Working Overseas and the Foreign Income Exclusion

U.S. citizens and residents face a number of challenges when they accept a foreign assignment. One of the most significant challenges is understanding the application of U.S. and foreign tax laws. This article is designed to help U.S. citizens and residents understand the unique tax provisions that apply to them while they are on foreign assignment.

One thing to mention up front is starting with the year 2006, taxpayers claiming the foreign earned income exclusion will pay tax at the tax rates that would have applied had they not claimed the exclusion. That means, instead of having their income taxed starting at the 10% rate, most expatriates will be taxed starting at the 25% tax bracket

If you are part of a corporate expatriate program, your employer may have a policy that ensures you are not disadvantaged from a tax perspective due to your foreign assignment. These employer tax policies are generally referred to as “Tax Equalization” or “Tax Protection” policies. This article does not discuss the general application of these policies. If your company has a tax equalization or tax protection policy, you should work with your company to obtain specific details.

U.S. expatriates will usually discover that their tax matters become extremely complex. Your taxable income may increase substantially due to assignment related expenses paid or reimbursed by your employer and tax returns are required in the U.S. and the foreign country. You will also encounter tax issues relating to the sale or rental of your home, moving expenses, state residency issues, foreign earned income and housing exclusions, foreign tax credit, foreign tax planning, tax equalization, and much more.

This article discusses in general terms some provisions of the U.S. federal income tax law that apply to U.S. citizens and resident aliens who live or work abroad and who expect to receive income from foreign sources. This article does not cover the Foreign Housing Deduction as that area depends on many factors too complex for discussion here, except to say that you will calculate any housing exclusion if you have taxable foreign income left over after taking the maximum allowable income exclusion.

As a U.S. citizen or resident alien, your worldwide income generally is subject to U.S. income tax regardless of where you are living. Also, you are subject to the same income tax return filing requirements that apply to U.S. citizens or residents living in the United States.

To exclude foreign income from taxes you must qualify for the exclusion by one of two methods. The "Bona Fied Residence" test or the "Physical Presence" test.

Bona Fide Residence Test

You meet the bona fide residence test if you are a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year. You can use the bona fide residence test to qualify for the exclusions and the deduction only if you are either:

A U.S. citizen, or

A U.S. resident alien who is a citizen or national of a country with which the United States has an income tax treaty in effect.

You do not automatically acquire bona fide resident status merely by living in a foreign country or countries for 1 year.

To meet the bona fide residence test, you must have established such a residence in a foreign country. Your bona fide residence is not necessarily the same as your domicile. Your domicile is your permanent home, the place to which you always return or intend to return.

Questions of bona fide residence are determined according to each individual case, taking into account factors such as your intention, the purpose of your trip, and the nature and length of your stay abroad. You must show the Internal Revenue Service (IRS) that you have been a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year. The IRS decides whether you qualify as a bona fide resident of a foreign country largely on the basis of facts you report on Form 2555. IRS cannot make this determination until you file Form 2555.

You are not considered a bona fide resident of a foreign country if you make a statement to the authorities of that country that you are not a resident of that country, and the authorities:

Hold that you are not subject to their income tax laws as a resident, or
Have not made a final decision on your status.

To qualify for bona fide residence, you must reside in a foreign country for an uninterrupted period that includes an entire tax year. An entire tax year is from January 1 through December 31 for taxpayers who file their income tax returns on a calendar year basis. During the period of bona fide residence in a foreign country, you can leave the country for brief or temporary trips back to the United States or elsewhere for vacation or business. To keep your status as a bona fide resident of a foreign country, you must have a clear intention of returning from such trips, without unreasonable delay, to your foreign residence or to a new bona fide residence in another foreign country.

Physical Presence Test

You meet the physical presence test if you are physically present in a foreign country or countries 330 full days during a period of 12 consecutive months. The 330 days do not have to be consecutive. Any U.S. citizen or resident can use the physical presence test to qualify for the exclusions and the deduction.

The physical presence test is based only on how long you stay in a foreign country or countries. This test does not depend on the kind of residence you establish, your intentions about returning, or the nature and purpose of your stay abroad.

330 full days. Generally, to meet the physical presence test, you must be physically present in a foreign country or countries for at least 330 full days during a 12-month period. You can count days you spent abroad for any reason. You do not have to be in a foreign country only for employment purposes. You can be on vacation time. You do not meet the physical presence test if illness, family problems, a vacation, or your employer's orders cause you to be present for less than the required amount of time.

