The goal of this article is to provide a comprehensive checklist of information for the US person to consider
prior to accepting an assignment outside the US. This article is not designed to teach you the technical
competence required to perform self compliance however, it will certainly arm you with what you need to
know to determine if your US tax preparer knows all that they should know to provide you with adequate
professional services.
General concepts of US taxation:
All United States (US) citizens, green card holders and persons meeting the Substantial Presence Test
(SPT) are considered US resident aliens. The third category, or SPT, is irrelevant for these discussions as
this test must continue to be met on an annual basis. All citizens and green card holders (also US resident
aliens) are subject to US Federal taxation on their worldwide income for life, regardless of where their
income is earned, what currency it is in or where their income is deposited to.
For state tax purposes the requirements can be quite different and vary from state to state. Typically there
are state specific facts and circumstances tests in addition to tests of domicile. Some states could hold you
to be a continuing resident even while away on a foreign assignment, if your ultimate intention is to return
after the termination of your foreign assignment. For more information on state residency issues, please
consult us separately.
In fact the US is the ONLY country in the world to tax its individuals based upon their citizenship and not
based upon their “tax residency”. Other countries have a “tax residency” concept, where “tax residency” is
determined by a variety of tests or features unique to each country’s tax system. However, the overriding
tax principle is that tax residents of a particular country are taxed in that country on their worldwide income
and tax non-residents of a particular country are taxed in that country only on income from that country and
NOT on their worldwide income.
There are three ways to help avoid double taxation while abroad on assignment. The Foreign Earned
Income Exclusion (FEIE), the Foreign Housing Exclusion (HE) or/ and the Foreign Housing Deduction
(HD), and the Foreign Tax Credit (FTC).
The Foreign Earned Income Exclusion and Form 2555:
Many years ago in an attempt to help mitigate the above double taxation inequity to US persons abroad (the
US treatment of citizens and green card holders versus other countries, as above) the US introduced
legislation that would give US resident aliens (citizens and green card holders) a break on the income that
they earned abroad. The break is contained on IRS Form 2555- Foreign Earned Income Exclusion (FEIE)
currently set at $80,000, which allows US resident aliens the ability once included as either wage income or
self-employed income, to exclude up to the first $80,000 of foreign (non US) earned (wages or selfemployed
income, but not pension, annuity, social security benefit, or US government wage income)
income in years in which they are abroad for a full year. The exclusion is pro-ratable in partial (non full
years) years abroad, based upon the number of days in the foreign assignment over 365 days. Earned
income may also include business profits, royalties and rents, but certainly excludes income from property
such as interest, dividend and capital gain income, and other income such as alimony, prizes and gambling
winnings.
Who qualifies for the FEIE:
To qualify for the FEIE you must meet two tests: 1) the Tax Home Test (THT) and 2) either a) the Bona
Fide Residence Test (BFR) or b) the Physical Presence Test (PPT).
Your tax home is generally perceived as your main place of business, employment or post of duty and is
the place where you are permanently or indefinitely (must be in excess of one year) are engaged to work as
an employee or self-employed person.
The BFR is a strictly qualitative test for US citizens or resident aliens the nationals of countries with whom
have an income tax treaty with the US. BFR requires you to first be abroad for one full calendar year (i.e. a
January 1 to December 31 period).
The PPT is for US citizens or US resident aliens and is a strictly quantitative test requiring 330 full days (a
full day is a complete twenty four hour period) of presence abroad out of any 12 month (365 day)
consecutive period. Thus, this can incorporate a non calendar period and any fiscal period, as for example
April 21, 20X1 to April 20, 20X2.
You are not allowed to file Form 2555 with Form 1040 until meeting both of the above two tests. You may
therefore, be required to substantially delay your filing. Form 2350- Application for Extension of Time to
Filer US Income Tax Return- would be the correct extension form to employ in these circumstances. Also
IRS Form 673- Statement for Claiming Benefits Provided by Section 911 of the Internal Revenue Code-
may be used by the expatriate as a payroll form to avoid the withholding of US taxes on excluded income.
Typically the PPT is used in years of transition that is in both years of expatriation abroad out of the US
and in years of repatriation back to the US. PPT places an advantage over BFR in these transition years as
if up to the point of expatriating or repatriating the taxpayer has not been back to the US in excess of 35
days in the 12 month consecutive period, there is opportunity to use those 35 days (365 consecutive period
less the 330 days required to meet the test) as slide days to increase the total days abroad for the purposes
of calculating PPT. This is accomplished by either sliding the taxpayer back or ahead by those 35 days,
depending on whether they are expatriating or repatriating respectively. This is used, as above, in partial
years abroad where the FEIE is prorated by those days abroad over 365. Therefore, using the PPT we may
be able extend the period covered by the FEIE using the 35 slide days in a US persons expatriating or
repatriating years to increase the amount of the fractional exclusion that we claim on their behalf. So it is
prudent planning in expatriating and repatriating years to limit your days back to the US, such that we can
optimize these 35 slide days to obtain excess FEIE.
