Foreign Earned Income Exclusion: Explanations and Plans?
Updated: May 16, 2022
American taxpayers must report their worldwide income on their US tax returns, should they have a filing obligation. The foreign earned income exclusion may assist lower their US tax liability though should they qualify for it and elect to use it. I will discuss the FEIE three prong tests and how you should plan for it to be eligible to exclude some or all of your foreign earned income.
United States resident aliens such as foreign nationals who have been granted a permanent resident permit (green cards) and foreign nationals who meet the substantial presence test are generally subject to tax on their worldwide income and gains similar to U.S. citizens with some exceptions.
A U.S. citizen or resident alien who earns income in a foreign country may also be taxed on that income by the foreign host country, which can lead to double taxation. Several Internal Revenue Codes (IRC) provisions are intended to help mitigate this situation, including the foreign earned income exclusion and the housing exclusion or deduction, under IRC section 911.
Do I qualify for foreign earned income exclusion?
To qualify for the foreign income and housing exclusion tax benefits, you must be a qualified individual under IRC section 911(d)(1), that is a U.S. taxpayer who:
has tax home in a foreign country,
has foreign earned income, and
is a U.S. citizen or a resident alien who meets the bona fide residence test (BFR) or the physical presence test (PPT) in a foreign country.
A tax home, under Section 911(d)(3), is generally the taxpayer’s regular place of business or employment. If the individual has more than one regular place of business, then the tax home is located at his or her principal place of business or employment. If the individual has no principal place of business because of the nature of the business, or because the individual is not engaged in a trade or business, his or her tax home is at the individual’s regular place of abode. The location of the abode is based on where the taxpayer maintains their family, economic and personal ties.
Special circumstances for certain individuals: Individuals serving in an area designated by the President of the United States by Executive order as a combat zone for purposes of section 112 in support of the Armed Forces of the United States have a foreign tax home despite the fact that their abode is within the United States. Plan accordingly!
A foreign country includes any territory under the sovereignty of a government other than that of the United States. This excludes international waters and airspace above them, Antarctica or U.S. territories such as Puerto Rico, Guam, the Commonwealth of the Northern Mariana Islands, the U.S. Virgin Islands, and American Samoa. The days spent in the excluded area listed above do not count as days in a foreign country. Plan accordingly!
Foreign earned income
Under I.R.C. § 911(b), foreign earned income means an amount received by a qualified individual from sources within a foreign country or countries which constitute earned income attributable to services performed by such individual during the qualification period. This is the period during which the qualified individual meets the bona fide residency test or the physical presence test.
Earned income under section 911(d)(2) means wages, salaries, or professional fees (such as freelance fee, gig payments), and other amounts received as compensation for personal services actually rendered, exception applies.
The source of your earned income is the place where you perform the services for which you received the income. That is, foreign earned income is therefore income you receive for performing personal services within a foreign country. Where or how you are paid has no effect on the source of the income. For example, the income you receive for work physically done in Mexico is income from a foreign source even if the income is paid directly to your bank account in the United States and the entity paying you is located in Japan, UK, or United States.
Generally, dividends, interest, annuities, pensions, unemployment income, portion of a compensation that represents distribution of earnings of profits from a corporation, salary paid by the United or its agency, and social security and welfare type benefits are not earned income for foreign earned income exclusion purposes.
Bona fide Residence Test
To meet the bona fide residence test under the foreign earned income exclusion (FEIE) section 911, an individual must generally be:
(1) 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 (for example, January 1 through December 31, for calendar-year taxpayers), or
(2) A U.S. resident alien who is a citizen or national of a country with which the United States has an income tax treaty and who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year, (example from January 1 through December 31, for calendar-year taxpayers)