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Tax Court Offers New Definition on Foreign Earned Income

With international borders all but disappearing in an increasingly global economy, there seems to be more confusion among American Expats as to what qualifies as foreign earned income.  While the IRS allows US Expats to deduct a portion of their foreign earned income from their total income taxable by the United States, the amount excluded must qualify as foreign earned income as defined by the Internal Revenue Service.  Additionally, American Expats who have deductable foreign earned income must meet residency requirements in a country other than the United States in order to legitimately qualify for the Foreign Earned Income Exclusion (FEIE).

Understanding Foreign Earned Income 

To better understand how the IRS is viewing and defining foreign income let’s take a look at a live example for which the tax court entered a judgment on March 13 of this year.  A US Citizen with dual residency in Hong Kong worked for United Airlines as a flight attendant and would typically fly to countries abroad.  In previous tax years, this flight attendant had claimed all of her income as foreign earned income on her US expat tax return – both her income that was earned while abroad and her income that was earned while in the United States.

This year, the IRS refused to allow her the foreign earned income exclusion because she had claimed way too much in the past by claiming all of her US sourced income as foreign earned income.  The IRS determined that she was – in fact – eligible to deduct a portion of her income as foreign earned income, but nowhere near the entire amount.  The tax court made a decision that only income earned in a territory run by another government besides the US may be deducted as foreign earned income.

There was also a definition offered for ‘being in the territory’.  A flight to Japan, for example, doesn’t qualify as foreign earned income.  At the beginning of the flight you are not in Japan; if the flight departs from the United States you are on American soil and therefore earning American income.  When the plane is in the air over international airspace you are still considered to be working in the United States.  Only when you arrive in Japan are you present and working in another country.

Foreign Residency Requirements 

Showing up in a country abroad for an assignment, however, is still not enough of a qualification to claim the FEIE.  If you are a resident of the United States and you are on a temporary assignment for which you will only be in a foreign country for less than 10-12 months, you will not have been in a foreign territory long enough to meet either the Bona Fide Resident Test or the Physical Presence Test qualifications that would allow you to claim the exclusion.

It’s also important to understand that if you are working in a territory that’s identified as a United States Possession such as American Samoa, the Commonwealth of the Northern Mariana Islands, Guam, Puerto Rico, or the US Virgin Islands, you will not qualify for the Foreign Earned Income Exclusion.

Additional Limitations Placed by the IRS 

Figuring your allowable foreign earned income exclusion amount is not only necessary for avoiding future penalties on your US expat tax return; there have also been limitations placed on the Foreign Housing Allowance which are contingent upon having properly calculated your foreign earned income amount.  You will not be allowed to claim more housing credits than the amount equal to 30% of your FEIE.

This applies to ALL American Expats – even those who live in a territory in which allowances have been increased because of it having been identified as a territory with a higher cost of living than the global average.  Now more than ever it is imperative for US Expats to pay close attention to regulations and requirements of each available deduction.  You could be filing a false return and have every reason to believe that you’re staying within legal guidelines.

Don’t Gamble With Your Taxes

If you’re not sure how to prepare your next US expat tax return in consideration of these new procedures by the IRS, you can always turn to a qualified international tax expert at Taxes for Expats.  We’ve been helping US Expats stay current on their US tax liability for over 20 years and we offer an affordable flat rate on tax return preparation.