The Foreign Earned Income Exclusion (FEIE) is one of the only expat’s line of defense against the IRS. It’s a tax relief on your foreign earned salary, which allows expats to exclude up to a certain amount of their income to avoid making payments twice on it, both in the United States and in your country of residence.
If used correctly, the FEIE can help you exclude hundreds to thousands of dollars from your taxes. As an amount that is adjusted annually for inflation, for 2020 it allows you to exclude up to US $107,600 in wages, if you’re married you could exclude up to US$215,200 from your U.S. taxable income. In turn it can provide additional benefits to those living, working, and operating a business abroad.
FEIE, a sort of relief package, as mentioned before applies to employment income in foreign countries, either from your own business, as an employee, or if you are self-employed. By earned income it includes money you obtain from exchange of goods and services. It doesn’t apply to passive earnings such as retirement, or other investment income. In other words, if you’re a pensioner retiring offshore, it’s something you don’t need to consider.
Like anything to do with the fiscal system, 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:
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 with your local tax authorities before moving abroad to ensure you don’t get hit with a surprise tax bill. Some states of the United States do not honor the provisions of tax treaties.
There Are Two Tests To Qualify For The FEIE
The Physical Presence Test
A U.S. citizen or a U.S. resident alien who is physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months. 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 Bona Fide Residence Test
A U.S. citizen who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax 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 bona fide 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 amount of evidence in case you use of the FEIE is questioned… especially if your intentions change and you return to the United States after a few years.
Tax Home In A Foreign Country
The last step to qualify for the FEIE, the foreign housing exclusion, or the foreign housing deduction is your tax home, which must be in a foreign country throughout your period of bona fide residence or physical presence.
U.S. Income Tax Treaties
The United States has bilateral Income Tax Treaties with many countries which if imposed to foreign taxes entitles you as an American citizen to certain credits, exemptions, deductions, and reductions in the rate of taxes of the country you are residing abroad.
Time Waiver For The Bona Fide And Physical Tests
The bona fide residence test and the physical presence test have minimum time requirements. The minimum time requirements can be waived if you must leave a foreign country because of war, civil unrest, or similar adverse conditions in that country.
COVID-19 Waiver Of Time Requirement
You may still be able to meet the requirements of the bona fide residence or physical presence test for 2019 and 2020 for purposes of determining the FEIE and housing cost exclusion or deduction if, due to COVID-19, you had to leave your home country of:
- China (excluding the Special Administrative regions of Hong Kong and Macau) on or after December 1, 2019, but on or before July 15, 2020; or
- Another foreign country on or after February 1, 2020, but on or before July 15, 2020.
Income Tax Doesn’t Include Standard Deductions And Social Taxes
Such as FICA, Social Security, Medicare, 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.
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.
To Get The Benefit Of The FEIE, You Must File Your U.S. Tax Returns
As a U.S. citizen, you are taxed on your worldwide income. Your citizenship comes hand in hand with paying U.S. taxes.
If you don’t file your tax return while abroad the IRS will chase you down and you’ll lose the right of 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.
If you qualify, you can use Form 2555 to figure out your foreign earned income exclusion and your housing exclusion or deduction.
As mentioned above, the FEIE is loaded with complexities and nuances. Before you start an offshore business or work overseas, be sure to consult with a tax expert in this specific 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.