Chapter 18: I don’t pay taxes in the country where I live. Can I “exclude” my foreign income from the U.S. tax return?

The short answer is, as long as it is “earned income”, kind of YES!!!

It’s about the S. 911 of the Internal Revenue Code Foreign Earned Income Exclusion or the “FEIE” for short

If you live in a country that does NOT impose income taxation at all, or you just want a very simple filing situation, read on!

The “Foreign Earned Income Exclusion” – For those who are NOT interested in claiming tax credits on “earned income” (Form 2555)

The Foreign Earned Income Exclusion is found in S. 911 of the Internal Revenue Code. I strongly recommend that you read the actual section in the Internal Revenue Code.

See form 2555 or (better yet) Form 2555EZ.

Who is entitled to the exclusion?

There are two groups:

First, those with “foreign income” who are “bona fide residents of another nation” (this usually means they are tax residents and paying tax to other nations.

Second, those with “foreign income” who are outside the United States for at least 330 days in the year. Note that this group may NOT be paying tax in other nations ANYWHERE. Think “digital nomads” – yes it IS possible to live outside the United States and NOT pay taxes anywhere. But, remember it can be expensive to cut residency ties with a country that levies a “departure tax” (like Canada).


What may be excluded?

S. 911 includes (but is NOT limited to):

Exclusion from gross income

At the election of a qualified individual (made separately with respect to paragraphs (1) and (2)), there shall be excluded from the gross income of such individual, and exempt from taxation under this subtitle, for any taxable year—

  • the foreign earned income of such individual, and
  • the housing cost amount of such individual.

Foreign earned income

Definition

For purposes of this section—

In general

The term “foreign earned income” with respect to any individual means the amount received by such individual from sources within a foreign country or countries which constitute earned income attributable to services performed by such individual during the period described in subparagraph (A) or (B) of subsection (d)(1), whichever is applicable.

(B) Certain amounts not included in foreign earned income

The foreign earned income for an individual shall not include amounts—

received as a pension or annuity, paid by the United States or an agency thereof to an employee of the United States or an agency thereof, included in gross income by reason of section 402(b) (relating to taxability of beneficiary of nonexempt trust) or section 403(c) (relating to taxability of beneficiary under a nonqualified annuity), or received after the close of the taxable year following the taxable year in which the services to which the amounts are attributable are performed.

Heads up!!! Note that one CANNOT use the “Foreign Earned Income Exclusion” for “pensions” or “annuities”. This means that amounts that are “pensions” or “annuities” must be included on your U.S. tax return. The “pension” or “annuity” income could be subject to the Foreign Tax Credit rules which may mitigate the effects of U.S. tax. What would be the rate of U.S. tax payable? See the discussion of the “Stacking Provisions” below.

Those who either have a simple life or want a simple life can make a specific ELECTION (the election must actually be made) to “exclude” from your income up to approximately $100,000 USD of earned income per year.

The “Stacking Rule” – what if you your income exceeds the amount that you can exclude under the “Foreign Earned Income Exclusion”?

This is explained by the IRS as follows:

On May 17, 2006, TIPRA was enacted into law. Section 515 of TIPRA made several changes to section 911 of the Code. First, TIPRA increased the foreign earned income exclusion cap by indexing it for inflation after 2005. Thus, the amount of foreign earned income that may be excluded in 2006 is $82,400. Second, TIPRA modified the housing cost amount by changing the manner in which the floor is calculated and by generally imposing a cap equal to 30% of the maximum amount of the taxpayer’s foreign earned income exclusion. Third, TIPRA imposed a “stacking” rule on the amounts excluded under section 911, so that income not excluded by section 911 is subject to the same rate of tax as would have been applicable had the taxpayer not elected the section 911 exclusion. Thus, an individual with $82,400 of excluded income and $20,000 of taxable income will be taxed at rates that apply to taxable income in the range of $82,400 to $102,400 (25% or 28%), rather than $0 to $20,000 (10% or 15%).

See also the discussion starting on page 14 of the following publication from KPMG:

us-tax-americans-abroad-KPMG

Possible disadvantages of using the Foreign Earned Income Exclusion

  1. You are losing the possibility of generating foreign tax credits to offset against future U.S. taxation (this would be true if you the taxes you were paying on equivalent income in your country of residence were higher)
  2. You MAY end up paying more tax because of the “Stacking Rule” (see above)
  3. Remember that the Foreign Earned Income Exclusion applies ONLY to “earned income”

Possible advantages of using the Foreign Earned Income Exclusion

  1. Simplicity
  2. If the U.S. tax rate on your “earned income” is higher than the tax rate in your country of residence.
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