Tax Planning for U.S. citizens working abroad
The Foriegn Earned Income Exclusion: An Update
By Josph R. Oliver In Brief
Taking Advantage of Foreign Residency
In this increasingly global society, it is becoming more and more common for individuals to work abroad for long stretches at a time. Such placements may have significant tax consequences, including the opportunity to exclude earned income from U.S. taxation. Taxpayers should be aware of this in order to elect the best tax treatment.
IRC section 911 provides for two ways to achieve foreign residency and the opportunity to exclude income from taxation. The first is to become a bona fide resident, which requires specific intent on the part of the taxpayer and may not be a realistic option for most. The second, a 330-day residency, is easier to achieve, requiring only a prolonged stay.
The author reviews what steps need to be taken to calculate the foreign earned income exclusion for a number of different scenarios. The pluses and minuses of the election can vary by case, so careful review of the facts is critical.
With the increasing globalization of business, more Americans are working abroad for extended periods. The worldwide income of U.S. citizens and resident aliens is subject to U.S. income tax, but IRC section 911 allows eligible taxpayers to exclude up to $74,000 of foreign earned income in 1999, and the exclusion increases in steps to $80,000 in 2002. For tax years beginning after 2007, the amount is adjusted for inflation. Certain housing allowances are also excludable or deductible.
There are matters to consider even before a taxpayer leaves the country. These include how to meet and document IRC section 911 requirements and how to evaluate employment agreements for base compensation, bonuses, and reimbursement of housing and moving costs. After returning to the United States, the taxpayer must determine whether to elect the exclusion or use the foreign tax credit and, later, whether to leave the exclusion election in effect or to revoke it.
How to Qualify
To exclude foreign earned income under IRC section 911, a taxpayer must fall into one of two categories:
* Bona fide residence. A U.S. citizen establishes bona fide residence in a foreign country or countries for an uninterrupted period that includes an entire tax year (January 1December 31 for a calendar year taxpayer).
* 330-day presence. A U.S. citizen or resident is physically present in a foreign country or countries during at least 330 days of any 12 consecutive months.
The minimum time requirements for either category may be waived under IRC section 911(d)(4) if the taxpayer is required to leave the foreign country because of war, civil unrest, or other adverse conditions. Only the actual period of residence or presence is used in determining the individual's exclusion, however.
IRC section 911 does not exclude amounts paid by the U.S. government or any U.S. government agency or instrumentality to its employees. Such individuals may exclude other compensation received abroad, however, and may qualify for certain tax and nontax benefits under IRC section 912 and other provisions beyond the scope of this article.
Bona fide Residence
The key to claiming bona fide residence is intent, determined by several factors, including the following:
* Length of stay. The taxpayer must intend to establish a bona fide residence in the foreign country or countries, generally for an indefinite or extended period lasting a year or more, and set up permanent quarters.
* Purpose and nature of stay. The purpose of the taxpayer's stay generally should involve more than performing a specific task. An individual who goes to a foreign nation for a definite purpose is not a resident, even if it takes a year of residency to complete. For example, an individual transferred abroad for a construction job to be completed in a specified length of time may not qualify even if he or she works there more than a year.
* Statements to foreign authorities. The individual must not claim to be a nonresident of the foreign country, particularly in order to avoid that country's tax on earnings.
* Tax treaties and agreements. Provisions of a tax treaty or agreement between the United States and another country may prevent individuals from becoming bona fide residents of other nations, depending on the employer and the assignment.
* Form 2555. The IRS relies heavily on the information reported in Part I of Form 2555, Foreign Earned Income (including information about tax homes), in deciding whether or not the taxpayer qualifies as a bona fide resident.
Bona fide residence does not mean permanent residence; an individual may intend to return to the United States. Even though residence is required for an uninterrupted period, temporary visits to the United States for vacations or business generally are acceptable.
Once a taxpayer establishes bona fide residence for a full tax year, the residence status can be extended to partial tax years. For instance, it extends backward to a prior partial year beginning with the date that the residence actually began and forward to any subsequent partial year ending with the date of return to the United States. Foreign earned income attributable to services performed during those periods is also eligible for exclusion.
A U.S. citizen who is unable to establish bona fide residence may still be eligible for the exclusion if physically present in a foreign country or countries during 330 days of any 12 consecutive months. With limited exceptions, a resident alien must qualify under this category because the bona fide residence test generally is not available.
A day is defined as a continuous period of 24 hours from midnight to midnight. The following rules apply under Treasury Regulations section 1.911-2(d):
* An individual is deemed to be inside a foreign country if she is present in the country at some point during a 24-hour period and then travels over areas not within the country for less than 24 hours.
