US citizens or resident aliens living abroad are subject to paying federal income taxes. The IRS automatically grants a two-month extension to file tax returns, but any taxes due must be paid by April 15 to avoid penalties and interest. In this guide to foreign income tax we discuss the Foreign Earned Income Exclusion in depth and how you can qualify.
The IRS imposes a worldwide tax on income, no matter what its origin. However, foreign residents can get some relief through the Foreign Earned Income Exclusion (FEIE). The FEIE allows for exclusion of just over $100,000 per year in qualified foreign earnings to be exempted from US income taxes. That exemption also allows deduction of foreign income tax payments in the foreign country where the taxpayer resides.
FEIE applies to earned income—salaries and wages, professional fees, consulting income. It does not apply to unearned income such pensions, social security payments, interest and dividends. FEIE also does not apply to income from US sources, including fees earned at US conferences, etc. Such income will be taxed normally.
Important: In the case of the self-employed, taxpayers are still liable for payment of self-employment taxes (Social Security and Medicare).
1) The Physical Presence Rule
To qualify for FEIE, the taxpayer must pass the physical presence test. Anyone who spends more than 330 days in foreign countries in a consecutive 12-month period, starting or ending in the tax year in question passes the physical presence test.
Like most IRS rules, it can get complicated, and it is important to understand the rules on temporary absence, etc.
2) The Bona Fide Resident Rule
The second qualifier is the bona fide residence test. This test follows the calendar year, rather than the tax year. Long-term US expatriates who have set up a residence in a foreign country for a calendar year and have no immediate plans for moving away qualify for the FEIE exemption.
3) The Tax-Home Rule
Again, there are circumstances where a taxpayer could meet both the physical presence and bona fide residence rules and still not qualify for the FEIE. The kicker is the two-word, simple sounding yet complicated term :tax home.
The bottom line is that the taxpayer’s tax home must be outside the United States in the general area of the place of employment, regardless of where the taxpayer maintains the family home. Again, it gets complicated with a long list of exceptions and qualifications.
Forms required and pitfalls to avoid
Attach IRS Form 2555 to IRS Form 1040 to claim FEIE. It is very important to understand and correctly complete Parts II and III of IRS Form 2555. For example, completing both parts will automatically disqualify the taxpayer from FEIE. Also, if you check “yes” to item 13a, you will be disqualified from FEIE.
Special filing requirements under FBAR and FATCA
Foreign Bank and Financial Accounts (FBAR)
FBAR is how a taxpayer informs the US Treasury of a financial relationship with foreign banks and accounts. This information provides an audit trail for criminal, tax, and other regulatory investigations by the government.
Regardless of residence, US persons who have more than $10,000 in foreign financial accounts must file FinCEN Form 114 online. This requirement is separate from the regular tax return. The filing deadline is April 15 with an automatic extension to October 15.
The Foreign Account Tax Compliance Act (FATCA)
FATCA requires that foreign financial institutions report on foreign assets held by their US account holders. Failure to report could subject those foreign institutions to US sanctions and withholding of payments. Likewise, the act requires US persons to report their foreign financial accounts and foreign assets.
Under FATCA, US taxpayers must report those assets to the IRS on Form 8938. Currently, anyone living abroad and having more than $200,000 of specified foreign financial assets ($50,000 for US residents) must report those assets. See IRS website topic Summary of FATCA Reporting for US Taxpayers for details.
DIY or get professional help?
Our foreign income tax guide was only a thumbnail sketch of what US persons living abroad need to know about their tax liability. The FEIE is complex, and one mistake could result in disqualification and tax penalties. Likewise, FBAR and FATCA regulations impose heavy fines for failure to file.
Why risk fines and penalties when you can hire experienced professionals like Chandler & Knowles, CPAs, PLLC? Our tax preparation and planning experts have over 20 years’ experience in working with the IRS and helping clients stay compliant while claiming the maximum deductions allowed. Contact us and let us know how we can help.