What Does It Take To Exclude Foreign Income?

At this point of the tax season I usually lament not having won the lottery since last year’s tax season. I would travel extensively, most likely overseas.

That would put me out of the country, and you may have heard that there is a tax “break” for people who work outside the country.  I sincerely doubt it would apply to me in my imaginary lottery-fueled world, but let’s talk about it.

If you work overseas, you get to exclude up to $100,800 of earned income – such as salary – from U.S. tax. This sounds like a great deal, and usually it is, but remember that you would have been allowed a credit for income taxes paid the other country. If the foreign taxes are the same or higher than the U.S. taxes, the effect of the income exclusion is likely a push. If the other country has lower taxes than the U.S., however, this could be a very sweet deal for you.

There are ropes to claiming this exclusion. You have to meet one of two tests. The first test is being outside the U.S. for at least 330 days during the year. Think about this for a second. You take a job in Japan for a couple of years, but your family stays in the U.S. This means that you can see them up to 35 days a year – or forfeit the exclusion. I suppose they could travel to Japan instead, but you get the idea.

There is a second way, and that is to be a “bona fide” resident of the foreign country. This is hard to do, as it means that your home is there and not here. “Home” in this context does not just mean a place where you hang clothes and keep food in the refrigerator. The tax Code wants more: it wants your “main” home to be overseas.

Does this happen much? You bet. Think an American expatriate – perhaps retired military or someone who married overseas. I have family for example who have lived in England for decades. They have gone to school, worked, married and raised children there. They would easily qualify for the foreign income exclusion under the bona fide test.

What if one works overseas but still maintains ties to the U.S.? Can one also be a bona fide citizen of another country?

You can expect the IRS to be skeptical, especially if you leave a house or family behind. This is the IRS equivalent of New York Department of Revenue not believing you when you tell them you moved to Florida.

Let’s look at one someone who recently tried to make the bona fide argument.

Joel Evans took a job on Sakhalin Island in Russia, which has to count as going to the end of the world. He was working the oil rigs, both on land and offshore. His normal schedule was 30 days on followed by 30 days off. A 30- day stretch gave him the flexibility to return frequently to the U.S.  

He had a house in Louisiana, and somewhere in there he got divorced. His daughter moved into his house for a while. He returned to Louisiana whenever he could. He eventually married a second time, and his wife moved into, and his daughter moved out of, his house in Louisiana.

He claimed the foreign income exclusion for years 2007 through 2010. The IRS said no and wanted over $31,000 in back taxes from him

He had absolutely no chance under test one, as he spent way more than 35 days annually in the U.S. He argued instead that he was a bona fide resident of Russia.

I give him credit, I really do. It was his only argument. He spent a lot of time in Russia. He learned a little Russian. He fixed up a place to stay. He made friends. He even dated some Russian women, which I presume he ceased doing when he got remarried.

But that isn’t the test, is it?

The test is where his main home was. He pretty much gave his hand away when he kept returning to Louisiana almost every thirty days.

The Tax Court agreed with the IRS and disallowed his foreign income exclusion. He was not a bona fide resident of Russia, and he could not exclude his foreign earned income. He had failed both tests.

Let’s state the obvious: he had no chance winning this one.

In my practice, almost everyone relies on the 35-day test, and it is common to monitor the 35 days like a hawk. I suppose if I were an expat (that is, living overseas) preparing taxes for other expats, I would see the bona fide test more frequently. There are not too many bona fides who would need my services in Cincinnati.

Which rule – the 35 day or the bona fide – would trip me up when I hit the lottery?

Neither. It takes earned income – think self-employment or a salary – to power the foreign earned income exclusion. I have no intention of working.