Thursday, April 5, 2012

Foreign Earned Income Exclusion - WARNINGS!

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**I have written an update to this with a link to it at the end of this article - Read it Too!**

The Foreign Earned Income Exclusion is a wonderful tax benefit that is available to Americans working abroad.  Unfortunately, many employers and employees are unwittingly over-stating the benefits and applicability of the rules with devastating consequences.  The over-riding myth is, "You're working overseas - that means you're exempt from taxes on the income!"  Some employers actually use the exclusion as a recruiting tool, touting the tax benefit as an exemption from all taxes.

This is not really true.  When using the exclusion, it is important to understand the limits and qualifications.  You can generally accept a big employer with lots of foreign employees assertion that you will qualify (though you can't hold them accountable if you don't.)  I will assume for this article that you will qualify if you stay with your employer.  I want to focus on the pitfalls that you run into even if you do qualify.  Here they are:

Staying Qualified:  Even if you and your employer set you up for qualification, you still, at a minimum, have to spend 330 out of a 365 day period overseas.  If you fail to do this, even for very good reasons, you will lose the exclusion, and all your income will be taxable.  There is only one real way out of this: being forced to leave due to adverse conditions.  The IRS specifically lists those places, and there are very few!  Don't assume just because some IED's went off near your place of work that you can pack up and go home.  A commenter has pointed out, correctly, that you can also meet the requirements for the exclusion via the Bona Fide residence test, but this one is in may ways even more restrictive - see the comments for more info and a useful link.

Filing Deadlines:  That 365 day period above affects this too.  If your first year ends after 4/15, you won't meet the test by the filing deadline.  You can get an automatic extension to 10/15, but you may need to file form 2350 if your year ends after that.  If you don't you could be subject to interest and penalties.

The Big One - There's a MAX:  The maximum credit is $92900, plus some housing expense if you have to pay for housing.  Let's assume housing is not an issue.  If you go overseas on 10/2/2011, you only have 90 days overseas in 2011, so you only get 90/365 x 92900 or $22906 of exclusion.  Anything more than that is taxable!  Even with 365 days in the tax year overseas, anything over $92900 is taxable.

The Tax Rate Can Be Higher:  You figure taxes on any remaining income at the tax rate as if the exclusion was not taken, so whatever income is left after the exclusion is taxed at a higher rate.  Also, if you have another job, or your spouse works, their withholding might be inadequate even if you get the full exclusion.

It Limits Other Credits: No Earned Income Credit or Foreign Tax Credit on the same income.

Other Issues: Taking the Exclusion is an election that can be revoked, but can affect other opportunities later.  They are too complex for this article, but you need expert advice if you plan on working or living abroad for a long time.  You also need to make sure your state honors the exclusion (I did not research this specifically, even though I think all of them do in one form or another.)

Be very careful.  Your employer may ask you to fill out Form 673 (or equivalent) to exempt your income from withholding.  This is what this whole article is trying to protect you from.  If you file that form and you make more money than the exclusion covers, return before meeting the testing period, or have to file a tax return before meeting the test for other reasons (college financial aid, home buying) you could have a HUGE tax bill.  I recently prepared taxes for a man who made $150,000 working overseas.  He received the full exclusion and still had a Federal tax bill of over $20,000!

If you know you will make less than the exclusion, you're confident you will meet the test, you have no other significant income, and you can wait to file until you meet the test, go ahead and go exempt if you want.  Otherwise, let them withhold and get the big refund later.

Update HERE

IRS Pub 54

23 comments:

  1. This blog is very helpful.
    My friend needs a clear clarification on foreign earned income. He has some interest income and rental income (totally Rs. 3.50 lakhs or about $7000 only FROM iNDIA) Hope this will not be added as a fOREIGN EARNED INCOME> Foreign earned income covers only Salary and wages earned outside US, Is that right?

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  2. This wouldn't be a Foreign Earned Income Exclusion issue. The income is fully taxable in the US (we tax worldwide income.) I am assuming he is a US citizen or resident. He would then use Form 1116 to take the Foreign Tax CREDIT to reduce US taxes by the amounts he paid to India (with limitations.)
    Feel free to contact me with questions: taxadvisor@email.com

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  3. This comment has been removed by the author.

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  4. One of my kids will be heading to college in a year and half. How can I show on the US income tax that the Foreign Earned Income or the amount that is excluded is also taxed at foreign source? My concern is that financial aid review boards may look at the whole untaxed amount of Foregin Earned Exclusion amount as the "available" income toward family contribution but in fact it is also taxed at the source.

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  5. Foreign Income is treated just like any other income by Financial Aid even if is taxed by the foreign country. Here is a copy of the relevant instruction:

    Foreign income
    Income earned in a foreign country is treated in the same way as income earned in the U.S. Convert all figures to U.S. dollars, using the exchange rate in effect on the day you complete the FAFSA. Your parents can find information on current exchange rates at
    www.federalreserve.gov/releases/h10/current.
    Your parents should also include the value of any taxes paid to the foreign government in the “U.S. income tax paid” line item. (If the income earned in the foreign country was not taxed by the central government of that country and was not subject to the foreign income exclusion based on filing an IRS Form 2555 or 2555EZ, the income should be reported as untaxed income in Question 92(i).
    In many cases, if your parents file a return with the IRS for a year in which foreign income was earned, a portion of the foreign income can be excluded on IRS Form 2555 for U.S. tax purposes. The figure reported on line 45 of Form 2555 (or line 18 of Form 2555EZ) should not be reported in Question 92(i).

