Americans working abroad may be eligible to exclude certain foreign earned income (wages, compensation for services) from US taxable income under the rules governing the Foreign Earned Income Exclusion (FEIE). The FEIE amount is adjusted annually for inflation. This amount for 2014 is $99,200. If a couple is married, each spouse can claim the full FEIE amount (e.g., for 2014, each spouse can exclude up to $99,200 of his or her earned income). If one spouse does not earn enough salary to fully utilize the exemption amount and has “excess” FEIE, this excess cannot be used by the other spouse to exclude amounts beyond his or her own exemption.
The exclusion can apply regardless of whether any foreign tax is paid on the foreign earned income, provided certain tests are met. Generally, for an individual to qualify for the FEIE, a “tax home” must be maintained in a foreign country and either the Bona Fide Foreign Resident (BFR) or Physical Presence Test (PPT) must be met.The exclusion benefits can be claimed only if a US tax return is filed within certain time deadlines. Those who have dropped out of the tax reporting system risk losing the FEIE benefit unless prompt action is taken to correct the filing situation.
This blog post will focus on what is meant by “earned income”. First, however, it will provide a brief overview of the major qualification tests for claiming the FEIE.
Qualification Tests for FEIE
For an individual to qualify for the FEIE, a “tax home” must be maintained in a foreign country and either the BFR or PPT must be met.
Generally, a “tax home” is the location of the main place of business, irrespective of where a family home is maintained. If the nature of a person’s work means that there is no regular or main place of business, then the tax home may be the place where the person regularly lives. A person is not considered to have a tax home in a foreign country if the person’s household is maintained in the US. Temporary presence in the US (for example, for vacation or for employment), does not necessarily mean that the household is in the US during such time. In defining what is meant by a “tax home” the law provides that the taxpayer shall not be treated as having a “tax home” in a foreign country “for any period for which his abode is within the United States.” What is the difference between one’s “tax home” and one’s “abode”? This is itself, a somewhat complicated question and I have done a separate blog posting on this issue. Access it here.
The BFR Test
To meet the BFR Test, a person must be a bona fide resident of a foreign country for an uninterrupted period which includes a full calendar year. A resident is one who, based on the facts and circumstances, has established a “tax home” and has in effect settled in that country. Green Card holders living in a foreign country can also qualify under the BFR Test under certain circumstances.
To meet the PPT an individual must be a US citizen or a resident alien, who is physically present in a foreign country or countries for 330 days in any 12 consecutive months. The 330 days do not have to be consecutive, but they must be whole days present in a foreign country. Travel time does not count toward the requisite 330 days if the travel is in the US or its possessions for periods of 24 hours or more, or takes place over international waters. Recordkeeping is critical. The Physical Presence Test often helps an individual on short assignment. It also enables an individual to come back to the US for short periods (generally up to one month) in any consecutive 12-month period and still qualify for the exclusions.
What is meant by “Earned Income”?
“Earned income” means just that – income that is earned for personal services performed in a foreign country. Some easily understood examples of “earned income” include salaries and wages, commissions, bonuses, tips and the fees one receives from the performance of professional services such as those from being engaged in a professional occupation (e.g., accountant, doctor or attorney). Earned income also includes amounts that are related to one’s employment such as the fair market value of noncash remuneration received through meals, lodging, personal use of a company vehicle; it includes amounts paid for vacation, sick leave, severance pay, as well as certain reimbursements and home leave and other similar allowances. An artist derives “earned income” from the sale of his or her own paintings. If one receives a scholarship or fellowship grant, any income that is paid for teaching, research or other services is considered “earned income” if it must be included in gross income.
“Earned Income” does not include any other types of income, for example, such as dividends or interest, pension or annuity payments, including social security benefits. IRS Publication 54 provides a list of income items that qualify as “earned income” and items that do not so qualify.
Between the two extremes of easily classifiable income items, certain types of income will arise that cannot easily be categorized as “earned” or “unearned’ income.
Treatment of Income from a Sole Proprietorship or Partnership. Income from a business such as a partnership or sole proprietorship must be carefully examined. It must be determined whether capital investment is the driving force in producing the income of the business or whether personal services produces that income.
Income earned from a business in which capital investment is an important part of producing the income may be treated as “unearned income”. If a taxpayer is a sole proprietor or partner and the taxpayer’s personal services also play an important role in producing the income, the part of the income that represents the value of the personal services will be treated as “earned income”. If capital investment is an important part of producing the income, then the law imposes a cap on the amounts that can be treated as “earned income”. Under the tax rules in such a case, no more than 30% of the share of the net profits of the business can be treated as earned income. In the event the business has no net profits, the part of the gross profit that represents a reasonable allowance for personal services actually performed is considered “earned income” and the 30% limit does not apply.
Examples: Juliette is a US citizen who meets the BFR test. Juliette invests significant sums of money into an oil and gas exploration partnership based in Saudi Arabia. Juliette performs no services for the partnership. At the end of the tax year her share of the net profits is $90,200. The entire $90,200 is unearned income and none of it can qualify for the FEIE.
Assume the same facts as above, but assume that Juliette spends significant time running the exploration activities of the business. Her share of the net profits is $90,200; 30% of Juliette’s share of the profits is $27,060. Juliette may treat as earned income eligible for the FEIE, the value of her services, subject to this cap of $27,060. If the value of her services for the year is only $ 25,000, then Juliette’s earned income is limited to the value of her services (i.e. $25,000).
If capital is not an income-producing factor and personal services produce the business income, the 30% rule does not apply. The entire amount of business income is “earned income” eligible for the FEIE.
Example: You and Virginia La Torre Jeker are US tax consultants and operate as equal partners in performing US tax consulting services in the United Arab Emirates. In this example, the tax consulting service itself is the income-producing factor, not capital. As such, all the income from the partnership is considered “earned income” and the 30% cap does not apply to limit the amount you may treat as eligible for the FEIE.
Treatment of Income from a Corporation. The salary you receive from a corporation may be treated as “earned income” only if it represents reasonable compensation for the actual work undertaken for the corporation. Any amount that goes beyond a reasonable salary paid within the industry, is treated as “unearned income” and is not eligible for the FEIE.
Example: Romeo is a US citizen and has been named as the Vice President of Simex corporation, a corporation organized in Senegal. Even though Romeo has the title of Vice President, he does not carry out any work or service of any kind for the corporation. During the tax year Romeo received a $20,000 “salary” from the corporation. The $20,000 is unearned income and not eligible for the FEIE. On the other hand if Romeo did carry out bona fide services in his position as Vice President, and the $20,000 salary was reasonable compensation for the work he performed, then the $20,000 is “earned income” eligible for the FEIE.
Original Post By: Virginia La Torre Jeker, J.D.