Dateline: Yerevan, Armenia
I started living the Nomad Capitalist lifestyle many years ago.
I wanted to travel the world. I felt comfortable living in other places and I wanted to see what was out there. With almost 200 countries in the world, I didn’t want to spend my entire life in just one.
And it turns out that I’m not the only person who feels that way.
The number of US citizens living overseas has been estimated to be as high as 9 million.
But over my years of traveling, working with clients, and collaborating with tax attorneys who focus on taxes for expats, it has become painfully clear just how basic some of the mistakes people make when going overseas and taking their business and money offshore.
But beyond a shadow of a doubt, the biggest mistake people make is to assume that they don’t have to pay taxes or even file a US tax return once they leave the United States.
If they were a citizen of almost any other country in the world, that could very well be the case.
But not for US citizens.
However, there are ways to reduce how much you have to pay.
In addition to the many offshore strategies that we discuss on this site, the cornerstone of any plan to legally minimize the taxation of a US citizen’s personal income has always been the Foreign Earned Income Exclusion (FEIE).
The FEIE has been available to US citizens living abroad in one way or another for almost a century as a means of helping reduce the tax burden for expats by allowing qualifying individuals to exclude the first $107,600 (in 2020 and $108,700 for tax year 2021) of their active income from their federal income tax.
While the amount of the exclusion adjusts on an annual basis to account for inflation, the underlying laws of the Foreign Earned Income Exclusion have not changed for years.
However, recent changes made to the overall US tax system brought about by the Trump tax reform have drastically changed how the FEIE can be used in a holistic offshore tax strategy.
The FEIE itself has not changed, but some of the application has.
With that in mind, it is time for a detailed and updated review of the Foreign Earned Income Exclusion. Here’s what we will cover in this article:
- What is the Foreign Earned Income Exclusion?
- Active Income
- Passive Income
- Other Income
- How Does the FEIE Reduce Taxes for Expats?
- The Foreign Housing Credit
- Who Benefits the Most From the FEIE?
- What the FEIE Does Not Do
- Can I Save Taxes Offshore As A US Citizen?
- No Exemption from Self-Employment Tax
- No Exemption from Filing Requirements
- Beware of State and City Taxes
- No Reduction to Your Tax Bracket
- No Elimination of Foreign Taxation
- How To Qualify for the Foreign Earned Income Exclusion
- The Physical Presence Test
- The Bona Fide Residence Test
- COVID-19 FEIE Relief & Tax Waiver
- How To Claim the FEIE: Form 2555
- The Trump Tax Reform and the FEIE
- The FEIE in Review
WHAT IS THE FOREIGN EARNED INCOME EXCLUSION?
As mentioned, the Foreign Earned Income Exclusion is the cornerstone of all legal tax reduction for US citizens living overseas as expats or digital nomads.
Essentially, it is the United States’ alternative to the tax non-residency procedures used by the majority of countries in the world.
If you’re an Australian living abroad, for example, you can meet a bunch of different tests and be deemed tax non-resident in Australia.
The Australian government will impose an exit tax when you leave, but once you’re out and pay any final tax, you’re done until you return. You don’t have to deal with Australia any more – that means no taxes and no filing requirements.
Unlike Australian, British, or Canadian citizens, a US person living overseas cannot simply declare him or herself “tax non-resident” and opt-out of the system.
As we’ve discussed before on the site, only the United States and Eritrea (and possibly North Korea… yes, great company) effectively implement this citizenship-based tax system for all of their citizens.
The ugly fact is that US citizens and green card holders – i.e., US persons – are unequivocally subject to US tax on their worldwide income (theoretically, it’s even possible for a non-US person to become subject to this worldwide tax by spending too much vacation time in the US).
However, if you spend enough time living overseas, the IRS does allow you to earn some money tax-free by claiming the FEIE.
Think of it as the government’s way of paying you to travel.
But don’t get too excited.
Remember, this is NOT a full exemption from all tax responsibilities. The Foreign Earned Income Exclusion does not exempt but excludes from tax a certain amount of “earned” income derived from services you perform while living outside of the United States.
Before we go any further, let’s look at exactly what the IRS means by “foreign earned income.” For the purposes of the FEIE, the IRS breaks your income into two categories: active and passive.
1. ACTIVE INCOME
Active income is what puts the “earned” in the Foreign Earned Income Exclusion.
This is income you are actively working towards earning, whether it is from wages you earn at a job, self-employment income you receive while working in a foreign country, a salary you are paid by an employer or your own business, or a bonus you get as an employee or independent contractor.
This can even include earnings from a US-based business or client.
In fact, as long as you earned the money while living and working in a foreign country, you can be employed by a US-based company and still qualify for the FEIE.
To do so, you will need to complete Form 673 and submit it to your employer. Then, if you meet all the requirements to qualify for the FEIE, your US employer will be able to exclude up to the maximum amount of federal income tax allowed under the FEIE and foreign housing credit from any wages you earned while living overseas in a given tax year.
If you work for a US employer or you are one, creating foreign assignments that allow you or your employee to take advantage of the Foreign Earned Income Exclusion can prove beneficial to both parties.
For most Nomad Capitalists, however, Form 673 will not apply to their situation as they are entrepreneurs and investors instead of employees. Contractors, consultants, and other non-employees have the benefit of not having to deal with withholding taxes to begin with.
