U.S. citizens and permanent residents are subject to federal income tax on worldwide income – it doesn’t matter where you generate income. Fortunately, the U.S. government offers an important tax relief to many Americans living and working abroad in the form of the foreign earned income exclusion.

Foreign earned income exclusion (Form 2555)

1. For 2018, up to $104,100 of foreign earned income generated while living abroad can be excluded from federal tax;
2. You must either meet the bona fide residence or physical presence test (explained below)
3. Individuals who work abroad for the U.S. government are not eligible

Foreign earned income excludes any U.S. based income including pension and other retirement or deferred income. It also excludes any foreign income that was not earned (e.g., interest, dividends, rental income, pension). The maximum exclusion amount works alongside standard deductions and exemptions. As a result, an expat filing as a single can have $115K in income, and pay no taxes. If you’re married filing jointly, it’s possible to double the exclusion amount, provided both you and your spouse are earning income abroad.

Many business owners, however, continue to be subject to the self-employment tax. The foreign earned income exclusion applies after self-employment tax has been factored. It may be possible to avoid self-employment tax by establishing a foreign business entity and setting oneself up as an employee. Unfortunately, the paperwork and scrutiny involved is extensive (and generally not recommended for small business owners).

Bona fide residence and physical presence tests

• The bona fide residence test is met if you have an established residence within a foreign country and lived there during an entire calendar year. Furthermore, your intentions must be to stay in that country indefinitely.
• The physical presence test is met if you are outside the U.S. for 330 out of 365 consecutive days.

Most expats who qualify for the foreign earned income exclusion for the first time meet the requirement via the physical presence test. The 365 days is not based on a calendar year. It usually starts around the time that you begin living abroad. Below is a couple of examples to explain the physical presence test.

• Jane Smith moves to Costa Rica on March 1, 2018. She does not leave the country. Jane qualifies for the physical presence test 330 days later. Jane can file her 2012 expat tax return prior to April 15.
• Kevin Johnson moves to Thailand on October 1, 2018. He does not leave the country. Kevin also qualifies for the physical presence test 330 days later. In order for Kevin to qualify for the foreign earned income exclusion, he should file for a 6-month extension.

In the examples above, both Jane and Kevin would not be able to exclude the full exclusion amount. That is because the maximum exclusion amount is prorated based on the number of days during the applicable tax year that Jane and Kevin were abroad.

Revoking the foreign earned income exclusion

Some people elect to revoke the foreign earned income exclusion. However, once the exclusion is revoked, the person generally cannot utilize the exclusion again for 5 years. Therefore, it is important to carefully consider one’s potential tax circumstances in the future before making such a decision.

For general information on US expat taxation, please read: US Taxes for Americans Living Abroad – Ultimate Guide.