In an earlier article, I mentioned a topic that needs an article of its own – the Foreign Earned Income Exclusion and Housing Exclusion and Deduction. It’s very relevant to living in the Philippines – particularly to hard working residents and entrepreneurs.
It’s a legal method promulgated by the Internal Revenue Service (IRS) to reduce your taxable income and, consequently, your tax liability.
This article is not all-inclusive. As with other elements of tax calculations, your particular situation may affect your eligibility or benefits. The discussion will cover the basics, and give you an idea of how these exclusions and deduction could apply to your tax return.
It’s a good idea to have a copy of IRS Publication 54, “Tax Guide for U.S. Citizens and Residents Aliens Abroad.” Along with providing excellent detail about many “expat-related” tax issues, it treats this topic quite well (in Chapter 4).
NB – Information provided herein is current as of this writing. With current U.S. income tax rules and regulations in a state of flux, change may occur. I’ll include any changes as a comment to the article.
If you have a personal tax question regarding this topic, please contact me here or use the similar tab just above this article.
THE BASICS — QUALIFYING
Good news: U.S. taxpayers may be able to exclude up to a specific amount of foreign earned income ($91,400 for tax year 2009) from their taxable income. Indexed for inflation, this amount varies year-to-year. Additionally, these taxpayers may be able to treat a limited amount of income used for housing expenses as nontaxable by the U.S. or deduct a portion of their housing expenses from taxable income (important definitions of the bold, italicized terms follow below).
Not-so-good news: There are basic requirements that a U.S. taxpayer must meet to qualify for either of these exclusions or the deduction:
The taxpayer
- must have a tax home in a foreign country,
- must have foreign earned income, and
- must be either:
- a U.S. citizen living in a foreign country, who meets the bona fide residence test,
- a U.S. resident alien, who is a citizen or national of a foreign country with which the U.S. has an income tax treaty in effect, is living in a foreign country, and meets the bona fide residence test, or
- a U.S. citizen or U.S. resident alien, who meets the physical presence test.
To claim the exclusions or deduction, the taxpayer must complete and file Form 2555 (or Form 2555-EZ, if eligible) with their Form 1040 tax return. (Form 1040 is required for individuals filing Form 2555.)
THE DEFINITIONS — KNOW YOUR TERMS
As the old ballpark vendor’s saying goes, “Ya can’t tells ya players wid-out a program!” There are a number of “players” involved in this discussion, and this list of definitions will serve as your program. You may want to have it handy when we discuss the “mechanics” of qualifying for, calculating of, and form completing regarding the exclusions and/or deduction.
Bona Fide Residence Test – The bona fide residence test determines that a taxpayer is a bona fide resident of a foreign country if he/she resides in that country for an uninterrupted period that includes an entire tax year. (An entire tax year is from January 1 to December 31).
Foreign Earned Income – Generally, foreign earned income is income that you received for services you perform during a period in which you meet two requirements: 1) your tax home is in a foreign country; and 2) you meet either the bona fide residence test or the physical presence test.
NB: The classification of certain items of income as either earned or unearned income depends upon circumstances surrounding its receipt. Please refer to Publication 54 for details regarding income categorization for use in this topic.
Green Card Test – The green card test determines that a taxpayer is a U.S. resident if he/she was a lawful permanent resident of the U.S. at any time (i.e., he/she possesses a “Green Card”).
Physical Presence Test – The physical presence test determines that a taxpayer meets physical presence requirements if he/she is physically present in a foreign country at least 330 full days in a period of 12 consecutive months. The 330 days do not have to be consecutive.
Substantial Presence Test – The substantial presence test determines that a taxpayer is substantially present in the U.S. if he/she lives in the U.S. for a minimum of 31 days during the current calendar year and a total of 183 days during the current calendar year and two previous calendar years. For purposes of counting the 183 days, count all of the days of physical presence in the current year, but only one-third of the number of days of physical presence in the preceding year, and only one-sixth of the number of days of physical presence in the second preceding year.
Tax Home – A taxpayer’s tax home is the general area of his main place of business or employment, regardless of where the taxpayer maintains the family home. A taxpayer does not have a tax home in a foreign country for any period in which he/she has an abode in the U.S. An “abode” is one’s home or place of dwelling. (E.g., a taxpayer who works in Mexico but lives in the U.S. does not have a tax home in a foreign country.)
U.S. Resident Alien – A U.S. resident alien is an individual who is not a citizen of the U.S. and who meets either the green card test or the substantial presence test for the calendar year.
U.S. Taxpayer – A U.S. taxpayer is a U.S. citizen or a U.S. Resident Alien generally subject to U.S. income tax regardless of where he/she lives.
COMING IN PART II – THE MECHANICS
In our conclusion, Part II, we’ll discover the “mechanics” of the exclusions and deduction. We’ll see the different requirements between using Form 2555 and Form 2555-EZ, and we’ll discuss what to do with any leftover foreign earned income that you can’t exclude.
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IRS Circular 230 Disclosure
To ensure compliance with requirements imposed by the IRS, I must inform you that any U.S. federal tax advice contained in this document is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter that is contained in this document.
Hi Paul- Not another serial, if anything should happen to me between now and the end of you and the other Paul’s stories I’ll never forgive you both lol.
Regards.
Jim.
Hi Jim – I’ll apologize up front for the serial! It truly didn’t start out to be one. Once written and reviewed, its size was monstrous. I had to decide whether to cut it into parts or patent it as a holistic approach to sleep aids. Since the patent involves feeding the government bureaucracy money, I opted for the cut.
