FOREIGN EARNED INCOME EXCLUSION: BONA FIDE VS PHYSICAL PRESENCE TEST

People who live and work outside the United States may be able to exclude all or part of their foreign-source wages and self-employment income from the federal income tax through a provision called the foreign earned income exclusion. To qualify for the foreign earned income exclusion, a person needs to:
•Work and reside outside the United States, and
•Meet either the Bona Fide Resident or Physical Presence tests.

Persons who qualify are eligible to exclude up to $100,800 in foreign earned income annually, depending on the year. The amount of the foreign earned income exclusion changes each year.
Persons may also be eligible to to exclude an additional amount for housing using the foreign housing exclusion or deduction. Types of Income to Which the Foreign Earned Income Exclusion Applies: The foreign earned income exclusion applies only to income arising from performing services either as an employee or as an independent contractor. “The term ‘earned income’ means wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered (Internal Revenue Code section 911(d)(2)(A)). Thus, wages and self-employment income may qualify for the foreign earned income exclusion. Other types of income cannot be excluded using this provision. From Which Tax is Income Excluded? The foreign earned income exclusion functions to exclude earned income from the federal income tax. The foreign earned income exclusion does not exclude income from Social Security or Medicare taxes. Thus, the foreign earned income exclusion does not reduce the self-employment tax, which is the mechanism by which self-employed persons pay in the Social Security and Medicare taxes.  Further, self-employed persons are eligible to take the foreign housing deduction instead of the foreign housing exclusion. Persons must meet one of two qualification tests to claim the Foreign Earned Income Exclusion. A person must meet either the bona fide residence test or the physical presence test.
BONA FIDE

A person is considered a “bona fide resident” of the foreign country if that person resides in that country for “an uninterrupted period that includes an entire tax year.” A tax January 1 through December 31. The qualifying period for the bona fide residence test must include one full calendar year.Trips outside the Foreign Country. Brief trips or vacations outside the foreign country will not jeopardize a person’s status as a bona fide resident, as long as the trips are brief and the person clearly intended to return to the foreign country. A person can even make brief trips to the United States.

Statement to Foreign Authorities
A person is not be considered a bona fide resident of a foreign country if a person has submitted a statement to the foreign country that he or she are not a resident of that country, and the foreign government has determined that the person is not subject to their tax laws as a resident.

Tax Treaty
Special treatment of income under an income tax treaty does not prevent a person from meeting the bona fide residence test.

Physical Presence Test
A person is considered physically present in a foreign country (or countries) if the person resides in that country (or countries) for at least 330 full days in any consecutive 12-month period.
A person can live and work in any number of foreign countries but must be physically present in those countries for at least 330 full days.
Full Day
A “full day” is 24 hours. So, the day of arrival in and the day of departure from a foreign country are generally not counted towards the physical presence test.12-Month Period
The qualifying period can be any consecutive 12-month period of time. A person does not have to begin his or her qualifying period with the first day in a foreign country. A person can choose which 12-month period to use for the physical presence test. This gives the taxpayer freedom to choose a 12-month period that provides the greatest income exclusion. Both vacation and business days spent in the foreign country count towards meeting the 330 day threshold.
Travel Outside the Foreign Country

Travel outside of the foreign country where a person resides generally will not jeopardize the 330 full days requirement for the physical presence test. The IRS explains it this way, “You can move about from one place to another in a foreign country or to another foreign country without losing full days. If any part of your travel is not within any foreign country and takes less than 24 hours, you are considered to be in a foreign country during that part of travel.”

How does the Foreign Earned Income Exclusion Impact the Tax Calculation?

Taxpayers claiming the foreign earned income exclusion will pay tax at the tax rates that would have applied had they not claimed the exclusion. In other words, the federal income tax is calculated by first calculating the amount of income tax on income without taking the foreign earned income exclusion into account, and then subtracting the tax as calculated on the amount of foreign earned income that is excluded. The result is the amount of the federal income tax liability. To facilitate this calculation, taxpayers use the Foreign Earned Income Tax Worksheet found in the Instructions for Form 1040. This special method of figuring the tax has been in effect since 2006.

About the author...

Joshua Katz, CPA

After working for several accounting large firms, I founded Universal Tax Professionals because I knew I could give expats more personalized services at lower rates. Feel free to email me directly at josh@universaltaxprofessionals.com.

Joshua Katz, CPA