While many expats assume that the Foreign Earned Income Exclusion (FEIE) is the best way to save on US expat taxes, there are some situations where you would actually owe more US tax if you use it! Let’s take a closer look at the FEIE and when it may not be the best way to reduce your US tax liability.
Foreign Earned Income Exclusion Basics
Tax payers can qualify to use the FEIE either through the Physical Presence Test (spending at least 330 days inside a foreign country during a continuous 365 day period) or through the Bona Fide Residence Test where you have set up long-term residence in a country (at least one calendar year abroad).
The FEIE is only allowed on foreign earned income and if you work for the US Government overseas, you are not considered to have foreign earned income–this includes State Department Employees, Military Members, and some employees on military bases or in US embassies. Also, income earned while you are in the United States is not eligible for exclusion, even if your employer is still in a foreign country. Income is earned where the work is done, not were the employer is located.
Once you choose to use the FEIE and/or the Foreign Housing Exclusion you must use it every year you have foreign earned income unless you formally revoke it. There are downsides to both the original election and the revocation.
Why wouldn’t you want to use the Foreign Earned Income Exclusion?
If you are located in a country with taxes at or higher than the rates charged in the US, you may be better off not invoking the FEIE. In addition, if your earned income is higher than the exclusion amount, this may also make the FEIE disadvantageous. This is due to the way the IRS figures tax on the amounts of earned income over the exclusion. The following is an example of how the IRS calculates that tax and why electing to use the FEIE can sometimes cost you more.
Using the Foreign Earned Income Exclusion
|Total foreign earned income in USD:||$200,000|
|Total Foreign Taxes Paid on Earned Income||$48,000|
|2014 Foreign Housing costs (less 16% of FEIE 15,872)|
|Total housing costs 28,000||$12,128|
|Total Excluded Income||$111,328|
|Adjusted Gross Income after exclusion||$88,672|
|Standard Single Deduction||$6,200|
|Standard Single Exemption||$3,950|
|US Taxable Income||$78,522|
|US tax due on total earned income less Standard Deduction and Exemption||$46,509|
|US tax on excluded income||$24,348|
|Remaining US Tax Payable||$22,161|
|Amount of Foreign Tax Excluded With FEIE|
|Remaining Foreign Tax Credit Available||$21,281|
|US Tax due using FEIE||$22,161|
|Foreign Tax Credit available to offset US tax||$21,281|
|Tax payable to US||$880|
|If the FEIE is not utilized|
|Standard Single Deduction||$6,200|
|Standard Single Exemption||$ 3,950|
|US Taxable Income||$189,850|
|US Tax on Income||$46,509|
|Foreign Tax Credit (dollar-for-dollar credit on foreign taxes paid)||$48,000|
|Foreign Tax Credit to be carried over to next year||$1,491|
As shown in this example, you would owe tax to the IRS if you were to invoke the FEIE. As you can see, by not using the FEIE you actually have a foreign tax credit carryover which you can use to reduce future tax for up to 10 years. You can also choose to carry that credit back one year and amend the prior tax return if you owed money to the US.
Another reason to not invoke the FEIE is if you know there is a chance will be moving to a country with a lower tax rate or no tax (such as many countries in South East Asia, former Soviet Republics and the Arab peninsula). While choosing to use only the Foreign Tax Credit now may result in paying the US a small amount of tax, it may be worth it in order to preserve those foreign tax credit carryovers for future years.
Revoking the Foreign Earned Income Exclusion
If you have already invoked the FEIE and you do not want to use it one year, you must formally revoke it. Once revoked it cannot be used for another 5 years without requesting permission from the IRS in a Private Letter Ruling, at a cost of $2,000. The IRS does not always grant these exceptions. There are times when you may want to revoke the exclusion and it is appropriate, such as the above example. If you have permanently moved to a country with a higher tax rate than the US and it appears that you would owe US tax if you use the FEIE then it will be in your best interest to revoke the exclusion. You should always work with your tax professional to determine which option is right for you, as the calculations can be confusing.
What if I have no Foreign Earned Income?
If you have a year (or more) with no foreign earned income and have previously invoked the FEIE you do not lose the ability to use the FEIE in the future. You are only required to file Form 2555 in years that you do have foreign earned income–not filing the form in years without foreign earned income does not constitute a revocation. So if you move back to the US temporarily or permanently, there is no need to do a formal revocation.
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