The following is the second installment in a two-part series by regular Taxing Subjects contributor Ben Tallman. While Part I looked at Foreign Bank Account Reporting (FBAR) and FATCA in detail, Part II examines the foreign earned income exclusion and how tax preparers can determine the residence requirement for their clients.
Foreign Earned Income Exclusion
The foreign earned income exclusion does not guarantee that all income earned abroad is tax exempt, and living in a foreign country is not always sufficient grounds for excluding that income from US taxes.
The maximum foreign earned income exclusion for 2016 is $101,300. I.R.C. § 911 includes three criteria for claiming the exclusion:
- Earning income in a foreign country
- Satisfying a residence requirement
- Making a timely election
Foreign Earned Income
Foreign earned income includes wages, salaries, commissions, professional fees, bonuses, and tips, as well as taxable fringe benefits and housing allowances provided by the employer, plus self-employment income from personal services performed in a foreign country.
Fringe benefits are included in income or excluded from income under the same rules that apply to employees working within the United States. Only the taxable benefits are included in compensation.
Earned and Unearned Income
Income from a sole proprietorship or partnership is sometimes partly earned income and partly unearned income for this purpose. If a capital investment and personal services are both important in producing the income, no more than 30% of the net profit can be counted as earned income for the foreign exclusion. Most rents, royalties, scholarships, and fellowships are not earned income. However, operating a rooming house may be a business generating earned income if substantial personal services are provided. Royalties received by a writer are generally earned income, and grants received for teaching or research services are earned income.
Investment income and retirement income are not earned income, so pensions, annuities, social security benefits, alimony, dividends, interest, capital gains, and gambling winnings are not eligible for the exclusion.
Earned in Foreign Country
The income must be compensation for services performed in a foreign country or territory that is under the sovereignty of a government other than the US government. This includes income earned in a foreign country’s airspace and territorial waters, but it excludes income earned in Antarctica (no sovereignty), sanctioned countries, international waters, or international airspace. Generally, the location of the payer is not a factor, but wages earned as an employee of the US government or its agencies are not eligible for the exclusion. Independent contractors who meet the I.R.C. § 911 criteria can exclude income from the US government for services performed in a foreign country. What’s the difference? Contract payments are not the same as wages.
One of two residence tests, bona fide foreign residence or physical presence, must be met before a taxpayer can claim the foreign earned income exclusion. In either case, the taxpayer must have established a tax home outside the United States. An individual’s tax home is the general area of his or her main place of business, employment, or post of duty, regardless of where the family home is located. The tax home is the place where the individual is permanently or indefinitely engaged to work as an employee or as a self employed person.
Bona Fide Foreign Residence
The bona fide foreign residence test generally requires an extended, indefinite stay in a foreign country. It also specifically requires the taxpayer to be a resident of a foreign country or countries for at least 1 complete tax year (the calendar year for most taxpayers). Residing overseas for more than 12 months, but less than a complete tax year does not qualify as bona fide residency. But if the taxpayer establishes bona fide residency for a full tax year, the test can also be met for partial periods of foreign residency of the two adjacent tax years.
Establishing bona fide foreign residency requires more than just a physical presence. Indications of residency include buying or renting a dwelling unit (rather than staying in a hotel), participating in community affairs, and moving family members to the foreign country. Trips back to the United States for vacation or business purposes do not prevent filing as bona fide.
The taxpayer’s actions can defeat the test. If an individual declares to the foreign country that he or she is not a resident of that country, and the foreign authority holds that the person is not a resident of that country for income tax purposes, the bona fide foreign residence test cannot be met. You cannot “double-dip”! You must be subject to foreign tax, whether or not it is collected.
Example 1: Bona Fide Foreign Residence
Sally arrived in Germany on March 18, 2014, for a 27-month assignment, and she returned to the United States permanently on June 14, 2016. Because she resided in Germany for all of 2015, she could qualify as a bona fide resident for the entire period she is in Germany from 2014 to 2016. If Sally had arrived February 8, 2015, and returned home November 28, 2016, she could not claim to be a bona fide resident of Germany even though she lived there for 21 months. However, she could still qualify for the foreign earned income exclusion using the physical presence test, explained next.