If you are not sure whether you are considered an employee, the IRS defines an employee as someone who works at a time and place dictated by the employer, who in turn provides the employee with the tools needed to complete the job and directions for how the work is to be done.
If this doesn’t fit your job description, then you are likely a contractor and do not need Form 673 to avoid withholding taxes on your income. You will, however, need a good business structure to ensure that you are optimizing your taxes offshore.
It also doesn’t matter if you get paid in US dollars or do your business banking through a US bank account. This is one advantage that US expats have over citizens from other western countries. You don’t have to get rid of your local bank (or jump through dozens of other hoops) to get the tax benefits of going overseas.
It is pretty straightforward: As long as you performed the work while in a foreign country, all active income can qualify for the FEIE.
2. PASSIVE INCOME
Passive income, on the other hand, cannot be excluded from federal income tax.
This means that any income from passive activities such as stock trading, forex trading, day trading, cryptocurrency trading, capital gains, buying and selling of real estate, pension income, IRA distributions, rental income, social security benefits, etc. will be taxed without exception.
There are certain tests, however, for people who are professional stock traders or professional real estate investors who buy and sell and flip houses overseas as part of their business that may allow them to classify passive income as active income.
While complicated, there are ways to make this type of situation work that we can discuss if you want to apply for help. However, in general, if you’re engaged in passive income, this isn’t the article for you as passive income is much more difficult to exclude from taxes.
This article is specifically about reducing your tax on active income via the Foreign Earned Income Exclusion.
Increasingly, people who do have passive income – especially high levels of passive income like cryptocurrency trading or day trading with high levels of short-term capital gains – are finding that it is worth it to them to renounce their US citizenship for purely financial reasons.
In large part, this is because the Foreign Earned Income Exclusion does not allow them a way to legally avoid paying taxes in excessive amounts.
The only other option for reducing taxes on passive income without renouncing is to take advantage of Puerto Rico’s tax incentives for US citizens.
OTHER INCOME THAT DOES NOT QUALIFY FOR THE FEIE
There are a few additional types of income that do not qualify for the Foreign Earned Income Exclusion. According to the IRS, foreign earned income does not include:
- Pay received as a military or civilian employee of the U.S. Government
- Pay for services conducted in international waters (more on this later)
- Payments received after the end of the tax year in question, even if the service was performed during the tax year
- Meals and lodging that are excluded from income if furnished for the convenience of the employer
It used to be that contractors and employees working in specific combat zones could not qualify for the FEIE even though they were overseas, but an Executive Order from the US President in 2018 changed this rule. Now, this income is excludable from federal income tax, even when the individual working in the combat zone has a home in the US.
Finally, if you are just learning about the Foreign Earned Income Exclusion and the fact that you still have to file and pay taxes while living overseas, you likely have some years to catch up on filings and payments. You may still have a chance to file and claim the FEIE, but you must act before the IRS contacts you.
If you need to catch up on your tax filings, the IRS introduced the Streamlined Procedure in 2014 that allows expats to file for past years and still claim the FEIE and other exemptions and credits available to expats without consequence.
You must file your tax returns from the last three years, your last six FBARs (if applicable), and declare that your failure to file was not intentional. If you do this in a timely manner, you can avoid the heavy fees the IRS slaps on late filers.
However, if the IRS reaches out to you first about you late returns, you will not be so lucky.
Case law in the past decade suggests that expats who wait to be audited by the IRS before trying to claim the FEIE will not only be denied the exclusion but will also be liable for all tax owed as well as interest and penalties.
HOW DOES THE FEIE REDUCE TAXES FOR EXPATS?
1. The Exclusion
We will talk in more detail about how you can qualify for the FEIE in a moment, but if you do qualify, you can exclude the first $107,600 of your foreign source income from your federal income tax in 2020 and $108,700 for tax year 2021.
If you’re a married couple, you can double that up and potentially exclude over $200,000 of your foreign source income. However, your spouse must also qualify for the FEIE and have qualifying foreign income in order to double the exclusion.
For example, if you run a business and your spouse earns an income from the business as well, you must both legitimately work in the business. You cannot just pay your spouse to sit around and do nothing – they need to do some work.
There is also a debate as to whether the spouse should take quite as much in pay if they are only an employee and not the CEO or founder or whatever title you have given yourself. If they didn’t start the business with you, the IRS may question how much the spouse should actually be paid.
However, ostensibly, you can take $215,200 in income tax-free in a married couple situation.
The excludable amount is adjusted each year to reflect the rising costs of living due to inflation. The following are the amounts an individual was allowed to exempt in recent years:
- 2021 = $108,700
- 2020 = $107,600
- 2019 = $105,900
- 2018 = $104,100
- 2017 = $102, 100
- 2016 = $101,300
- 2015 = $100,800
- 2014 = $99,200
- 2013 = $97,600
- 2012 = $95,100
- 2011 = $92,900
2. The Foreign Housing Credit
In many cases, you can also qualify for a foreign housing credit that you can add on top of the Foreign Earned Income Exclusion. You can exclude anything you paid for housing that is in excess of 16% of the FEIE.
