| Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad |
2006 Tax Year |
4.
Foreign Earned Income and Housing: Exclusion - Deduction
Topics - This chapter discusses:
-
Who qualifies for the foreign earned income exclusion, the foreign housing exclusion, and the foreign housing deduction,
-
How to figure the foreign earned income exclusion, and
-
How to figure the foreign housing exclusion and the foreign housing deduction.
Useful Items - You may want to see:
Publication
-
519
U.S. Tax Guide for Aliens
-
570
Tax Guide for Individuals With Income from U.S. Possessions
-
596
Earned Income Credit (EIC)
Form (and Instructions)
-
1040X
Amended U.S. Individual Income Tax Return
-
2555
Foreign Earned Income
-
2555-EZ
Foreign Earned Income Exclusion
See chapter 7 for information about getting these publications and forms.
Who Qualifies for the Exclusions and the Deduction?
If you meet certain requirements, you may qualify for the foreign earned income and foreign housing exclusions and the foreign
housing deduction.
If you are a U.S. citizen or a resident alien of the United States and you live abroad, you are taxed on your worldwide income.
However, you may
qualify to exclude from income up to $82,400 of your foreign earnings. In addition, you can exclude or deduct certain foreign
housing amounts. See
Foreign Earned Income Exclusion and Foreign Housing Exclusion and Deduction, later.
You may also be entitled to exclude from income the value of meals and lodging provided to you by your employer. See Exclusion of Meals and
Lodging, later.
To claim the foreign earned income exclusion, the foreign housing exclusion, or the foreign housing deduction, you must satisfy
all three of the
following requirements.
-
Your tax home must be in a foreign country.
-
You must have foreign earned income.
-
You must be either:
-
A U.S. citizen who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an
entire tax year,
-
A U.S. resident alien who is a citizen or national of a country with which the United States has an income tax treaty in effect
and who is a
bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year, or
-
A U.S. citizen or a U.S. resident alien who is physically present in a foreign country or countries for at least 330 full
days during any
period of 12 consecutive months.
See Publication 519 to find out if you qualify as a U.S. resident alien for tax purposes and whether you keep that alien status
when you
temporarily work abroad.
If you are a nonresident alien married to a U.S. citizen or resident alien, and both you and your spouse choose to treat you
as a resident alien,
you are a resident alien for tax purposes. For information on making the choice, see the discussion in chapter 1 under Nonresident Alien Spouse
Treated as a Resident.
Waiver of minimum time requirements.
The minimum time requirements for bona fide residence and physical presence can be waived if you must leave a foreign
country because of war, civil
unrest, or similar adverse conditions in that country. This is fully explained under Waiver of Time Requirements, later.
See Figure 4-A
and information on the following pages to determine if you
are eligible to claim the exclusion or deduction.
Tax Home in Foreign Country
To qualify for the foreign earned income exclusion, the foreign housing exclusion, or the foreign housing deduction, your
tax home must be in a
foreign country throughout your period of bona fide residence or physical presence abroad. Bona fide residence and physical
presence are explained
later.
Your tax home is the general area of your main place of business, employment, or post of duty, regardless of where you maintain
your family home.
Your tax home is the place where you are permanently or indefinitely engaged to work as an employee or self-employed individual.
Having a “tax
home” in a given location does not necessarily mean that the given location is your residence or domicile for tax purposes.
If you do not have a regular or main place of business because of the nature of your work, your tax home may be the place
where you regularly live.
If you have neither a regular or main place of business nor a place where you regularly live, you are considered an itinerant
and your tax home is
wherever you work.
You are not considered to have a tax home in a foreign country for any period in which your abode is in the United States.
However, your abode is
not necessarily in the United States while you are temporarily in the United States. Your abode is also not necessarily in
the United States merely
because you maintain a dwelling in the United States, whether or not your spouse or dependents use the dwelling.
“Abode” has been variously defined as one's home, habitation, residence, domicile, or place of dwelling. It does not mean your principal
place
of business. “Abode” has a domestic rather than a vocational meaning and does not mean the same as “tax home.” The location of your abode
often will depend on where you maintain your economic, family, and personal ties.
Example 1.
You are employed on an offshore oil rig in the territorial waters of a foreign country and work a 28-day on/28-day off schedule.
You return to your
family residence in the United States during your off periods. You are considered to have an abode in the United States and
do not satisfy the tax
home test in the foreign country. You cannot claim either of the exclusions or the housing deduction.
Example 2.
For several years, you were a marketing executive with a producer of machine tools in Toledo, Ohio. In November of last year,
your employer
transferred you to London, England, for a minimum of 18 months to set up a sales operation for Europe. Before you left, you
distributed business cards
showing your business and home addresses in London. You kept ownership of your home in Toledo but rented it to another family.
