In the realm of tax discussions, the spotlight often falls on corporate provisions, such as the territorial tax system, ushered in by the Tax Cuts and Jobs Act (TCJA). However, there exists a longstanding provision that extends significant tax benefits to U.S. individuals working abroad—the Foreign Earned Income Exclusion. This provision, outlined in section 911 of the Tax Code, offers a host of advantages to U.S. citizens and residents living overseas.
Unpacking the Exclusion
At its core, the foreign earned income exclusion empowers U.S. individuals working abroad to exclude a specified amount of foreign earned income from U.S. taxation. This exclusion extends to a designated housing amount, presenting an appealing alternative for those residing in low-tax foreign jurisdictions. It offers a streamlined approach, sidestepping the intricate calculations tied to the foreign tax credit.
To qualify for the benefits accorded by section 911 of the Code, individuals must meet the criteria of a "qualified individual." This entails:
- Physical Presence or Bona Fide Residence:
- The individual must be physically present in a foreign country for at least 330 days during any 12-month period.
- Alternatively, the individual can qualify as a bona fide resident of a foreign country for an uninterrupted period encompassing an entire taxable year.
- Tax Home in a Foreign Country:
- The individual's tax home must be in a foreign country, indicating their principal or regular place of business.
This exclusion strictly applies to foreign-source income earned during the period meeting the foreign tax home requirement and satisfying either the bona fide foreign resident test or the 330-day physical presence test.
A notable development under the Bipartisan Budget Act of 2018 now extends the exclusion to contractors providing support to U.S. Armed Forces in designated combat zones, even if their tax home remains in the United States.
Navigating Exclusion Limits
The maximum foreign earned income eligible for exclusion undergoes annual adjustments for inflation:
|
Year |
Maximum/Indexed Amount |
|
2014 |
$99,200 |
|
2015 |
$100,800 |
|
2016 |
$101,300 |
|
2017 |
$102,100 |
|
2018 |
$103,900 |
This maximum amount is prorated based on the number of qualifying days in a taxable year. For instance, if an individual qualifies as a qualified individual for the 2017 tax year but only accrues 325 qualifying days, the maximum exclusion becomes the 2017 maximum/indexed amount of $102,100 multiplied by 325/365.
Housing Exclusion: Calculating Eligible Expenses
In addition to the foreign earned income exclusion, taxpayers can benefit from a housing exclusion. This exclusion equals the excess of eligible housing expenses over a base amount. Qualifying expenses include rent, utilities, property insurance, rental of furniture and accessories, and household repairs.
The base housing amount is 16% of the maximum/indexed amount for foreign earned income during the tax year. For 2018, the calculation unfolds as follows:
Base Housing Amount=16%×$103,900 (Maximum/Indexed Amount for 2018)=$16,624
Base Housing Amount=16%×$103,900(Maximum/Indexed Amount for 2018)=$16,624
Housing expenses exceeding the base amount are eligible for the housing exclusion, but they cannot surpass a specified limit linked to the taxpayer's location. In most cases, this limit is set at 30% of the maximum/indexed foreign earned income amount for the tax year.
Strategic Considerations and Limitations
While the foreign earned income exclusion presents an attractive tax strategy, certain considerations and limitations must be acknowledged:
- Foreign Tax Credit and Deductions: Taxpayers cannot claim a foreign tax credit for income taxes tied to the excluded foreign earned income, and deductions linked to excluded foreign earned income are disallowed.
- Remaining Tax Calculation: If a taxpayer claims the foreign earned income exclusion or the housing exclusion, they must calculate the tax on the remaining non-excluded income using the tax rates that would have applied without the exclusions.
To elect the foreign earned income exclusion, taxpayers must file Form 2555, Foreign Earned Income, with the IRS. This form establishes the taxpayer's qualified individual status, computes foreign earned income, and specifies the total exclusion amount for inclusion on Form 1040.
In essence, the foreign earned income exclusion emerges as a powerful tool offering both quantitative and qualitative advantages to U.S. individuals residing abroad. While the foreign tax credit traditionally serves as the primary mechanism to mitigate double taxation, this special exemption for foreign-source income provides a unique avenue. It allows taxpayers operating in low-tax jurisdictions to benefit from reduced taxes overseas and circumvent the complexities entwined with the foreign tax credit.
As individuals tread the path of international work and residence, the foreign earned income exclusion stands as a beacon, offering a strategic means to optimize tax outcomes and enhance financial well-being.