For example, 16% of the 2020 limit is $17,216. So, if you spend $25,000 on housing during the 2020 tax year, you can exclude the $107,600 allowed under the FEIE plus an additional $7,784 via the foreign housing credit.
In general, the more expensive your housing, the more you can take.
That means someone living in Costa Rica will be able to claim a smaller housing credit than someone living in Japan.
WHO BENEFITS THE MOST FROM THE FEIE?
Where the Foreign Earned Income Exclusion really comes into play is for the following individuals:
- Digital nomads,
- Perpetual travelers,
- Anyone practicing flag theory,
- Location-independent business owners who can move their business offshore by using an offshore company (think consultants, freelancers, internet business owners, Amazon sellers, etc.),
- Someone who has a job in a country whose taxes are lower than the United States or has no tax at all.
For example, I have a friend who is the president of a bank in the Middle East in a country where there is no tax. Despite living in a zero-tax country, he is subject to US tax on everything he earns because there are no tax treaties or tax credits available in his expat home.
Since he pays no tax in the place where he lives, he doesn’t have anything to credit against his US tax obligations and is required to pay US tax on his entire income – a bill that can easily come to over $400,000 a year.
However, the Foreign Earned Income Exclusion does give him a little bit of relief, allowing him to exclude the first $107,600 of his income from federal income tax and reducing his overall tax bill by just over $37,000.
For someone making as much as my friend, that’s not a huge relief, but it is something.
Prior to the Trump tax reform, there was a way that anyone who could control their salary (business owners in particular) could wield greater control over their tax situation and slash their tax bill to zero.
In the wake of the reform, however, most US expats are now in the same boat as my friend.
WHAT THE FEIE DOES NOT DO
The Foreign Earned Income Exclusion is not a fast-track ticket to zero tax or filing obligations.
There’s no way to ever fully check out of the US through the FEIE.
If you want to entirely exempt all of your foreign earned income, passive income, and all income earned in tax-free countries from US tax – 100%, no matter what – your only option is to renounce US citizenship.
Do US citizens have to pay taxes on foreign income? Yes.
Can the FEIE reduce the amount US citizens must pay? Yes, in some cases even to zero.
Can the FEIE eliminate all tax and filing obligations? No.
Now, let’s go even deeper to fully explain the answer to that last question as well as others.
CAN I SAVE TAXES OFFSHORE AS A US CITIZEN?
There are many misconceptions about what the Foreign Earned Income Exclusion can and cannot do. Let’s take on the five biggest:
1. NO EXEMPTION FROM FILING REQUIREMENTS
Some US persons erroneously believe that they do not need to file a US tax return if the Foreign Earned Income Exclusion reduces their tax obligations to zero, but this couldn’t be farther from the truth.
The FEIE is not something that is automatically given to you. It must be claimed on your federal tax return. Even if you don’t owe any tax thanks to the exclusion, you have to prove that to the IRS through your US tax return.
Even if you’re paying taxes to another country, you still need to file forms with the IRS. Like with the FEIE, you may not owe anything to the IRS thanks to tax treaties and credits, but you still have to report.
No matter where you live or how much you owe, if you are a US citizen and meet the applicable return threshold, you must file by the US expat tax return deadline. You must report all income, foreign bank accounts, and companies, and pay any tax due.
If you have foreign bank accounts and/or companies, you always have to file. And if you are only filing for income, the threshold in 2020 is $12,200 for single (double for married filing jointly), a measly $5 for married filing separately, and $400 for self-employed.
If you were unaware of the filing requirements in the past and have unfiled tax returns, technically the FEIE can only be claimed on a timely filed US federal tax return or a return filed before a taxpayer is audited by the IRS.
Not only is it important to file your federal tax return every year to maintain transparency and 100% legality, but doing so in a timely manner also gives you the benefit of claiming the Foreign Earned Income Exclusion.
2. NO EXEMPTION FROM SELF-EMPLOYMENT TAX
The Foreign Earned Income Exclusion will not shield you from anything beyond, well, federal income tax.
A qualifying self-employed individual can claim the FEIE and exclude their first $107,600 (or $108,700 for tax year 2021) of active income from income tax, but this will not automatically eliminate any self-employment tax (namely, Social Security and Medicare) that they may owe.
They must pay self-employment tax on their entire net profit – even the amount they excluded from income tax.
In 2021, the self-employment tax rate is 15.3% (12.4% for Social Security and 2.9% for Medicare) and applies in full on up to $137,700 in income. The 2.9% Medicare tax applies to all earned income, even past the $137,700 threshold.
And if you earn more than $200,000 as a single filer ($250,000 for couples), there is an additional 0.9% Medicare tax you will need to pay on top of that.
So, if you earned $100,000 through self-employment during the tax year, you could exclude the full $100,000 through the FEIE. At that income level, you would be in the 24% tax bracket, which makes for a savings of $24,000 in federal income taxes…
… but you would still have to pay $15,300 in self-employment tax.
Is there any way to avoid the self-employment tax?
The IRS defines someone as self-employed as long as they work for themselves. It doesn’t matter if you work full- or part-time or whether or not you have registered as a sole proprietor.
Even if you have a US LLC and did not elect to have it taxed as a corporation, you will still have to pay self-employment tax because US LLCs are considered pass-through entities for tax purposes.
However, there are offshore strategies that you can use to free yourself of self-employment taxes.