You placed your car in
storage. In November of last year, you moved your spouse, children, furniture, and family pets to a home your employer rented
for you in London.
Shortly after moving, you leased a car and you and your spouse got British driving licenses. Your entire family got library
cards for the local
public library. You and your spouse opened bank accounts with a London bank and secured consumer credit. You joined a local
business league and both
you and your spouse became active in the neighborhood civic association and worked with a local charity. Your abode is in
London for the time you live
there. You satisfy the tax home test in the foreign country.
Temporary or Indefinite Assignment
The location of your tax home often depends on whether your assignment is temporary or indefinite. If you are temporarily
absent from your tax home
in the United States on business, you may be able to deduct your away-from-home expenses (for travel, meals, and lodging),
but you would not qualify
for the foreign earned income exclusion. If your new work assignment is for an indefinite period, your new place of employment
becomes your tax home
and you would not be able to deduct any of the related expenses that you have in the general area of this new work assignment.
If your new tax home is
in a foreign country and you meet the other requirements, your earnings may qualify for the foreign earned income exclusion.
If you expect your employment away from home in a single location to last, and it does last, for 1 year or less, it is temporary
unless facts and
circumstances indicate otherwise. If you expect it to last for more than 1 year, it is indefinite. If you expect it to last
for 1 year or less, but at
some later date you expect it to last longer than 1 year, it is temporary (in the absence of facts and circumstances indicating
otherwise) until your
expectation changes.
To meet the bona fide residence test or the physical presence test, you must live in or be present in a foreign country. A
foreign country usually
is any territory (including the air space and territorial waters) under the sovereignty of a government other than that of
the United States.
The term “foreign country” includes the seabed and subsoil of those submarine areas adjacent to the territorial waters of a foreign country
and over which the foreign country has exclusive rights under international law to explore and exploit the natural resources.
The term “foreign country” does not include Puerto Rico, Guam, the Commonwealth of the Northern Mariana Islands, the U.S. Virgin Islands, or
U.S. possessions such as Johnston Island. For purposes of the foreign earned income exclusion, the foreign housing exclusion,
and the foreign housing
deduction, the terms “foreign,” “abroad,” and “overseas” refer to areas outside the United States, American Samoa, Guam, the
Commonwealth of the Northern Mariana Islands, Puerto Rico, the U.S. Virgin Islands, and the Antarctic region.
American Samoa, Guam, and the Commonwealth of the Northern Mariana Islands
Residence or presence in a U.S. possession does not qualify you for the foreign earned income exclusion. You may, however,
qualify for an exclusion
of your possession income on your U.S. return.
American Samoa.
There is a possession exclusion available to individuals who are bona fide residents of American Samoa for the entire
tax year. Gross income from
sources within American Samoa may be eligible for this exclusion. Income that is effectively connected with the conduct of
a trade or business within
American Samoa also may be eligible for this exclusion. Use Form
4563, Exclusion of Income for Bona Fide Residents of American Samoa, to figure the exclusion.
Guam and the Commonwealth of the Northern Mariana Islands.
An exclusion will be available to residents of Guam and the Commonwealth of the Northern Mariana Islands if, and when,
new implementation
agreements take effect between the United States and those possessions.
For more information, see Publication 570.
Puerto Rico and U.S. Virgin Islands
Residents of Puerto Rico and the U.S. Virgin Islands cannot claim the foreign earned income exclusion or the foreign housing
exclusion.
Puerto Rico.
Generally, if you are a U.S. citizen who is a bona fide resident of Puerto Rico for the entire tax year, you are not
subject to U.S. tax on income
from Puerto Rican sources. This does not include amounts paid for services performed as an employee of the United States.
However, you are subject to
U.S. tax on your income from sources outside Puerto Rico. In figuring your U.S. tax, you cannot deduct expenses allocable
to income not subject to
tax.
You meet the bona fide residence test if you are a bona fide resident of a foreign country or countries for an
uninterrupted period that includes an entire tax year. You can use the bona fide residence test to qualify for the exclusions
and the deduction only
if you are either:
You do not automatically acquire bona fide resident status merely by living in a foreign country or countries for 1 year.
If you go to a foreign
country to work on a particular job for a specified period of time, you ordinarily will not be regarded as a bona fide resident
of that country even
though you work there for 1 tax year or longer. The length of your stay and the nature of your job are only some of the factors
to be considered in
determining whether you meet the bona fide residence test.
Bona fide residence.
To meet the bona fide residence test, you must have established such a residence in a foreign country.
Your bona fide residence is not necessarily the same as your domicile. Your domicile is your permanent home, the place
to which you always return
or intend to return.
Example.
You could have your domicile in Cleveland, Ohio, and a bona fide residence in Edinburgh, Scotland, if you intend to return
eventually to Cleveland.
