Americans working abroad may be eligible to exclude certain foreign earned income (wages, compensation for services) from US taxable income under the rules governing the Foreign Earned Income Exclusion (FEIE). The FEIE amount is adjusted annually for inflation. The amount for 2018 is US$104,100 per individual; for 2019 the amount is US$105,900 per individual. In the case of married couples, each spouse can claim the full FEIE amount only with respect to his or her own earned income. Thus, for example, if in 2018 one spouse’s earned income is only $94,100, the remaining unused FEIE amount of $10,000 cannot be used by the other spouse to exclude amounts beyond his or her own FEIE exemption.
The exclusion can apply regardless of whether any foreign tax is paid on the foreign earned income, provided certain tests are met. Generally, for an individual to qualify for the FEIE, a “tax home” must be maintained in a foreign country and either the Bona Fide Foreign Resident (BFR) or Physical Presence Test (PPT) must be met. The exclusion benefits can be claimed only if a US tax return is filed within certain time deadlines. Those who have dropped out of the tax reporting system risk losing the FEIE benefit unless prompt action is taken to correct the filing situation.
This blog post will focus on what is meant by “earned income”. First, however, it will provide a brief overview of the major qualification tests for claiming the FEIE.
Qualification Tests for FEIE
For an individual to qualify for the FEIE, a “tax home” must be maintained in a foreign country and either the BFR or PPT must be met. The term “foreign country” refer to areas outside the United States but does not include Antarctica or US territories such as Puerto Rico, Guam, the Commonwealth of the Northern Mariana Islands, or the US Virgin Islands, and American Samoa.
Generally, a “tax home” is the location of the main place of business, irrespective of where a family home is maintained. If the nature of a person’s work means that there is no regular or main place of business, then the tax home may be the place where the person regularly lives. A person is not considered to have a tax home in a foreign country if the person’s household is maintained in the US. Temporary presence in the US (for example, for vacation or for employment), does not necessarily mean that the household is in the US during such time. In defining what is meant by a “tax home” the law provides that the taxpayer shall not be treated as having a “tax home” in a foreign country “for any period for which his abode is within the United States.” What is the difference between one’s “tax home” and one’s “abode”? This is itself, a somewhat complicated question and will be the subject of a separate blog posting.
The BFR Test
To meet the BFR Test, a person must be a bona fide resident of a foreign country for an uninterrupted period which includes a full calendar year. The individual will usually not meet the BFR test in the first year abroad, unless he has moved to the foreign country and is residing there on January 1 of the relevant year.
Whether one is a bona fide “resident” is determined based on all of the facts and circumstances. The individual must have established a “tax home” there and in effect “settled” in that country. For example, one would look to whether the individual has rented an apartment in the foreign country, opened a local bank account, joined local social groups, obtained a local driver’s license, and so on.
Not only US citizens, but green card holders living in a foreign country can also qualify under the BFR Test. This is a tricky area since claiming BFR status may impact the individual’s immigration status and may impact retention of the green card. A separate blog posting will address this issue.
To meet the PPT an individual must be a US citizen or a resident alien, who is physically present in a foreign country or countries for 330 days in any 12 consecutive months. The 330 days do not have to be consecutive, but they must be whole days present in a foreign country. Travel time does not count toward the requisite 330 days if the travel is in the US or its possessions for periods of 24 hours or more, or takes place over international waters.
Recordkeeping is obviously very critical. The Physical Presence Test often helps an individual on short assignment. It also enables an individual to come back to the US for short periods (generally up to one month) in any consecutive 12-month period and still qualify for the exclusions.
What is meant by “Earned Income”?
“Earned income” means just that – income that is earned for personal services performed in a foreign country. Some easily understood examples of “earned income” include salaries and wages, commissions, bonuses, tips and the fees one receives from the performance of professional services such as those from being engaged in a professional occupation (e.g., accountant, doctor or attorney).
Earned income also includes amounts that are related to one’s employment such as the fair market value of noncash remuneration received through meals, lodging, personal use of a company vehicle; it includes amounts paid for vacation, sick leave, severance pay, as well as certain reimbursements and home leave and other similar allowances. An artist derives “earned income” from the sale of his or her own paintings. If one receives a scholarship or fellowship grant, any income that is paid for teaching, research or other services is considered “earned income” if it must be included in gross income.
