How To Take Advantage Of The FEIE
You know my advice in tax season is to “beat the IRS” at its own game by complying with every technicality of our complex tax code… including (especially) those “loopholes” and technicalities that work to your advantage…
One of the most powerful rules in the U.S. tax code is summed up by four letters: FEIE.
That stands for the “Foreign Earned Income Exclusion.” And it’s perhaps the most significant advantage available to Americans overseas.
Let me explain…
As a U.S. person, the FEIE allows you to exclude up to US$120,000 in earned income on your taxes if you live and work outside the United States.
If you’re married, you can exclude up to US$240,000.
These figures are both for 2023, and the amount generally goes up every year by a small increment—to keep up with inflation.
It’s important to note that this exclusion applies to earned income, which means that the income must be the result of actual wages from an employer (including you, if you are the owner of a business).
Income from social security, private pensions, dividends, alimony benefits, and the like do not qualify.
(But there are other “loopholes” and rules in the IRS code you can use to minimize your taxes on that income… as my team and I explain in our new 2023 expat taxes guide.)
The FEIE is meant to mitigate the tax burden for United States citizens working abroad. For some workers, however, it may be better to forego the FEIE if you are earning a high salary in a high tax country. In that case, you could owe less U.S. taxes if you take the foreign tax credit.
Keep in mind that once you start taking the FEIE, you have to continue to take it unless you revoke your usage. If you do stop using it, you won’t be able to take the FEIE again for five years… so it’s imperative that you evaluate your potential long-term situation before deciding how to handle the FEIE.
For most people, it’s a straightforward decision, as the FEIE is the biggest tax benefit you have as an American working and earning income overseas… if you qualify.
How To Qualify For The FEIE
To qualify for the Foreign Earned Income Exclusion, you must pass one of two tests—the physical presence test or the bona-fide resident test.
In some cases, such as a temporary (one year) assignment overseas, you will have to qualify under the physical presence test even if you can prove compliance with the bona fide resident test.
Physical Presence and Bona Fide Residency Tests
The physical presence test is fairly black and white. To qualify for the FEIE this way you have to be in a foreign country for 330 days in a 12-month period. The wording of the rule is such that it’s not days outside the United States but days in a foreign country. This seemingly small twist can create a problem for people working in maritime industries (days in international waters aren’t days in a foreign country), and for all those people living on the lifestyle cruise ships that travel the world from port to port (although those people probably aren’t working).
For ordinary folks, it means a day traveling through the States to go from Latin America to Europe can be two days not in a foreign country, as a day is counted from midnight to midnight.
Nevertheless, even given the tight definition of days in a foreign country, it should be fairly straightforward to determine whether you pass this test or not. If you do, then you qualify for the FEIE.
The bona fide residency isn’t as black and white as the physical presence test. Holding a residency permit for another country is only the starting point of qualifying for the FEIE under this test. You must meet other criteria. One that helps a lot is being liable for taxes in your country of residency. Most everyone who is living full-time in another country should fall into that category.
Your housing situation can also help solidify your bona fide residency status, i.e. by not maintaining a residence in the United States… and/or by investing in a home in the foreign country will help show you are truly a resident overseas. It’s not that keeping a house in the U.S. will disqualify you from the FEIE, but if other factors don’t clearly show where you are living, then you might be disqualified.
Having kids who go to school in the country, owning a car, having a local driver’s license, being a member of local organizations… all these kinds of things help toward creating bona fide residency.
If you pass the bona fide residency test, then you don’t have to worry about how many days you’re in a foreign country (or how many days you’re in the United States). You qualify for the FEIE regardless of your comings and goings day-to-day… except in the case of a temporary assignment, in which case, you’ll have to meet the physical presence test.
While you won’t have to worry about how many days you are in the States for your bona fide residency test, you won’t be able to spend more than six months Stateside in a calendar year as tax residency rules apply to anyone who spends 183 days or more in most countries, including the United States.
Additionally, even if you’re a bona fide resident of another country, any work you do in the United States is not eligible for the FEIE.
Example:
An example would be a vice president of Latin American operations for a U.S. company going to the States for two weeks training. The salary that relates to those two weeks isn’t eligible for the FEIE.
How Is The FEIE Calculated?
The FEIE is calculated on Form 2555. You’ll have to include information about your earnings, decide which test you want (or need) to qualify under, and your employer’s information. It’s a fairly straightforward form.
Your earned income is indicated on your 1040 Form under wages (or, if you are self-employed—which, as I’ll explain shortly, is generally a bad idea from a tax perspective—on your Schedule C), but you’ll enter a negative amount on line 21 for the amount calculated on Form 2555 as your FEIE. In other words, it’s an above-the-line exclusion that reduces your adjusted gross income, phasing out many credits and deductions. Some credits and deductions add back in the amount of your FEIE in the worksheets to calculate them, but not all.
Foreign Housing Exclusion (FHE)
In addition to the Foreign Earned Income Exclusion, if you’re working and receiving earned income in another country, you may also qualify for the Foreign Housing Exclusion (FHE). You calculate this on Form 2555. The FHE applies if you are renting your residence while earning income in a foreign country. A base amount of 16% of the FEIE is used to reduce your actual rental expense; this amounts to US$16,944 for 2019. The IRS limits your qualifiable rental expense to 30% of the FEIE, or US$31,770, unless you live in a high-cost destination. This means up to an additional US$14,826 that can be excluded from your income for U.S. tax purposes for tax year 2019 (assuming you don’t live in a high-cost location).
How To Retain Earnings Offshore
To enjoy tax-deferred earnings offshore, you must first:
- Be living and working abroad and qualify for the FEIE
- Operate through a properly structured and maintained offshore corporation
- Generate ordinary (active) business income in excess of the FEIE
- Pay yourself a salary up to the FEIE amount
- Retain profits in excess of the FEIE in the corporate bank account
- Pay tax in the United States on those retained earnings in your offshore corporation when you take them out in the form of dividends or other payments