The Foreign Earned Income Exclusion v. Foreign Tax Credit

Sep 22, 2017

This post will compare the pros and cons of whether to elect the foreign earned income exclusion ("FEIE") or the foreign tax credit ("FTC"). Generally, these two options are available to those living and working outside the United States. So expats should tune in!  Before delving into the complexities explored in this article, you may wish to determine your own offshore reporting obligations by checking out the free FBAR Wiz app - which will tell you some of the tax Forms you need to file and give you an overview of your filing obligations with respect to foreign assets and/or foreign accounts. FBAR forms are highly common among expats. Foreign Earned Income Exclusion United States Citizens and resident aliens who live and work abroad may be able to exclude all or part of their foreign salary or wages from their income when filing their U.S. federal tax return. They may also qualify to exclude compensation for their personal services or certain foreign housing costs. To qualify for the foreign earned income exclusion, a U.S. citizen or resident alien must have a tax home in a foreign country and income received for working in a foreign country, otherwise known as foreign earned income. The taxpayer must also meet one of two tests: the bona fide residence test or the physical presence test. The foreign earned income exclusion is adjusted annually for inflation. The foreign earned income exclusion for 2017 is $102,100, up from $101,300 in 2016. The foreign earned income exclusion and the foreign housing exclusion or deductions are claimed using Form 2555, Foreign Earned Income, which should be attached to the taxpayer’s Form 1040. A shorter Form 2555-EZ, Foreign Earned Income Exclusion, is available to certain taxpayers claiming only the foreign income exclusion. Once the foreign earned income exclusion is chosen, a foreign tax credit or deduction for taxes cannot be claimed on the excluded income. If a foreign tax credit or tax deduction is taken on any of the excluded income, the foreign earned income exclusion will be considered revoked. For more information about the Foreign Earned Income Exclusion see Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad and the instructions for Form 2555 or Form 2555-EZ. Definition of Earned Income

  • Salaries and wages, commissions, bonuses, professional fees, tips
  • Noncash income - Fair market value of property or facilities provided by your employer in the form of the following: lodging, meals, or use of a car
  • Allowances or reimbursements – Includes allowances or reimbursements you receive, such as the following amounts: Cost of living allowance; Overseas differential; Family allowance; Reimbursement for education or education allowance; Home leave allowance Quarters allowance
  • Exclusion of Meals and Lodging from income only if the following conditions are met: (1) The meals are furnished on the business premises of your employer, and for the convenience of your employer. (2) Lodging is furnished on the business premises of your employer, for the convenience of your employer, and as a condition of your employment.

If the above conditions are met, do not include the value of the meals or lodging in income. These exclusions are not foreign earned income, and not included in the total reported on the W-2 in box 1 as "wages." To claim the foreign earnings income exclusion, the foreign housing exclusion, or the foreign housing deduction, you must meet all three of the following requirements:

  • Your tax home must be in a foreign country
  • You must have foreign earned income.
  • You must be either: (1) A U.S. citizen who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes en entire tax year; (2) A U.S. resident alien who is a citizen or national of a country with which the U.S. has an income tax treaty in effect and who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year, or (3) A U.S. citizen or a U.S. resident alien who is physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months.

If you qualify, the foreign income exclusion is voluntary and tax withholding can be stopped once you complete and submit IRS Form 673, or similar statement, to your employer. Form 673 can be used by U.S. citizens only. The foreign earned income exclusion remains in effect for that year, and all subsequent years until you revoke it. If you claim the foreign earned income exclusion, you cannot claim a deduction or credit for any item that can be allocated to or charged against the excluded income, specifically a foreign tax credit. Foreign Tax Credit If you plan to take a foreign tax credit, instead of foreign earned income exclusion, you may be eligible for additional withholding allowances on form W-4. You can take these additional withholding allowances only for foreign tax credits attributable to taxable salary or wage income. The foreign tax credit is intended to relieve you of a double tax burden when you foreign source income is taxed by both the U.S. and the foreign country. Generally, if the foreign tax rate is higher than the U.S. rate, there will be no U.S. tax on the foreign income. Foreign taxes that qualify for the credit: Generally four tests must be met for any foreign tax to qualify for the credit.

  • The tax must be imposed on you.
  • You must have paid or accrued the tax.
  • The tax must be the legal and actual foreign tax liability.
  • The tax must be an income tax (or a tax in lieu of an income tax).

Options for Expat Employees Living and/or Working Outside the U.S. The tax option chosen by the expatriate employee will depend upon whether the employee fits the requirements and elects the Foreign Earned Income and/or Foreign Housing Exclusions, or whether the employee qualifies for and chooses to file for a foreign tax credit. Foreign Earned Income Exclusion – To qualify, must meet the criteria outlined above and in IRS Publication 54. Submit IRS Form 673 or similar statement to the University’s Payroll Services to stop withholding income tax on excluded income. The 2017 exclusion limit is $102,100. Complete and submit IRS form 2555 or 2555-EZ with your form 1040 tax return. Form 2555-EZ is only used if you do not claim the Foreign Housing Exclusion Foreign Tax Credit – Cannot be used if you claim the foreign Earned Income Exclusion Four tests must be met to claim the Foreign Tax Credit. See above and IRS publication 514 for more information. Complete and submit a new Form W-4 to claim additional allowances for the foreign tax credit. For a related article that will teach you about the important passive foreign investment company ("PFIC") classification, check out this blog post and know your rights!