The fact that you go to Scotland does not automatically make Scotland your bona fide residence. If you go there as a tourist,
or on a short
business trip, and return to the United States, you have not established bona fide residence in Scotland. But if you go to
Scotland to work for an
indefinite or extended period and you set up permanent quarters there for yourself and your family, you probably have established
a bona fide
residence in a foreign country, even though you intend to return eventually to the United States.
You are clearly not a resident of Scotland in the first instance. However, in the second, you are a resident because your
stay in Scotland appears
to be permanent. If your residency is not as clearly defined as either of these illustrations, it may be more difficult to
decide whether you have
established a bona fide residence.
Determination.
Questions of bona fide residence are determined according to each individual case, taking into account factors such
as your intention, the purpose
of your trip, and the nature and length of your stay abroad.
You must show the Internal Revenue Service (IRS) that you have been a bona fide resident of a foreign country or countries
for an uninterrupted
period that includes an entire tax year. The IRS decides whether you qualify as a bona fide resident of a foreign country
largely on the basis of
facts you report on Form 2555. IRS cannot make this determination until you file Form 2555.
Statement to foreign authorities.
You are not considered a bona fide resident of a foreign country if you make a statement to the authorities of that
country that you are not a
resident of that country, and the authorities:
-
Hold that you are not subject to their income tax laws as a resident, or
-
Have not made a final decision on your status.
Special agreements and treaties.
An income tax exemption provided in a treaty or other international agreement will not in itself prevent you from
being a bona fide resident of a
foreign country. Whether a treaty prevents you from becoming a bona fide resident of a foreign country is determined under
all provisions of the
treaty, including specific provisions relating to residence or privileges and immunities.
Example 1.
You are a U.S. citizen employed in the United Kingdom by a U.S. employer under contract with the U.S. Armed Forces. You do
not qualify for special
status under the North Atlantic Treaty Status of Forces Agreement. You are subject to United Kingdom income taxes and may
qualify as a bona fide
resident.
Example 2.
You are a U.S. citizen in the United Kingdom who qualifies as an “employee” of an armed service or as a member of a “civilian component”
under the North Atlantic Treaty Status of Forces Agreement. You do not qualify as a bona fide resident.
Example 3.
You are a U.S. citizen employed in Japan by a U.S. employer under contract with the U.S. Armed Forces. You are subject to
the agreement of the
Treaty of Mutual Cooperation and Security between the United States and Japan. You do not qualify as a bona fide resident.
Example 4.
You are a U.S. citizen employed as an “official” by the United Nations in Switzerland. You are exempt from Swiss taxation on the salary or
wages paid to you by the United Nations. This does not prevent you from qualifying as a bona fide resident if you meet all
the requirements for that
status.
Effect of voting by absentee ballot.
If you are a U.S. citizen living abroad, you can vote by absentee ballot in any election held in the United States
without risking your status as a
bona fide resident of a foreign country.
However, if you give information to the local election officials about the nature and length of your stay abroad that
does not match the
information you give for the bona fide residence test, the information given in connection with absentee voting will be considered
in determining your
status, but will not necessarily be conclusive.
Uninterrupted period including entire tax year.
To qualify for bona fide residence, you must reside in a foreign country for an uninterrupted period that includes
an entire tax year. An entire
tax year is from January 1 through December 31 for taxpayers who file their income tax returns on a calendar year basis.
During the period of bona fide residence in a foreign country, you can leave the country for brief or temporary trips
back to the United States or
elsewhere for vacation or business. To keep your status as a bona fide resident of a foreign country, you must have a clear
intention of returning
from such trips, without unreasonable delay, to your foreign residence or to a new bona fide residence in another foreign
country.
Example 1.
You arrived with your family in Lisbon, Portugal, on November 1, 2004. Your assignment is indefinite, and you intend to live
there with your family
until your company sends you to a new post. You immediately established residence there. On April 1, 2005, you arrived in
the United States to meet
with your employer, leaving your family in Lisbon. You returned to Lisbon on May 1, and continued living there. On January
1, 2006, you completed an
uninterrupted period of residence for a full tax year (2005), and you meet the bona fide residence test.
Example 2.
Assume the same facts as in Example 1, except that you transferred back to the United States on December 13, 2005. You would not meet
the bona fide residence test because your bona fide residence in the foreign country, although it lasted more than a year,
did not include a full tax
year. You may, however, qualify for the foreign earned income exclusion or the housing exclusion or deduction under the physical
presence test
(discussed later).
Bona fide resident for part of a year.
Once you have established bona fide residence in a foreign country for an uninterrupted period that includes an entire
tax year, you will qualify
as a bona fide resident for the period starting with the date you actually began the residence and ending with the date you
abandon the foreign
residence. You could qualify as a bona fide resident for an entire tax year plus parts of 1 or 2 other tax years.
Example.
