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The Unofficial Guide to Form 2555 Foreign Income Exclusion

The Unofficial Guide to Form 2555 Foreign Income Exclusion

The United States is one of the few governments that attempts to collect tax on its citizens, no matter where they may live in the world. However, for years expatriate Americans simply did not file returns, secure in the fact that they were under the radar and faced few consequences for not filing. This has all recently come screeching to a halt as the government is desperately groping for more revenue and many overseas taxpayers, who have failed to file for years, have received notices from the IRS reminding them that they are not forgotten back stateside.

The silver lining of this cloud is that the U.S. congress has given the expatriated (and reluctant) taxpayer two weapons to help fend off the avariciousness of the IRS, the Forms 2555 and 1116. For those actually living overseas, the 2555 is the big gun in the armory, as it allows a direct exclusion of certain income under certain conditions. Of course, it wouldn’t be U.S. tax law if it was easy to understand, and so I have included here an emphatically NOT by the IRS guide to the Form 2555.

How the Form 2555 Helps You
In its essence, the Form 2555 means that the first $91,000 of income (for 2010) that you earned while living overseas as a resident of a foreign country is subtracted back out of your U.S. income in your tax computation. For U.S. citizens who live abroad and who make the vast majority of their income through their labor but aren’t business tycoons, professional athletes, or investment bankers this may result in their U.S. tax return being a mere formality with no money due. “So Tyler,” you ask me, “I don’t make over 91 grand and I’m sure that I don’t owe anything, why should I have to expend the time and money that it would take to file?” I’ll admit it does seem unfair, but I have to warn that if you don’t file, the IRS can make up a return for you, and it won’t be in your favor!

The Pitfalls of Not Filing

  • The statute of limitations never runs out! Except in the case of fraud or tax evasion the IRS can only audit a tax return three years from the date of filing. If you don’t file, they can go back forever.
  • The IRS can make up a return for you that can be totally erroneous or only include information prejudicial to you. For example, they will include income without the offsetting expenses or capital gains without showing any basis on the sale.
  • The IRS is a mean sonofabitch as a debtor and can garnish social security benefits or retirement plan income in order to pay back taxes that you probably wouldn’t even have owed if you only would have filed!

Additional Benefits to Form 2555
The $91,000 is per person, so if you and the spouse each work then both will file the form. Also, Congress is aware that many U.S. corporations provide housing allowances for expatriate workers (which they then must include in income on their W-2) and so has added an exclusion for housing allowances which is added on top of the extant $91K. The trick is that the IRS determines the maximum amount of the exclusion based upon the cost of living in the area that you live. If, for example, you live in Japan and your employer sends you to Tokyo then you get an allowance of a whopping $295.62 per day for a total of $107,900 per year. On the other hand, if you get sent to humble little Gifu than the maximum allowance that you can exclude is $29,200. The complete table is available on the instructions for the Form 2555 and makes for some fascinating reading; especially if you’re about to get sent to Moscow, Russia, and you want to know how the cost of living compares to your current post in Doha, Qatar. Plus, it makes for some excellent tax planning for expats employed by U.S. corporations; your human resources person should claim your salary as housing allowance up to the limit and then everything after that is salary.

Form 1116 Plays Robin to the Form 2555’s Batman
If you’re a high roller and you’ve exhausted your exclusion of $91,000 plus potentially up to $107,900 in housing allowance then you might figure that you are going to owe your old Uncle Sam a share of the pot. Not so fast, if you are a tax resident of a foreign country then it stands to reason that you also owe tax to your host country. This is where Form 1116 comes along. It basically gives you a dollar for dollar tax credit for taxes paid to foreign governments. Of course, being the U.S. tax code there has to be about ten thousand restrictions on what you actually get the credit for, so check out the instructions first.

Am I Eligible to File Form 2555?
To be eligible to file Form 2555 you have to clear two hurdles: first, your tax home is in a foreign country and second, you have to either be a bona fide resident of that country or have had a physical presence in a country or countries outside of the United States

Tax Home Is a Foreign Country
Your tax home is the principal country or jurisdiction in which you carry out your business or employment. It would therefore be logical that you can have only one tax home at any given point in time and, to qualify for Form 2555, this tax home must have been outside of the United States for at least a portion of the tax period you are filing for.

Bona Fide Resident Test
Once you have established that your tax home was a foreign country for at least a portion of the year that you are filing for, then you must move on to see whether you were a bona fide resident or you meet the physical presence test. As a generality, if you had a single foreign country as your tax home for the entire tax period and you were residing in that country for a permanent or indefinite period of time then you will choose to qualify as a bona fide resident.
Some factors that could be important in establishing yourself as a bona fide resident:

  • type of visa you entered the foreign country with; does it need to be said that a tourism visa may raise some eyebrows?
  • Visa limit stay? See above
  • maintain home in US while living abroad? if so disclose and explain. This isn’t a deal breaker but it could signal that your intention was less than that of a permanent or indefinite nature.?

Once you have established yourself as a bona fide resident than it is assumed that you continue to be a bona fide resident until you establish otherwise.

Physical Presence Test
If you don’t meet the criteria for being a bona fide resident of another country, then you can look to the physical presence test. To qualify, you must have lived outside the US for at least 330 days of any period of 12 months in a row. There are lines on the form (line 16) that you will need to fill out showing what countries you were resident in and for what dates. Generally, the physical presence test will be useful to those who have moved outside of the United States but were not established in their country of bona fide residence as of the first day of the tax year, for those who were outside the U.S. but in multiple jurisdictions, and for those who have a job or vocation that has taken them outside the country but who fail to meet the semi-permanent or indefinite period requirement. An important point to note is that you don’t have to have met the 330 day requirement by the end of the tax year, but by the filing date, including extensions. Also, if your period outside the United States extends into subsequent periods then you could be allowed a pro-rated amount of the exclusion. For example, if you move to England on July 1, 2009 and stay there through July 1, 2011 then you could possible qualify for one half of the amount of the exclusion for 2009, the entire amount for 2010, and one half for 2011. As you can imagine, it is much more complicated than that and you might find that you don’t qualify for any of the exclusion for any of these periods. See the instructions to Form 2555 and Publication 54 for details.

Can I Exclude Income from My Investments?
No, Form 2555 only helps for income earned from your employment or from your trade or business while qualifying under the tests above. If you have paid tax on your foreign investments then you may be able to take a credit for that on your form 1116.

In conclusion, the expatriated American has recently earned increased scrutiny from Congress and the Internal Revenue Service. For most Americans, however, avoiding unnecessary taxes can be a fairly straightforward matter thanks to the ability to exclude their foreign sourced earned income on Form 2555.