* A taxpayer who is physically present in the United States for less than 24 hours because of a stopover during a trip between two nonU.S. locations is not treated as being present in the United States but as traveling over areas that are not within a foreign country.
The 330 days need not be consecutive; they may be interrupted by periods during which the individual is not present in a foreign nation. All days of presence in a foreign country or countries within 12 consecutive months are totaled. The 12 months may begin with any day and end on the day before the corresponding day in the 12th succeeding month. The 12-month period may begin before or after arrival in a foreign country and end before or after departure.
Example: Hal, a U.S. citizen, was assigned a Brazil-based position of his U.S. employer. Hal arrived in Brazil on April 24, 1998, and remained there until March 21, 1999, when he left for the United States. Hal was present in Brazil for 330 days during each of the following 12-month periods:
* April 25, 1998April 24, 1999
* March 21, 1998March 20, 1999
Depending on differences in Hal's income in 1998 and 1999, he may be better off choosing one period or the other.
Before taxpayers leave the United States, they should consider the importance a travel diary may play in proving 330-day presence.
A taxpayer need not demonstrate an intent to remain in the foreign country in order to meet the 330-day presence test, as would be required of a bona fide resident. However, intent remains an important element in establishing a tax home, and whether an individual is a bona fide resident or spends 330 days abroad, her tax home must be in the foreign country or countries throughout the period. If the nature of the business causes a taxpayer to have no regular or principal place of business, Regulations section 1.911-2(b) looks at where she regularly resides.
The location of a tax home depends partly on whether the individual is in the foreign country on a temporary or indefinite basis. If the assignment is for an indefinite period, generally expected to last for more than a year, the tax home is more likely to be the foreign place of employment. If the assignment is clearly temporary, the taxpayer may not qualify for the foreign earned income exclusion but may be eligible to deduct travel expenses such as meals and lodging under IRC section 162(a).
Income Eligible for Exclusion
Foreign earned income attributable to services performed during the period of bona fide residence or during the 330-plus days of a 12-month period is eligible for exclusion. The location where the money changes hands or is deposited is irrelevant, according to Regulations section 1.911-3(a), as long as the earned income is from sources within a foreign country, i.e., is attributable to services performed in the country.
The exclusion is from U.S. income tax only. The taxpayer generally must pay Social Security and Medicare taxes if the employer is American or affiliated with a U.S. employer, or if the country in which the taxpayer works has a binational social security agreement with the United States. Self-employment tax generally applies to self-employed persons.
For purposes of IRC section 911, earned income is wages, salaries, professional fees, and other compensation for personal services, whether paid in cash or in some other medium. Earned income may include the value of services or facilities, such as a home, meals, or automobile provided for the employee's convenience, and may also include cost of living or overseas allowances and reimbursements for family and educational costs, home leave, and other purposes.
Fees received by a professional such as a lawyer, doctor, or accountant are earned income even if assistants perform part or all of the services, assuming the clients or patients are the professional's and hold her responsible for the services rendered.
Earned income may be derived from a business in which both personal services and capital are material income- producing factors. Under Regulations section 1.911-3(b), the portion of profits deemed earned income cannot exceed the smaller of a reasonable allowance as compensation for the personal services actually rendered by the individual or 30% of the individual's share of the trade or business' net profits. A reasonable allowance as compensation for personal services rendered to a corporation would be earned income, but any distribution of corporate earnings and profits would not.
Certain amounts are specifically not earned income for this purpose and may be subject to U.S. income tax. Per Regulations section 1.911-3(c), these generally include the following:
* Amounts received after the close of the tax year following the year in which the services generating the payments are rendered;
* Pension and annuity payments, including Social Security;
* Amounts includable in gross income under certain rules applicable to nonexempt employees' trusts [IRC section 402(b)] and nonqualifying employee annuities [IRC section 403(c)];
* Unallowable moving expenses that are recaptured; and
* Amounts already excluded under other rules, such as meals and lodging furnished for the convenience of an employer.
A taxpayer's maximum exclusion depends on the year in which services are performed. (See Exhibit 1.)
A taxpayer does not automatically exclude the maximum amount. The exclusion is the lesser of a) foreign earned income for the year that qualifies for the exclusion or b) the maximum exclusion for the year multiplied by the following fraction:
Qualifying days in the tax year
Days in the tax year
Example: Ken is a U.S. citizen and a cash basis calendar year taxpayer. His tax home was in a foreign country, and he was physically present there for at least 330 days during the 12-month period from July 4, 1998, through July 3, 1999. During 1998, the number of qualifying days totaled 181. Consequently, Ken may exclude up to $35,704 of compensation earned in 1998.
