Foreign Earned Income Exclusion Basics
The Foreign Earned Income Exclusion (FEIE) is the expat’s first, and sometimes only, line of defense against the IRS. It allows you to eliminate up to US$101,300 in salary from your U.S. taxable income in 2016 and can provide additional benefits to those living, working, and operating a business abroad.
Note that the FEIE applies to salary you earn from your own business or as an employee. It doesn’t apply to retirement or other investment income. In other words, if you’re a pensioner with no intention of getting a job or starting a business offshore, it’s something you don’t need to think about.
But let’s say you’re an employee of a corporation in Belize who qualifies for the FEIE. If you earn US$65,000 in wages, you’ll pay no federal income tax. If you earn US$200,000 in salary while qualifying for the exclusion, you’ll only pay U.S. tax on the amount over US$101,300, or on US$98,700.
Like anything to do with tax, the FEIE is full of rules and exceptions to those rules. If you’re planning a move overseas, you should engage help from a tax advisor to understand your own situation. But, to get started, here are some basic things a would-be expat should know:
1. The exclusion applies to federal-income tax. It’s possible to qualify for the FEIE and still be considered a resident of a state in the United States…especially an aggressive cash-starved state like California. In that scenario, you may have to pay state tax on 100% of your salary. You should review your state laws before moving abroad to ensure you don’t get hit with a surprise tax bill.
2. There are two ways to qualify for the FEIE: the physical presence test and the residency test.
You qualify for the FEIE under the “physical presence test” if you’re absent from the United States for 330 out of any 365-day period. It doesn’t require you to be out of the country for 330 days in a calendar year: any 12-month period will do. When you rely on the physical presence test, it doesn’t matter where you are in the world. You can move around as much as you like, are not required to have a home base, and are not required to be in any one country for a certain period of time.
The “residency test” requires you to be resident in a country for a full calendar year. This usually means adopting the physical presence test your first year abroad, and then stepping up to the residency test. The key to the test is your intent to move to that place for the long term, with no intent to return to the United States. Any time a tax issue is determined by something as fuzzy as “intent,” you’re asking for trouble in an audit. You must compile a great litany of evidence in case your use of the FEIE is challenged…especially if your intentions change and you return to the United States after a few years.
3. Income tax doesn’t include social taxes, such as FICA, Social Security, Medicare, Obamacare or self-employment taxes. If you’re an employee of a U.S. company while qualifying for the exclusion, you and your employer will pay these taxes. If you’re running a business and not incorporated offshore, you’ll pay about 15% in self-employment tax, which is not reduced by the FEIE. To avoid this, you or your employer can incorporate a subsidiary offshore from which you’ll draw a salary.
4. The exclusion is based on earnings in U.S. dollars. If your country’s currency is appreciating against the dollar, the value of the exclusion to you is declining.
5. To get the benefit of the FEIE, you must file your U.S. tax returns. If you don’t file and the IRS chases you down, you’ll lose the right to take the exclusion. Even if you spent every day for five years outside of the United States, and there would be no question of your qualifying, the IRS has the right to take away the exclusion for your failure to file.
As mentioned above, the FEIE is fraught with complexity and nuance. Before you start an offshore business, or go to work outside the United Sates, be sure to consult with an expert in this area. Even if you’ve been living abroad for years, it’s in your best interest to have an experienced professional review your prior filings, plan out your next few years, and make sure you are in compliance.