As a U.S. citizen, all of your income—no matter where it was earned or how it was received—must be reported on your annual tax return. This includes income you earned while working in a foreign country either as an employee or independent contractor. However, you may be able to exclude some or even all of your income (to a maximum of $100,800 for 2015) as part of the Foreign Earned Income Exclusion.
Of course, some conditions apply and you must meet various criteria in order to take this income exclusion. To start, you must meet either the Bona Fide Resident or Physical Presence tests.
Bona Fide Resident Test
For the Bona Fide Resident test, you must first reside and work in a foreign country (or countries) for an uninterrupted entire tax year—Jan. 1 through Dec. 31, not simply 12 continuous months. You may take short trips back to the U.S. or elsewhere for vacation or business without negating your Bona Fide Resident status. However, the duration of your stay and nature of your work are only two factors in determining Bona Fide Resident status. You must set up permanent living quarters even if you maintain your domicile in the U.S. and eventually plan to return there. Any questions about whether or not you are a Bona Fide Resident are determined by the IRS on a case-by-case basis according to the facts you report on Form 2555, Foreign Earned Income.
If you think you are earning tax-free money as a Bona Fide Resident, think twice! To be a Bona Fide Resident youcannot make a statement to the authorities of the foreign country that you are not a resident in order to avoid that country’s taxation. The bottom line: You probably have to pay taxes somewhere. Any treaties or international agreements may also impact your status as might the type of visa you have to live and work in that country.
Physical Presence Test
The Physical Presence Test offers a bit more flexibility regarding your time abroad. According to the IRS, you meet this test “if you are physically present in a foreign country or countries 330 full days during a period of 12 consecutive months.” When the IRS says “full day,” it means the full 24-hour period, so travel days into or out of a foreign country probably don’t count toward the 330-day threshold.
As a taxpayer, you get to choose the 12-month period for the Physical Presence Test, so you gain flexibility in choosing the period that will provide the greatest exclusion.
Excluded Income and Taxes
The Foreign Earned Income Exclusion applies to just that: earned income. This includes wages, salaries, professional fees, and other compensation amounts for services rendered. Other types of income (e.g. investment income) cannot be excluded.
This exclusion applies to federal income tax. It does not reduce the self-employment tax (the vehicle through which those who are self-employed pay Social Security and Medicare taxes) unless the foreign country in which you reside has a similar type taxation to which you are subjected. If so, self-employment tax may be excluded or reduced.
Taking this exclusion does not reduce your tax rate. Your federal income tax rate is calculated on your total income before excluding qualified foreign income. Also keep in mind that there is a maximum exclusion allowed—$100,800 for 2015.
Foreign Housing Exclusion
If you are working abroad, you can also claim an exclusion or deduction from income for housing expenses. You must first meet either the Bona Fide Resident or Physical Presence test. Some of the qualifying excludable expenses include (but are not limited to): rent, fair rental value of employer-provided housing, repairs, utilities (excluding telephone), property insurance, and occupancy taxes.
Expenses you may not exclude or deduct include (but are not limited to): lavish housing (determined by your circumstances), cost of buying property, domestic labor, home improvement, or depreciation.
For complete information and calculations, see IRS Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad. Or contact Waddy Accounting Services for expert tax advice and guidance to pay the correct amount you owe. Additionally, we can help you keep track of currency fluctuations while you are abroad as this rate is an important factor in your overall tax scenario.
Always keep in mind that there are very stiff penalties if you fail to disclose your income and investments or otherwise attempt to hide money from taxation.