You were a bona fide resident of Singapore from March 1, 2004, through September 14, 2006. On September 15, 2006, you returned
to the United
States. Since you were a bona fide resident of a foreign country for all of 2005, you also qualify as a bona fide resident
from March 1, 2004, through
the end of 2004 and from January 1, 2006, through September 14, 2006.
Reassignment.
If you are assigned from one foreign post to another, you may or may not have a break in foreign residence between
your assignments, depending on
the circumstances.
Example 1.
You were a resident of Pakistan from October 1, 2005, through November 30, 2006. On December 1, 2006, you and your family
returned to the United
States to wait for an assignment to another foreign country. Your household goods also were returned to the United States.
Your foreign residence ended on November 30, 2006, and did not begin again until after you were assigned to another foreign
country and physically
entered that country. Since you were not a bona fide resident of a foreign country for the entire tax year of 2005 or 2006,
you do not meet the bona
fide residence test in either year. You may, however, qualify for the foreign earned income exclusion or the housing exclusion
or deduction under the
physical presence test, discussed later.
Example 2.
Assume the same facts as in Example 1, except that upon completion of your assignment in Pakistan you were given a new assignment to
Turkey. On December 1, 2006, you and your family returned to the United States for a month's vacation. On January 2, 2007,
you arrived in Turkey for
your new assignment. Because you did not interrupt your bona fide residence abroad, you meet the bona fide residence test.
You meet the physical presence test if you are physically present in a foreign country or countries 330 full days during a
period of 12 consecutive
months. The 330 days do not have to be consecutive. Any U.S. citizen or resident alien can use the physical presence test
to qualify for the
exclusions and the deduction.
The physical presence test is based only on how long you stay in a foreign country or countries. This test does not depend
on the kind of residence
you establish, your intentions about returning, or the nature and purpose of your stay abroad.
330 full days.
Generally, to meet the physical presence test, you must be physically present in a foreign country or countries for
at least 330 full days during a
12-month period. You can count days you spent abroad for any reason. You do not have to be in a foreign country only for employment
purposes. You can
be on vacation time.
You do not meet the physical presence test if illness, family problems, a vacation, or your employer's orders cause
you to be present for less than
the required amount of time.
Exception.
You can be physically present in a foreign country or countries for less than 330 full days and still meet the physical
presence test if you are
required to leave a country because of war or civil unrest. See Waiver of Time Requirements, later.
Full day.
A full day is a period of 24 consecutive hours, beginning at midnight.
Travel.
When you leave the United States to go directly to a foreign country or when you return directly to the United States
from a foreign country, the
time you spend on or over international waters does not count toward the 330-day total.
Example.
You leave the United States for France by air on June 10. You arrive in France at 9:00 a.m. on June 11. Your first full day
of physical presence in
France is June 12.
Passing over foreign country.
If, in traveling from the United States to a foreign country, you pass over a foreign country before midnight of the
day you leave, the first day
you can count toward the 330-day total is the day following the day you leave the United States.
Example.
You leave the United States by air at 9:30 a.m. on June 10 to travel to Kenya. You pass over western Africa at 11:00 p.m.
on June 10 and arrive in
Kenya at 12:30 a.m. on June 11. Your first full day in a foreign country is June 11.
Change of location.
You can move about from one place to another in a foreign country or to another foreign country without losing full
days. If any part of your
travel is not within any foreign country and takes less than 24 hours, you are considered to be in a foreign country during
that part of travel.
Example 1.
You leave Ireland by air at 11:00 p.m. on July 6 and arrive in Sweden at 5:00 a.m. on July 7. Your trip takes less than 24
hours and you lose no
full days.
Example 2.
You leave Norway by ship at 10:00 p.m. on July 6 and arrive in Portugal at 6:00 a.m. on July 8. Since your travel is not within
a foreign country
or countries and the trip takes more than 24 hours, you lose as full days July 6, 7, and 8. If you remain in Portugal, your
next full day in a foreign
country is July 9.
In United States while in transit.
If you are in transit between two points outside the United States and are physically present in the United States
for less than 24 hours, you are
not treated as present in the United States during the transit. You are treated as traveling over areas not within any foreign
country.
How to figure the 12-month period.
There are four rules you should know when figuring the 12-month period.
-
Your 12-month period can begin with any day of the month. It ends the day before the same calendar day, 12 months later.
-
Your 12-month period must be made up of consecutive months. Any 12-month period can be used if the 330 days in a foreign country
fall within
that period.
-
You do not have to begin your 12-month period with your first full day in a foreign country or end it with the day you leave.
You can choose
the 12-month period that gives you the greatest exclusion.
-
In determining whether the 12-month period falls within a longer stay in the foreign country, 12-month periods can overlap
one another.
Example 1.
You are a construction worker who works on and off in a foreign country over a 20-month period. You might pick up the 330
full days in a 12-month
period only during the middle months of the time you work in the foreign country because the first few and last few months
of the 20-month period are
broken up by long visits to the United States.