181 days x $72,000 = $35,704
If Ken earned $50,000 during that 181-day period, his exclusion from Form 1040 is $35,704. If he earned $25,000, he excludes the entire $25,000.
For the purposes of the exclusion, income generally is attributable to the tax year in which it is earned (the services are performed) even if received in another tax year, under Regulations section 1.911-3(d) and (e). Reimbursements generally are attributable to the tax year in which related services are performed, not to the year of payment. For instance, a tax equalization payment might be received in 1999 for services performed in 1998. Nevertheless, for purposes of exclusion computations the payments generally would be attributed to 1998, rather than to 1999. A cash basis taxpayer generally reports income when received, however.
Example: Suppose Ken (preceding example) received $30,000 in 1998 and $10,000 in 1999, for a total of $40,000 attributable to services rendered in the foreign country during 1998. Of the $40,000, Ken may exclude no more than the $35,704 determined in the preceding example, the result of his 181 days of physical presence for 1998. Thus, $4,296 of the $10,000 ($40,000 $35,704) is subject to U.S. income tax in 1999. This is the result even though Ken's 1999 computation might offer additional exclusion. If his qualifying days for 1999 totaled 183, the maximum exclusion for 1999 is $37,101.
183 days x $74,000 = $37,101
Ken's 1999 compensation for services rendered in the foreign country, aside from the $10,000 attributable to 1998 services, might amount to only $20,000. Still, $4,296 of the $10,000 is taxed in 1999 because it is subject to 1998 exclusion computations.
Certain normal payroll disbursements, such as early January payment for December services, are exempt from the general rule and are subject to exclusion computations in the year received, under Regulations section 1.911-3(e)(3).
A U.S. company may pay bonuses to employees transferred abroad, perhaps to induce service in undesirable locations. Bonuses are generally attributable to all of the services that give rise to them on the basis of all the facts and circumstances, per Regulations section 1.911-3(e)(4). The same rule applies to property that is nontransferable and subject to substantial risk of forfeiture, such as certain stock options. A bonus or other value transferred often is divided by the number of months in the period in which the services were rendered and multiplied by the number of such months falling into each tax year.
Example: Jane's employer offers her a $96,000 bonus for four years of service in a foreign nation. Jane begins work in the country on July 1, 1999, and works there during all of 2000, 2001, and 2002, returning to the United States on July 1, 2003. The corporation pays her $96,000 upon her return. For Jane, a cash method calendar year taxpayer, the bonus amounts to $2,000 for each of the 48 months she served in the foreign country. (See Exhibit 2.)
The portion of Jane's bonus attributable to each year is excludable under the computations for that year. If she earns $60,000 of regular salary in 2002, a year in which her maximum exclusion is $80,000, Jane can exclude $20,000 of the $24,000 bonus attributable to 2002. The remaining $4,000 of the bonus is taxed on her Form 1040 for 2003, the year in which the bonus is received. Since the IRC section 911 exclusion does not apply to amounts paid after the close of the tax year following the year in which services are rendered, the portion of Jane's bonus (paid in 2003) attributable to 1999, 2000, and 2001 cannot be excluded.
Unless regular salary exceeds the maximum exclusion, a taxpayer in Jane's circumstances should carefully negotiate the timing of bonus payments. Certain elections for stock options and other property, beyond the scope of this article, may affect the years to which they are attributed and whether the compensation is earned income for purposes of the exclusion or is capital gain (not excludable under these provisions).
Moving Expense Reimbursement
In general, reimbursement of expenses for moving to a foreign country is attributable to services performed in that country, but reimbursement of expenses for moving back to the United States is attributable to services performed in the United States. To attribute the latter to foreign services, the employer and employee must sign a written agreement before the move to the foreign nation which stipulates that the reimbursement is part of an inducement for the move. The agreement must promise reimbursement of moving expenses back to the United States whether or not the individual continues to work for the employer upon return. Alternatively, a written statement of company policy may suffice. A reimbursement is allocated between years under Regulations section 1.911-3(e)(5)(ii) if the employee is not eligible for the foreign earned income exclusion for at least 120 days in the year of the move.
Double benefits are not allowable. Moving expenses allocated to and excluded as foreign earned income may not also be deducted on Form 1040. Similarly, no deduction or foreign tax credit may be taken relative to other amounts excluded under IRC section 911.
