Dateline: Kuala Lumpur, Malaysia
If you’re a US citizen looking to legally reduce your tax burden, chances are you’ve considered pursuing Foreign Earned Income Exclusion.
Since the US uses a system of citizenship-based taxation, US citizens and permanent residents must file income tax every year – regardless of whether they actually live in the US.
Therefore, unlike countries that use residential tax systems, such as Canada or the UK, US citizens cannot simply cut certain ties, leave the country, and become tax non-residents.
Instead, they can use Foreign Earned Income Exclusion.
Foreign Earned Income Exclusion is the US answer to these tax non-residency procedures. While you still have to file tax each year as a US person, you can exclude a large portion of your active income if you live and work abroad.
Foreign Earned Income Exclusion is thus the backbone of any strategy to legally reduce your taxes as a US citizen or permanent resident. However, to qualify for it, you must meet the requirements of one of two tests:
The Physical Presence Test or the Bona Fide Residence Test.
Of these two tests, the Physical Presence Test is the simpler one by far. To qualify under it, you must spend more than 330 days outside of the US during that tax year – nothing more, nothing less.
Although you’re limited to just 30 days in the US per year, qualifying for Foreign Earned Income Exclusion under the Physical Presence Test is fairly straightforward.
The Bona Fide Residence Test, on the other hand, gives you more time in the US per year, but meeting its requirements can be a bit more challenging.
To qualify under the Bona Fide Residence Test, you must be a tax resident of another country for more than one tax year, and you must establish that residency with the intention of permanently leaving the US.
While this test gives you the ability to spend more than just 30 days in the US, it’s a more difficult threshold to meet, so even minor missteps could cause you to lose your offshore tax status.
If you’re thinking of using the Bona Fide Residence Test to qualify for Foreign Earned Income Exclusion, then you’ll need to understand whether you can – and should – use it to lower your US tax bill.
Who Should Use the Bona Fide Residence Test?
Although you can easily qualify for Foreign Earned Income Exclusion under the Physical Presence Test, it severely limits the amount of time that you can spend in the US.
For many people looking to get out of the US tax net, this isn’t much of an issue.
Before I renounced my US citizenship, I used the Physical Presence Test to qualify for income exclusion, and frankly, I wasn’t too upset about limiting my days in the US.
I felt more comfortable making friends and meeting women outside of the US, and I wanted to be part of other cultures. I had no desire to spend much – if any – time back home.
So, for me, the Physical Presence Test worked best, and the same goes for many other people who want to go offshore and become global citizens.
However, that’s not the case for everyone.
You may want to spend more than 30 days with your family each year, or you might need more flexibility to attend to your US business interests.
US persons who don’t want to limit their time in the US to just 30 days should therefore consider using the Bona Fide Residence Test to qualify for income exclusion.
How Can You Qualify for the Bona Fide Residence Test?
Although I generally recommend that people use the Physical Presence Test to qualify for Foreign Earned Income Exclusion, using the Bona Fide Residence test can be beneficial in some cases.
To meet the requirements of the Bona Fide Residence Test, you must:
- Be a tax resident of a foreign country for more than one uninterrupted tax year;
- Intend to reside in that country for an extended or indefinite amount of time; and
- Not qualify as a US person under the Substantial Presence Test.
These requirements aren’t terribly complex, but meeting the threshold of the Bona Fide Residence Test isn’t as simple as just staying out of the US. Bad information and poor planning can easily cause you to lose your offshore status.
For example, a few weeks ago, a couple approached me claiming that they had found a way to qualify under the Bona Fide Residence Test and spend most of their year in the US.
They had recently attended an offshore conference where they learned about getting tax residency in Panama, where you only need to spend a day in the country per year to maintain your tax resident status.
Then, according to the couple, they could spend the majority of their time in the US while qualifying for the Bona Fide Residence Test due to their Panamanian tax residency.
Unfortunately for them, it’s not that easy.
While getting a second residence in Panama isn’t the worst idea, their plan falls far short of meeting the requirements of the Bona Fide Residence Test.
That’s the problem with those kinds of conferences – they make going offshore sound quick and simple when, in reality, it takes time, patience, and planning.
One of the many misconceptions floating around about the Bona Fide Residence Test is that you can easily establish tax residence elsewhere to qualify under it.
While that’s certainly important, it won’t happen overnight, and you need to do more than just say you pay tax elsewhere to take advantage of Foreign Earned Income Exclusion.