To understand how this works, it is important to first understand one crucial fact: foreign employees do not have to pay Social Security and Medicare tax.
For instance, if you went to work in the UK, you would not have to pay into the US Social Security system because you would already be paying into the UK system through your employer.
In general, this exception is possible due to a “totalization agreement” between the US and the foreign country into whose Social Security system you are paying.
You can do the same thing with your business by making it a foreign company. By avoiding US LLC pass-through laws and setting up an offshore company, you can effectively separate yourself from your company.
You and your company will no longer be considered the same entity for tax purposes.
If you are running a business that makes $100,000 in profit every year and you have set that company up in a low or zero-tax jurisdiction like Belize or the BVI or Malta, you can then “hire” yourself as an employee of your company and pay yourself a regular salary that will be taxed at a low rate.
By doing this, you will essentially be in the same position as the individual who went to work for a company in the UK.
You are now an employee of a foreign company.
In summary, setting up your company in a low or zero-tax offshore jurisdiction helps you to achieve two important goals:
A. Reduce Your Income Tax:
With a foreign company, you can pay yourself an income below the FEIE limit of $107,600 (2020, $108,700 in 2021) to avoid paying taxes on that income in the US. And by setting up your company in a low- or zero-tax jurisdiction, you will also pay low or no tax on that income in the country where you actually earned the money.
B. Eliminate Your Self-employment Tax:
By setting up a foreign company and hiring yourself as an employee, you are no longer considered self-employed and are instead considered an employee of a foreign company… and employees of foreign companies do not have to pay the self-employment tax.
However, where your company is based is just one element of making these two goals a reality.
The second element is where you, the owner of the company, are based.
This is where a lot of people get tripped up. I’ve talked before about the nomad tax trap where people think that if they just put their business in a Belize company with zero tax that they won’t pay any tax.
As we’ll see in a minute, where you are when you earn that money is just as important as where you base your company because qualifying for the FEIE hangs entirely on your location and not on the location of your business.
You can still use the FEIE to reduce what you pay in income tax overall, but qualifying for the exclusion in the first place depends entirely on your location.
So, why would you still need a foreign company?
People have argued that since the Trump tax reform now makes the rules for going offshore extremely difficult, a foreign company is no longer a useful tool. But it is still essential for a holistic tax reduction strategy, not because it helps you with the foreign income exclusion but because it allows you to eliminate all self-employment tax.
Will I Lose Social Security Benefits By Going Offshore?
In short, the answer is yes.
If you do not pay into Social Security or Medicare in the United States, you’re not going to get as much out of it when you retire.
And, if you’re really young when you go offshore and you never pay much into Social Security, you won’t have the necessary 40 quarters of contributions to get anything out of it at all.
I’m not a Social Security expert, but if you don’t pay into the system, you’re not going to get anything out of it.
Even if you take 20 years off and don’t pay anything and then come back and work in the US and qualify for Social Security benefits, you’re not going to get nearly as much as someone who worked in the US and paid into the system their entire life.
However, losing out on Social Security and Medicare is not the end of the world.
With all that you save on self-employment tax by living and doing business overseas, you can invest in solutions that will serve you better long-term that are not connected to a government system that dictates how much money and what type of care you can receive in your “golden years.”
3. No Guaranteed State and City Tax Relief
The Foreign Earned Income Exclusion is federal tax law. However, in the case of 45 states, the states match the federal program and automatically apply the same exclusion.
If you’re from California, Colorado, South Carolina, Virginia, or New York, you’re not as lucky and you will need to look into your specific state’s laws for US expat taxes.
There are certain rules about how you can avoid paying state taxes, but these five states don’t really match the FEIE by default. It may be possible, but you will have a slightly harder time avoiding state tax.
If you’re leaving the United States, one way to resolve this issue is to simply move to a zero tax state like Florida, Nevada, Washington, etc. before you leave.
Some cities will mirror the federal income tax exclusion as well, but not all do so you should also check that your municipal government doesn’t charge you city income tax while living abroad.
4. NO REDUCTION TO YOUR TAX BRACKET
While the FEIE allows you to exclude the first $107,600 of your active income from your income tax, it does not mean that the IRS will ignore those $107,600 when calculating your tax bracket.
If you earned $200,000 during the 2020 tax year, you cannot subtract $107,600 from that income and declare yourself to be in the 24% tax bracket with an income of $92,400. Your income is $200,000 and that puts you in the 32% tax bracket.
However, because of the foreign earned income exclusion, you will only have to pay 32% of $92,400 for a total income tax bill of $29,568 instead of 32% of $200,000 and a total tax bill of $64,000.
So, while it does not reduce your tax bracket, the FEIE will reduce your tax bill.
The FEIE has functioned in this manner since 2006 when changes were made to the tax law that made it less of an exclusion and more of a tax credit equal to the amount of tax that would have been owed on the eligible foreign income.
5. NO ELIMINATION OF FOREIGN TAXATION
If you live in a high-tax country, the Foreign Earned Income Exclusion is not going to help you all that much in terms of reducing your tax bill.
The offshore tax reduction strategies we use here at Nomad Capitalist involve living in low-tax countries or being globally mobile.
You didn’t think Spain was going to let you live there 365 days a year tax-free, right?
