One of the common discussions I have with US clients working overseas is how to exclude their foreign income from US taxation. Many people know about Foreign Earned Income Exclusion (FEIE) already, but are concerned about being able to meet the physical presence requirement.
Specifically, getting this tax benefit seems to be interfering with their lives. What if I want to take my kids back to visit grandparents for the whole summer, not just for a month? What if my employer asks me to return to the US for work trips? What if my parents get sick and I need to return unexpectedly? People ended up agonizing over visiting the US.
In general, if your income is way above the FEIE limit ($104,100 in 2018), then it’s basically your judgment call. Is going back to the US longer worth the incremental taxes you need to pay? Some may say absolutely, some may think not. In my opinion, if you really do want to visit the US longer, just budget in the extra taxes you need to pay and be done with it.
Nevertheless, there are ways to exclude all of your income from taxation and still stay in the US for over 35 days. You may find that one of these situations applies to you so you don’t have to worry about keeping track of your days in the US.
The reason I’m writing this post is so that you can truly evaluate your options and choose to live the way you want, instead of compromising quality time in the US solely for financial gain.
So here we go.
How to visit the US for over 35 days and still exclude foreign income
#1: Establish Bona Fide Residence
In addition to Physical Presence test, another way to qualify for FEIE is establishing Bona Fide Residence. This test usually applies to people who actually move their household to another country and become a resident there.
IRS has a list of criteria to qualify a Bonafide Residence, and there are plenty of past cases where IRS dispute tax payer’s claim of Bone Fide Residence during audit. It’s likely that if you use this test, you truly have more ties in one foreign country than the US at the moment. You derive income in another country, pay mortgage/rent and taxes locally, even during the period that you are visiting the US. After you visit the US briefly, you return to the foreign residence.
In this case, even if you choose to take long vacation or business trips back in the US, you may be able to claim the full FEIE up to the limit. This is perhaps the most beneficial route for US citizens who earn more but moved to a country with low tax liability permanently.
#2: Take Foreign Tax Credit
Another common tactic is to use Foreign Tax Credit (FTC) instead of FEIE. Generally speaking, if your US tax liability is equal or lower than the local one, you can choose to pay normal taxes in the US and take a credit against the taxes you’ve paid on the same income to a foreign government.
There is no “test” you need to meet. Even if you live in the US full-time, you are able to claim FTC against US tax. So it takes the days you visit the US out of the equation.
In practice, you will likely accumulate credit against future US taxable income, instead of getting a payment from the IRS. When you complete your Form 1040, you will have calculated your tax liability before you apply FTC. Once you apply FTC (your foreign tax bill), which hopefully is bigger than your US tax, you may technically end up with a negative number.
Since FTC is a nonrefundable credit, this negative number can be carried back for one year and forward for 10 years. This means that FTC is most beneficial in the first year you move abroad if you do not expect to return to the US, and to those who eventually will have US tax liability again.
One other consideration is that claiming FTC can be more complicated when the foreign tax year does not correspond to the US tax year. You end up having to figure out what taxes you’ve paid on the income in different reporting periods, and strategizing when to file in both countries. This is something cross-border tax preparers regularly deal with, but for those who file on their own can be a headache.
#3: Take Partial Foreign Earned Income Exclusion
This is the main thing that triggered me to write this post. Many US expats erroneously assume that if they even breach the Physical Presence test by one day, they will not be able to claim any FEIE and will have to pay the taxes on the full income. This causes a lot of unnecessary angst.
In reality, your FEIE is reduced, rather than taken away entirely, if you can meet the 330 days test in any 12 months period that starts or ends in the tax year.
What does this mean? It might be easier to show this on a graph. Any of the three scenarios below allow you to take partial FEIE.
As you can now deduct, in order to get the maximum FEIE, you should look for any 12 months period with 330 days abroad that has the most days overlapped with the tax year.
Let’s use a simple example. You have been living abroad since 2017/01/01. In 2018, you decided to go back to visit family for 3 months from 2018/06/01 to 2018/09/30. After that you do not expect to visit again until 2020.
So for tax year 2018, you will not be able to claim the full FEIE, but you will be able to claim a “partial” FEIE. The 12 months period with at least 330 days abroad and with the longest overlap with tax year 2018 is from 2017/07/06 to 2018/07/05. This gives you 187 qualifying days.
As a percentage, it gives you 51.23% of the full FEIE. So your partial FEIE is $104,100* 0.5123 = $53,330. (See Form 2555 Part VII for the calculation.)
(You can also choose the second half of the year if you will be overseas continuously in 2019. This will require you to file for extension so you can submit tax return after you’ve met the 330 days abroad threshold. However, in this example it gives you fewer countable days in 2018.)
Why is this important? This is related to the second misunderstanding many people have. Many people think that if they breach the 35 days threshold, they will have to pay full taxes on part of their income.
This is far from the truth. When you claim FEIE, you still need to report your entire income and net that against the partial FEIE (a negative number). Your FEIE may be reduced, but it might still be large enough to cover your entire income!
Let’s say you are teaching overseas and earn only $50,000 a year. In the above scenario, you will report $50,000 as your wages on Form 1040, but negative $53,384 as your FEIE on line 21. So before you even get to deductions, you have ZERO gross income!
Implications for Small Business Owner and Digital Nomad
This is something small business owner expat and digital nomads should pay attention to. While your business may generate good income, you have more control over how much you pay yourself as taxable wages through different business structures. In years you expect to visit the US for longer periods of time, you may not have to pay yourself up to the FEIE limit if you don’t need the extra income to live on.
On the other hand, if you make close but less than the FEIE limit, you may be able to calculate the extra number of days you can stay in the US. That may make a difference between attending a best friend’s wedding versus not!
Lastly, timing of visit can be more important than number of days in the US. In the previous example, if you are able to choose to visit from 2018/01/01 to 2018/03/31, you will be able to get a larger FEIE even though you stay in the US similar number of days.
The longest period in this case will be 2018/02/25 – 2019/02/24, which gives you 310 qualifying days, or $88,413 partial FEIE. For the teacher in the example above, it makes no difference. However, if you are self-employed, you may be able to exercise the flexibility you have with your earned income and timing of visits to get the best of both worlds!
So I hope this post provides a sense of relief for you. Getting the tax benefit shouldn’t keep you away from the US when you wish to go back. For people in the right situation, you can get both!