Establish a Foreign Tax Residence
If you plan to use the Bona Fide Residence Test, the most important part of your offshore strategy is establishing tax residence in another country.
Fortunately, in many countries, getting tax residency isn’t too difficult – even in low- or no-tax countries.
In Costa Rica, for example, anyone with a monthly income of over $2,500 can become a tax resident rather easily, and in nearby Guatemala, you need to make only $1,000 per month to qualify.
If South America isn’t your cup of tea, then you can head to glamorous Monaco, where buying real estate can be a gateway to residency, or you can move to bustling Kuala Lumpur, Malaysia.
However, establishing tax residence in any of these countries comes with some kind of catch.
When you decide where you want to establish your offshore tax residence, you’ll need to consider factors like time, residency requirements, and cost.
Getting your residency permit in Costa Rica takes at least six months – if you can find a competent attorney, that is – and to maintain tax residency in Guatemala, you need to spend nearly all of your time there.
Monaco and Malaysia, on the other hand, are easier, but more expensive.
Malaysia requires you to buy real estate or deposit around $70,000 in a Malaysian bank, and to establish residency in Monaco, expect to spend upwards of $1,100,000.
Therefore, as you plan to establish bona fide residence outside of the US, you should be sure you understand how you can establish tax residence in your country of choice and prepare accordingly.
Reside There for an Indefinite or Extended Amount of Time
After you establish a foreign tax residence, you need to actually live there to use the Bona Fide Residence Test.
You can’t just say you’re a tax resident and call it a day.
Put simply, your tax home needs to be your new home, and you need to plan to live there for the foreseeable future.
To see how this requirement works, let’s take a look at a couple of examples.
Suppose you’re a US citizen who accepts a position at a firm in Berlin.
If the position is a fixed 2-year contract, then you would not be able to claim exclusion under the Bona Fide Residence Test because the term of your stay isn’t indefinite if you only plan to stay for 2 years.
On the other hand, if the position is long-term, you could easily establish bona fide residence in Germany.
Because you would establish tax residence in Germany while moving there permanently for the position, you would qualify for exclusion under the Bona Fide Residence Test.
Although the IRS can make case-by-case decisions for frequent business travelers, you ultimately need to spend most of your time in your country of residence to qualify under this test.
This requirement is why I often suggest using the Physical Presence Test over the Bona Fide Residence Test.
The Physical Presence Test merely requires you to be out of the country. The IRS doesn’t necessarily care where you’re living or if you have tax residence elsewhere.
Bona fide residence, however, is much more difficult to establish.
You need to plan your travels so that you spend enough time there, and you need to be able to justify your tax home as your real home to the IRS.
Avoid Triggering the Substantial Presence Test
Once you’ve found and established your new bona fide residence, you then need to consider the Substantial Presence Test if you travel frequently to the US.
Another common misconception about the Bona Fide Residence Test is that it grants you unlimited time in the US as long as you maintain your offshore tax residence.
However, even if you meet all of the requirements of the Bona Fide Residence Test, you can still lose your Foreign Earned Income Exclusion through the Substantial Presence Test.
The IRS uses the Substantial Presence Test to determine whether or not someone is a US person for tax reasons.
Under this test, a person can only spend roughly 90-120 days in the US per year, and if they exceed that limit, their full income becomes taxable by the IRS.
Although this test is normally applied to non-residents using tourist visas, it also applies to anyone using the Bona Fide Residence Test to claim Foreign Earned Income Exclusion.
For example, suppose Jackie moves to Costa Rica and establishes bona fide residence there, but she needs to frequently visit the US to assist her business partner.
A business emergency arises, and Jackie needs to extend her stay in the US for two weeks. However, she has already maxed out the number of days that she can spend in the US this year.
In this scenario, Jackie would lose her Foreign Earned Income Exclusion by triggering the Substantial Presence Test.
US persons planning to use the Bona Fide Residence Test to qualify for exclusion should thus carefully calculate the amount of time that they can spend in the US to maintain their tax status.
For US citizens and permanent residents seeking Foreign Earned Income Exclusion, the Bona Fide Residence Test provides a useful alternative to the Physical Presence Test.
Unlike the Physical Presence Test, which significantly limits the time that you can spend in the US, US persons who qualify for exclusion under the Bona Fide Residence Test can comfortably spend 3-4 months in the US per year.
However, meeting the test’s requirements can be tricky at times, so without proper planning and information, your offshore tax strategy could go awry.
If you’re interested in learning more about how you can use the Bona Fide Residence Test to take advantage of Foreign Earned Income Exclusion, click here.
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