For example, if you are living in Paris and you are a tax resident there, you could be liable to pay as much as 45% of your income to the French government. If you tried to use the FEIE to reduce how much you owe to the US government, you would still owe taxes for anything above the excludable $107,600, plus whatever you owe to the French.
Thankfully, the US has tax treaties and foreign tax credits in place with many countries throughout the world that basically allow you to pay nothing to the US – but only because you are paying the equivalent (or higher) where you are a tax resident.
We won’t get into the specifics of these treaties or how running a business or working in another high-tax country works, but know that there are tax treaties and credits that will do much more to help reduce your tax bill (when living in high-tax countries) than the Foreign Earned Income Exclusion.
So, if you decide to live in Paris, you won’t have to worry about paying 40% here and 40% there and paying 80% in total. You’re going to pay once by taking credits or relying on treaties. You’ll still be paying 40% or more in taxes because you chose to live in a high-tax country, but at least you’re not paying double.
The FEIE, on the other hands, helps all the people who don’t otherwise have a tax treaty or tax credit because they have chosen to either travel non-stop without a tax residence or to live in a low- or zero-tax jurisdiction that does not have a tax agreement with the US.
HOW TO QUALIFY FOR THE FOREIGN EARNED INCOME EXCLUSION
Now, to the question you’ve probably been asking this entire time: How can you know if you even qualify for the Foreign Earned Income Exclusion?
You can always go check out the IRS’s Interactive Tax Assistant to get an idea of whether or not you qualify, but if you want to understand the principles governing qualification, read on.
In order to claim the FEIE, you must meet all three of the following:
- Have a tax home outside of the US,
- Have foreign earned income, and
- Pass either the physical presence test OR the bona fide residence test.
Having a tax home is not the same as having a tax residence. As long as you can claim that your main place of business, employment, or post of duty is indefinitely located outside of the United States, you meet the first requirement.
The second requirement is pretty straightforward, but meeting the third requirement can be slightly more complicated.
You only need to pass one of the two available tests to pass requirement number three, but one test is much more black and white than the other and both come with several requirements of their own.
1. THE PHYSICAL PRESENCE TEST
The physical presence test is the more straightforward, black-and-white option out of the two tests. As long as you spend 330 days or more in a foreign country or countries during a 365-day period, you qualify.
There are a few things to clarify within that simple definition, though.
First of all, the law does not dictate that the 330 days must all fall within the tax year in question. Instead, the rule is 330 days or more within a 365-day period. This allows you to straddle tax years, as long as the start or end date is in the tax year for which you are filing.
As an example, let’s say that you plan to spend Thanksgiving through the New Year with family in the United States at the end of this year. You’ve already scheduled your flight for November 20, 2018, and will not leave until January 5, 2019.
If you could only work with the 2020 tax year, you would not meet the 330-day qualification period and could not claim the FEIE.
However, by beginning your 365-day period in November of 2019, you could count an entire twelve-month period from November 20, 2019, to November 19, 2020, in which you were in a foreign country or countries, thereby qualifying for the foreign earned income exclusion.
The second clarification is that the physical presence test specifically states that those 330 days must be spent in “a foreign country or countries.” This means that you could spend your time in one country or any combination of countries.
It does not matter how long you stay in any given country, whether or not you have established tax residence somewhere, or what your intentions are in visiting or returning to a country. As long as you spend 330 days or more in a foreign country or countries, you can qualify.
However, notice that it is not 330 days outside of the United States, it is 330 days spent in a foreign country or countries.
Why does this matter?
International waters do not count as a foreign country or countries. Therefore, any time spent in international waters cannot count toward the 330-day total. The same generally applies to time spent traveling via air, although the rules are a bit more flexible.
The international waters rule can prove to be problematic if you do not make an effort to track days. For example, some nomads like to take nomad cruises on international waters. If you take that nomad cruise across the Atlantic for 11 days, those 11 days on international waters do not count toward the 330 days you need to qualify for the FEIE.
The cruise takes place outside of the US, but it is not in a foreign country or countries so those days cannot count.
This small detail proved to be a difficult one to overcome for a guy who came to me several years ago who does a lot of his work on yachts. While a yacht could be in a marina somewhere in territorial waters or a mile offshore, if it is cruising through the Mediterranean in international waters, any work done on the yacht does not count.
If you do a lot of travel in international waters, you will have to conduct your own analysis to figure out what does and does not count. It’s pretty clear where international waters are, so it’s up to you to keep those records.
The rules are less stringent when it comes to transiting through the air. Generally, as long as you spend less than 24 hours in the air (and you are not traveling to or from the US), you can still count that day toward your 330-day total.
Even if you transit through the United States, as long as you spend less than 24 hours in transit between two countries other than the US, you can still count that day.
Despite these small details and specific definitions, the physical presence test is the easier of the two tests for two very important reasons:
A. You don’t have to prove anything.
The only thing you have to prove under the physical presence test is that you were in a foreign country or countries for at least 330 days during a 365-day period.
You can do August 16th of this year to August 15th of next year. You can do whatever period you can create that works for you.
If you’re just looking to get out, this is the way to do it. You don’t have to wait until January 1st. You can get out now and qualify for the entire exclusion after your first 330 days.