Physical Presence Test
The physical presence test requires that the taxpayer be present in a foreign country or countries for at least 330 full days during 12 consecutive months. The 12-month period can begin and end in different tax years, and the 330 days do not have to be consecutive. This permits the taxpayer to return to the United States for no more than 35 days (including travel days) during the 12-month period. A full day is the period of time from midnight to midnight. If the taxpayer arrives in the foreign country at any time in the 24-hour period between midnights, the 330-day count does not begin until the next day.
Days in a foreign country can count for this test whether the individual is on vacation or present for business reasons. Days that the person is employed by the US government can also be counted. Travel in international airspace or international waters can cause days to be excluded from the 330-day count but only if the travel time outside foreign countries (such as in international waters) is at least 24 hours.
Example 2: Travel Time in Excess of 24 Hours
Randy arrived for a 15-month assignment in India on February 1, 2016, leaving his family in Michigan. He began counting his days of physical presence on February 2, the day after his arrival.
While in India, he flew to Hong Kong for a meeting. Because the flight was less than 24 hours, the time flying over international waters did not cause him to lose a day of physical presence.
Randy won a sales award of a 2-week cruise to Bora Bora beginning March 10 and ending March 25, 2016. The ship stopped at ports four times, spending 2 nights in each place. Each day that Randy was not in a foreign country from midnight to midnight must be withdrawn from the days used for the physical presence test. This includes days spent wholly or partially in international waters. Thus, Randy cannot count the day the ship sailed from India, the 8 days it arrived at and left each port, the day it spent wholly in international waters, or the day it arrived back in India. Counting the one full 24-hour period in each port as a day present in a foreign country means that the 15-day cruise cost him 11 days of physical presence in a foreign country.
If the taxpayer is not living and working in a foreign country for the entire tax year, the $101,300 maximum exclusion is prorated based on the number of days in the tax year that the taxpayer met one of the residence tests. The taxpayer can select a 12-month period for the 330-day physical presence test, and it may be advantageous to test several periods to find the one with the most days that can be counted. The 12-month periods can overlap for different tax years. The exclusion is an election made on Form 2555, Foreign Earned Income, which is filed with the taxpayer’s Form 1040. A simplified version, Form 2555-EZ, Foreign Earned Income Exclusion, can be used if the only foreign income is wages that do not exceed the maximum foreign earned income exclusion; it cannot be used if there is self-employment income, a moving or business expense deduction, or a foreign housing allowance or exclusion.
Example 3: Selection of 12-Month Period
Lily Morris left the United States on June 30, 2015, and worked in Japan for 16½ months, until November 16, 2016. She did not return to the United States during that time. The maximum exclusion for 2015 was $100,800. She could not file a return claiming the exclusion until she spent 330 days in Japan, so she chose to begin her 12-month period for the 2015 tax year on May 29, 2015 and end it on May 28, 2016 (the 330th day after her July 1, 2015, arrival).
Although she spent only 183 days during 2015 in Japan, her maximum exclusion is based on the number of days in her 12-month period that coincide with her tax year. This allows her to prorate the maximum exclusion based on 217 days (May 29–December 31), so her maximum exclusion is $59,928 ($100,800 x 217 ÷ 365). If Lily chose a 12-month period beginning on the first day she is counted as present in Japan (July 2, 2013–July 1, 2016), her maximum exclusion for 2015 would be $50,538 ($100,800 × 183 ÷ 365). (Her days present in Japan in 2015 are counted beginning with July 2, 2015, the day after she arrived.)
For 2016, Lily should choose a 12-month period that begins November 27, 2015, and ends November 26, 2016 (35 days before December 31). This allows her to count 330 days in 2016 (January 1–November 26), so that her maximum exclusion is $91,586 ($101,300 x 330 ÷ 365), even though her actual presence in Japan during 2016 included only 319 days.
If the individual’s tax home is in a foreign country for the entire tax year, days spent in transit or in the United States do not reduce the maximum exclusion as long as the bona fide residence test or the physical presence test is met. Thus, up to 35 days can be spent outside foreign countries without losing any of the tax benefit if the physical presence test is used. There is no similar restriction on the number of days if the bona fide residence test is met.