Example 2.
You work in New Zealand for a 20-month period from January 1, 2005, through August 31, 2006, except that you spend 28 days
in February 2005 and 28
days in February 2006 on vacation in the United States. You are present in New Zealand 330 full days during each of the following
two 12-month
periods: January 1, 2005 - December 31, 2005, and September 1, 2005 - August 31, 2006. By overlapping the 12-month periods
in this way,
you meet the physical presence test for the whole 20-month period. See Figure 4-B below.
Waiver of Time Requirements
Both the bona fide residence test and the physical presence test contain minimum time requirements. The minimum time requirements
can be waived,
however, if you must leave a foreign country because of war, civil unrest, or similar adverse conditions in that country.
You also must be able to
show that you reasonably could have expected to meet the minimum time requirements if not for the adverse conditions. To qualify
for the waiver, you
must actually have your tax home in the foreign country and be a bona fide resident of, or be physically present in, the foreign
country on or before
the beginning date of the waiver.
Early in 2007, the IRS will publish in the Internal Revenue Bulletin a list of countries qualifying for the waiver for 2006
and the effective
dates. If you left one of the countries on or after the date listed for each country, you can qualify for the bona fide residence
test or physical
presence test for 2006 without meeting the minimum time requirement. However, in figuring your exclusion, the number of your
qualifying days of bona
fide residence or physical presence includes only days of actual residence or presence within the country.
You can read the Internal Revenue Bulletin on the Internet at
www.irs.gov. Or, you can get a copy of the list of countries by writing to:
Internal Revenue Service
International Section
P.O. Box 920
Bensalem, PA 19020-8518
If you are present in a foreign country in violation of U.S. law, you will not be treated as a bona fide resident of a foreign
country or as
physically present in a foreign country while you are in violation of the law. Income that you earn from sources within such
a country for services
performed during a period of violation does not qualify as foreign earned income. Your housing expenses within that country
(or outside that country
for housing your spouse or dependents) while you are in violation of the law cannot be included in figuring your foreign housing
amount.
For 2006, the only country to which travel restrictions applied was Cuba. The restrictions applied for the entire year.
However, individuals working at the U.S. Naval Base at Guantanamo Bay in Cuba are not in violation of U.S. law. Personal service
income earned by
individuals at the base is eligible for the foreign earned income exclusion provided the other requirements are met.
To claim the foreign earned income exclusion, the foreign housing exclusion, or the foreign housing deduction, you must have
foreign earned income.
Foreign earned income generally is income you receive for services you perform during a period in which you meet both of the
following
requirements.
To determine whether your tax home is in a foreign country, see Tax Home in Foreign Country, earlier. To determine whether you meet
either the bona fide residence test or the physical presence test, see Bona Fide Residence Test and Physical Presence Test,
earlier.
Foreign earned income does not include the following amounts.
-
The value of meals and lodging that you exclude from your income because it was furnished for the convenience of your employer.
-
Pension or annuity payments you receive, including social security benefits (see Pensions and annuities, later).
-
Pay you receive as an employee of the U.S. Government. (See U.S. Government Employees, later.)
-
Amounts you include in your income because of your employer's contributions to a nonexempt employee trust or to a nonqualified
annuity
contract.
-
Any unallowable moving expense deduction that you choose to recapture as explained under Moving Expense Attributable to Foreign
Earnings in 2 Years in chapter 5.
-
Payments you receive after the end of the tax year following the tax year in which you performed the services that earned
the income.
Earned income.
This is pay for personal services performed, such as wages, salaries, or professional fees. The list that follows
classifies many types of income
into three categories. The column headed Variable Income lists income that may fall into either the earned income category, the unearned
income category, or partly into both. For more information on earned and unearned income, see Earned and Unearned Income, later.
| Earned |
Unearned |
Variable |
|
Income |
Income |
Income |
|
Salaries and
|
Dividends
|
Business
|
|
wages
|
Interest
|
profits
|
|
Commissions
|
Capital gains
|
Royalties
|
|
Bonuses
|
Gambling
|
Rents
|
|
Professional
|
winnings
|
Scholarships
|
|
fees
|
Alimony
|
and
|
|
Tips
|
Social security
|
fellowships
|
| |
benefits
|
|
| |
Pensions
|
|
| |
Annuities
|
|
In addition to the types of earned income listed, certain noncash income and allowances or reimbursements are considered
earned income.
Noncash income.
The fair market value of property or facilities provided to you by your employer in the form of lodging, meals, or
use of a car is earned income.
Allowances or reimbursements.
Earned income includes allowances or reimbursements you receive, such as the following amounts.
-
Cost of living allowances.
-
Overseas differential.
-
Family allowance.
-
Reimbursement for education or education allowance.
-
Home leave allowance.