B. You don’t need to establish residence anywhere.
In countries with residential-based taxation like Canada, Australia, and most countries in Europe, the key to getting tax relief by living overseas is to become a tax non-resident.
Under these systems, the focus is on your tax home and proving that you’ve established a residence and substantial ties in that tax home.
This is where being a US citizen is actually a bit easier.
You don’t need to set up ties or prove that you live somewhere else. You can be a full-fledged digital nomad and that’s good enough. It’s very black and white. There are ways to make sure you are keeping track of this properly, but that’s the deal.
2. THE BONA FIDE RESIDENCE TEST
The rules for the bona fide residence test are much more nebulous than the physical presence test. However, if you can pass the bona fide residence test, you can spend much more time in the United States and still qualify for the Foreign Earned Income Exclusion.
One of the few black and white rules of the bona fide residence test is that you must be able to claim one specific country as your tax home for an entire calendar year, beginning January 1st. After that, while there’s some room for argument, you should generally spend at least half your time in that country.
You can travel to other countries, including the United States, but you need to spend more time in your tax home than you do in the United States to successfully claim it as your bona fide residence.
This test is about more than how much time you spend in any particular country, though. As with the tax non-residence programs in other countries, the bona fide residence test is about proving that you have connections with your new tax home.
You should have a long-term or permanent residence permit in the country, as well as a home or long-term lease, and all of your travel should be to and from that country.
The more ties you can show to the local economy – like a driver’s license, electric bills in your name, etc. – the easier it will be to make your case to the IRS.
You should also be able to state that you have no intention of returning to the US. If your stay is indefinite, that works. On the other hand, if you have been given a two-year work assignment in the country, that probably won’t count as a bona fide residence.
If you can prove sufficient ties to your new tax home, you will be able to spend approximately four months a year in the United States under this system.
On average, the substantial presence test allows you to spend 120 days per year in the United States. The IRS uses an entire formula to determine whether or not you have established a “substantial presence” in the United States.
The main part of the formula considers whether or not you:
- Were or will be in the US for at least 31 days during the current year; and
- Will spend at least 183 “days” in the US within a three-year period.
This 183-day limit does not give equal value to the days from each year. The formula used to calculate how many days you spent in the US is as follows:
- Days you were present in the current year = 1
- Days you were present in the previous year = 1/3
- Days you were present two years previous = 1/6
So, if you spent 90 days in the US in year two, only 30 of those days would count toward the 183-day limit. Conversely, if you spent 183 days in the US during the current year, then you will automatically qualify as a tax resident regardless of how many days you spent in the US the two years previous.
While you could work with various combinations of days spent in the US each year to stay within the limit, the general rule is that if you are physically present in the US for 120 days or less each calendar year, you will avoid qualifying as a US tax resident indefinitely.
If you’ve been living in the United States 365 days a year for the last two years and you go offshore this year, you will not get to spend the full 120 days in the United States because you’ll have those previous years counted as partial days.
What’s really interesting about this formula is that everyone in the world is subject to the substantial presence test. If you’re a Mexican citizen and you spend six months in the US three years in a row, you’ll fail the substantial presence test and need to pay US tax.
That’s the bad part.
The good part is that if you were to renounce your US citizenship, you would still be able to spend the same amount of time in the United States as a non-US citizen as you would as a US citizen. The difference is that you would be free of all the reporting and taxpaying obligations of a US citizen.
When people talk about being afraid to renounce their US citizenship, the reality is that you get just as much time in the US if you’re trying to avoid paying taxes as a citizen as you would as a non-citizen because the substantial presence test applies in both cases.
The tough part about spending time in the United States in these circumstances is that you really shouldn’t be doing work there during that time. That creates a whole issue as to how you’re going to structure your company because spending four months working and doing deals in the United States could give your company tax problems.
If you want to do this, it’s worth some proper planning.
In the end, it’s all about making a story and a case that you can present. It’s not black and white. You can’t just show the IRS your passport and say that you haven’t been in the US. It’s about making a case where, if they audit you, you can say that you are or are not a bona fide resident of a foreign country.
It is all about demonstrating as many ties to that country as you can. This may be easier for married couples with children in school or a spouse who has a job in the other country. In those cases, it’s easy to see that there’s a pretty serious connection.
One possible scenario is if your wife has a job in Dubai and you spend six months there and then you travel around for a month or two and then you spend 3-4 months in the US. That could work as long as you have enough ties in Dubai to claim it as your bona fide residence.
But, again, it’s more nebulous.
For me, it requires a lot of careful planning. Don’t take this as actionable advice. You need to do some proper planning before trying to claim the Foreign Earned Income Exclusion by passing the bona fide residence test.
ALERT: COVID-19 FEIE Relief & Time Waiver
Due to COVID-19, many US citizens were forced to return to the United States as a result of immigration laws or health reasons in March and April of 2020.
In response, the Treasury Department and the IRS issued “Revenue Procedure 2020-27” on April 21, 2020, that provides some relief to US expats who would have been able to claim the Foreign Earned Income Exclusion if not for the worldwide impact of the coronavirus.
The relief measure waives the time requirement normally in place to qualify for the FEIE as a bona fide resident or by passing the physical presence test.
