What Is The U.S. Foreign Earned Income Exclusion?
All legitimate and permissible tax reductions for U.S. citizens living abroad as expats or digital nomads are based on the Foreign Earned Income Exclusion (FEIE). In essence, it is the United States’ response to the majority of countries’ tax non-residency procedures.
For instance, if you’re an Australian residing abroad, you can be classified as a tax non-resident in Australia if you pass a series of tests. When you leave Australia, the government will levy an exit tax, but once you’re out and have paid the final taxes, you’re done until you return. You no longer have to deal with Australia, which means there are no taxes or filing procedures. Unlike Australian, British or Canadian nationals, a U.S. citizen residing abroad cannot simply proclaim himself a “tax non-resident” and opt out of the system.
The unfortunate reality is that U.S. citizens and green card holders — i.e., U.S. persons — are unambiguously liable to U.S. taxation on their worldwide income. Theoretically, a non-U.S. person may be subject to this worldwide tax requirement by spending too much vacation time in the U.S. So, who qualifies for the foreign earned income exclusion? If you spend enough time living abroad, the IRS will enable you to claim the FEIE and earn money tax-free. Consider it the government’s way of compensating you for your travel.
Remember that this is not a complete exemption from all tax obligations. You need to understand that the FEIE does not exempt but rather excludes from taxation a specified amount of “earned” income generated from services provided while living outside of the United States. You also need to fulfill certain requirements for foreign earned income exclusion. Before we proceed any further, let’s define “foreign earned income” as defined by the IRS, which divides your income into two groups for the purposes of the FEIE: active income and passive income.
Rules For Active Income
The “earned” part of the Foreign Earned Income Exclusion is active income. This is money you actively labor for, whether through a job, self-employment revenue earned while working in a foreign nation, a salary paid by an employer or your firm, or a bonus you receive as an employee or independent contractor. This can even include earnings from a client or firm in the United States.
In fact, you can work for a U.S.-based corporation and yet qualify for the FEIE if you earn money while living and working in a foreign nation. To do so, you’ll need to fill out Form 673 and give it to your boss. Complete all of FEIE’s conditions. Your U.S. employer will be able to deduct up to the maximum amount of federal income tax and foreign housing credit allowed under the FEIE from any wages you received while residing abroad in a given tax year.
Creating international assignments that allow you or your employee to take advantage of FEIE might be beneficial to both parties if you work for a U.S. employer or if you are the employer. However, because most digital nomads are entrepreneurs and investors rather than employees, Form 673 will not apply to them. Contractors, consultants and other non-employees benefit from the fact that they do not have to deal with withholding taxes in the first place.
If you’re not sure if you’re an employee, the IRS defines one as someone who works at a given time and location set by the employer, who then gives the employee the tools necessary to do the task and instructions on how to do it. If this does not apply to you, then you are most likely a contractor who does not require Form 673 to avoid withholding taxes on your earnings. You need to optimize your taxes abroad, and for that, you will need a good corporate structure.
It also doesn’t matter if you’re paid in U.S. dollars or have a U.S. bank account for your business. One benefit that American expats have over citizens of other Western countries is this. To reap the tax benefits of traveling overseas, you don’t have to ditch your local bank (or jump through dozens of other hoops). It’s simple: As long as the work was done while you were in a foreign country, all active revenue is eligible for the FEIE.
Rules For Passive Income
This type of income is not exempt from federal income tax. It implies that any income from passive activities such as stock trading, FX trading, social security payments, etc., would be taxed without exception. However, professional stock traders and professional real estate speculators who buy, sell and flip residences overseas as part of their business may be able to classify passive income as active income if they pass specific standards.
It is possible to do this. However, in general, if you’re interested in passive income, this isn’t the topic for you, as passive money is considerably more difficult to exempt from taxes. This post focuses on using the Foreign Earned Income Exclusion to reduce your tax on active income.
People with passive income — exceptionally high levels of passive income such as cryptocurrency trading or day trading with large levels of short-term capital gains — are increasingly deciding that it is financially worthwhile to renounce their U.S. citizenship. The reason is that FEIE does not provide them a way to avoid paying taxes in excessive quantities lawfully. The only other option for decreasing taxes on passive income without renouncing is to take advantage of Puerto Rico’s tax benefits for U.S. citizens.
Income Sources That Are Not Eligible For Foreign Earned Income Exclusion
A few other types of income are not eligible for the Foreign Earned Income Exclusion. The following income sources are omitted:
- Pay received as a U.S. government military or civilian employee
- Reimbursement for services rendered in foreign waters
- Payment received after the tax year is not deductible
- If meals and accommodations are provided for the employer’s convenience, they are not considered income