-
Quarters allowance.
-
Reimbursement for moving or moving allowance (unless excluded from income as discussed later in Reimbursement of employee
expenses under Earned and Unearned Income).
The source of your earned income is the place where you perform the services for which you received the income. Foreign earned
income is income you
receive for working in a foreign country. Where or how you are paid has no effect on the source of the income. For example,
income you receive for
work done in Austria is income from a foreign source even if the income is paid directly to your bank account in the United
States and your employer
is located in New York City.
Example.
You are a U.S. citizen, a bona fide resident of Canada, and working as a mining engineer. Your salary is $76,800 per year.
You also receive a
$6,000 cost of living allowance, and a $6,000 education allowance. Your employment contract did not indicate that you were
entitled to these
allowances only while outside the United States. Your total income is $88,800. You work a 5-day week, Monday through Friday.
After subtracting your
vacation, you have a total of 240 workdays in the year. You worked in the United States during the year for 6 weeks (30 workdays).
The following shows
how to figure the part of your income that is for work done in Canada during the year.
| |
Number of days worked in Canada during the year (210)
|
×
|
Total income ($88,800)
|
=
|
$77,700
|
|
| |
Number of days of work during the year for which payment was made (240)
|
|
Your foreign source earned income is $77,700.
Earned and Unearned Income
Earned income was defined earlier as pay for personal services performed. Some types of income are not easily identified as
earned or unearned
income. Some of these types of income are further explained here.
Income from a sole proprietorship or partnership.
Income from a business in which capital investment is an important part of producing the income may be unearned income.
If you are a sole
proprietor or partner and your personal services are also an important part of producing the income, the part of the income
that represents the value
of your personal services will be treated as earned income.
Capital a factor.
If capital investment is an important part of producing income, no more than 30% of your share of the net profits
of the business is earned income.
If you have no net profits, the part of your gross profit that represents a reasonable allowance for personal services
actually performed is
considered earned income. Because you do not have a net profit, the 30% limit does not apply.
Example 1.
You are a U.S. citizen and meet the bona fide residence test. You invest in a partnership based in Cameroon that is engaged
solely in selling
merchandise outside the United States. You perform no services for the partnership. At the end of the tax year, your share
of the net profits is
$80,000. The entire $80,000 is unearned income.
Example 2.
Assume that in Example 1 you spend time operating the business. Your share of the net profits is $80,000, 30% of your share of the
profits is $24,000. If the value of your services for the year is $15,000, your earned income is limited to the value of your
services, $15,000.
Capital not a factor.
If capital is not an income-producing factor and personal services produce the business income, the 30% rule does
not apply. The entire amount of
business income is earned income.
Example.
You and Lou Green are management consultants and operate as equal partners in performing services outside the United States.
Because capital is not
an income-
producing factor, all the income from the partnership is considered earned income.
Income from a corporation.
The salary you receive from a corporation is earned income only if it represents a reasonable allowance as compensation
for work you do for the
corporation. Any amount over what is considered a reasonable salary is unearned income.
Example 1.
You are a U.S. citizen and an officer and stockholder of a corporation in Honduras. You perform no work or service of any
kind for the corporation.
During the tax year you receive a $10,000 “salary” from the corporation. The $10,000 clearly is not for personal services and is unearned income.
Example 2.
You are a U.S. citizen and work full time as secretary-treasurer of your corporation. During the tax year you receive $100,000
as salary from the
corporation. If $80,000 is a reasonable allowance as pay for the work you did, then $80,000 is earned income.
Stock options.
You may have earned income if you disposed of stock that you got by exercising a stock option granted to you under
an employee stock purchase plan.
If your gain on the disposition of stock you got by exercising an option is treated as capital gain, your gain is
unearned income.
However, if you disposed of the stock less than 2 years after you were granted the option or less than 1 year after
you got the stock, part of the
gain on the disposition may be earned income. It is considered received in the year you disposed of the stock and earned in
the year you performed the
services for which you were granted the option. Any part of the earned income that is due to work you did outside the United
States is foreign earned
income.
See Publication 525, Taxable and Nontaxable Income, for a discussion of the treatment of stock options.
Pensions and annuities.
For purposes of the foreign earned income exclusion, the foreign housing exclusion, and the foreign housing deduction,
amounts received as
pensions or annuities are unearned income.
Royalties.
Royalties from the leasing of oil and mineral lands and patents generally are a form of rent or dividends and are
unearned income.
Royalties received by a writer are earned income if they are received:
-
For the transfer of property rights of the writer in the writer's product, or
-
Under a contract to write a book or series of articles.
Rental income.
Generally, rental income is unearned income. If you perform personal services in connection with the production of
rent, up to 30% of your net
rental income can be considered earned income.
Example.