Exception. You can be physically present in a foreign country or countries for less than 330 full days and still meet the physical presence test if you are required to leave a country because of war or civil unrest.

Full day. A full day is a period of 24 consecutive hours, beginning at midnight.

Travel. When you leave the United States to go directly to a foreign country or when you return directly to the United States from a foreign country, the time you spend on or over international waters does not count toward the 330-day total.

How to figure the 12-month period.

There are four rules you should know when figuring the 12-month period.

Your 12-month period can begin with any day of the month. It ends the day before the same calendar day, 12 months later.

Your 12-month period must be made up of consecutive months. Any 12-month period can be used if the 330 days in a foreign country fall within that period.

You do not have to begin your 12-month period with your first full day in a foreign country or end it with the day you leave. You can choose the 12-month period that gives you the greatest exclusion.

In determining whether the 12-month period falls within a longer stay in the foreign country, 12-month periods can overlap one another.

You can begin a foreign assignment in one year and end in another and qualify each tax year for the exclusion. The amount of foreign income you can exclude in any tax year depends on the number of days you were outside the US during that tax year.

Example: You were outside the US for 180 days in 2009. The maximum exclusion amount of $91,400 is pro-rated to the number of days you were outside the US, giving a maximum exclusion amount of $45,074. You would only owe tax on income that exceeds this amount.

click here for a calculator to determine your exclusion and taxable income.

If you could have qualified for a foreign income exclusion in a previous year and did not claim it on your return you can amend that year to claim the exclusion. The years available for amending are 2006, 2007, and 2008.

Foreign Income Taxes

In some cases, foreign income tax you pay can be credited against your U.S. tax liability or deducted in figuring taxable income on your U.S. income tax return. It is usually to your advantage to claim a credit for foreign taxes rather than to deduct them. A credit reduces your U.S. tax liability, and any excess can be carried back and carried forward to other years. A deduction only reduces your taxable income and can be taken only in the current year. You must treat all foreign income taxes in the same way. You generally cannot deduct some foreign income taxes and take a credit for others.

Tax credit. If you choose to credit foreign taxes against your tax liability, you generally must complete Form 1116, Foreign Tax Credit (Individual, Estate, Trust, or Nonresident Alien Individual), and attach it to your U.S. income tax return. Do not include the foreign taxes paid or accrued as withheld income taxes on Form 1040.

Limit. Your credit cannot be more than the part of your U.S. income tax liability allocable to your taxable income from sources outside the United States. So, if you have no U.S. income tax liability, or if all your foreign income is excludable, you will not be able to claim a foreign tax credit.

If the foreign taxes you paid or incurred during the year exceed the limit on your credit for the current year, you can carry back the unused foreign taxes as credits to the 2 previous tax years and then carry forward any remaining unused foreign taxes to the next 5 tax years.

You will not be subject to this limit and may be able to claim the credit without using Form 1116 if the following requirements are met.

You are an individual.
Your only foreign source income for the tax year is passive income (dividends, interest, royalties, etc.) that is reported to you on a payee statement (such as a Form 1099-DIV or 1099-INT).
Your qualified foreign taxes for the tax year are not more than $300 ($600 if filing a joint return) and are reported on a payee statement.
You elect this procedure for the tax year.

If you make this election, you cannot carryback or carryover any unused foreign tax to or from this tax year.

State Tax Issues

There are 50 states with 50 different rules on this question. If prior to leaving the U.S., you lived in a no tax state such as Nevada, Washington, Texas or Florida no return is required. Some other states say if you are gone for more than six months, no return is required. Other states such as Virginia, South Carolina, New Mexico and California look at whether you still have a “tax domicile” in the state and then still require you file a return tax returns (for all years of your absence) even though you have been gone for years. They look at your intent to return to the state after your stay abroad, and various indices that may indicate you never planned on giving up your “tax domicile” such as if you still maintain a state drivers license; state voter registration; library card; bank accounts; real property; license plates for your car; or if you children still go to school in the state.

If you want to avoid tax problems with your previous home state with “tax domicile laws” many years down the line demanding you file state income tax returns for the entire period you lived abroad, and demanding you pay all of the taxes, interest and penalties due for that period, you should not move back to that state when you return permanently to the U.S. You must also upon moving abroad give up all state drivers licenses, bank accounts, real property, voter registration, etc. Not all states are this tough, but some like Virginia, New Mexico, South Carolina and California do impose very tough rules. Investigate the tax law in your state of residency prior to your departure to live abroad to avoid having to file state tax returns with some certainty that those state taxes will not later be assessed while you are still abroad or upon your return.