If you have a client who is an expat working in a foreign country, or if your client is a foreign national living in the U.S. but with income from a foreign country, they are required to file U.S. tax returns. On the upside, there is a good chance they are entitled to substantial tax breaks through the:
- Foreign Earned Income Exclusion
- Foreign Tax Credit
- Tax Treaties or
- Other ways to reduce taxes
Foreign Earned Income Exclusion
How FEIE Works
For those who are eligible, the Foreign Earned Income Exclusion (FEIE), entitles them to exclude a tidy sum from their taxes. (See IRS Form 2555.) This amount is adjusted annually for inflation, but for the tax year 2020, the amount taxpayers may exclude is $107,600 of foreign earned income. Other types of income such as income from the U.S, pensions, capital gains and so forth may not be excluded under FEIE.
So, let’s say your client has $200,000 in foreign earned income for 2020. They may deduct 107,600 leaving $92,400 in taxable income. However, the $92,400 is taxable at the rate applicable for $200,000 rather $107,600.
Who is Eligible for FEIE
To be eligible to claim the Foreign Earned Income Exclusion, your client must be able to show either:
- Physical presence in the foreign country for at least 330 full days during a period of 12 consecutive months or
- They are a Bona-Fide Resident of a foreign country for an uninterrupted period that includes an entire tax year. They must be either
- A U.S. citizen or
- A U.S. resident alien who is a citizen or national of a country with which the United States has an income tax treaty in effect
Foreign Housing Exclusion
If your client is eligible for the Foreign Earned Income Exclusion, they may also be eligible for the Foreign Housing Exclusion, which is reported on IRS Form 2555 along with foreign earned income. However, be aware that the money your client pays for housing must have been provided by their employer – though there is a Foreign Housing Deduction for those who paid for their housing with self-employment income. There is a limit on the amount your client can deduct.
Foreign Tax Credit
Another method to reduce foreign earned income is through the Foreign Tax Credit (see IRS Form 1116), which enables a taxpayer to subtract some of what they pay in taxes to a foreign country from their U.S. taxes. However, they cannot take a foreign tax credit for income deducted under IRS Form 2555 for the Foreign Earned Income Exclusion. They can only claim a foreign tax credit for foreign taxes on the same income the U.S. government is taxing.
There is a formula for the ratio of non-excluded income to total income used to determine how much foreign taxes may be taken as a tax credit: Let’s assume the money earned is in euros.
- Euro 100,000 converted to U.S. Currency – Allowable Earned Income Credit Exclusion ($107,600 for tax year 2020) ÷ Euro 100,000 converted to U.S. Currency = Fraction of foreign taxes that can be taken as a credit.
- The fraction of foreign taxes that can be taken as a credit x Amount of foreign taxes converted to U.S. currency on Euro 100,00 = Net specific foreign country tax that can be taken as credit.
- Net U.S. tax payable after subtracting FEIE – Net specific foreign country tax that can be taken as credit = Amount owed in U.S. taxes.
In some cases, your client may reduce more taxes by only using the tax credit and not using the FEIE at all depending on various factors such as whether or not the foreign country has a higher tax rate than that of the United States.
It is important to know from which country your client earned their foreign income, because the United States has tax treaties with several countries that may impact the amount your client owes. Under such a treaty, the U.S. citizen or resident may sometimes be taxed less than normal by a foreign country, because they are paying U.S. taxes. A treaty is more likely to help your U.S. clients with their foreign taxes than with their U.S. taxes. You can file IRS Form 8802 in order to provide evidence that your client paid U.S. taxes if the foreign government requires it. See Publication 901 for more information about countries that have tax treaties with the United States.
Tips to Keep in Mind
- If your client’s foreign earned income is less than the exclusion amount under the FEIE ($107,600 for 2020), they can use the FEIE to reduce their income tax to 0. If their income is more than the FEIE exclusion amount, they may be able to use a foreign tax credit on the remainder. If they can reduce their tax to 0, they must still file a return.
- If your client claims the FEIE and then one year decide to only claim the foreign tax credit, they may not return to using the FEIE for the following six years without specific IRS permission.
- If a taxpayer using the FEIE has a spouse who is a U.S. citizen, and that spouse also has foreign income, both may use the FEIE up to the total exclusion amount ($107,600 in 2020) for their own income. However, a spouse may not apply their exclusion amount to the other’s income.
- Just because a taxpayer is eligible for the Foreign Earned Income Exclusion, does not necessarily mean they are exempt from state taxes. States vary, so it is necessary to research the law for your client’s state.
Want to learn more about FEIE to help your clients? Become a Certified Tax Planner through the American Institute of Certified Tax Planners.