Larry Smith, a U.S. citizen living in Australia, owns and operates a rooming house in Sydney. If he is operating the rooming
house as a business
that requires capital and personal services, he can consider up to 30% of net rental income as earned income. On the other
hand, if he just owns the
rooming house and performs no personal services connected with its operation, except perhaps making minor repairs and collecting
rents, none of his
net income from the house is considered earned income. It is all unearned income.
Professional fees.
If you are engaged in a professional occupation (such as a doctor or lawyer), all fees received in the performance
of these services are earned
income.
Income of an artist.
Income you receive from the sale of paintings is earned income if you painted the pictures yourself.
Scholarships and fellowships.
Any portion of a scholarship or fellowship grant that is paid to you for teaching, research or other services is considered
earned income if you
must include it in your gross income. If the payer of the grant is required to provide you with a Form W-2, these amounts
will be listed as wages.
Certain scholarship and fellowship income may be exempt under other provisions. See Publication 970, Tax Benefits for Education,
chapter 1.
Use of employer's property or facilities.
If you receive fringe benefits in the form of the right to use your employer's property or facilities, the fair market
value of that right is
earned income. Fair market value is the price at which the property would change hands between a willing buyer and a willing
seller, neither being
required to buy or sell, and both having reasonable knowledge of all the necessary facts.
Example.
You are privately employed and live in Japan all year. You are paid a salary of $6,000 a month. You live rent-free in a house
provided by your
employer that has a fair rental value of $3,000 a month. The house is not provided for your employer's convenience. You report
on the calendar-year,
cash basis. You received $72,000 salary from foreign sources plus $36,000 fair rental value of the house, or a total of $108,000
of earned income.
Reimbursement of employee expenses.
If you are reimbursed under an accountable plan (defined below) for expenses you incur on your employer's behalf and
you have adequately accounted
to your employer for the expenses, do not include the reimbursement for those expenses in your earned income.
The expenses for which you are reimbursed are not considered allocable (related) to your earned income. If expenses
and reimbursement are equal,
there is nothing to allocate to excluded income. If expenses are more than the reimbursement, the unreimbursed expenses are
considered to have been
incurred in producing earned income and must be divided between your excluded and included income in determining the amount
of unreimbursed expenses
you can deduct. (See chapter 5.) If the reimbursement is more than the expenses, no expenses remain to be divided between
excluded and included income
and the excess reimbursement must be included in earned income.
These rules do not apply to the following individuals.
-
Straight-commission salespersons.
-
Employees who have arrangements with their employers under which taxes are not withheld on a percentage of the commissions
because the
employers consider that percentage to be attributable to the employees' expenses.
Accountable plan.
An accountable plan is a reimbursement or allowance arrangement that includes all three of the following rules.
-
The expenses covered under the plan must have a business connection.
-
The employee must adequately account to the employer for these expenses within a reasonable period of time.
-
The employee must return any excess reimbursement or allowance within a reasonable period of time.
Reimbursement of moving expenses.
Earned income may include reimbursement of moving expenses. You must include as earned income:
-
Any reimbursements of, or payments for, nondeductible moving expenses,
-
Reimbursements that are more than your deductible expenses and that you do not return to your employer,
-
Any reimbursements made (or treated as made) under a nonaccountable plan (any plan that does not meet the rules listed above
for an
accountable plan), even if they are for deductible expenses, and
-
Any reimbursement of moving expenses you deducted in an earlier year.
This section discusses reimbursements that must be included in earned income. Publication 521, Moving Expenses, discusses
additional rules that
apply to moving expense deductions and reimbursements.
The rules for determining when the reimbursement is considered earned or where the reimbursement is considered earned
may differ somewhat from the
general rules previously discussed.
Although you receive the reimbursement in one tax year, it may be considered earned for services performed, or to
be performed, in another tax
year. You must report the reimbursement as income on your return in the year you receive it, even if it is considered earned
during a different year.
Move from U.S. to foreign country.
If you move from the United States to a foreign country, your moving expense reimbursement is generally considered
pay for future services to be
performed at the new location. The reimbursement is considered earned solely in the year of the move if you qualify for the
exclusion for a period
that includes at least 120 days during that tax year.
If you do not qualify under either test for 120 days during the year of the move, a portion of the reimbursement is
considered earned in the year
of the move and a portion is considered earned in the year following the year of the move. To figure the amount earned in
the year of the move,
multiply the reimbursement by a fraction. The numerator (top number) is the number of days in your qualifying period that
fall within the year of the
move, and the denominator (bottom number) is the total number of days in the year of the move.
The difference between the total reimbursement and the amount considered earned in the year of the move is the amount
considered earned in the year
following the year of the move. The part earned in each year is figured as shown in the following example.
Example.