The Foreign Housing Exclusion (HE) or Deduction (HD):
In addition to the FEIE there is a little known about jewel, the Foreign Housing Exclusion (HE) for
employed persons or the Foreign Housing Deduction (HD) for self-employed persons. In addition to the
above FEIE of $80,000, there is an opportunity to augment this basic earned income exclusion by an
overseas taxpayer’s reasonable qualified foreign housing expenses. Qualified foreign housing expenses are
typically much higher than a taxpayer’s included employer paid for housing income, or quarters.
The nice feature of the HE or HD is that the list of qualified housing costs is very broad and all-inclusive:
rent, Fair Market Value (FMV) of employer provided housing, foreign real-estate or occupancy taxes, TV
taxes, utilities but not telephone, real or personal property insurance, “key” money or other similar
nonrefundable deposits paid to secure a lease, repairs and maintenance, furniture rental, temporary living
expenses and residential parking.
This list is quite exhaustive, but the increasingly amazing feature about the HE or HD is that IT DOES
NOT MATTER WHO PAYS FOR THESE QUALIFIED HOUSING EXPENSES!!! Regardless of
whether you the employee pay directly for these costs or whether your employer directly pays or
reimburses you for these above costs, these costs are still includable in the HE or HD. However, these
costs may also need to be included in your employment income, that is if paid or reimbursed by your
employer.
To Be Employed Versus Self-Employed (SE):
Generally it is the author’s opinion that if you are employed and you go overseas you have a distinct
advantage over being self-employed (SE) overseas.
Simply put although your ‘foreign’ unreimbursed employee expenses will be excluded from Schedule A
without affecting your FEIE, all overseas SE persons Schedule C ‘foreign’ expenses and applicable
‘foreign’ self-employed adjustments on Form 1040 line(s) 23-32 will dollar for dollar reduce the amount of
the $80,000 FEIE available to you for use. This would also apply to any moving expenses whether
employed or self-employed, in that if claimed and to the extent that they are considered foreign they would
reduce the amount of the $80,000 FEIE available. Moves back to the US are NOT considered foreign.
Additionally, as SE all of your net SE income is subject to US FICA (Federal Insurance Contributions Act)
taxes- social security (6.2% on the first $87,900 of wages for 2004) and Medicare (1.45% on all wages)
taxes, however for SE persons they additionally end up paying for both the employee and employer
portions. This effectively combines to 15.3% (6.2% + 1.45% = 7.65% x 2) FICA taxes for all SE persons
reporting net income on a Schedule C, which is ALWAYS assessable if net income on Schedule C arises.
However persons employed abroad and NOT on US payroll, but instead locally hired are NOT subject to
US employee FICA taxes AT ALL. They would become subject to the social security tax regime of the
respective country in which they work, if any.
There is a way however, that SE persons can avoid US FICA SE taxes. Any “Foreign Controlled
Corporation” FCC (where foreign is non US) is deemed to have all of its income earned directly by the
controlling US person. So the ability for the deferral of income in a FCC is impossible. However, FCC’s
have one interesting feature, wherein if all of the net income of an FCC is waged out to the controlling
shareholder so as to avoid the above deemed income rule those wages would NOT be subject to the US
FICA SE taxes of 15.3%!! This is a frequent suggestion of the author’s, to US SE persons abroad, that is to
do business through an FCC to avoid US FICA SE taxes. However you must consider the implications of
the host country’s social security regime, which might make this suggestion more costly.
What happens when your FEI is in excess of the $80,000 plus the HE or/ and HD?:
Under US domestic law and also included in most federally negotiated international income tax treaties,
there is a provision to avoid “double taxation”. The provision is reportable on IRS Form- 1116- as the
“Foreign Tax Credit” (FTC). The FTC is a dollar for dollar reduction of tax in respect of non excluded
foreign tax on non excluded foreign income. In other words, you are NOT allowed to take a FTC credit on
income that has already been excluded and the amount of foreign tax eligible for the FTC must also be
scaled down for excluded income. As a result of the FTC you are always protected and theoretically should
NEVER pay double tax on your worldwide income. However, as the FTC is limited to the lower of the
actual tax you pay or the US tax on that foreign income, if the US tax on that income is less it is calculated
using your average rate of US tax. So what happens if your average rate of US tax is 28%, but your
marginal tax rate (US tax on your last dollar of income) is at the 35% level? Then theoretically the
avoidance of double tax is not a perfect mechanism. It is for this reason that if we have a choice we will
ALWAYS prefer to max out on your available exclusions prior to using the FTC.