Funny thing – a couple of small changes in the tax code occurred after I made my decision. Having cut it into parts turned out to make life easier when re-editing and adding the changed material.
I’ll provide you a “secret clue” about the ending so that, if something should happen, you’ll know how things turned out before “things happen”! The clue: [Good wins over evil, the princess is saved by the prince, the horse that handicappers laughed at won the race, and the tax man goes home empty handed.]
😆
I think I’m excluded too…
Obama told me that “no family making less than $250,000 a year will see a tax increase” He is the president after all and I believe him.
Hi Hudson – Yes, there’s no reason to doubt the POTUS.
There may be increases in:
– fees,
– service charges, and
– taxes to businesses and those making more that $250,000 a year.
There also may be decreases in:
– services provided by the government, and
– services provided by those private companies and individuals who are affected by tax and other regulatory increases.
All of these, of course, will be passed on to consumers (regardless of their family income level), BUT no family making less than $250K@year will SEE a tax increase!
😯
Hi Paul,
I ment my comment tounge in cheek. Sorry for the miscommunication. Here is some info to chew on…
Starting Jan. 1, 2011: Personal income tax rates will rise. The top income tax rate will rise from 35 to 39.6 percent (this is also the rate at which two-thirds of small business profits are taxed). The lowest rate will rise from 10 to 15 percent. All the rates in between will also rise. Itemized deductions and personal exemptions will again phase out, which has the same mathematical effect as higher marginal tax rates. The full list of marginal rate hikes is below:
– The 10% bracket rises to an expanded 15%
– The 25% bracket rises to 28%
– The 28% bracket rises to 31%
– The 33% bracket rises to 36%
– The 35% bracket rises to 39.6%
Higher taxes on marriage and family. The “marriage penalty” (narrower tax brackets for married couples) will return from the first dollar of income. The child tax credit will be cut in half from $1000 to $500 per child. The standard deduction will no longer be doubled for married couples relative to the single level. The dependent care and adoption tax credits will be cut.
The return of the Death Tax. This year, there is no death tax. For those dying on or after January 1 2011, there is a 55 percent top death tax rate on estates over $1 million. A person leaving behind two homes and a retirement account could easily pass along a death tax bill to their loved ones.
Higher tax rates on savers and investors. The capital gains tax will rise from 15 percent this year to 20 percent in 2011. The dividends tax will rise from 15 percent this year to 39.6 percent in 2011. These rates will rise another 3.8 percent in 2013.
Then, if Cap and trade passes, and they are also talking of a VAT in congress also….Hold on to your wallet.
Hi Hudson – My tongue was firmly planted in the same place!
Yes, I know of everything coming down the pike on 1/1/2011 if the “Bush Tax Cuts” (as they are referred to by many) are allowed to expire. I still hope Congress has a little bit of courage to renew them. (Remember, I’m a tax accountant – I have to keep on top of all of these issues!)
I did see (and I’m tempted to obtain) an official “Obama Tax Hike Exemption Card” that will protect me from those nasty tax hikes, seeing how my family’s annual income is less than $250,000!
Card is available from Americans for Tax Reform at: https://www.atr.org/card.html
Thank you Paul for this fantastic article. This is the kind of thing I need as I ramp up for my eventual move to the Philippines with my amazingly beautiful filipina wife. I am starting up some business ideas and websites under construction to support my little family of 2 plus 2 (her parents) in the Phils and I have always been curious as to protecting myself and my money. This article ansers a ton of questions I had in my mind. I look forward to more. Be well.
Hi Mike – Thank you for the kind words and for taking time to read the articles. The follow-on part(s) will provide info on how to go about “doing it”!
Remember, though, there will be taxes to pay somewhere and some way. Don’t run any business based on thoughts or ideas about taxes. Doing so will result in failure – you can trust me on that! Run your businesses in a manner that brings in as much revenue as can be received.
Taxes are a “cost of doing business” and an “ordinary and necessary expense” of business operations. Treat them as an expense and, as with every expense, try to keep expenses to a minimum in order to maximize net income.
😉
Hey Paul thanks for writing this its a great article and a big help to me and clears up some questions I had cant wait to read part 2. Do you do taxes for people Paul my tax guy was just arrested for tax evasion and selling untaxed liqour and ciggs and possesion of marijuana. So im kinda in the market for a new one I dont think he will be available next year.
Hi Jason – Thank you for the kind words. There’s more coming on this topic – too much info for just one part.
Yes, I do taxes for individuals and businesses. I’ll contact you via email with more info if you don’t mind. (Bob’s system forwarded your email address to me – we don’t want to “broadcast” it here!)
Thanks again. 😉
Hi Paul, Great post, answered many questions of mine. I need a new accountant as well. I am still trying to sell properties in the U.S. to move to the the islands. Can you get my email address from bob so i can find out what your rates are? Thanks Scott
Hi Scott – Thanks for the comment! I hope all of my articles have similar effect in answering questions!
I’ll get in touch with you, Scott, and give you a little info! 😉
Hi Paul. You have some informative and relavent articles to expats here in the Philippines!
Hope I can call you for some possible future tax consultation. Have extended my 2010 taxes, but would like to get it sorted ASAP. Please e-mail me your details, and the best time to reach you.
Hi Aldwin — thanks for your kind words.
Check your e-mail for a response! 😉
Will keep the articles coming — but will sprinkle them among “less boring” articles.