capital not a factor
If capital is not an income-producing factor and personal services produce the business income, the 30% rule does not apply. The entire amount of business income is treated as earned income.
Income from a corporation
The salary a taxpayer receives from a corporation is earned income only if it represents a reasonable allowance as compensation for work performed for the corporation. Any amount over what is considered a reasonable salary is unearned income.
Stock options
A taxpayer may have earned income if he or she disposed of stock that was received by exercising a stock option granted under an employee stock purchase plan.
If the taxpayer’s gain on the disposition of stock received from exercising an option is treated as capital gain, the gain is classified as unearned income.
However, if a taxpayer disposes of the stock less than 2 years after they were granted the option or less than 1 year after they received the stock, part of the gain on the disposition may be earned income. It is considered received in the year the taxpayer disposed of the stock and earned in the year the taxpayer performed the services for which they were granted the option. Any part of the earned income that is due to work performed outside the United States is foreign earned income.
Pensions and annuities
For purposes of the foreign earned income exclusion, the foreign housing exclusion, and the foreign housing deduction, amounts received as pensions or annuities are unearned income.
Royalties
Royalties from the leasing of oil and mineral lands and patents are generally a form of rent or dividends and are unearned income.
Rental income
Generally, rental income is unearned income. If a taxpayer performs personal services in connection with the production of rent, up to 30% of their net rental income can be considered earned income.
Use of employer’s property or facilities
If a taxpayer receives fringe benefits in the form of the right to use their employer’s property or facilities, the fair market value of that right is earned income. Fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being required to buy or sell, and both having reasonable knowledge of all the necessary facts.
The Bona Fide Residence Test
A taxpayer satisfies the bona fide residence test if they are a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year. Only a U.S. citizen or U.S. resident alien who is a citizen or national of a country with which the United States has an income tax treaty in effect can utilize the bona fide residence test to qualify for the exclusions and the deduction.
A taxpayer does not automatically acquire bona fide resident status merely by living in a foreign country or countries for a year. The length of the taxpayer’s stay and the nature of their job are only two of the factors considered in determining whether a taxpayer satisfies the bona fide residence test.
To meet the bona fide residence test, a taxpayer must have established a bona fide residence in a foreign country. A taxpayer’s bona fide residence is not necessarily equivalent to the taxpayer’s domicile. A domicile is a permanent home—the place to which a taxpayer intends to return.
Bona fide resident status is determined based on the facts and circumstances of each individual case, taking into account factors such as the taxpayer’s intention, the purpose of their trip, and the nature and length of their stay abroad. To meet the bona fide residence test, a taxpayer must be able to demonstrate that they have been a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year. The taxpayer must file a Form 2555.
If a taxpayer lives in a foreign country to work on a particular job for a specified period of time, the IRS mantis that the taxpayer ordinarily will not be regarded as a bona fide resident of that country even though they work there for one tax year or longer.
The IRS employs a specific rule where the taxpayer has made certain statements to foreign authorities. A taxpayer is not considered a bona fide resident of a foreign country if they make a statement to the authorities of that country that they are not a resident of that country, and the authorities (i) hold that the taxpayer is not subject to the country’s income tax laws as a resident, or (ii) has not made a final decision on the taxpayer’s status.
Special agreements and treaties. An income tax exemption provided in a treaty or other international agreement does not itself prevent a taxpayer from being a bona fide resident of a foreign country. Whether a treaty prevents a taxpayer from becoming a bona fide resident of a foreign country is determined under all provisions of the treaty, including specific provisions relating to residence or privileges and immunities.
Uninterrupted period including entire tax year. To meet the bona fide residence test, a taxpayer must reside in a foreign country or countries for an uninterrupted period that includes an entire tax year. An entire tax year is from January 1 through December 31 for taxpayers who file their income tax returns on a calendar year basis. During the period of bona fide residence in a foreign country, a taxpayer can leave the country for brief or temporary trips back to the United States or elsewhere for vacation or business. To maintain status as a bona fide resident of a foreign country, a taxpayer must have a clear intention of returning from such trips, without unreasonable delay, to the foreign residence or to a new bona fide residence in another foreign country.
Bona fide resident for part of a year. Once a taxpayer has established bona fide residence in a foreign country for an uninterrupted period that includes an entire tax year, the taxpayer is a bona fide resident of that country for the period starting with the date they actually began the residence and ending with the date they abandon the foreign residence. The period of bona fide residence can include an entire tax year plus parts of other tax years.
The Tax Home Test
To meet the tax home test, a taxpayer’s tax home must be in a foreign country, or countries, throughout the period of bona fide residence or physical presence. For this purpose, the applicable period of physical presence is the 330 full days during which the taxpayer was present in a foreign country, or countries—not the 12 consecutive months during which those days occurred.
If the taxpayer did not live 330 full days in a foreign country, or countries, during a 12-month period, the taxpayer is not entitled to claim the foreign earned income exclusion. The 330 qualifying days, however, do not have to be consecutive.
The IRS maintains that taxpayer’s tax home is their regular or principal place of business, employment, or post of duty, regardless of where the taxpayer maintains their family residence. If a taxpayer does not have a regular or principal place of business because of the nature of their trade or business, the taxpayer’s tax home is their regular place of abode.
The Physical Presence Test
To meet this test, a taxpayer must be a U.S. citizen or resident alien who is physically present in a foreign country, or countries, for at least 330 full days during any period of 12 months in a row.
To figure 330 full days, add all separate periods the taxpayer was present in a foreign country during the 12-month period. The 330 full days can be interrupted by periods when the taxpayer was traveling over international waters or are otherwise not in a foreign country.
A taxpayer can be physically present in a foreign country or countries for less than 330 full days and still meet the physical presence test if they are required to leave a country because of war or civil unrest.
International and Offshore Tax Compliance Attorneys
Need help with tax issues? Contact us as soon as possible to discuss your rights and the ways we can assist in your defense. We handle all types of cases, including complex international & offshore tax compliance. Schedule a consultation or call (214) 984-3000 to discuss your international tax concerns or questions.
