Foreign earned income is considered a compensation for personal services that were performed in the foreign country and the taxpayer meets either the foreign residence test or the physical presence test. Earned income does not include pensions or annuities, or any type of investment income, or other types of income that was not earned by providing services, such as gambling and alimony.
Foreign earned income does not include any earnings from countries subject to US government travel restrictions, or income earned in geographical areas outside of the jurisdiction of any particular country, such as Antarctica, international waters, or international airspace.
If the source of business income is only for personal services, then 100% of that income is considered earned income. However, if capital is also an income-producing factor, then the value of the personal services provided is considered earned income but the amount cannot exceed 30% of the taxpayer's share of the net profit. In calculating the 30% share, the net profit must be reduced by the 50% self-employment tax deduction. Profits earned by a passive partner are not considered earned income. If the business suffers losses, a reasonable allowance for personal services is considered earned income.
If a US partnership has a foreign branch, then the partnership agreement determines the tax status of the allocation of foreign earnings to partners living abroad as to whether it is considered foreign earned income. However, an allocation based primarily on tax savings may not be recognized by the IRS.
Earnings from copyrights are considered earned income, but not patents nor the leasing of oil and mineral lands. Rental income is generally not considered earned income, unless the taxpayer performs personal services, such as managing the rental.
If the taxpayer moves back to the United States, but remains with the same employer, then moving expenses are considered US sourced income, and, thus, cannot be excluded. However, if the taxpayer changes employers after returning to the US, but the old employer pays for the moving expenses, then that is considered foreign earned income for services rendered in the foreign country.
Foreign earned income that was earned in a prior tax year but was paid later does not qualify for the foreign income exclusion. However, it may be tax-free if the amount was less than the foreign income exclusion that was available in the previous year. Income that was earned in the previous year but paid in the next year can be excluded if the payment was within a normal payroll period of 16 days or less.
If foreign taxes are paid on foreign earned income that is tax-free within the United States, then no credit or deduction can be claimed, since there is no US tax liability for the income.
