US citizens and resident aliens of the United States living and working abroad are subject to the same filing requirements as US taxpayers residing the USA. Moreover, American expats are taxed on their worldwide income regardless of the country of residence. However, Americans living overseas can minimize US expat taxes and claim the foreign earned income exclusion if they qualify.
Foreign Earned Income Exclusion for American expats working abroad
Are American expats required to file US expatriate tax return if they live or work abroad?
American expats are required to file US expat tax return and report their worldwide income if they meet the minimum filing requirements. The following factors determine whether a US taxpayer is subject to federal tax reporting:
- Filing status
- Gross Income from worldwide sources
Which income should Americans living abroad report on their US expat tax return?
US citizens and resident aliens living abroad are taxed on their worldwide income. Consequently, US expats have to report the following items on the US expat tax return:
- Earned Income like gross wages, bonuses, commissions, self-employment earnings.
- Passive income like rental income, dividends, interest, capital gains/losses, alimony.
- Foreign Income regardless of the country of residence. Foreign income must be converted into US dollars from the foreign currency.
What is Foreign Income?
Foreign income includes both the foreign earned income and foreign passive income.
What is foreign earned income?
Earned income is the cash as well as non-cash compensation for the services provided. Foreign earned income includes:
- Salaries and wages
- Commissions and Bonuses
- Self-employment income
- Fair market value of property or facilities provided by the employer in the form of lodging, meals, or car
- Allowances and reimbursements for the following categories:
- Cost of living
- Overseas differential
- Home leave
- Moving expenses
Which income might be considered either earned or unearned?
The following categories of income might be classified either earned or unearned per the individual circumstances:
- Business earnings from sole proprietorships, partnerships, and corporations
- Royalties and rents
- Stock options
- Certain Fringe benefits
- Scholarships and Fellowships
What is not considered foreign earned income?
- Income earned as a US Government employee
- Dividends, interest, capital gains
- Gambling winnings
- Pensions and annuities (including social security benefits)
- Value of meals and lodging provided for the employer’s convenience
- Payments received after the end of the tax year following the tax year in which an American expat performed the services that earned the income
- Amounts that are included in the expat income because of the employer’s contributions to a foreign nonexempt employee trust or to a nonqualified annuity contract
Does the type or origin of payment affect the income source rules?
The type or origin of payment does not change the income source rules. For example, the person works in Spain but the company makes payments from the USA. This earned income is still considered the foreign earned income because the actual services were performed in Spain. Even if the payment is made to the USA bank, this income will still be considered a foreign earned income.
If an American expat worked several days in the USA and earned income for these days, is this income considered the foreign earned income?
If an American expat earned income while in the USA on business, then this income will be qualified as the US sourced income. The amount of US-sourced income is calculated as a fraction of the total income earned in a tax year. The numerator will be the number of days worked in the USA. The denominator is the total number of work days in a calendar year.
What should an American expat do if s/he cannot determine the amount of foreign income earned in the USA and/or abroad?
If an American expat cannot determine the amount earned in each country, then s/he should identify the source of income. The second step will be to calculate the amount of time spent in each location. The travel calendar will help identify the number of workdays during the year.
Does an American expat have to pay US expat taxes on the foreign income?
U.S. citizens and resident aliens might be subject to US expat taxes as well as self-employment taxes on the income earned in a foreign country.
US expats might be required to pay Social Security and Medicare taxes for the services performed in a foreign country in the following situations:
- US expats perform the services on or in connection with an American aircraft or vessel AND this taxpayer either entered into the employment contract with the US company or if the aircraft or vessel lands at a the US port at the time of employment.
- American expats work in one of the countries that has an international social security agreement with the United States. US taxpayer obtained the Certificate of Coverage and s/he is subject to self-employment taxes in the USA only.
- US expat works for a US employer.
- An American taxpayer works for a foreign affiliate of a US employer that has signed a voluntary agreement with the US Department of Treasury.
Unless the above conditions are met, American expats are not required to pay self-employment taxes on the earnings in a foreign country.
Additionally, American expats can minimize US expat taxes by claiming the foreign earned income exclusion and foreign housing exclusion or deduction.
Can any American expat claim the foreign earned income exclusion?
