U.S. citizens or resident aliens, and specifically contractors or their employees supporting the U.S. Armed Forces in combat zones, may qualify for the foreign earned income exclusion.
Qualified individuals may exclude from gross income, subject to certain limitations, wages or self-employment income earned for services performed outside the United States. To be entitled, however, a taxpayer must satisfy several requirements.
One of the requirements is that an individual’s tax home be a foreign country. A tax home is where you conduct business or perform work as an employee or self-employed individual and isn’t necessarily the same as your residence.
The Internal Revenue Code also previously stated that an individual wouldn’t be treated as having a tax home in a foreign country for any period for which his or her abode is within the United States. In other words, an individual whose abode is within the United States couldn’t establish that his or her “tax home” was in a foreign country. “Abode” has been variously defined as one’s home, habitation, residence, domicile, or place of dwelling.
However, the Bipartisan Budget Act of 2018 changed that requirement. Now, eligible taxpayers can claim the foreign earned income exclusion even if their abode is in the United States. The new law applies for tax year 2018 and subsequent years. (Previously, many otherwise eligible taxpayers who lived and worked in designated combat zones failed to qualify because they had an abode in the U.S.)
Under the exclusion, taxpayers can choose to exclude their foreign earned income up to a certain dollar amount. For 2018, that dollar amount limit is $103,900.
In Information Release 2018-173, the IRS emphasizes that the foreign earned income exclusion isn’t automatic. Eligible taxpayers must file a U.S. income tax return each year with either Form 2555 (“Foreign Earned Income”) or Form 2555-EZ (“Foreign Earned Income Exclusion”). The IRS notes that these forms and instructions, and IRS Publication 54 (Tax Guide for U.S. Citizens and Resident Aliens Abroad), will be revised later this year to reflect this clarification.
Two residency tests
To qualify for the exclusion, a taxpayer must meet either the bona fide residence test or the physical presence test.
A taxpayer meets the bona fide residence test if he or she is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year. He or she can use the test to qualify for the foreign earned income exclusion only if he or she is either:
- A U.S. citizen, or
- A U.S. resident alien who is a citizen or national of a country with which the United States has an income tax treaty in effect.
A taxpayer doesn’t automatically acquire bona fide resident status merely by living in a foreign country or countries for one year.
To meet the physical presence test, a taxpayer must be physically present in a foreign country or countries for 330 full days during a period of 12 consecutive months. The 330 qualifying days don’t have to be consecutive. This test applies to both U.S. citizens and U.S. resident aliens.
Taxpayers choosing the foreign earned income exclusion can’t take advantage of any other exclusion, deduction or credit related to the excluded income. This includes any expenses, losses or other items that would have been deductible had the exclusion not been claimed.
Federal employees and military excluded
The IRS also points out that, as in the past, the foreign earned income exclusion isn’t available to federal employees or members of the military. But service members in combat zones continue to qualify for the combat pay exclusion.
Contact a B&V tax advisor, at 713-667-9147 or firstname.lastname@example.org, for more information or if you have any questions.