I. FACTS
Assume that a U. S. taxpayer ( a U.S. citizen or resident for tax purposes) accepts employment outside the U.S. for two years at an annual salary of $70,000, payable by a foreign company directly to the taxpayer residing in that country. In addition, the company pays a housing allowance of $25,000 per year. The taxpayer leaves the U.S. in March 2001.
1. Does the taxpayer qualify for any U.S. tax credits or exclusions?
2. If so, how do such, exclusions and/or credits apply?
What procedures must be followed by the taxpayer in order to claim these benefits?
III. CONCLUSION
In general, the taxpayer may elect to exclude a portion of his earned income and housing expenses from U.S. taxation. Alternatively, the taxpayer may forego the earned income exclusion and, instead, use the foreign tax credit to offset U.S. taxes levied against the foreign income. In some cases, the taxpayer may use a combination of the earned income exclusion and the foreign tax credit.
In addition, taxpayers are entitled to elect a foreign housing exclusion, whether or not they claim the earned income exclusion
IV. ANALYSIS
U.S. taxpayers are taxed on their world-wide income and must file U.S. tax returns, regardless of the country in which they live. These taxpayers pay U.S. income taxes on their world-wide income, and are entitled to the same deductions, exclusions, and credits that taxpayers residing in the U.S. receive. In this case, even though the taxpayer is paid by a foreign company[1] directly to his account in the foreign country where he works, U.S. taxpayers are still required to file U.S. tax returns and pay taxes on their income.
A taxpayer who also pays taxes to a foreign country, in most cases, will benefit from a foreign tax credit which will reduce or possibly eliminate U.S. tax on the income.[2]
Note: The amount of the foreign tax credit cannot exceed the amount of U.S. tax payable on the foreign income. Thus, in general, the taxpayer will end up paying an overall tax that is equal to the higher of the U.S. or foreign country’s tax rates.
Example: One earns $70,000 while living in Country X which taxes income at an average rate of 40%, thus the taxpayer pays $28,000 in taxes. The taxpayer reports the $70,000 on his U.S. tax return and is charged $20,000 in U. S. taxes. The taxpayer is entitled to a foreign tax credit of $20,000 and will owe no additional U.S. taxes. In contrast, if Country X taxed $15,000, then the foreign tax credit would be $15,000 and he would pay an additional $5,000 in U.S. taxes. Thus, the taxpayer winds up paying taxes at the highest overall rate, but is not taxed twice on compensation.
Alternatively, if the taxpayer qualifies, they may elect a foreign earned income exclusion on the amounts earned in the foreign country. The foreign earned income exclusion applies regardless of the amount of tax, if any, that is paid to the foreign country. Consequently, electing the foreign earned income tax exclusion is beneficial if the foreign country has a low (or no) tax rate on the income, compared to the U.S. tax rate.
To qualify for the foreign earned income exclusion, a U.S. citizen working abroad must have a "tax home" in a foreign country. Note: American Samoa, Guam, the Commonwealth of the Northern Mariana Islands, Puerto Rico, the Virgin Islands and the Antarctic region are not considered foreign countries under this rule.
If one’s tax home – where they have their regular or principal place of business or employment – is in a foreign country, and one meets either the bona fide residence test or the physical presence test, then they qualify for the foreign earned income exclusion. The foreign exclusion amounts are as follows:
| Tax Year | Maximum Exclusion Amount |
| 2000 | $76,000 |
| 2001 | $78,000 |
| 2002 and thereafter | $80,000 |
The foreign tax credit will not apply to amounts that qualify for the exclusion; however, the taxpayer may use the foreign tax credit for earned income that exceeds the exclusion limitations. For instance, if the foreign exclusion is $78,000 and the taxpayer earns $150,000, the foreign tax credit will be available for the $72,000 exceeding the limitation ($150,000 - $78,000 = $72,000). Of course, the taxpayer must pay foreign taxes on $150,000 to gain a credit for taxes paid.
To qualify under the bona fide residence test, one must be a bona fide resident of a foreign country or countries for an uninterrupted period that includes a full tax year. Where one is a calendar year taxpayer, this would include a January to December period. During a period of bona fide residence, one may leave the foreign country for brief or temporary trips elsewhere for vacations or business. See IRC Sec. 911(d)(1)(A).[3
Even if one does not qualify under the bona fide residence test, one may still be eligible for the exclusion if they qualify under the physical presence test. Under this test, one would qualify if 330 full days out of any 12-consecutive month period are spent in a foreign country or countries. See IRC Sec. 911(d)(1)(B).[4] Physical presence in 2000 can be counted in determining whether one meets the 330 day physical presence test during a consecutive 12-month period for purposes of the 2001 exclusion.
