As promised, this week we are going to discuss the Foreign Earned Income Exclusion, or FEIE for short.
Since I expect many of you to already be familiar with the FEIE, and for those of you living in the USA it is not currently relevant, we are going to do this via FAQs. This will allow you to skip the questions that don’t interest you or don’t apply to you and focus on the ones that do.
The questions covered today address the purpose of the foreign earned income exclusion, it’s history, who can claim it and the conditions they need to meet to do so.
We also touch on the foreign housing exemption or deduction, an additional exclusion that supplements the foreign earned income exclusion.
And we end with IRS Coronavirus Foreign Earned Income Exclusion Relief for workers who had to return to the USA due to the pandemic, but who would have qualified for the exclusion if it weren’t for that.
Are you ready? Let’s begin.
Foreign Earned Income Exclusion – FAQs – Part I
What is the Foreign Earned Income Exclusion, or FEIE?
The FEIE is a provision in US tax law that allows certain US taxpayers who earn wages or who earn income from self-employment overseas, to exclude their compensation, up to a limit that is adjusted annually for inflation, from US income taxation.
This provision is codified in Section 911 of the Internal Revenue Code.
Why is the Foreign Earned Income Exclusion even a thing?
The FEIE is necessary because the United States continues to tax the compensation of US tax persons, which includes US citizens and green card holders, when they live and work outside the United States. The foreign countries where these US citizens and green card holders live are extremely likely to also tax this income. Without the FEIE, this compensation would be doubled taxed.
This double taxation puts US citizens and green card holders at a disadvantage compared to citizens of other countries, who are not taxed by their country of citizenship or permanent residence when they live and work overseas.
95 years ago, in 1926, the 69th Congress of the United States recognized this disadvantage, didn’t think it was right, and enacted an exclusion that allowed to remove from gross income the foreign earned income of US tax persons. The original exclusion applied to “…..all amounts received from sources without the United States if such amounts constitute earned income….”
The original FEIE was unlimited. Imagine that! Those were the days…..
Since then, the FEIE has been amended at least ten times, with some of those amendments being more significant than others. Almost every time it was amended, guess what? The limitation got a little less effective at eliminating double taxation and a little harder to calculate and report. The current version of the FEIE is both more burdensome and less effective than the original provision.
Thank you very much, Congress!
Is the Foreign Earned Income Exclusion relevant only to US citizens working abroad?
No, it isn’t. It is also available to green card holders if they meet the exemption requirements.
Technically speaking, from an immigration point of view, green card holders are required to remain physical residents of the USA.
But some green card holders are sometimes placed in foreign assignments by their US employers or may have personal or family reasons to leave the United States for a number of years. In those situations, they may establish a tax home in a foreign country and if they work when they are overseas, they may qualify for the exclusion.
Beyond the tax ramifications, green card holders contemplating a long stay outside the United States should pay attention to green card immigration rules and re-entry permits or should consult an immigration attorney before leaving the USA, to avoid jeopardizing the legal status of their green card.
If a married couple are both living and working abroad, do they get two Foreign Earned Income Exclusions?
Yes! whether filing jointly or separately, married US persons each have the right to claim their own FEIE if they meet the requirements.
If filing a joint tax return, the FEIE is not aggregated. It is computed separately for each spouse.
Is a tax return necessary if the foreign earned income is lower than the maximum exclusion amount?
Yes. One of the requirements of the FEIE is that it needs to be claimed on a timely filed US tax return, including extensions. Not filing a tax return is the equivalent of giving up the right to the exclusion.
How is the Foreign Earned Income Exclusion claimed on a US tax return?
The FEIE is claimed by fully and accurately completing Form 2555 – Foreign Earned Income and filing it with the timely filed US income tax return, Form 1040.
The 2555 Form includes six pages of instructions plus six pages of housing expense limitation information, listed by country and city, for the calculation of the limitation on the Foreign Housing Exemption or Deduction.
Foreign Housing Exemption or Deduction, what is that?
The Foreign Housing Exemption, and its sister, the Foreign Housing Deduction apply to employees and the self-employed, respectively, allow taxpayers who qualify for the FEIE to additionally exclude certain foreign housing expenses from US gross income.
The excludible expenses must be above a base amount and under a certain cap. For most locations, the floor and ceiling caps result in a foreign housing exemption or deduction that is maxed out at 14% of the FEIE amount.
Some cities with high housing costs, like Hong Kong, Zurich, London, and others, have higher ceilings, thus allowing a greater exclusion or deduction.
Excludible expenses include rent, or the fair rental value of foreign housing provided directly by the employer, utilities, real estate taxes, renter’s insurance, furniture rental, residential long-term parking garage rental fees, minor repairs, and other similar expenses.
Extravagant expenses, such as the labor cost of gardeners or house cleaning services, are not eligible for this exclusion.
What are the requirements to qualify for the Foreign Earned Income Exclusion?
There are three main requirements:
- Establishing a foreign tax home,
- Meeting one of two tests: the bona fide residency test or the physical presence test, and
- Having foreign earned income
What does it mean to establish a foreign tax home?
Normally, a person’s tax home is the place where they permanently or indefinitely work, or where they have their place of business. A person working in France, for example, would be presumed to have a French tax home.
And there is always a BUT with many US tax rules….
If that individual is a US citizen or green card holder, and that individual keeps an abode in the United States while indefinitely working in France, that individual will NOT be treated as having established a foreign tax home and will be treated instead as maintaining a US tax home.
