Barron's International Tax Service

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American Expats and Foreign Earned Income

Some years ago an exasperated engineer decided how he could avoid filing tax returns and paying taxes to the Infernal Revenue Service.  Wasn't there something called a Foreign Earned Income Exclusion (FEIE), he asked.  If he worked abroad, couldn't he take advantage of FEIE and thereby rid himself of paying into the "onerous" American tax system?

What he really wanted was anonymity.  By moving abroad and settling into a new job, he could stop filing tax returns with IRS.  As the foreign country of residence would tax his earnings, he reasoned that he could not possibly be required to file returns stateside.

What he didn't realize is that IRS does require that US citizens, wherever they reside, report their world-wide income annually on a tax return.  FEIE enables tax filers to exclude up to $80,000 of foreign earned income reported stateside.  However, any US citizen or resident who fails to report his or her foreign earned income to IRS can also be denied FEIE.  This means that a single person could be liable for up to $14,794, plus penalties and interest on the unreported income; income which has already been reported to and taxed by the foreign country.

What is foreign earned income?  It includes salaries, wages, commissions, professional fees, bonuses for personal services, allowances for housing and other expenses, and the value of leasing a car provided by an employer.  It may also include business profits, royalties and rents if the income is tied to the performance of services.  It does not include pension or annuity income, dividends, interest, capital gains, alimony, gambling winnings, or payments for nonqualified employee trusts or nonqualified annuities.  Employees of government agencies may not exclude their pay from US taxation.  The tax liability of a civilian or military employee of the US government killed in action may be waived.  Finally FEIE is denied anyone who works in a country subject to US government travel restrictions.

When a foreign country and the United States establish a tax treaty, the taxing agencies of both countries are able to share tax filing information through the click of a mouse.  Chances are therefore probable for any non-filing expatriated American to receive an audit enquiry from IRS on his foreign earned income, requiring that he or she file tax returns for the last three years.  In the event that fraud is suspected, IRS will require that additional years be filed.

The Service can be forgiving to those who voluntarily submit the required tax returns even after years of non-compliance.  This means that they can claim FEIE as long as they have met the foreign residence or physical presence test and properly elected the exclusion.

So what happens if the engineer who protested filing tax returns to IRS voluntarily submits tax returns for the last three years on an annual equivalent income of $90,000?  Can he be taxed twice on the income that exceeds the $80,000 FEIE limit?  Perhaps.  He could apply for the Foreign Tax Credit.  But if improperly elected, he could be disqualified from FEIE for the next five years.