While Congress offers the foreign earned income exclusion (FEIE form 2555) and the foreign tax credit (FTC form 1116) to lighten the tax burden of American workers abroad, they don’t want it too light!
What Is The Revoked Exclusions Rule?
Each year a foreign worker can choose to between FEIE and FTC to pay the lowest amount of taxes. The revoked exclusion rule is designed to prevent taxpayers abroad from switching each year between FEIE and FTC. Simply put, if you had been using FEIE then switch to using FTC, then you are prohibited from switching back to use FEIE for a period of five years.
Sadly, retail tax software products offer the choice without communicating the consequences for subsequent years. Also since the vast majority of domestic tax preparers never use form 2555, they are unaware also, of the implications of switching between the two. Revoked exclusions are, in my opinion, a senseless complexity designed to deprive foreign workers of flexibility and to entrap them in the complexity of the tax code. But it is the law. How can we protect ourselves? Let’s dissect what it means to revoke exclusion.
How is an exclusion elected?
Before you can revoke exclusion, you must first “elect” exclusion. The FEIE and the housing exclusion are elected by actually using them on form 2555 in a return. The first time you complete form 2555, you have effectively elected to exclude either your foreign income or housing or both, depending on how you completed the form. Once you make this election, it remains in effect for subsequent years until you revoke the election.
How is the election revoked?
It is revoked by simply not claiming the exclusion on your return. The most likely scenario is when someone is working offshore for a while and determines that using the foreign tax credit (form 1116) will save him or her a couple thousand dollars more than using the exclusion during that year.
Here’s the rub: when exclusion is revoked, you are prohibited from claiming the exclusion again for five years. This is what the form questions are aiming for.
How to avoid audit risks on form 2555 related to revoked exclusions?
There are three audit risks related to revoked exclusions:
- Line 6a should always be the prior tax year, assuming you actually filed a form 2555. If you did not file from 2555 for the previous year, list the last year you filed. If you previously revokedyour election, this year should be five tax years before the current tax year. A number five year or less is an audit
- If there is a story why it is not the last tax year, I recommend entering “See Statement 1” and attaching an explanation of the answer. This approach frustrates the IRS computers, which are doing simple number checks. At the same time, you are being forthright .
- If this is the first year you have filed a form 2555in your life, you can leave 6a, 6c and 6d blank.
Can the foreign housing exclusion also be revoked?
If you have filed form 2555 before but never used the housing exclusion, this is not the same as revoking the housing exclusion. Again, in order to revoke exclusion, you first would have had to invoke it. Be cautious, because any confusion here can attract audit questions.
What if you have used form 2555 to invoke the exclusion and the housing exclusion/deduction, but then in the next year, you do not need the housing exclusion? What should you do?
If you fail to invoke the housing exclusion in a year, then you have “revoked” the housing exclusion and you must wait until the sixth year to use it again. I recommend completing the form to use the housing exclusion even if the excluded amount turns out to be $0; this prevents you from automatically revoking the housing exclusion and it takes nothing away from your income exclusion.
Portions of this post are from the book written by Clinton Donnelly on Foreign-Earned-Income-Exclusion – Avoiding IRS Audits Of Form 2555 now available on Amazon.
Americans Living Abroad…Have a question on foreign earned income? Contact Clinton Donnelly
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