2017-01-02 The United States (US ) government taxes the income of its citizens, resident aliens, and domestic corporations regardless of where the income is earned. Likewise, nonresident aliens and foreign corporations are also taxed on income that is effectively connected to a trade or business conducted within the US. Most other countries do likewise. Hence, a US taxpayer who earns money in a foreign country incurs a tax liability to both the foreign country and to the United States. Since this double taxation can be quite onerous, the US tax code allows a taxpayer to claim the foreign earned income exclusion, a foreign tax credit, or deductions for foreign expenses.
- Adjusted annually for inflation. The maximum base foreign housing amount = 16% of Annual Exclusion Limit on housing expenses that exceed base housing amount = 30% of Annual Exclusion If qualifying days < 365, then the above limits = Number of Qualifying Days / 365 Qualifying days are those that meet the physical presence or foreign residence test Source: Foreign Earned Income Exclusion
To claim the exclusion, the taxpayer must have a tax home in the foreign country and must satisfy either the foreign residence or physical presence test. US government employees may not claim any exclusion for government pay earned abroad.
If foreign income is not excluded, then the taxpayer can either deduct the foreign tax paid or claim the foreign tax credit. Generally, the tax credit will yield greater tax savings. However, if the foreign income tax rate is high and the amount of foreign income to US income is small, then a deduction may be more advantageous. In any given tax year, the taxpayer must choose either to use the tax credit or take the deduction — it cannot do both in a single tax year. However, choosing to claim deductions will allow the taxpayer to carry back any unused credit from a future tax year.
The applicable tax year for foreign earned income is the year in which the income is earned, not when it is received. If gross income exceeds the filing threshold for the filing status of the taxpayer, a US income tax return must be filed even if the taxpayer owes no taxes on the income.
The exclusion is not automatic, but must be claimed on Form 2555, Foreign Earned Income. which is attached to Form 1040. The election for the housing cost exclusion is also claimed on Form 2555. Form 2555-EZ, Foreign Earned Income Exclusion can be used if the taxpayer has no self-employment income or does not claim the foreign housing exclusion or deduction, or any business or moving expenses, and if income is less than the foreign earned income exclusion.
An employer must withhold taxes from payments to employees, but an employee can file Form 673, Statement for Claiming Exemption from Withholding on Foreign Earned Income Eligible for the Exclusion(s) Provided by Section 911 with the US employer to claim the exemption from withholding on wages because of the expected foreign earned income exclusion or foreign housing exclusion. However, the taxpayer must certify, under penalty of perjury, that the taxpayer has a reasonable basis for believing that he will qualify under the foreign residence or physical presence test. Estimated foreign housing costs must also be certified.
If the foreign income exclusion is claimed, then the taxpayer may not claim any business deductions that are allocable to the excluded income — foreign taxes paid on the excluded income cannot be claimed either as a credit or a deduction, and neither traditional nor Roth IRA contributions can be based on the excluded income.
Any taxable income that is not subject to the earned income and housing exclusions will be taxed as though no exclusions have been claimed. Regular tax liability must be calculated on the Foreign Earned Income Tax Worksheet in the Form 1040 instructions and the AMT liability is calculated on the Foreign Earned Income Tax Worksheet in the Form 6251 instructions.
Generally, to maximize tax savings, the taxpayer will have to calculate taxes using the foreign exclusion and without the foreign exclusion but using the foreign tax credit and allowable deductions.
If the taxpayer chooses the exclusion, then that election remains in effect until the taxpayer specifically revokes it, after which the taxpayer cannot choose the exclusion again for 5 years without IRS consent. Foreign earned income exclusion and the housing income exclusion must be revoked separately by attaching a statement to the tax return. However, the IRS will generally allow a change in calculating foreign income if there's been a substantial change in the tax law of the foreign country, the taxpayer moves to a different country with different tax rates, or the taxpayer changes employers.
If the taxpayer claims the foreign tax credit or the housing credit, then the IRS will consider that to be a revocation of the election to claim the foreign earned income exclusion.
