It’s on like donkey kong when it come to expats and our accountants deciding which is more beneficial – the Foreign Earned Income Exclusion or Foreign Tax Credits. To determine which tax exemptions are better, we must analyze the benefits and requirements of both.
As a US person living abroad, you have the obligation to pay United States taxes on your worldwide income. You can choose to apply the Foreign Income Exclusion OR the Foreign Tax Credit, but no double dipping. So which one is better? Just like the answer to every other tax question, “it depends.”
For US persons with foreign source income I will break down both. At the end of this article I’ll show the pros and cons of the Foreign Earned Income Exclusion and the Foreign Tax Credit, and explain which is best for your situation.
Foreign Earned Income Exclusion (FEIE)
“Foreign” refers to non US source income, which is money made outside of the US and its territories. In most cases, foreign source income is profits from services performed in a foreign country. Foreign sourced income is not income from work performed in the US, even if the customer or client is abroad.
That is to say, it’s irrelevant where the customer is. All that the IRS cares about is where you are when you perform the work.
“Earned Income” refers to active income (salary, wages, self employment, tips, etc…) as opposed to passive income (dividends, interest, gambling, alimony, pension, capital gains, etc…). Income that was actively worked for earned, even if earned from your own offshore corporation.
“Exclusion” refers to the maximum amount of money that can excluded from Federal income taxes. You can exclude up to $102,100.00 of your active income. (amounts adjusted for inflation annually)
Now, what does the FEIE mean for a person that worked abroad?
If a US person is a resident of a foreign country, and not a tax resident of the United States, they can exclude income under FEIE by meeting certain tests.
I have to take tests? Yes, you have 2 options:
Physical Presence Test
The physical presence test is easy to calculate but difficult to qualify for. This test require you to be present in a foreign country for 330 day in a 12 month period. To qualify, you simply need to be out of the US for the prescribed number of days… see how easy that is?
While the physical presence test is easy to understand, it’s difficult to use in practice. Most clients try to push the envelope by spending more days in the US. If they’re off by even one day, because of a flight delay or family emergency, the entire exclusion is lost.
How are the days counted ?
Cruises, international waters, and long flights back and forth to the US, do not count towards the number of required days present. Your physical presence is counted for a 12 month period regardless of calendar year. And you can be in one country or a few countries as long as you are present on non-US land. For more, see: Changes to the FEIE Physical Presence Test Travel Days
Bona Fide Residence Test
The residence must cover an entire tax year (Jan 1- Dec 31) and requires you be a legal resident of a foreign country. Even so, it’s much easier to use than the physical presence test.
How is that easier to meet? Its lenient on your days in the United States, so the amount days become less important. If you spend a few extra days in the United States, no big deal so long as you’re never here more than 182 days in a calendar year.
And you can add foreign housing exclusion or deduction to the FEIE. Which is an addition part of gross income from your housing that may be deducted for tax purposes.
What’s the difference between deduction and exclusion?
The foreign housing exclusion is for employees.
The foreign housing deduction is for self employment.
Under the Foreign housing exclusion/deduction, you may exclude up to 30% of FEIE additionally (for 2017 up to $30,600).
If you are not a foreign resident for entire year you can take a daily rate. I won’t go into details here, but take a read through Foreign Housing Exclusion or Deduction on the IRS website.
Foreign Tax Credit
The Foreign Tax Credit provides a credit in the US for foreign income taxes paid. The purpose is to avoid the same income being taxed in two countries (double taxed).
To qualify, taxes must have been paid or accrued and the Foreign Tax Credit can not be combined with The Foreign Earned Income Exclusion. Any unused foreign tax credit can be carried back 1 year and forward 10 years.
Foreign tax credits and the FEIE only reduce income taxes. They do not reduce self employment tax. They only way to eliminate SE tax is to live abroad, qualify for the FEIE, and operate your business through an offshore corporation. For more, see: How self employment tax works when you’re offshore
A Foreign Tax Credit limit (calculation to determine limit). The definition of this deduction is as follows:
“Foreign” in this case refers to any income source outside of the 50 US states and DC (District of Columbia). Includes all foreign source income from foreign country or US possession (US territories.).
“Tax” refers to legal taxes imposed and paid in another location (foreign country or US territories) for foreign source income.
“Credits” refers to an amount of money that may be subtracted from US taxes owed, generally a dollar for dollar credit for foreign taxes paid. It’s not a deduction, exclusion or exemption which reduces the amount of taxable income, tax credits reduce the actual amount of tax.
Foreign taxes that don’t qualify for credit are; taxes refundable to you, taxes from 3rd party (related to you), taxes that are not a legal requirement, tax from certain countries (declared anti US terrorism, severed diplomatic relations with US, and if the US doesn’t recognized country’s government unless Arms Export Control Act is enacted in country).
|Foreign Earned Income Exclusion||Foreign Tax Credits|
|Locations||Foreign Countries||US possession and Foreign countries|
|Amounts||Up to $102,000 of income(2017)
Up to ~$30,000 for housing
|Tax reduction depends foreign tax code|
|Income||Excludes Passive||May include passive|
|Qualifications||Residency Tests||No residency requirement|
|Life of the tax benefit||Only available in year money is earned||Carry back 1 yr and Carry over 10 yrs of unused credit|
|Tax freedom||Worldwide income deducted from earned active income||Worldwide income has tax subtracted based on taxes paid somewhere else|
- Foreign tax credits are better for those working in countries with high income tax rates (for example, Germany and France).
- FEIEs is best for those working in or operating a business in a low tax country (for example, Dubai and Panama).
- Foreign tax credit is better for the first year of living in foreign territory because residence tests are a challenge.
- FEIE in conjunction with foreign housing exclusion might allow you to exclude up to around $120,000 from foreign income, if requirements are met.
- FEIE is always better for a business owner operating from a country that doesn’t tax foreign source income.
- FEIE always best if you are in a low tax country and will have retained earnings.
I hope you’ve found this article on the foreign tax credit vs the foreign earned income exclusion to be helpful. For assistance in setting up an offshore business, please contact us at firstname.lastname@example.org or call us at (619) 550-2743. All consultations are free and confidential.