How to Calculate the Foreign Earned Income Exclusion
In this post, I’ll describe how to calculate the foreign earned income exclusion. This is meant as a general guide for calculating the FEIE and I assume that most will either use a software program to calculate the foreign earned income exclusion or hire a professional to prepare their complex tax return.
Before we get to calculating the foreign earned income exclusion, we should first determine if you need to bother. When should you use the foreign earned income exclusion?
First, I note that you must file a return and calculate the foreign earned income exclusion on Form 2555 to get the benefit of the exclusion. Just because you will pay zero tax with the exclusion, it doesn’t mean you are not required to file.
In fact, the FEIE is the only tax calculation that’s “use it or lose it.” If you don’t file your return and calculate the foreign earned income exclusion, and you’re audited by the IRS, you can lose the exclusion and be forced to pay US tax on your worldwide income, even if you did not or don’t live in the United States.
Second, you need only calculate the foreign earned income exclusion if your income exceeds the Standard Deduction. If your income is less than the Standard Deduction, then you probably don’t need to bother with the FEIE.
The Standard Deduction for 2021 is $12,400 for a single taxpayer and $24,800 for married filing joint taxpayers. If your income is less than this, you probably don’t need to calculate the foreign earned income excursion, but you probably do need to file a return (if living abroad).
Third, you need only calculate the foreign earned income exclusion if you live in a low or no-tax country. If the country you’re living in has a tax rate higher than or about the same as the United States, then you will use the foreign tax credit and not the foreign earned income exclusion.
This is because you get a dollar-for-dollar credit for paying tax in a foreign country. So, if your US Federal tax rate is 30% and your tax rate in France is 35%, just use the foreign tax credit to pay zero US tax.
Do I Qualify for the Foreign Earned Income Exclusion?
When it comes to calculating the FEIE, it’s an all-or-nothing situation. You either get to take the full exclusion or none of it. There is no prorated amount (unless you qualify using the 330-day test over two calendar years, see below). That is to say, if you do not qualify, or miss qualifying by even one day, you lose the entire exclusion and 100% of your income is taxable in the United States.
I should also point out that the foreign earned income exclusion applies to ordinary income, salary, self-employment income, and/or business income. It does not apply to capital gains or passive income. Therefore, this article considers only ordinary income.
There are two ways you can qualify for the foreign earned income exclusion.
Physical Presence Test: be out of the United States and in a foreign country for 330 of any 365 day period. This is a simple test… be out of the US for 330 days of 365 and you qualify. However, if you miss it by even one day, you get zero FEIE.
Residency Test: be a tax resident of any foreign country for a full calendar year. This country should be your home and you should put down roots there. It usually means you will file and pay taxes in that country.
Most clients use the physical presence test during their first year abroad. Then they move to the residency test once they are ready to put down roots. Also, because the residency test requires you to be a tax resident for a full calendar year, it’s much easier to begin your life outside of the US with the physical presence test.
As stated above, the physical presence test can be taken over any 12 month period. So, it would be possible to use a March to March foreign earned income exclusion. In that case, you would prorate the FEIE for 10 months of 2021 and then 2 months in 2022.
The FEIE for 2021 is $108,700, which amounts to $9,058 per month, or about $90,580 for the 10 month period. This amount could be doubled if a husband and wife both qualify for the FEIE, both worked in the business, and both took out a salary.
How to Calculate the Foreign Earned Income Exclusion
To calculate the foreign earned income exclusion on salary, be it salary from your own foreign corporation or when you work for someone else outside of the United States, you simply take the exclusion amount and reduce your income by that number.
Again, keep in mind that you either get all or none of the FEIE, so prorating is only an issue when taken over two calendar years. In this section, I’ll assume you are taking the FEIE over only one calendar year.
So, let’s say you earned $90,000 in 2021 and qualified for the FEIE. You would use form 2555 to report the salary and subtract it from $108,700. You would thus pay zero tax.
Next, let’s say you earned $208,700 in 2021 from work and qualified for the FEIE. You would subtract $108,700 from $208,700, and pay US tax on the remaining $100,000.
The bad news is that, when you calculate the tax, you use the tax bracket of someone who earned $208,700 and not the tax bracket of someone who earned $100,000.
Self Employed Persons Reporting on Schedule C
Calculating the foreign earned income exclusion for self-employed persons that are reporting on Schedule C, and not using a foreign corporation, is much more complicated. I will simplify it here, but for more accurate calculations, see the IRS website.
To oversimplify a complex matter, when you report your foreign income on Schedule C, about 50% of your expenses are allocated to the FEIE. That means that the FEIE is reduced by about 50% of your business expenses.
For example, let’s say your business income is $250,000 and your expenses are $50,000. When you calculate the FEIE, it is reduced by about $25,000, from $108,700 to $83,700. The result is that you can use $83,700 of the exclusion to reduce your taxable income from $200,000 to $116,300. You will pay US tax on this amount.
Next, you will have to pay Self Employment Tax on your net profit. The FEIE does not apply to Self Employment Tax and thus you’re paying full SE tax on your business profits. The self-employment tax rate for 2021 is about 15.3%.
Again, these are just “back of the napkin” calculations to help you think about how to calculate the foreign earned income exclusion. I assume that you will be using a software program or a CPA to prepare your complex tax return.
Options
The solution to the problem of calculating the FEIE on a Schedule C can be eliminated by forming an offshore corporation. Set up a foreign corporation and open an international bank account. Then draw a salary from that corporation of up to the FEIE amount.
The FEIE and an offshore corporation work great for those earning $110,000 a year, or a husband and wife netting $220,000. But, what if your income is significantly higher than this? What if you’re taking home $500,000 in business income?
Then you should consider moving to the US territory of Puerto Rico. This island has unique tax deals that are only available in a territory. This is because, no matter in which state you live, you pay Federal Tax. Also, Americans living abroad are taxed by the IRS. But, Americans living in Puerto Rico are only taxed by Puerto Rico.
If you move a qualifying business netting $500,000 a year to Puerto Rico, your tax rate will be 4%. This amounts to $20,000 in tax paid. This same income using the FEIE results in about $120,000 in tax paid (assuming a 30% blended Federal rate).
I hope you’ve found this article helpful. For more information on forming an offshore corporation that qualifies to use the FEIE, or on moving to Puerto Rico, please contact me at info@premieroffshore.com. I will be happy to work with you to structure your international plan.
