Working Abroad
Consider the Foreign Earned Income Exclusion on your U.S. tax return.
FOREIGN EARNED INCOME IS TYPICALLY INCOME RECEIVED FOR SERVICES PERFORMED IN A FOREIGN COUNTRY.
U.S. citizens and resident aliens working abroad are required to report their worldwide income to the IRS annually, regardless of where they live or work, but they may benefit from the Foreign Earned Income Exclusion. This exclusion allows eligible individuals to elect to exclude all or a portion of their foreign earned income for 2020 up to a maximum of $107,600 (note this amount is indexed for inflation annually). Taxpayers must meet the eligibility requirements to claim the exclusion and should consider whether or not the exclusion is beneficial to their individual tax situation or if they should consider other tax credit options.
Individuals are eligible if they have foreign earned income while their tax home is in a foreign country and they meet either the bona fide residence test or physical presence test. Foreign earned income is typically income received for services performed in a foreign country. Examples of earned income are salaries, wages, bonuses, commissions and costof-living allowances received.
The IRS describes an individual’s tax home as the place where one is engaged to work permanently or indefinitely. A frequent business traveler may not have a regular place of business, and then a tax home can be considered where one habitually lives. To meet the bona fide residence test, one must be considered a bona fide resident of a foreign country or countries for an entire year. A U.S. resident alien must also have a citizenship or nationality from a country that has an income tax treaty in effect to meet this test. Generally, a taxpayer is considered a bona fide resident of a country if the taxpayer goes to work in that country for an indefinite amount of time and establishes living quarters there for themselves and their family. To meet the physical presence test the taxpayer must be physically present in a foreign country or countries for at least 330 full days (for any reason) during a consecutive 12-month period. This 12-month period can begin on any day of the month and does not need to be in a calendar year.
To claim the exclusion, the taxpayer must file Form 2555 (an affirmative election under IRC Section 911) with their tax return by the filing due date (including extensions) for the first year the exclusion is claimed. The form must be filed annually for all years the exclusion is claimed until it is revoked. In the first year of claiming exclusion, the taxpayer may benefit from filing an extension in order to fulfill the 330-day count for the physical presence test. The exclusion will remain in effect until the taxpayer revokes it.
Each taxpayer’s situation is different and requires thoughtful planning to determine which approach is more beneficial: either claiming the foreign tax credit for taxes paid on income earned abroad, or filing to exclude the income under the Foreign Earned Income Exclusion. Generally, taxpayers living in countries with tax rates higher than those of the United States may benefit more from foreign tax credit planning than from taking the exclusion. The exclusion is generally more beneficial if the taxpayer’s income is below the exclusion amount or the taxpayer lives or earns a living in a low-taxing jurisdiction. An international tax advisor should perform an analysis to determine the best approach for an individual’s tax needs.