The United States is one of the few countries in the world that uses a worldwide tax system, making U. S. citizens and green card holders subject to tax on all of their income, regardless of source.
Most nations use a territorial regime, taxing only income derived within that country. A worldwide system subjects taxpayers to double taxation, first paying tax in the country of origin and then paying tax on the same income in the United States.
Fortunately, two provisions in the law alleviate some of this tax burden – the foreign earned income credit or exclusion and the foreign tax credit.
A qualifying taxpayer may exclude a certain amount of foreign earned income from taxable income. A qualifying individual may also claim a credit for the taxes paid on the foreign income, but the amount available as a credit must be reduced on a pro rata basis because of the exclusion.
If the host country has a lower tax rate than the United States, the exclusion may be more beneficial, depending on the amount of earned income. For 2015, an individual may exclude up to $100,800. This amount is indexed for inflation. Each spouse of a couple in which both spouses work can exclude income up to this amount.
In addition to the foreign earned income credit, qualified individuals may take an exclusion or a deduction for foreign housing costs.
There are three requirements for the foreign earned income credit:
1. The taxpayer’s tax home must be in a foreign country.
2. The taxpayer must have foreign earned income.
3. The taxpayer must meet the bona fide resident or the physical presence test.
First, the tax home must be in a foreign country. The IRS defines a tax home as “the general area of your main place of business, employment, or post of duty, regardless of where you maintain your family home.”
A foreign country does not include the Antarctic or U. S. possessions such as American Samoa, Guam, the U. S. Virgin Islands or Puerto Rico. Alternative benefits may be available for U.S. citizens resident in U.S. possessions.
Foreign Earned Income
Foreign earned income is income in the form of wages, salaries, commissions, bonuses, professional fees and tips. Civilian employees of the U.S. government and the U. S. military do not qualify for the exclusion.
The source of earned income is the place where individuals perform the services for which they are compensated. The exclusion does not apply to Social Security, Medicare or self-employment taxes if the individual is otherwise subject to such taxes. A taxpayer must file a return to take the exclusion even if there is no tax liability.
Bona Fide Resident or Physical Presence
Taxpayers must meet either the bona fide residence test or the physical presence test to qualify.
The bona fide residence test is met if individuals are bona fide residents of a foreign country for an uninterrupted period that includes an entire tax year. Qualification is determined on a case-by-case basis, but taxpayers must generally be able to prove that they are living as residents of a foreign country and intend to do so indefinitely.
The physical presence test is met if individuals are physically present in a foreign country or countries for 330 days during a period of 12 consecutive months. If they are not physically present for the entire tax year, the amount of the exclusion will be prorated.
For example, if taxpayers arrived in a foreign country on Aug. 2, 2015, they would meet the 330-day requirement on June 27, 2016, assuming they didn”t return to the United States during that time.
For 2015, they would have been physically present in a foreign country for 151 days. Their exclusion amount would be 151/365 X $100,800 = $41,370. Since they didn’t meet the 330-day test until June 27, they should file for an extension and then file the return once the test is met.
Alternatively, they can file without taking the exclusion and file an amended return when qualified. Once they have met the test, they continue to be qualified until they return to the United States for more than 35 days in a 12-month period.
Individuals do not have to be working or remain in the same country to qualify. For example, assume that their assignment ended and they have been in a foreign country for only 315 days. They could remain in a foreign country for an additional 15 days and meet the physical presence test, but they would need to be employed during that time and retain their foreign tax home.
The only exception to the 330-day test applies if taxpayers must leave the country because of war, civil unrest or adverse conditions in that country. The IRS publishes an annual list of countries that qualify for the waiver.
The exclusion is taken by filing Form 2555. When income is excluded under the foreign earned income exclusion, any remaining taxable income will be taxed at the rate it would have been subject to if the exclusion had not been taken.
For example, assume a filing status of married filing jointly with earned income in 2015 of $110,000. If taxpayers qualify for the full exclusion, it reduces their taxable income to $9,200. This amount of taxable income would normally be subject to a 10 percent rate. Lacking the exclusion, taxpayers would be in the 25 percent bracket, so their $9,200 would be taxed at 25 percent.
Sometimes the earned income will be fully excluded. In these cases, the employee can file a Form 673 with the employer, instructing the employer to discontinue income tax withholding. U.S. withholding can also be stopped if foreign withholding is imposed.
Foreign Tax Credit
Many Americans have foreign-based income but do not qualify for the foreign earned income credit. A foreign tax credit (FTC) is another way to relieve the burden of double taxation.
This credit is allowed against the U.S. income tax for income taxes paid to a foreign government. The credit may be taken for foreign income taxes paid on income such as interest and dividends.
It is also available to reduce the U.S. taxes on earned income in excess of the exclusion, but the amount of credit available is reduced pro rata because of the exclusion. Taxpayers resident in a treaty country should consult the treaty for beneficial rules regarding claiming foreign tax credits.
Form 1116 should be used for this credit with the amount of the credit shown on line 47 of Form 1040. If the amount of the foreign taxes was not more than $300 ($600 for married filing jointly), Form 1116 is not required.
There are other situations in which Form 1116 may not be required. If the tax rate of the foreign country is the same or greater than the U.S. rate – and it frequently is – the FTC will largely eliminate most of the U.S. tax due on that foreign income.
Properly applied, these two credits or exclusions can do much to reduce the burden of double taxation of foreign-sourced income. For more details of these tax breaks, consult your tax professional.