If you’re a US citizen living and working abroad, your first line of defense against the IRS is the Foreign Earned Income Exclusion. This loophole in the US tax code allows you to exclude up to $101,300 of salary / wages on your Federal tax return.
Whether you’re running a one man offshore company or a 20 woman online business, international tax planning starts with the Foreign Earned Income Exclusion.
Before I go any further, let me point out that the FEIE applies to earned income only. That means you can exclude your salary from US taxes. So long as you hold a US passport, you still get the joy of paying the IRS on your capital gains, dividends, interest, foreign real estate sales, rental profits, or any other kind of passive income.
Here’s how to qualify for the Foreign Earned Income Exclusion
There are two ways to qualify for the Foreign Earned Income Exclusion. You can use the Physical Presence Test (commonly referred to as the 330 day test) or the Residency Test.
The Physical Presence Test is simple. You must be out of the United States for 330 out of 365 days. Miss the 330 by even one day and lose the Foreign Earned Income Exclusion in its entirety.
And this is 330 out of any 365 day period. Qualify from June 2016 to June 2017 and you can exclude your salary for this period from US Federal taxation.
The Physical Presence Test is simple but inflexible. Need to spend a few extra days in the US for a family emergency? You will lose the Exclusion for that year making 100% of your salary taxable in the United States.
If you will be abroad for a few years, and want to spend more than 34 days per year in the US, then you might to work towards qualifying under the Residency Test. If you meet the requirements, you can spend up to 4 months a year in America.
As the name implies, to use the Residency Test to qualify for the Foreign Earned Income Exclusion, you must be a resident of a foreign country. This means you must have a residency permit and/or work permit, enter into a long term lease or own property, file taxes in the country, and that your country of residence is your home base.
A home base is the place where you put down roots. If you have kids, they are in school there. When you travel, you depart from and return to this city. You are a part of the community and it’s where you plan to make your life for the foreseeable future.
You are NOT a resident of a foreign country if you go there on a two year job posting and plan to return to the US when that job is finished. Likewise, you are not a resident of a country if you are a perpetual traveler, never putting down roots or building a base. In these cases, you must use the Physical Presence Test to qualify for the Foreign Earned Income Exclusion.
As you can see, the 330 Day Test is simple math. The Residency Test hinges on your intentions (and on getting a residency permit). Any time the IRS can question your thought process, you need to have plenty of evidence to support your position should you be audited.
A number of countries understand the importance of providing residency and work permits if they want to attract US businesses. The easiest are Panama and Cayman Islands. For an article on Cayman, see: Move Your Internet Business to Cayman Tax Free. For Panama, see: The Panama Friendly Nations Visa.
Here’s how to pay zero tax with an offshore corporation using the Foreign Earned Income Exclusion
If you qualify for the Foreign Earned Income Exclusion, you can operate your small business offshore and pay no tax to the US. Setup in the right country, or in a tax free zone, and you won’t pay tax to any government.
- Again, keep in mind that I’m referring here to income from an active business operated outside of the United States. Passive income and capital gains do not qualify for the FEIE.
First, note that I’ve used the term “free from Federal income tax” several times in the paragraphs above. This is because you can get stuck paying other taxes if you are not structured properly.
For example, if you take a salary from a US corporation, you will pay social taxes (Medicare, FICA, etc.) at 7.5% and your employer will pay the same. You qualify for the FEIE but must pay these social taxes which are not excluded under the FEIE.
Likewise, if you’re self employed, and do not use a corporation, your income is reported to the US on Schedule C. You will pay Self Employment tax at 15% on your net profits. Again, you qualify for the FEIE, but SE tax is not excluded by the FEIE. Self Employment tax is not an income tax.
Adding insult to injury, if you report using Schedule C, your FEIE is reduced by your business expenses. For example, if your expenses are 50% of your gross income, your FEIE will be cut in half and you will only get to exclude the first $50,650 of salary.
The solution to these issues is simple: incorporate offshore. If you operate your business through an offshore corporation, you can draw a salary of up to $101,300 tax free and be exempt Self Employment and social taxes. Salary taken from an offshore corporation is not subject to US employment taxes.
With a little planning, you can earn net profits of $101,300 tax free. If you and your spouse are both working in the business, you get double this amount, $202,600, tax free. This saves you $15,000 to $30,000 in SE or social taxes.
What if your net profit is more than the Foreign Earned Income Exclusion? Then you can retain excess profits in the corporation tax deferred. You can use them to grow the business, or hold them in the account, and only pay US tax when you take them out.
For more information on retained earnings, see How to Manage Retained Earnings in an Offshore Corporation.
FEIE: Use it or Lose It!
The IRS built a time bomb into the Foreign Earned Income Exclusion. If you fail to file your US returns, and the IRS audits you, you won’t be able to take the FEIE. Even if you are working abroad and would owe Uncle Sam nothing had you filed, you will pay US taxes on 100% of your income!
The same goes for someone who files their US returns but omits their foreign salary. If you are audited, you can lose the Foreign Earned Income Exclusion and pay US tax on 100% of your salary. You must claim the FEIE or lose it.
Maybe you thought you only needed to report your US income to the US and your foreign source income to your country of residence…. you have no idea how many times I’ve heard that one… so you did not report your foreign salary to the IRS. Well, that’s an error that can cost you big time.
Just last week I had a client who was a US citizen living in Colombia for 15 years. He spent about 10 days a year in the US and had a rental property here. He reported his rental property to the IRS, but nothing else. He did not tell Uncle about his salary or assets in Colombia.
The IRS audited his rental property and found out that he was living in Colombia. Of course this raised all kinds of red flags (or you could say the Auditor saw dollar signs and a commendation in her future). The examination quickly turned hostile and, bottom line, cost him over $300,000 in tax, interest and penalties.
Had this client been reporting to the IRS properly over the years, and been taking the Foreign Earned Income Exclusion, he would have owed ZERO to the United States.
The moral of the story is simple: The US government wants you to file. If you fail to report or take the Foreign Earned Income Exclusion, you may lose it.
What to do if you have missed filing a few US tax returns
Had my Colombian client not been audited, he could have come forward voluntarily and paid nothing. Had he amended his US returns to add on the Foreign Earned Income Exclusion, and had he gone through the Offshore Voluntary Disclosure Program, he could have gotten back into the US tax system and saved himself $300,000.
The key to the Offshore Voluntary Disclosure Program is that you must come forward voluntarily. If you are audited, you lose access to the OVDP as well as the FEIE.
Navigating the OVDP without losing your shirt is complex matter covered in my article IRS Offshore Voluntary Disclosure Program. Suffice it to say, Mr. Colombia would have qualified for the foreign streamlined program and would have received a free pass with the IRS.
I hope you have found this article helpful. For more on US taxation, please see the Escape Artist International Tax Portal.
For more information on the forming an offshore corporation, international tax planning, and/or filing your US tax returns, please contact me for a free and confidential consultation. You can reach me directly at firstname.lastname@example.org or by calling (619) 550-2743.