An individual whose tax home is outside the United States for the entire year can exclude only the income earned in a foreign country. Any portion of compensation earned for work performed in the United States or in international waters or air space is not excludable.
Exclusion Applies to Year Income Is Earned
If income that was earned in 2015 is received in 2016, the exclusion is claimed on the 2016 return (the year it was received) but calculated under the 2015 limits. Income paid after the end of the tax year following the year it was earned (e.g., income earned in 2014 and paid in 2016) is not eligible for the exclusion.
Election to Exclude
A US citizen living abroad who is eligible to exclude all of his or her income is still required to file a US income tax return if there is a filing requirement before the exclusion is calculated. If the exclusion is elected, all qualifying foreign earned income up to the annual limit must be excluded. Electing the exclusion is a bar to some other tax benefits, including the following items:
■ Excluded income is not compensation for determining eligible contributions to traditional or Roth IRAs. If all of the taxpayer’s earned income is excludable and the exclusion is elected, no contribution can be made.
■ The earned income credit cannot be claimed if any foreign earned income is excluded.
■ The foreign tax credit cannot be claimed for excluded income, although it is still available for income that is not excluded.
■ As with other tax-exempt income, expenses directly related to excluded foreign earned income are not deductible. Rev. Rul. 75-86, 1975-1 C.B. 242, provides examples of allocating business expenses between excluded and included foreign earned income.
A taxpayer who chooses the exclusion is still entitled to the full amount of the personal exemptions deduction and either the standard deduction or itemized deductions that are not directly related to the excluded income. But the excluded income is considered in calculating the tax on any remaining net taxable income for both regular tax and alternative minimum tax (AMT) purposes, so that the tax on the remaining income is paid at the marginal rate(s) that would apply if there were no exclusion.
Once made, the exclusion election applies to the election year and all future years. It can be revoked by attaching a statement to the first return that does not claim the exclusion, but once it is revoked, a new election cannot be made during a 5-year period without IRS approval, which requires a letter ruling request. Situations where a reelection might be approved without a waiting period include a return to the United States for a period of time, a move to another foreign country with different tax rates, a change of employer, and a change in the current country of residence’s tax laws.
The election can be revoked inadvertently. If a taxpayer who elected to exclude foreign earned income decides the foreign tax credit is more advantageous in a subsequent year and claims the credit for the excludable foreign earned income, the election is automatically revoked and the taxpayer cannot reelect the exclusion for 5 years [Rev. Rul. 90-77, 1990-2 C.B. 183].
In addition to the foreign earned income exclusion, foreign housing costs in excess of a base amount can be excluded by an employee or deducted by a self-employed person. The housing expense benefit is generally limited to 14% of the maximum foreign earned income exclusion (30% minus a 16% base amount). For 2016, the base amount is $16,208 (16% x $101,300) if the taxpayer qualifies for the entire year. This limits the additional housing exclusion or deduction to $14,182 [(30% x $101,300 = $30,390) – $16,208]. However, the IRS can adjust this figure based on the cost of living in the foreign country.
An IRS notice is issued near the end of each tax year providing amounts for areas where the maximum deduction is higher or lower than the general amount. These limits are also included in the instructions for Form 2555. Housing expenses include rent, utilities (except telephone charges), real and personal property insurance, residential parking, furniture rental, and household repairs. Otherwise deductible costs such as mortgage interest and property taxes are not included, nor are the costs of buying a home or furnishings. If a second foreign household is maintained for family members because living conditions in the worker’s country of residence are adverse or dangerous, the cost of the separate foreign household is also includable.
Calculating the Foreign Tax Credit
For each tax year, an individual may choose between claiming the foreign tax credit or taking an itemized deduction for the creditable taxes that were paid or accrued during the tax year. If the deduction is chosen, no foreign taxes paid or accrued during that tax year can be claimed for the credit. In addition, carry-back or carry-forward foreign tax credits cannot be used in the deduction year but the carryover must be reduced by the amount that would be used if the credit were taken instead of the deduction.
