Most Americans working abroad know they may be eligible to exclude certain foreign earned income (wages, compensation for services) and housing amounts from US taxable income. This means that, unlike their counterparts working in the USA, they won’t be taxed on some or all of the amounts paid by their employer when they are living and working in a foreign country. These exclusions are permitted under the rules governing the Foreign Earned Income Exclusion (FEIE) and Foreign Housing Exclusion (FHE) of Section 911 of the Internal Revenue Code.
What many seem to be unaware of is that a tax return must be filed within certain time limits in order to claim these exclusion benefits. Many individuals who come to see me are under the mistaken belief that if their compensation is below the exclusion amounts, they need not file a tax return at all. This is very troublesome because Americans who have dropped out of the tax reporting system risk losing these benefits unless prompt action is taken to correct the filing situation.
Since tax returns are soon due, here is a handy reminder of the basic rules. If you realize you have missed the boat on filings, don’t panic. In all likelihood your tax situation can be corrected without too much pain!
Taxpayers Must Make an Election to Claim the FEIE/FHE
In order to claim the FEIE and FHE benefits, an election must be made on the individual’s US income tax return. The election is usually made by filing Form 2555 with an original income tax return or with an amended income tax return that is timely filed. Once made, the election remains in effect for that year and for all subsequent years unless it is revoked by the taxpayer. Sometimes a taxpayer working overseas who has not been filing tax returns is contacted by the Internal Revenue Service (IRS) about the tax delinquencies, and the delinquencies can span for many back tax years leading to a huge tax bill, plus interest and very harsh penalties. Can the taxpayer claim the FEIE and FHE in these late-filing cases?
Timing is Everything
Claiming the exclusions is permitted for any tax year, no matter how far back and no matter when the delinquent returns are filed so long as the IRS has not taken the first step and notified the taxpayer of their failure to make the election and that tax is owed. On the other hand, if the IRS contacts the taxpayer first, the benefits can be denied. On the brighter side, IRS denial won’t occur if the taxpayer “owes no federal income tax”. If nothing is owed, then the taxpayer is automatically permitted to use the exclusion benefits even if the IRS has contacted him first.
The question often comes up as to what is meant by whether the taxpayer “owes no federal income tax”. Does the law permit you to make the tax calculations after taking into account the FEIE and FHE exclusions or must the calculations be made without taking them into account once the IRS has contacted the taxpayer? Obviously this will make a big difference if tax must be paid on these otherwise excludable amounts. The FEIE amount that can be excluded for 2015 is USD 100,800 and for 2016, it is USD 101,300; in addition certain housing amounts can be excluded. The IRS Treasury Regulations are quite clear and fortunately provide that the FEIE and FHE benefits are first to be taken into account in computing tax liability. Treas. Reg. §1.911-7(a)(2)(i).
Practically speaking, what this means is that not one penny of tax must be owed after taking into account the FEIE and FHE benefits in order to be eligible to use the FEIE and FHE on late tax returns in the situation when the IRS has discovered the delinquency. The IRS has followed this position and allowed the tax calculation to first make use of these valuable exclusion benefits. The IRS has recognized that the intent of the Treasury Regulation section is to allow a taxpayer whose only income at issue is excluded foreign earned income to file a late section 911 election.
It is also the position of the IRS that the phrase “owes no federal income tax”, means that IRS agents should first apply any payments, such as withholding tax, estimated tax, foreign tax credits and so on to offset any federal income tax liability. The agent should examine whether a taxpayer has a refund or a balance due. If the taxpayer has a refund or no balance due, the taxpayer “owes no federal income tax” and the late election is permissible.
In some cases, the taxpayer has filed income tax returns and made the election to use the FEIE and FHE. Then, for whatever reason, a number of years will go by without the taxpayer filing any returns at which time he is then contacted by the IRS. If he owes tax after taking into account the FEIE and FHE benefits etc., he may have a problem, per above. However, I have had success with the position that since the taxpayer had filed an earlier tax return and made the election, that the election carries forward for all subsequent years since the election was not revoked by the taxpayer.
If all else fails, the taxpayer can request late election relief by a private letter ruling request to the IRS pursuant to Code Section 9100 to allow the election. There is a significant filing fee as well as the professional fees associated with preparing this type of ruling request. Given all the headache and complexity, overseas taxpayers should make sure they are in full US tax compliance.
Please see my US Tax Information page for Americans abroad to read more detail about the FEIE and FHE as well as many other topics of relevance to US persons overseas.
Before It’s Too Late – A Simple Fix
Those who are learning they have not been in compliance with their US tax obligations (be it filing of tax returns or the notorious FBARs) may have a relatively painless solution to their tax woes in the IRS Streamlined Offshore Procedures. You can learn more about these procedures here.
Green Card Holders – Think Twice!
A special word for green card holders who are living and working abroad – Claiming the FEIE and FHE tax benefits means that one can risk loss of the green card and can cause issues when applying for naturalization to US citizenship. Please speak to your immigration counsel before blithely claiming the exclusion amounts. Saving tax dollars can put the maintenance of one’s green card or his naturalization application under close scrutiny since claiming the tax benefits entails representing that one is a “bona fide resident” of a foreign country or that one is physically present in a foreign country for a minimum of 330 days during a 12 month period.
These assertions can evidence that the individual has abandoned his green card or that he is unable to satisfy the physical requirements of time in the US for naturalization. Very few tax return preparers will be knowledgeable about the possible immigration consequences of claiming the foreign earned income and housing exclusions. This should be carefully examined with input from both tax and immigration advisors working together.
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