Reduce or Eliminate Your US Tax Bill with the Foreign Earned Income Exclusion

The foreign earned income exclusion (the “FEIE”) is often the centerpiece of an expat’s tax strategy. However, there are some ins and outs here—the FEIE is not simply a “get out of US tax free” card.

Written by Stewart Patton

The FEIE allows a US citizen or green card holder who lives and works outside the United States to completely eliminate US income tax on up to about $100,000 of “foreign earned income” each year. (The exact amount is tied to inflation and so varies each year—it’s $101,300 for 2016.)

For a married couple, the FEIE applies to each spouse separately.  So, each spouse mush separately meet the tests described below, and they can each exclude up to about $100,000 of their own foreign earned income.

Income to which the FEIE Applies

The FEIE only applies to “foreign earned income,” which is income from services you perform while you live outside the United States. Earned income includes wages, salary, and bonuses you earn as an employee or an independent contractor.

The above is the only requirement for income to qualify as foreign earned income. So, it doesn’t matter if

Special Rules for the Self-employed

If you’re an independent contractor, a professional, or you operate a business in your own name or through a flow-through entity (such as a US LLC), then you’re treated as “self-employed” for US tax purposes. There are several special rules that apply to you.

First, you still must pay US self-employment tax—the FEIE does not apply for self-employment tax purposes. Self-employment tax is 15.3% on income up to $118,500, and 2.9% above that. If you live in a country that has a “totalization agreement” with the US, and you pay into that country’s equivalent of Social Security, then you will likely be able to get out of paying US self-employment tax. You would need to get a “certificate of coverage.” Click HERE to find out if your country has a totalization agreement (and then you can get to the actual text as well).

Additionally, if you own a business in your own name or through a flow-through entity (such as a US LLC), there are two other rules that severely limit the effectiveness of the FEIE. Generally, these rules are as follows:

  1. Under the “30% rule,” you can only treat up to about 30% of the net income from your business as “foreign earned income”-you’d just have to pay US tax on the rest. This rule only applies to businesses where “capital is a material income-producing factor”-so, businesses with inventory or that require a significant capital investment to get started.
  2. Under the “scaleback rule,” the amount you can exclude under the FEIE is reduced to take into account business deductions. The idea here is that you can’t have a double benefit-you can’t use the FEIE and a business deduction against the same dollar of gross income. The net effect of this rule is that you still may have to pay US income tax even if your net is under about $100,000.

For this reason, it’s generally much better to operate your business through a non-US corporation instead of in your own name or through a flow-through entity. These issues are discussed more fully in this article.

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Rules to qualify for the FEIE

To take the FEIE, you must pass two tests. You first must pass the “tax home test.” Then, you must pass either the “physical presence test” or the bona fide residence test.”

Let’s discuss each of these in turn.

Tax Home Test

You can only claim the FEIE if your “tax home” is in a foreign country. Your tax home is the place where you’re permanently or indefinitely engaged to work as an employee or self-employed individual. This test is normally not a big deal. If you’ve moved to a foreign country or you’ve become a digital nomad and you intend to be outside the US for at least a year, your tax home has almost always moved outside the US as well.

Foreign Residence Tests

In addition to the tax home test, you must also meet one of two tests designed to insure that your stay outside the US is sufficiently lengthy to warrant application of the FEIE. The two tests are the “physical presence test” and the “bona fide residence test.”

To meet the physical presence test, you must be physically present in one or more foreign countries for at least 330 days during any 12-month period. Any day spent traveling to or from the US does not count as a day of physical presence in a foreign country. If you meet the physical presence test, you can claim the FEIE for the parts of each tax year that fall within that 12-month period. The amount of income you can exclude with the FEIE is pro-rated based on the number of days in the tax year that you qualify.

To meet the bona fide residence test, you must establish a new home in a foreign country for an uninterrupted period that includes an entire taxable year. The determination of whether you have established a new home in a foreign country is made based on all the facts and circumstances. You absolutely must have some sort of immigration status in the foreign country that allows you to stay there permanently or at least for some extended period-tourist visa isn’t enough.

Once you’ve met the bona fide residence test, you’re no longer restricted to only 35 days back in the US each year. You could spend several months back in the US and still meet the bona fide residence test as long as you haven’t actually moved back to the US and abandoned your residence in the foreign country.

Insure your FEIE Eligibility

Some US citizens mistakenly believe they don’t need to file a US tax return if the FEIE eliminates their entire US tax liability. That’s not the case—you must file a return each year that your gross income is over the applicable return threshold, even if your income is under the FEIE cap of about $100,000.  This threshold is generally $10,000 for single filers, $3,900 for married filing separately, and only $400 for those with income from self-employment.

Additionally, the FEIE can only be claimed on a timely filed US tax return or a return that is filed before the taxpayer is under IRS audit. Therefore, if you don’t file a return and you’re audited, you’re not allowed to go back and claim the FEIE at that point—it’s too late. An expat who doesn’t file a US tax return each year runs the risk of squandering a golden opportunity.

Want to know more?

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Stewart Patton

I'm Stewart Patton, US tax attorney and expat entrepreneur based in beautiful Belize. Read more about me here, or email me at [email protected] to discuss how I can help.

U.S. Tax Services, P.O Box 2651 Belize City, Belize • Belize tel: (+501) 629-6007 • U.S. VOIP: (312) 675-8571 • Email: [email protected]