Foreign earned income includes foreign source wages, salaries, commissions, bonuses, cost of living differential, home leave, non-cash income (e.g., lodging, car), tips or professional fees, as well as other forms of compensation for the rendering of personal services during the period that the taxpayer’s tax home was located in a foreign country and the taxpayer met either the bona fide residence test or the physical presence test.
If income qualifies for the exclusion, it is non-taxable even if it is received when the taxpayer resides in the U.S. For instance, if the taxpayer qualifies for a $78,000 exclusion in 2001 and is paid $40,000 in 2001 and the balance in 2002, the entire amount qualifies for the exclusion even if the taxpayer resides in the U.S. during 2002. Conversely, if the taxpayer receives a payment for work performed while residing in the U.S., the fact that he qualifies for the exclusion at the time payment is received does not convert the payment to earned income which is excludable under the foreign earned income exception (the income was not “foreign” earned income).
Examples of unearned income include: alimony, annuities, capital gains, dividends, gambling winnings, interest, pensions and unemployment benefits. Rents and royalties are usually considered unearned income, but this depends on the degree of personal services, if any, that contributed to the production of the income.
If one meets the bona fide residence or the physical presence test, one may also exclude an amount based upon employer-provided foreign housing costs, although this might limit their foreign earned income exclusion. In general, if the taxpayer spent the entire year in the foreign country, the foreign housing exclusion will be the excess of housing costs over $10,171, a number which is calculated with reference to a percentage of a federal employee’s salary[5]
For example, if the taxpayer’s housing cost was $25,000, the exclusion will be $14,829 ($25,000 - $10,171 = $14,829), assuming he was out of the country for the entire year.
One must make a separate election for each of these exclusions - they are not automatic. One elects and claims the foreign earned income and housing exclusions on Form 2555, which is attached to Form 1040. Those living overseas on April 15th have a two-month extension to June 15th to file their individual income tax returns (Form 1040). Generally, a person working abroad, files their tax returns at the Internal Revenue Service Center, Philadelphia, PA 19255-0002. One should inform their employer not to withhold taxes on amounts that are subject to these exclusions, by providing the employer with a completed IRS Form 673, which can be downloaded from the IRS website (http://www.irs.ustreas.gov/prod/forms_pubs/forms.html).
Remember, if one has a foreign bank account or engages in certain foreign currency transactions, they will need to report these activities on Form 4790 (International Transportation of Currency) and TD F 90-22.1 (Foreign Banks and Financial Accounts). In general, check out IRS Publication 54, “Tax Guide for U.S. Citizens and Residents Abroad” for additional information regarding tax filing obligations: (http://www.irs.ustreas.gov/prod/forms_pubs/pubs/p54toc.htm)
[1] It does not matter whether the employer is a U.S. or foreign company, the taxpayer must report the income paid to him.
[2]The operation of the foreign tax credit is complicated and there are many limitations that apply. A thorough discussion of the foreign tax credit is beyond the scope of this discussion.
[3] IRC Sec. 911(d) (1) reads as follows:
Qualified Individual --The term "qualified individual" means an individual whose tax home is in a foreign country and who is--
(A) a citizen of the United States and establishes to the satisfaction of the Secretary that he has been a bona fide resident of a foreign country or countries for an uninterrupted period which includes an entire taxable year, or
a citizen or resident of the United States and who, during any period of 12 consecutive months, is present in a foreign country or countries during at least 330 full days in such period.
[4] Id.
[5] This number represents 16% of the annual salary earned by a Federal employee at grade level GS-14, as of January 1, of the calendar year in which the individual’s tax year begins (for 2000, the salary is $63,567). The taxpayer is entitled to exclude amounts over this amount, determined on a number of days during the year the taxpayer was either a bona fide resident or met the physical presence test. Thus, if the taxpayer met either test for the entire year, then the full exclusion would be available.
This number represents 16% of the annual salary earned by a federal employee at grade level GS-q4, as of January 1 of the calendar year in which the individual's tax year begins (for 2000, the salary was $63,567). The taxpayer is entitled to exclude amounts over this base amount, determined on a number of days during the year the taxpayer meets either foreign residency test. Thus, if the taxpayer met either test for the entire year, then the full exclusion would be available.