In addition to compensation for services, IRC section 911(c) and Regulations section 1.911-4 exclude certain employer-provided housing for the individual and any spouse or dependents that live with her in the foreign country. For this purpose, housing costs can include rent or the fair market value of housing provided by an employer, rental of furniture and accessories, utilities, real and personal property insurance, household repairs, certain occupancy taxes, residential parking, and nonrefundable fees paid to obtain a lease.
Only eligible housing costs above a base housing amount, determined on a daily basis, may be excluded. The base amount is 16% of the annual salary of a U.S. employee in Step 1 of grade GS-14, determined on January 1 of each calendar year. The base amount for 1998 was $9,643, or about $26.42 per day for a 365-day year.
Example: Al worked abroad for most of 1998, and his qualifying days total 345. His eligible housing costs in the foreign country total $30,000, of which his employer pays $20,000. Al's base amount for 1998 is $9,115 (345 x $26.42). No more than $20,885 ($30,000 $9,115) of his 1998 housing costs qualify for exclusion.
The total of salary and employer-provided housing that a client excludes cannot exceed his or her foreign earned income for the year. The individual must first claim the full housing exclusion to which she is entitled; the limit, if applicable, decreases the amount of salary that is excludable, not the housing exclusion.
Example: Susan was a bona fide resident of a foreign country where her tax home was located for all of 1998. Her employer paid her a $70,000 salary and provided housing with a fair rental value of $15,000. Since she had no additional income, Susan's gross income and foreign earned income for 1998 were each $85,000 ($70,000 + $15,000). Susan paid an additional $10,000 of housing expenses out of her pocket. Accordingly, her housing costs eligible for exclusion were $15,357 [$25,000 ($15,000 + $10,000) less the full $9,643 base amount for 1998]. Subtracting this $15,357 from Susan's foreign earned income of $85,000 yields $69,643, the limit on exclusion for her 1998 salary. Although the statute allows Susan to exclude as much as $72,000 of payment for services in 1998 (because she spent 365 days abroad), she can actually exclude only $69,643. However, her total exclusion for the year is $85,000 ($69,643 of compensation for services and $15,357 of housing costs), the entire amount of salary and housing costs she received from her employer.
Suppose instead that Susan's salary was $80,000 and her foreign earned income $95,000 ($80,000 + $15,000 of housing). Her computed limit on excludable salary would be $79,643 ($95,000 $15,357 of housing costs). But this limit would be inapplicable because the 1998 statutory limit on excludable compensation for personal services was $72,000. Susan's total exclusion for the year would be $87,357 ($72,000 + $15,357). Therefore, of her $95,000 of foreign earned income, $7,643 would not be excludable.
Self-employed persons may not exclude housing costs, but IRC section 911(c)(3) allows them to deduct part or all of eligible housing costs above adjusted gross income. This deduction is limited to the portion of a taxpayer's foreign earned income from personal services for the year that is not excluded under IRC section 911(a). Housing costs exceeding the limit are carried forward for possible deduction only in the next tax year.
Rules for Working Couples
A husband and wife can each render services in a foreign country and have foreign earned income. Regulations section 1.911-5 excludes such income separately for each spouse, whether filing jointly or not. A working couple could exclude up to $148,000 (2 x $74,000) of compensation earned outside the United States in 1999. To do so, however, each spouse must earn at least $74,000.
Spouses that live together can compute their housing cost amount either jointly or separately. If they compute it jointly, only one of them can claim the housing cost exclusion or deduction. If they live together and file separate returns, they must compute their housing costs separately. The couple can divide separately computed costs or allocate all of them to one spouse.
Spouses that live apart in one or more foreign countries can each compute and exclude or deduct housing costs if they have different tax homes that are not within reasonable commuting distance of each other and neither spouse's residence is within reasonable commuting distance of the other's tax home.
Making and Revoking the Election
The exclusion of foreign earned income is elective, and a U.S. citizen or resident alien may be better off choosing a foreign tax credit under IRC section 901, depending on the U.S. tax bracket, applicable tax rates in the foreign jurisdiction, tax treaties, and other factors. An individual who elects the exclusion does so on Form 2555 (or Form 2555-EZ, if the circumstances are simple). If a husband and wife each qualify for the exclusion, each must file a separate form.
Once made, according to IRC section 911(e), an exclusion election remains in effect for that year and all subsequent years unless the taxpayer revokes it, perhaps upon moving to a high tax foreign jurisdiction where the foreign tax credit would be preferable. If the election for a year is revoked, however, the taxpayer cannot make another election (without IRS consent) before the sixth year after the tax year for which the revocation is made. *
Joseph R. Oliver, PhD, CMA, CFM, CPA, is a professor of accounting at Southwest Texas State University in San Marcos.
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