“Earned Income” does not include any other types of income, for example, such as dividends or interest, pension or annuity payments, including social security benefits. IRS Publication 54 provides a list of income items that qualify as “earned income” and items that do not so qualify.
Between the two extremes of easily classifiable income items, certain types of income will arise that cannot easily be categorized as “earned” or “unearned’ income. These should be reviewed with an experienced tax advisor.
Treatment of Income from a Sole Proprietorship or Partnership
Income from a business such as a partnership or sole proprietorship must be carefully examined. It must be determined whether capital investment is the driving force in producing the income of the business or whether personal services produces that income.
Income earned from a business in which capital investment is an important part of producing the income may be treated as “unearned income”. If a taxpayer is a sole proprietor or partner and the taxpayer’s personal services also play an important role in producing the income, the part of the income that represents the value of the personal services will be treated as “earned income”. If capital investment is an important part of producing the income, then the law imposes a cap on the amounts that can be treated as “earned income”. Under the tax rules in such a case, no more than 30% of the share of the net profits of the business can be treated as earned income. In the event the business has no net profits, the part of the gross profit that represents a reasonable allowance for personal services actually performed is considered “earned income” and the 30% limit does not apply.
Examples: Juliette is a US citizen who meets the BFR test. Juliette invests significant sums of money into an oil and gas exploration partnership based in Saudi Arabia. Juliette performs no services for the partnership. At the end of the tax year her share of the net profits is $90,200. The entire $90,200 is unearned income and none of it can qualify for the FEIE.
Assume the same facts as above, but assume that Juliette spends significant time running the exploration activities of the business. Her share of the net profits is $90,200; 30% of Juliette’s share of the profits is $27,060. Juliette may treat as earned income eligible for the FEIE, the value of her services, subject to this cap of $27,060. If the value of her services for the year is only $25,000, then Juliette’s earned income is limited to the value of her services (i.e., $25,000).
If capital is not an income-producing factor and personal services produce the business income, the 30% rule does not apply. The entire amount of business income is “earned income” eligible for the FEIE.
Example: You and Virginia La Torre Jeker are US tax consultants and operate as equal partners in performing US tax consulting services in the United Arab Emirates. In this example, the tax consulting service itself is the income-producing factor, not capital. As such, all the income from the partnership is considered “earned income” and the 30% cap does not apply to limit the amount you may treat as eligible for the FEIE.
Treatment of Income from a Corporation The salary you receive from a corporation may be treated as “earned income” only if it represents reasonable compensation for the actual work undertaken for the corporation. Any amount that goes beyond a reasonable salary paid within the industry, is treated as “unearned income” and is not eligible for the FEIE. If you are an owner of the company, this excess can be treated as a “dividend” and taxed accordingly.
Example: Romeo is a US citizen and has been named as the Vice President of Simex corporation, a corporation organized in a foreign country. Even though Romeo has the title of Vice President, he does not carry out any work or service of any kind for the corporation. During the tax year Romeo received a $20,000 “salary” from the corporation. The $20,000 is unearned income and not eligible for the FEIE. If Romeo was an owner of the company, that $20,000 can be treated as a “dividend” and fully taxed. The maximum rate is 37%; a lower 15 or 20% “qualified dividend” rate may be possible if the requirements are met. More on qualified dividends at my blog post here.
On the other hand if Romeo did carry out bona fide services in his position as Vice President, and the $20,000 salary was reasonable compensation for the work he performed, then the $20,000 is “earned income” eligible for the FEIE.
Posted April 19, 2019
All the US tax information you need, every week –
Just follow me on Twitter @VLJeker (listed in Forbes, Top 100 Must-Follow Tax Twitter Accounts 2017-2019).
Subscribe to Virginia – US Tax Talk to receive my weekly US tax blog posts in your inbox.
Visit my earlier US tax blog “Let’s Talk About US Tax” hosted by AngloInfo since 2011, it contains all my old posts. Some hyperlinks to my blog posts on AngloInfo may have expired. If you copy the expired URL, you can most likely retrieve the actual post by using the “Wayback Machine” which is an archiving service. Simply paste the URL into the Wayback Machine search box. It will show you the archived post was saved on a specific date. Click on that date to retrieve the post.