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  6. Hi TSTG:
    Please amend your above statement: "Even if you and your employer set you up for qualification, you still, at a minimum, have to spend 330 out of a 365 day period overseas"
    This is not true, according to the IRS rules. You may also qualify by being a "bona-fide resident" of a foreign country.

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  7. The General Rules To qualify for the foreign earned income exclusion, a U.S. citizen or resident alien must have a tax home in a foreign country and income received for working in a foreign country, otherwise known as foreign earned income. The taxpayer must also meet one of two tests: the bona fide residence test or the physical presence test.
    http://www.irs.gov/uac/Five-Facts-about-the-Foreign-Earned-Income-Exclusion

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  8. I understand your point, and, while true, the Bona Fide resident test has more restrictive qualifications than the presence test in that it requires a bona fide residence that covers at least a calender year. While the specific number of days become less important, the length of time becomes more restrictive. Since the point of my post was to warn of pitfalls of the exclusion, vice specify the exact rules, I felt that I didn't need to cover the bona fide residence test to make my point.

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  9. BTW, I do appreciate your comment and the link and have added a reference to it in the writeup.

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  10. I was previously told/led to believe that once you have established the bonafide residence test and have received the foreign earned income exclusion, for myself this has been true for the past 6 years, then you will be granted the exclusion unless you put forth in writing to the IRS that this is no longer true.
    Last year I worked 278 days overseas.
    Is this correct, perhaps I did not make it clear?

    Thanks

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  11. The bona fide residence test does not use exact day counting to establish. It takes a more holistic approach than the presence test. Essentially, your home/residence needs to be in a foreign country. The IRS will look at your actions more than your words to determine this. If you maintain a home in the foreign country, work a permanent job there, and return to the US primarily for visitation/temporary jobs with the intention of returning to your "home" in the foreign country, you can continue to use the bona fide residence basis for the exclusion. Maintaining home and family in the US is a detracting factor (though not necessarily disqualifying.) The automatically qualifying once established is not technically true, but establishing a bona fide residence in a foreign country, and maintaining it for 6 years does carry a lot of weight. It really depends on the nature of your work and the reasons you spend in the US.

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  12. Thank you for explaining this in more detail and simplistically. It is not easy to find hard facts on working in the offshore world and especially the tax implications associated with being in different parts of the World during any time of the year.
    Also, it is difficult to nail down specific documentation from the IRS/State Revenue services or other agency for what taxes should be paid while working on the Outer Continental Shelf of the U.S. Or, are there any tax benefits for oilfield workers while working on a foreign flagged vessel on the OCS. I thought maybe the OCSLA could help.

    Thank again!

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  13. "You were a bona fide resident of Singapore from March 1, 2010, through September 14, 2012. On September 15, 2012, you returned to the United States. Since you were a bona fide resident of a foreign country for all of 2011, you were also a bona fide resident of a foreign country from March 1, 2010, through the
    end of 2010 and from January 1, 2012, through September 14, 2012."

    Hi,

    Included above is an example given from publication 54. According to the example, you are considered Bonda Fide for the entire 2010, but when you file the tax return in April 2011 how are you qualified for that since at that time you haven't stayed for an entire tax year. Or do you have to wait until 2012 to establish the Bonda Fide (after including the entire 2011), and then go back and be qualified and claim the exclusion for 2010. Please advice. thanks!

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  14. A client received a bill from the IRS for 19,000 for 2003. Do you know if the
    Foreign income exclusion existed in 2003? He worked for a private contractor
    in Afghanistan and lived there full time. Thank you.

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  15. It did, the maximum exclusion was $80,000. You should be aware that the IRS has been getting sticky about the tax home part, so your client should be prepared to demonstrate stronger ties to Afghanistan than the US while over there.

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  16. Since foreign oil field workers-- 28 days out, 28 days back in U.S.-- apparently aren't eligible for either exclusion, are there any special exemptions, deductions or credits available for their foreign wages?

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  17. Let me preface by saying that I am not an expert on oil field workers, but, for US taxes there are no special carve outs, but they might be subject to a number of deductions if they meet the requirements. If they pay taxes to a foreign country, they could get a foreign tax credit. If their locations vary and are temporary in nature, they might be eligible for the usual travel expenses away from tax home. I would seek out an expert in this particular area, but be wary of scam artists who claim some "special loophole."

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  18. I thought I had read somewhere that if you earned foreign income is under a certain amount you can stay in the US for more than the 35 days... something like 55. Did I dream this or is it something you've heard about?

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  20. My daughter was in London for 366 days from 8-15-14 to 8-16-15, she earned $7600, is the entire amount excluded under the foreign Tax Exclusion being she lived there for over 330 days consecutively?

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    Replies
    1. That is not an answer I can give via blog comments. I can say she meets the presence test days requirement, but I can't say if she meets the other requirements. You should seek a tax pros assistants since its not as cut and dried as purple say. You should also read my other posts on the subject.

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    2. That is not an answer I can give via blog comments. I can say she meets the presence test days requirement, but I can't say if she meets the other requirements. You should seek a tax pros assistants since its not as cut and dried as purple say. You should also read my other posts on the subject.

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