For both the 2019 and 2020 tax year, you can still qualify for the FEIE and the housing cost exclusion or deduction if (due to COVID-19) you were required to leave:
- The People’s Republic of China (not including Hong Kong or Macau) on or after December 1, 2019, but on or before July 15, 2020; or
- Another foreign country on or after February 1, 2020, but on or before July 15, 2020.
If you had established residency or were physically living in a foreign country prior to these dates and can prove within reason that you would have otherwise qualified for the exclusion, you can still exclude any income earned while living abroad even though you did not pass the 330 days or bona fide resident tests.
Note: this does not exclude any income earned while living in the United States after your return, only the income earned while living abroad.
In Revenue Procedure 2020-27, the IRS provides two potential applications of the waiver. The first describes an individual who had reasonably anticipated working in China from September 1, 2019 to September 2020, but who left China due to COVID-19 on January 10, 2020.
For the 2019 tax year, this individual can exclude any income earned while working in China from September 1, 2019 to December 31, 2020. And for the 2020 tax year, they can exclude all income earned from January 1, 2020 to January 9, 2020.
This example shows how relief is only provided for the time the individual earned money while living in the foreign country. Any income earned upon returning to the US will be subject to regular taxation.
The second example is of an individual who had planned to work in the United Kingdom for the full 2020 calendar year but who left the UK on March 2, 2020 due to COVID-19, returned on August 25, 2020, and continued to work until the end of the year.
This individual would be able to exclude all foreign income earned from January 1, 2020 to March 1, 2020 and from August 25, 2020 to December 31, 2020.
This example demonstrates an interesting trait of the waiver: the individual left before the July 15 deadline but was able to exclude income earned after that date until the end of the 2020 calendar year even though they returned to the UK after the period covered by the waiver.
These were the only two examples provided by the IRS. Your situation may be different. The main thing you will need to prove to claim this waiver is that you would have qualified under the regular requirements had it not been for the COVID-19 emergency.
Finally, if you plan to claim the waiver, you will need to write “Revenue Procedure 2020-27” across the top of Form 2555 and attach it to your income tax return.
HOW TO CLAIM FEIE WITH FORM 2555
If you’re eligible to claim the Foreign Earned Income Exclusion, you will need to file Form 2555 along with your individual tax return – even if all your income is non-taxable under the exclusion.
As a US person, you will be liable for US tax and filing obligations no matter what, so you need to formally claim the FEIE through Form 2555 in order to get it. If you don’t file Form 2555, you will lose the exclusion and the IRS will tax your income normally.
Each expat is required to file a separate Form 2555. So, even if you and your spouse are filing jointly, you will each need to complete a copy of Form 2555 to claim the FEIE.
The filing deadline for US expats is June 15, although you can apply for an extension to submit your taxes – including Form 2555 – as late as October 15.
To successfully file Form 2555, you will need to include the following information:
1. GENERAL INFORMATION
Under the General Information section of Form 2555, you will need to include basic information such as your foreign address, employer information, your foreign tax homes, and whether you have previously filed Form 2555.
This section is quite straightforward, but you should double-check all fields for accuracy to ensure that your completed Form 2555 is not rejected.
2. FEIE QUALIFICATION TESTS
Next, you will need to fill out specific information regarding the test that you qualify under.
If you wish to claim the bona fide residence test, then you will need to provide detailed accounts of your foreign residence, US travel, employment status, and other pertinent details to establish bona fide residence.
Because this test is more difficult to qualify under, you should provide the most specific information possible.
The section for the physical presence test is far simpler. To complete it, you will only need to provide your time frame, principal country of employment, and travel record.
3. FOREIGN EARNED INCOME
Third, you will need to calculate your total foreign earned income that is eligible for exclusion.
If you earned all your income abroad, then this section will be nearly identical to your individual income tax return.
If you have any US-sourced income, however, you cannot include it on this form and must pay tax on it normally. So, even if you qualify for the FEIE, any time spent working in the US will not be eligible for exclusion.
You will enter all foreign earned income on Line 17 of Form 2555 and will then enter the amount allowed under the exclusion as a negative amount on Line 21 of Form 1040, “Other Income.”
4. HOUSING DEDUCTION OR EXCLUSION
If you are eligible for the foreign housing deduction or exclusion, then you will also need to claim it on Form 2555.
The foreign housing deduction is a bit complicated, and you can only deduct a limited amount of your foreign housing expenses on Form 2555.
Essentially, you can only exclude it if you pay over a certain amount for foreign housing, and you can only exclude it up to a certain point.
In general, you can count rent, mortgage, utilities and household repairs, real and personal property insurance, occupancy tax (that is not already deductible under Section 164), and any nonrefundable fees for securing a leasehold as part of your foreign housing costs.
Because this deduction can get a bit hairy, you must carefully follow the instructions on Form 2555, and you should probably consult a tax professional to ensure that your math is correct.
5. TOTAL DEDUCTIONS
Just as you include certain deductions on your regular income tax filing, you will also need to include them on Form 2555.
For the most part, these deductions are similar to the deductions you normally take on your standard income tax return.
However, for further deductions, you should also look into filing for the Foreign Tax Credit on tax that you have already paid abroad. To do so, you will need to use a separate form – Form 1116.
This is a good reminder that Form 2555 is not the only form you will need to fill out to ensure that all your tax affairs are in order. Depending on where you bank and do busines, you will likely need to file an FBAR, state returns, Form 5471, among other documents.
