Non-residents with financial activities
Understanding the Foreign Earned Income Exclusion
U.S. citizens and resident aliens who earn money in other countries are subject to U.S. income tax. A number of exclusions exist to benefit the taxpayer, though, and if you understand them you can substantially lower your overall tax liability.
The Foreign Earned Income Exclusion – According to the IRS, “U.S. citizens and resident aliens who live and work abroad may be able to exclude all or part of their foreign salary or wages from their income when filing their U.S. federal tax return. They may also qualify to exclude compensation for their personal services or certain foreign housing costs.”
In simple terms, this means you might not have to pay federal taxes on some or all of the money you earn outside of the United States. But to be relieved of this obligation, you’ll have to meet certain requirements.
Let’s go over them.
The General Rules – First, the IRS says that you need to receive income for working in another country. Second, you need to have a “tax home” in a foreign country. A “tax home” is the general area of your main place of business or employment, regardless of where your family home is. Your tax home is simply the place where you are permanently or indefinitely engaged to work.
Next, you need to pass either the “bona fide residence” test or the “physical presence” test.
• Bona Fide residence test – Bona fide residence is determined on a case by case basis. Just because you have a residence in a foreign country, it’s not automatically considered your bona fide residence by the IRS. However, even if you eventually intend to return to the U.S., if you set up a permanent residence for an indefinite amount of time in the foreign country for yourself and your family, you probably have established a bona fide residence there. If you are found to have a bona fide residence in the foreign country, you must reside there, uninterrupted, for the entire tax year in order to qualify for the exclusion.
• Physical Presence test – If you don’t pass the bona fide residence test, you might pass the physical presence test. This requires that you are physically present in the foreign country for a minimum of 330 days out of a 12-month period. The days do not have to be consecutive, but the 12 months do. Often, the 12 months do not correspond to the tax year. That’s ok – you can file an extension in order to take advantage of this provision.
Exclusion amount and limits – The IRS limits the amount of income you can exclude from federal taxes under the Foreign Earned Income Exclusion. In 2009, the limit was $91,400 per taxpayer. This amount is adjusted every year for inflation.
Housing exclusion – If you pass either the bona fide residence test or the physical presence test, you might also qualify for a housing exclusion. The housing exclusion is tied to a number of other factors, including the foreign earned income exclusion amount, the location of the tax home, and the number of qualifying days in the tax year, so it will vary on a case by case basis.
Other credits and deductions – The foreign earned income exclusion is not offered in addition to other foreign tax credits and deductions. You’ll need to speak with your tax professional to determine whether the exclusion or the credits and deductions will be best for you.
To find out more details about how the Foreign Earned Income Exclusion can apply to you, talk to a knowledgeable international tax professional. Hodgson CPA specializes in international accounting and can provide you with valuable tax guidance. You can also take a look at the IRS’s website for more information.