American expats may exclude a certain amount of foreign income by utilizing the foreign earned income exclusion. To qualify for the foreign earned income exclusion, the following criteria must be met:
- American expat must have foreign earned income.
- US taxpayer expat must have a tax home in a foreign country.
- American living abroad must meet either the physical presence test or bona fide residence test.
How much is the foreign earned income exclusion in 2016?
Each qualifying US expat can exclude up to $101,300 in foreign income by claiming the foreign earned income exclusion in 2016.
How much is the maximum amount of foreign earned income exclusion every year?
Americans living abroad can exclude the amount of foreign income that is limited to the annual maximum dollar amount or actual foreign wages, whichever is less. The maximum amount of foreign earned income exclusion is adjusted by the IRS every year.
The maximum amount for foreign income exclusion is as follows:
|Tax Year||Maximum Amount Foreign Income Exclusion|
How can American expats claim the foreign earned income exclusion?
In order to claim the foreign earned income exclusion, an American living abroad must file Form 2555 or Form 2555-EZ. Form 2555 must be filed if a US expat wants to claim the foreign earned income exclusion and foreign housing exclusion or deduction. Form 2555-EZ must be filed if a US taxpayer claims only the foreign earned income exclusion.
How do Americans living abroad withhold taxes from the foreign earned income?
Below are the three ways to withhold taxes from the foreign earned income:
- Limit or discontinue tax withholding: If an American expat expects to qualify for the foreign earned income exclusion under the bona fide residence test or physical presence test, then s/he should request an employer to discontinue withholding income tax from the wages. To do so, an American living abroad must complete and file Form 673, Statement for Claiming Exemption From Withholding on Foreign Earned Income Eligible for the Exclusion(s) Provided by Section 911.
- Pension payment withholding: Any distributions from the employer deferred compensation plans like an annuity, employer pension, profit-sharing plans, or individual retirement plans are subject to the income tax withholding. If an American expat wants to claim an exemption from the withholding, then s/he must provide the payer with a residence address in the United States.
- Estimated tax: American expats working in foreign countries with a lower income tax rate than in the United States might be subject to pay US expat taxes. Any tax due must be paid in full by April 15. To avoid any penalty on underpayment, US expats must pay estimated taxes since foreign employers do not withhold US taxes from wages. To calculate estimated taxes, an expat must exclude the income that s/he expects to exclude under the foreign earned income exclusion.
Several misconceptions about the foreign earned income exclusion
One misconception is about the foreign income exclusion and self-employment tax. If you are a self-employed American expat, you can exclude your self-employment income by applying the exclusion. However, many Americans living abroad who are self-employed believe that the foreign income exclusion minimizes not only the regular income tax but also the self-employment tax. This assumption is not correct. Self employed taxes in the USA include Social Security and Medicare taxes and it is applicable to people who are self-employed. The good news is that the USA has a totalization agreement with several countries that prevents double taxation of American expats who pay to foreign social security.
Another misconception is that the excludable foreign earned income should not be reported to the IRS. This is not the case. Americans living overseas have to be eligible for the foreign earned income exclusion and they have to file a tax return to claim it.
Can US government civilian employees claim the foreign earned income exclusion?
US government civilian employees cannot claim the foreign earned income exclusion. Most income earned by US government civilian employees is taxable. The income includes pay differentials. Pay differentials are the incentives for overseas employment due to adverse conditions like special incentive differentials, post differentials and danger pay. These differentials are reported on W-2 as a part of wages. However, some income received by US government civilian employee is tax free.
What types of income received by US government civilian employee working abroad are considered tax free?
There are three types of nontaxable allowances from overseas employment:
- Cost of living allowances
- Business travel allowances
- Some foreign area allowances
Certain foreign areas allowances include the following expenses:
- Motor vehicle shipment
- Transportation for medical treatment
- Some repairs on a leased home
- Temporary quarters
- Travel, moving, and storage
- Education of dependents in special situations
- Representation expenses
Cost of living allowances are granted by the regulations approved by the President to US citizens stationed outside of the United States.
Business travel allowances must be reported under the accountable plan to be considered tax-free.
US taxpayers must contact a CPA that provides expat tax services to review individual circumstances. Expat tax experts at Artio Partners will be pleased to assist you.