You are a U.S. citizen working in the United States. You were told in October 2005 that you were being transferred to a foreign
country. You
arrived in the foreign country on December 15, 2005, and you qualify as a bona fide resident for the remainder of 2005 and
all of 2006. Your employer
reimbursed you $2,000 in January 2006 for the part of the moving expense that you were not allowed to deduct. Because you
did not qualify as a bona
fide resident for at least 120 days in 2005 (the year of the move), the reimbursement is considered pay for services performed
in the foreign country
for both 2005 and 2006.
You figure the part of the reimbursement for services performed in the foreign country in 2005 by multiplying the total reimbursement
by a
fraction. The fraction is the number of days during which you were a bona fide resident during the year of the move divided
by 365. The remaining part
of the reimbursement is for services performed in the foreign country in 2006.
This computation is used only to determine when the reimbursement is considered earned. You would include the amount of the
reimbursement in income
in 2006, the year you received it.
Move between foreign countries.
If you move between foreign countries, any moving expense reimbursement that you must include in income will be considered
earned in the year of
the move if you qualify for the exclusion for a period that includes at least 120 days in the year of the move.
Move to U.S.
If you move to the United States, the moving expense reimbursement that you must include in income is generally considered
to be U.S. source
income.
However, if under either an agreement between you and your employer or a statement of company policy that is reduced
to writing before your move to
the foreign country, your employer will reimburse you for your move back to the United States regardless of whether you continue
to work for the
employer, the includible reimbursement is considered compensation for past services performed in the foreign country. The
includible reimbursement is
considered earned in the year of the move if you qualify for the exclusion for a period that includes at least 120 days during
that year. Otherwise,
you treat the includible reimbursement as received for services performed in the foreign country in the year of the move and
the year immediately
before the year of the move.
See the discussion under Move from U.S. to foreign country (earlier) to figure the amount of the includible reimbursement considered
earned in the year of the move. The amount earned in the year before the year of the move is the difference between the total
includible reimbursement
and the amount earned in the year of the move.
Example.
You are a U.S. citizen employed in a foreign country. You retired from employment with your employer on March 31, 2006, and
returned to the United
States after having been a bona fide resident of the foreign country for several years. A written agreement with your employer
entered into before you
went abroad provided that you would be reimbursed for your move back to the United States.
In April 2006, your former employer reimbursed you $2,000 for the part of the cost of your move back to the United States
that you were not allowed
to deduct. Because you were not a bona fide resident for at least 120 days in 2006 (the year of the move), the includible
reimbursement is considered
pay for services performed in the foreign country for both 2006 and 2005.
You figure the part of the moving expense reimbursement for services performed in the foreign country for 2006 by multiplying
the total includible
reimbursement by a fraction. The fraction is the number of days of foreign residence during the year (90) divided by the number
of days in the year
(365). The remaining part of the includible reimbursement is for services performed in the foreign country in 2005. You report
the amount of the
includible reimbursement on your Form 1040 for 2006, the year you received it.
In this example, if you qualified under the physical presence test for a period that included at least 120 days in 2006, the
moving expense
reimbursement would be considered earned entirely in the year of the move.
Storage expense reimbursements.
If you are reimbursed for storage expenses, the reimbursement is for services you perform during the period of time
for which the storage expenses
are incurred.
U.S. Government Employees
For purposes of the foreign earned income exclusion, the foreign housing exclusion, and the foreign housing deduction, foreign
earned income does
not include any amounts paid by the United States or any of its agencies to its employees. Payments to employees of nonappropriated
fund activities
are not foreign earned income. Nonappropriated fund activities include the following employers.
-
Armed forces post exchanges.
-
Officers' and enlisted personnel clubs.
-
Post and station theaters.
-
Embassy commissaries.
Amounts paid by the United States or its agencies to persons who are not their employees may qualify for exclusion or deduction.
If you are a U.S. Government employee paid by a U.S. agency that assigned you to a foreign government to perform specific
services for which the
agency is reimbursed by the foreign government, your pay is from the U.S. Government and does not qualify for exclusion or
deduction.
If you have questions about whether you are an employee or an independent contractor, get Publication 15-A, Employer's Supplemental
Tax Guide.
American Institute in Taiwan.
Amounts paid by the American Institute in Taiwan are not foreign earned income for purposes of the foreign earned
income exclusion, the foreign
housing exclusion, or the foreign housing deduction. If you are an employee of the American Institute in Taiwan, allowances
you receive are exempt
from U.S. tax up to the amount that equals tax-exempt allowances received by civilian employees of the U.S. Government.
Allowances.
Cost-of-living and foreign-area allowances paid under certain Acts of Congress to U.S. civilian officers and employees
stationed in Alaska and
Hawaii or elsewhere outside the 48 contiguous states and the District of Columbia can be excluded from gross income. Post
differentials are wages that
must be included in gross income, regardless of the Act of Congress under which they are paid.
More information.
Publication 516 has more information for U.S. Government employees abroad.
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