If the credit is chosen for eligible taxes, any foreign taxes paid or accrued during the year that do not qualify for the credit may still be deducted. Individual taxpayers deduct foreign income taxes and other non-business foreign taxes on line 8, “Other taxes,” of Schedule A (Form 1040), Itemized Deductions. An election to take the credit or to deduct the creditable taxes can be changed within a special 10-year limitations period. See Publication 514 for more information.
Categories of Income
Foreign income must be separated into five categories of foreign income if the taxpayer has more than one type of foreign income, and a separate Form 1116 must be completed for each category. Most taxpayers have only passive income and general category income. The other three categories are I.R.C. § 901(j) income (i.e., income from sanctioned countries), income re-sourced by treaty, and lump-sum distributions if Form 4972, Tax on Lump-Sum Distributions, is filed to reduce the US tax on a lump-sum distribution from a foreign pension plan.
Passive income for foreign tax credit purposes is not the same as passive income for passive activity loss purposes. Passive-category income generally includes the following types of income:
■ Rents and royalties that are not from an active business
■ Gains from disposition of non-business property
General-category income includes the following types of income:
■ Wages and salaries
■ Active business income
■ Gains from the sale of depreciable property used in a trade or business
■ High-taxed passive income (income subject to a foreign tax at a rate higher than the highest US tax rate that can be imposed on the income)
When Form 1116 Is Not Required
Individuals (but not estates or trusts) may elect to claim the foreign tax credit without filing Form 1116 if they meet the following three criteria [I.R.C. § 904(k)]:
- All of the individual’s foreign income is passive-category income (including high-taxed passive income).
- All of the foreign income and taxes paid are reported on IRS payee statements (e.g., Form 1099-DIV, Dividends and Distributions; Form 1099-INT, Interest Income; and Schedules K-1 for partners, shareholders, or beneficiaries) or similar substitute statements.
- The total creditable foreign tax reported on the statements does not exceed $300 ($600 if married filing a joint return).
Example 4: Form 1116 Not Required
Jeanne Joseph, who is single, owns shares in a mutual fund that invests in foreign stocks. Her Form 1099-DIV shows $2,500 of ordinary dividends and her $280 share of the foreign taxes paid by the mutual fund on the foreign-source dividends it received. Because Jeanne has no other foreign income and the total foreign tax does not exceed $300, she may claim the foreign tax credit without filing Form 1116. She makes this election simply by entering the $280 directly on line 47 of her Form 1040.
If the credit is claimed without filing Form 1116 and the creditable foreign tax exceeds the current year’s tax liability, a carryover of the excess credit is not allowed. Carryovers from prior years continue to carry forward, but the 10-year period is not extended.
When Form 1116 Is Required
All trusts and estates, as well as individuals who do not qualify for the direct credit, must file Form 1116 to claim the foreign tax credit. An accrual basis taxpayer can claim the credit only in the year the foreign taxes accrue. A cash-basis taxpayer may elect to take the foreign tax credit in the year foreign taxes accrue rather than in the year they are paid. Accrued credits claimed must actually be paid within 2 years of the tax year to which they relate. Form 1116 must also be used for carry-backs and carry-forwards, currency conversions back to US dollars, wages and business related income, foreign highly taxed passive income (above the highest rate charged in the United States).
ABOUT THE AUTHOR
Ben Tallman is an Alumnus of the University of West Georgia, he is an NTPI Fellow, and currently has a tax practice in Atlanta. He has taught as an instructor for many local, state, and national organizations over the past decade. Ben has served on the NAEA National Board as Chairman of the Education Foundation, where he is a prior member of the IRS Regional Liaison Committee, and a prior Education Director for two GA Affiliate Tax Organizations. He has appeared as a panelist on Tax Talk Today, as well as, conducting an NAEA 3-Part Webinar in discussions on the Affordable Care Act. He is a US Tax Court Practitioner and writes extensively for national tax publications and tax journals. Ben has served as a volunteer for an Atlanta night shelter and food bank; he has served as a board member on his local Jaycee Chapter, church school board, and two state tax organizations. He recently celebrated 40 years in tax preparation.