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Foreign Earned Income Exclusion

Bona Fide Residence Vs. Physical Presence Test

Written by: Josh Katz, CPA

What is Foreign Earned Income Exclusion?

Foreign Earned Income Exclusion (FEIE) is a tax benefit designed to alleviate the double taxation burden faced by US citizens and residents earning income abroad. Double taxation occurs when an individual is subject to taxes in both their home country (the United States) and the country where they earn income. FEIE allows qualifying individuals to exclude a specific amount of their foreign-earned income from their US taxable income.

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 Residence test or Physical Presence test.

Persons who qualify are eligible to exclude up to $120,000 in foreign earned income on their 2023 US tax return (which needs to be reported in 2024). The amount of the foreign earned income exclusion changes each year. Moreover, 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 (FEIE) 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. Nevertheless, self-employed persons are eligible to take the foreign housing deduction instead of the foreign housing exclusion. 

A person must meet either the bona fide residence test or the physical presence test to claim the Foreign Earned Income Exclusion.

Bona Fide Residence Test

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 year is from January 1 through December 31. The qualifying period for the bona fide residence test must include one full calendar year. 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.

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Tax Treaty

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

Foreign Earned Income Exclusion - Man on a hill

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.

Benefits of Foreign Earned Income Exclusion

FEIE offers a substantial advantage by reducing the tax liability of qualifying individuals. The ability to exclude a significant portion of foreign-earned income provides financial breathing room and encourages international mobility. Furthermore, by alleviating tax burdens, FEIE encourages US citizens and residents to engage in global opportunities without the fear of excessive taxation. 

Universal Tax Professionals

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 This not only fosters international career growth but also contributes to a more interconnected and globally aware workforce.

The Foreign Earned Income Exclusion is a valuable tool for US citizens and resident aliens living and working abroad. By understanding the eligibility criteria and benefits of the FEIE, individuals can take advantage of this provision to minimize their tax liabilities and enhance their financial well-being while contributing to a globally connected world.

If you need help claiming the Foreign Earned Income Exclusion or require other US expat tax services, feel free to contact Universal Tax Professionals.