Foreign Earned Income Exclusion for U.S. Taxpayers Living Abroad

August 22, 2007

In general, most people are aware that the United States taxes its citizens and residents on their worldwide income. Many people do not understand that the US taxes income earned by Americans living in foreign countries. For this reason, US citizens/residents (“US persons”) living abroad must file annual tax returns in the US. The deadline to file these is April 15. (Because many US citizens living abroad have in the past ignored this requirement, in 1986 Congress introduced Section 6039E to the Internal Revenue Code. Included in the Tax Reform Act Of 1986, it requires every US passport applicant to disclose his/her social security number, foreign address, etc., enabling the IRS to verify whether a person has filed a US tax return.)

The fact that US persons are taxed on income earned while living abroad puts US businesses at a disadvantage, because their transferred employees could end up being taxed twice on the same income—once in the country where earned, and a second time in the US, resulting in higher wages to compensate for this extra expense. One way of avoiding this is achieved by allowing a tax credit for taxes paid in the US person’s country of residence. Not only does the tax code allow for this, but it also contains a certain exception according to which such persons will not be taxed on income earned while living abroad. I.R.C. § 911 of the US tax code allows a US citizen/resident to exclude from his income a portion of foreign earned income equal to $80,000 plus housing costs, provided he/she was a resident of a foreign country for a full calendar year, or was physically present in a foreign country for 330 days out of any 12 consecutive months. The Code further defines the term “housing expenses” as reasonable expenses paid or incurred during the taxable year. Housing expenses do not qualify if lavish or extravagant.

Before making a 911 exclusion election, a taxpayer must remember that its value diminishes as a foreign country’s tax rate increases. For example, let’s assume unmarried US citizen “X” lives and work in Foreigopia for 12 consecutive months and earned income of $65,000 during this period. Foreigopia has an income tax rate of 10%, and X did not make a section 911 election. X will be liable to pay income taxes in the US in the order of $9,172 ($15,672 - $6,500 in tax credits), resulting in a total tax liability of $15,672. Should X make a section 911 election, he will not be liable to pay any taxes in the US, and have a total tax liability of $6,500. Let us now assume X is transferred the following year to Taxania where his salary is $80,000 while Taxania’s income tax rate is 50%. Should he not make a section 911 election, X’s US tax liability will be $0 ($20,322 - $40,000 in tax credits). If X were to make a section 911 election, he would still have a $0 US tax liability, but will not have available for carryback/carryforward purposes any excess tax credits. Therefore, if the US tax liability would be $0, one should not file for a § 911 exclusion.

It should be noted that only qualified taxpayers are allowed to claim an income exclusion pursuant to section 911. For example, only individual taxpayers qualify and, as mentioned earlier, they have to meet certain residence requirements. Such an individual’s tax home should be in the foreign country, not in the US. The IRS will not treat a taxpayer as having a tax home in a foreign country while the person’s abode is in the United States. In this regard “abode” has more of a domestic than a vocational meaning. For this reason determining a taxpayer’s abode calls for an inquiry into the way in which the person spends free time—Courts in the past have looked at factors like ownership of home-state dwelling, place and maintenance of bank accounts, time spent with family in the US, location of church attended, etc.

Making use of this income exclusion could result in significant tax savings. Should you have any questions in this regard, please feel free to contact Joe Dehner or any attorney in our International Services Group.