A Brief Overview of Foreign Earned Income Exclusion

Because the United States operates on a global taxation model, U.S. citizens and green card holders must report their worldwide income whether it was earned domestically or in a foreign country.

For many taxpayers, this means a sizable amount of their income is subject to income tax—especially if they no longer reside in the United States. There are several tax strategies to help combat this tax liability, including a foreign earned income exclusion.

Who qualifies for the foreign earned income exclusion?

The foreign earned income exclusion allows qualified taxpayers to exclude up to $107,600 from their taxable income in 2020. This figure is adjusted annually for inflation. To qualify, filers must meet the following criteria from the IRS:

1. The taxpayer must have earned income (such as wages) or generate self-employment income.
2. The taxpayer must meet the bona fide residence test or the physical presence test.
3. The taxpayer must call a foreign country his or her tax home.

Most individuals who qualify for foreign earned income exclusion also qualify for and benefit from foreign housing exclusion. Both exclusions are reported annually on IRS Form 2555 (Foreign Earned Income).

What constitutes foreign earned income?

Foreign income encompasses income from all sources and includes the following:

• Salaries
• Commissions
• Bonuses
• Rents from foreign real estate
• Capital gains from the sale of foreign property
• Interest
• Dividends
• Royalties

All foreign income is reportable on the annual income tax returns. However, only income considered earned by the taxpayer can be excluded on Form 2555.

Earned income is defined as compensation for personal services performed by the taxpayer. This includes salaries and wages, commissions and bonuses, tips, and professional and consulting fees.

It’s crucial for taxpayers to report all forms of foreign income with precision to avoid audit or non-compliance penalties. Audits triggered by mistakes or omissions pertaining to foreign income are extremely invasive, cost tens of thousands of dollars and take years to resolve.

What is bona fide residence vs. physical presence?

The most important criteria for claiming the foreign earned income exclusion is passing either the bona fide residence test or the physical presence test. These tests essentially make a person eligible to claim foreign income by validating their presence in another country.

The physical presence test requires a presence in a foreign country or countries for at least 330 (non-consecutive) days in a 12-month period beginning or ending in the tax year. While that’s simple enough, it may prove difficult to pass for taxpayers who often come back to the United States. Domestic visits, even while on assignment from a foreign job, are included as a presence in the United States and may disqualify a taxpayer from meeting the test. The taxpayer must provide their dates of presence in and outside of the states to prove that they qualify for the test.

The bona fide residence test is a facts and circumstances test. It’s also the last resort to qualify for foreign earned income exclusion if the physical presence test cannot be met. To qualify, you must demonstrate your intention to reside permanently in a foreign country. The following facts would support the bonafide residence test:

• Opening a bank account
• Getting a driver’s license
• Registering to vote
• Obtaining a permanent residence permit or visa
• Purchasing a home or signing a long-term lease
• Paying taxes in a foreign country as a resident of that country

Simply staying in a foreign country for longer than a year does not meet this test.

For example, let’s say a taxpayer is on a 2-year work assignment in a foreign country and intends to return to the United States as soon as the assignment is over. In this example, they would not meet the bona fide residence test.

When to consult with a tax professional?

The provisions for claiming foreign earned income exclusion are relatively straightforward. That said, the nuances of what qualifies as earned income and applicable residence in a foreign country can be tricky. U.S. taxpayers living abroad should also remember the requirements of disclosing their foreign financial assets.

For these reasons, we recommend consulting with an international tax professional before filing if you’re considering this exclusion.