THE TRUMP TAX REFORM AND THE FEIE
Previously, US citizens who ran active businesses – not a one-man show but an actual business where you’re not doing all the work – could use offshore corporations to retain any earnings above the FEIE limit and keep their earnings offshore, untaxed.
While US citizenship meant you could only pay yourself a salary of $100,000 despite making $1 million in profits, you didn’t have to pay taxes on the other $900,000 if the country you lived in or where you had incorporated your business didn’t charge tax.
The recent tax reform changed all this so that, now, all income generated in an active business (which generates active income, the kind that qualifies for the FEIE) is now deemed Subpart F income subject to US tax.
In other words, you can no longer retain your earnings in an offshore company, tax-free.
Many of the details of this law are still being figured out. Since it is a new law, there’s a lot of minutiae that’s worth getting advice on. If you want some help, reach out.
There are still ways to structure your business to improve your overall tax situation. However, the days of being able to make a million dollars in a business that you own overseas and paying zero tax as a US citizen are over.
You still get the Foreign Earned Income Exclusion. If you make $1 million in a business and you’re a US citizen, then you still get to exclude the first $107,600. The difference is that the other $892,400 is now unavoidably taxable in the US.
That’s what the Subpart F income is – they are treating actively earned income in a business that you own the same way they would treat passive income from royalties, trading, a US LLC, or anything else.
Any foreign corporation that has more than 50% US ownership is a US-controlled foreign corporation and will be subject to tax on its worldwide income. The FEIE lets you take your $107,600 as an untaxed salary, but then everything else is taxed.
There are ways to mitigate that, but there is no way to take your tax bill down to zero.
ONE POSSIBLE SOLUTION… FOR SOME
There is one possible solution, but I hate to even bring it up because you really have to have a legitimate plan in place to make this work and too many people hear of a way out and start to think that they can pull off shady tactics using nominees and slapping somebody’s name on their business.
However, if you legitimately have a foreign citizen spouse who is involved in your business or have foreign business partners who have a good chunk of your business, there may be special planning that you can do to reduce your tax, potentially even to zero.
But I cannot emphasize this enough: you want to keep it legal! No shady deals, please! Don’t go looking for some stooge to claim as your business partner. Don’t do it! It won’t work and you’ll likely get in trouble.
Just don’t even go there.
But if you already have legitimate people in place, or you want to sell part of your company to a foreigner, you could do that – again, if it really is legitimate. Don’t sell them 1% and claim it is 50%. If it’s legitimate, that could work.
WHO DOES THE CHANGE HURT THE MOST?
If you’re the guy working as a private bank employee in Abu Dhabi making $1 million a year, the Foreign Earned Income Exclusion has never been a huge help to you.
You’ve never been able to control your income, which means you’ve always had a substantial tax bill, even after taking into account the amount you could exclude through the FEIE.
The changes to the tax regime have done nothing to change that.
Who the tax reform really messes things up for is the location-independent business owner making over $100,000 a year. If you make less than the FEIE limit, the reform does not change your situation. You can still exclude your entire income.
The problem is when you go beyond the FEIE limit.
When you become successful, anything and everything you earn beyond that first $107,600 (or $108,700 in 2021) is now subject to ordinary income tax rates. And those rates can go as high as 35%, making for a very expensive tax bill.
There are ways to reduce the overall amount due, but you can no longer take it to zero.
The successful business owner is now as equally screwed as the employee who has no control over his income and how it is taxed.
Everyone is in the same boat now.
The question you have to ask is, at what point is it worth it to try and fix the situation?
In my opinion, if you make less than $500,000, just suck it up and pay some tax. Once you get past the $500,000 mark, it is worth it to reach out and get some help because, with proper planning, you can be saving an almost guaranteed six figures or more every year.
There’s definitely some work that needs to be done to get to that point. Even if you’ve previously structured your offshore company to be compliant with US laws before the tax reform, you need to make some changes to that structure now to see the largest tax benefits.
In my books, half a million dollars is the magic number where you can really start to do some planning that would involve some big decisions.
You may consider using some of the more complex structures so you can reduce your tax and remain a US citizen, or you may seriously want to consider renouncing your US citizenship and keeping your foreign corporation the way everyone else in the world does it.
THE FEIE IN REVIEW
The bottom line is that the Foreign Earned Income Exclusion in and of itself has not changed. You can still exclude $107,600 of your income from your federal income tax if you qualify for the exclusion through the physical presence or bona fide residence tests.
What has changed is the way that income above the FEIE is taxed. If you do not make more than the FEIE limit, your situation remains the same.
If you’re making more than the set amount – whether through employment or business – you’re screwed either way.
Deciding to do something to fix the problem is just a matter of how much more you’re making above the limit.
If you’re making $150,000, you don’t need to do a lot of planning. Just suck it up and pay some tax. If you’re making that magic $500,000 or more, you should reach out and get some help.
Even with all the details we’ve gone into here, the laws that govern the Foreign Earned Income Exclusion are nuanced and require personalized professional advice for each situation.
It is crucial that you speak to a professional tax advisor who understands taxes for expats.
I always refer my clients to a US tax attorney I trust, so if you’re looking for help, feel free to reach out. You could be missing out on tens of thousands of dollars in tax savings.