Keeping an abode within the United States makes such individual ineligible for the FEIE.
What in the world is an “abode”?
Words mean certain things in day-to-day language, and other things in tax language. For day-to-day purposes, what you would call your home is what the IRS would consider your abode. And to what you would normally refer to as your office or business location, is what the IRS would consider your tax home.
Let’s explore this further.
For tax purposes, a “tax home” is established by reasons of employment or business. It is the place where we work or from where we run our business.
For tax purposes, an abode is the place where a person normally resides. The place that we would colloquially call our “home”. For purposes of the FEIE, a US taxpayer must demonstrate that they have established a foreign abode before they can claim they have a foreign tax home.
Confusing? I thought so. You are not alone,
Because there was so much confusion around this, in 1993, the IRS issued Revenue Ruling 93-86, listing the three factors that they take in consideration to determine if someone has a foreign abode:
- Where does the immediately family live? If the family of the French worker in our example remains in the USA while the worker works in France, this worker may not have a foreign abode!
- Are housing expenses duplicated in the US and the foreign country? If the family of the French worker lived with in France but they also maintained an unoccupied US home used regularly for extended personal US stays while living in France, this worker may not have a foreign abode!
- In what location are the main business contacts? If the main business contacts of the worker in France remain in the USA, this worker may not have a foreign abode!
Sometimes, one or two of the factors listed above have been clearly met, for example, if they sell their US home and move together as a family to a new home in France. But other times, the situation is fuzzy. The US home was not sold, they use it during the summer, for the holidays and for extended family visits, they keep strong business ties to the USA, etc.
In such cases, the IRS may deny the FEIE and the taxpayer will need to appeal this denial, provide substantiation for the relevant facts they believe support that they have a foreign abode and wait for the results.
I cannot stress this enough:
The IRS has been challenging the FEIE, and very successfully, if I may say, in cases where the taxpayer had not clearly established a foreign abode and had been sloppy in keeping documentation to support their claim to the FEIE.
Despite not being as effective as in 1926, the FEIE can still provide significant protection from double taxation. Understanding the rules, playing by them, and keeping proper documentation, are critical for the successful claim of this exclusion.
So what happens next, after a foreign abode and foreign tax home have been established?
One of two additional tests needs to be met: the physical presence test or the bona fide residence test.
What is the physical presence test?
The physical presence test is a test that is available to both US citizens and green card holders working abroad. It requires being physically present in a foreign country for 330 full days within any consecutive 12-month period.
Let’s break it down:
- What are 330 full days? 330 24-hour periods beginning at midnight.
- What is a consecutive 12-month period? A period that can begin on any day of the year, and that ends 12 months later. For example, if a taxpayer moves permanently to a foreign country on March 20th, such a 12-month period could run from March 20th to March 19th of the following year.
Time spent on or above international waters (sailing or flying) do NOT count as days of physical presence in a foreign country. Partial days in the USA, except for purposes of connecting flights, also do not count as days of physical presence in a foreign country.
Once again, for this test, documentation is key.
If you need to rely on the physical presence test to qualify for the FEIE, you should keep good records to substantiate your physical location during the 12-month period you are using to claim the FEIE.
What is the bona fide residence test?
This test is an alternative residency test to the physical presence test. It is only available to US citizens and green card holders who are citizens of treaty countries with the USA. Green card holders from non-treaty countries can only use the physical presence test.
The bona fide residence test requires residing in a foreign country for the entire calendar year. Residency under this test must be established by January 1st.
As a result, US expats typically rely on the physical presence test to qualify for the FEIE in the year they move abroad and in the year they return to the USA, which are usually partial years. For the calendar years between the year of arrival and departure, US expats typically rely on the bona fide residence test.
An advantage of the bona fide residence test is that it provides more flexibility to spend time in the USA to families and individuals that need to visit the USA for family purposes, business reasons, or a combination of both.
A disadvantage of the bona fide residence test is that it is more subjective. It is easier for the IRS to argue that someone has not met the bona fide residence test than it is to argue that they have not met the physical presence test. A person has spent 330 days in a foreign country, or they haven’t, and this is easy to measure. The bona fide residence test instead is based on facts and circumstances, the interpretation of which can differ between the IRS and the taxpayer.
The FEIE and the pandemic
The COVID-19 global pandemic forced many taxpayers working abroad in foreign assignments to return to work from the USA. Do they lose the right to claim the FEIE because of the pandemic?
The short answer is NO.
IRS Revenue Procedure 2020-27 provides relief to certain individuals who fail to meet either the bona fide residence test or the physical presence test due to international travel restrictions resulting from the pandemic, if they would have been expected to meet one of these two tests otherwise.
One important clarification with regards to what this waiver means and what it doesn’t mean:
Qualifying for the FEIE despite being stuck in the USA due to the pandemic does not make income earned while working in the USA foreign. Income earned while working in the USA is from US sources, and because it is US income and not foreign income, it is not eligible to be excluded under the FEIE.
What good is this relief, then, you may wonder?
Well, the global pandemic was not declared until March 2020. Most travel restrictions, except for travel restrictions to and from China, began in earnest around mid-March. Some taxpayers were able to return to their foreign countries before the end of 2020.
Despite not being able to exclude the income they earned in the USA, the income earned before and after their time in the USA is still excludible. That’s the benefit for these taxpayers. Not as good as you may have thought initially, but better than losing the right to the FEIE altogether.
That is all for this week, folks.
Stay healthy and strong. See you in a couple of weeks.
Un abrazo y buena onda. Much love,