Other Interesting Form 2555- FEIE, HE and HD, Form 1116- FTC and General Facts:
• These exclusions are elected, strictly voluntary and not mandatory, so in cases where claiming the
election results in exclusion income they should not be elected. This would occur where Schedule
C expenses outstrip income and these expenses are added back actually creating income.
• You cannot pick and choose income that you wish to exclude and income for which you elect not
to exclude. It is an all or nothing deal.
• If you end your foreign assignment and continue with another foreign assignment abroad, then this
will NOT affect either the tax home or BFR or PPT tests. However, if you happen to pack up your
belongings and move back to the US then you are in danger of forgoing either the tax home test or
BFR tests, not to mention the PPT and you may need to meet these tests all over again.
• The HE and HD are both subject to a base deduction or “Housing Norm” which for 2003 is $30.77
per day. So if in 2003 you were abroad a full 365 calendar tax year you would first need to deduct
$11,231 prior to any of your Qualified Housing Costs counting towards the HE or HD.
• Theoretically if you have no US source income then between the FEIE, HE, HD and FTC your US
tax liability should be NIL.
• As a US resident alien since you are taxable on your worldwide income you are also able to deduct
your worldwide deductions. This would include foreign mortgage interest, real estate taxes and
other. However, as above, the ability to deduct foreign unreimbursed employee expenses on
Schedule A is prevented when the FEIE is used and the income to which the deductions relate is
excluded.
• There is an option to use either the Accrued or Paid basis to record foreign taxes for the purposes
of calculating the FTC. Generally we would use the paid basis if the foreign tax cycle is a
calendar year tax cycle analogous to the US and accrued basis if the foreign tax cycle is a fiscal
tax year, unlike the US tax system. The accrued election makes us recognize the foreign taxes for
US tax purposes by looking at the US calendar year in which the foreign fiscal year-ends. Thus,
the need to calculate the individual withholdings separately is obviated. However, once elected to
use the accrued method you must use it going forward indefinitely. Furthermore using the accrued
basis may be dangerous as although it may give a tax disincentive in the first year abroad;
however, providing relief in the last assignment year abroad it does create a series of mismatching
or a timing differences of foreign tax to foreign income. So there are pros and cons to the accrued
basis
• If the US has federally negotiated a Totalization or Social Security Agreement with the country
abroad that you are currently either employed or self-employed in, there may be an opportunity to
obtain a Certificate of Coverage retroactively to ensure that you continue to pay in to the US social
security system for a specified maximum number of years to ensure that you receive full benefit
for your social security contributions on earnings abroad in the US. Please visit
http://www.ssa.gov/international/ to determine if such an agreement exists in your circumstances.
• If you are outside the US on April 15 of any tax year, you automatically qualify for an extended
filing deadline of two months. You should write “Taxpayer Abroad on April 15” on the top of
your extension Form 4868.
• If you are unable to file your tax return by the Form 4868 first extension deadline of August 15, it
is possible to obtain an additional 2 month extension of time to file your US tax return using Form
2688 up until October 15 only. Despite popular belief it is currently impossible to extend a US tax
return beyond October 15 of any given tax year.
• Although there is a statutory three year limit with respect to claiming refunds, there is no statutory
limit to go back and either fix or claim the use of the FEIE. This means, for example, that should
you have 10 years ago NOT claimed the benefits of the FEIE, HE or HD when you were entitled
to you have an unlimited period of time to go back and make your claim.
• Sale of Principal residence: In the five year window prior to sale of your principal residence you
must have: 1) owned and 2) used or lived in the home for at least two years= 24 months = 730
days both spouses to qualify for the $250,000 per spouse exclusion. The two years for the owned
and use test do not have to be the same two years within the five years prior to sale. If you do not
have the two years for both tests you will not qualify for the exclusion unless: you have a change
in location of employment, health reasons or for unforeseen circumstances. Obviously the
handicap for expats is that although they usually meet the two year test of ownership they DO
NOT meet the test on use. If the home is NOT your "main home" or principal residence and you
have held it for more than one year then the gain would be taxed at the 15% long term capital gain
rate.
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