Ordinarily, the United States taxes U.S. citizens and resident aliens on their worldwide income, even when they live and work abroad for an extended period of time. To provide some relief, a U.S. citizen or resident who meets certain requirements can elect to exclude from U.S. taxation a limited amount of foreign earned income plus a housing cost amount. A double tax benefit is not allowed, however, and a taxpayer cannot claim a credit for foreign income taxes related to excluded income.
1. Exclusion versus Credit
Because the foreign earned income exclusion is elective, an expatriate must decide whether to elect the exclusion or to rely on the foreign tax credit. A key factor in deciding which option is most advantageous is the relative amounts of U.S. and foreign taxes imposed on the foreign earned income before the exclusion or credit. The exclusion completely eliminates the U.S. income tax on the qualifying amount of foreign earned income.
This allows expatriates who work in a low-tax foreign jurisdiction or who qualify for special tax exemptions in the countries in which they work, to benefit from the lower foreign tax rates. In contrast, under the foreign tax credit option, the United States collects any residual U.S. tax on lightly taxed foreign income and the expatriate derives no benefit from the lower foreign rates.
The exclusion also eliminates the U.S. tax on the qualifying amount of foreign earned income derived by an expatriate working in a high-tax foreign jurisdiction. The credit option also achieves this result, since the higher foreign taxes are sufficient to fully offset the U.S. tax on foreign earned income.
In addition, under the credit option, the expatriate receives a potential added benefit in the form of a foreign tax credit carryover. Foreign taxes in excess of the foreign tax credit limitation can be carried back one year and forward up to ten years. Therefore, an expatriate can use these excess credits in a carryover year in which he or she has foreign-source income that attracts little or no foreign tax.
2. Qualified Individuals
The foreign earned income exclusion is available only to U.S. citizens or resident aliens who meet the following requirements:
(a) the individual is physically present in a foreign country for at least 330 full days during a 12-month period or, in the case of a U.S. citizen, is a bona fide resident of a foreign country for an uninterrupted period that includes an entire taxable year, AND
(b) the individual’s tax home is in a foreign country.
Whether a person is a bona fide foreign resident is determined by his intentions with regard to the length and nature of the stay. Factors which suggest that an expatriate is a bona fide resident include: (i) the presence of family, (ii) the acquisition of a foreign home or long-term lease, and (iii) involvement in the social life of the foreign country.
3. Computing the Exclusion
The exclusion is available only for foreign-source income that was earned during the period in which the taxpayer satisfies:
(1) the foreign tax home requirement, and
(2) either (a) the bona fide foreign resident or (b) the 330-day physical presence test.
Therefore, when identifying compensation that qualifies for the exclusion, the determinative factor is whether a paycheck or taxable reimbursement is attributable to services performed during the qualifying period, not whether the expatriate actually received the compensation during that period. A deferred payment, such as a bonus, qualifies for the exclusion only if it is received before the close of the taxable year following the year in which it was earned. Pension income does not qualify for the exclusion.
Employment-related allowances, such as foreign housing and automobile allowances, also qualify for the exclusion. However, the allowance must represent compensation for services performed during the qualifying period. In this regard, any taxable reimbursement received for expenses incurred in moving from the United States to a foreign country are treated as compensation for services performed abroad. On the other hand, any taxable reimbursements received for expenses incurred in moving back to the United States are treated as U.S.-source income.
Any deductions allocable to excluded foreign earned income, such as reimbursed employee business expenses, are disallowed. Certain deductions are considered unrelated to any specific item of gross income and are always deducted in full. These include medical expenses, charitable contributions, alimony payments, IRS contributions, real estate taxes, mortgage interest on a personal residence, and personal exemptions.
4. Housing Cost Allowance
An expatriate that qualifies for the foreign earned income exclusion can also claim an exclusion for the housing cost amount. The housing cost amount equals the excess of eligible expenses incurred for the expatriate’s foreign housing over a stipulated base amount, which is prorated for the number of qualifying days in the year.
Eligible housing expenses normally include rent, utilities (other than telephone charges), real and personal property insurance, certain occupancy taxes, nonrefundable security deposits, rental of furniture and accessories, household repairs, and residential parking. Housing expenses do not include the costs of purchasing or making improvement to a house, mortgage interest and real estate taxes related to a house that the taxpayer owns, purchased furniture, pay television subscriptions, or domestic help.
5. Electing the Exclusion
The election to claim the foreign earned income exclusion and housing cost amount is made by filing Form 2555, Foreign Earned Income Exclusion, and remains in effect until revoked by the taxpayer. If uncertainties exist regarding whether to elect the exclusion, a taxpayer can file an original return without making the election, and then file an amended return at a later date electing the exclusion.
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