Physical Presence 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 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 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. But if any part of your travel is not within a foreign country or countries and takes 24 hours or more, you will lose full days.

Example 1.   You leave England 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.

1. Your 12-month period can begin with any day of the month. It ends the day before the same calendar day, 12 months later.
2. 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.
3. 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.
4. 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, 2001, through August 31, 2002, except that you spend 28 days in February 2001 and 28 days in February 2002 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, 2001 - December 31, 2001, and September 1, 2001 - August 31, 2002. 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 on the next page.

Table 4–1

Exceptions to Tests

There are two exceptions to meeting the requirements under the bona fide residence and the physical presence tests.

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 2003, the IRS will publish in the Internal Revenue Bulletin a list of countries qualifying for the waiver for 2002 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 2002 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.

U.S. Travel Restrictions

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.

Currently, the countries to which travel restrictions apply and the beginning dates of the restrictions are as follows:

• Cuba - January 1, 1987
• Iraq - August 2, 1990
• Libya - January 1, 1987

The restrictions are still in effect in all three countries.

Foreign Earned Income

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.

1. Your tax home is in a foreign country.
2. You meet either the bona fide residence test or the physical presence test.

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.

1. The value of meals and lodging that you exclude from your income because it was furnished for the convenience of your employer.
2. Pension or annuity payments you receive, including social security benefits (see Pensions and annuities, later).
3. Pay you receive as an employee of the U.S. Government. (See U.S. Government Employees, later.)
4. Amounts you include in your income because of your employer's contributions to a nonexempt employee trust or to a nonqualified annuity contract.
5. Any unallowable moving expense deduction that you choose to recapture as explained under Recapture of Moving Expense Deduction in chapter 5.
6. 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 fees	winnings
Tips	Alimony
	Social security
	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).

Source of Earned 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.

If you receive a specific amount for work done in the United States, you must report that amount as U.S. source income. If you cannot determine how much is for work done in the United States, or for work done partly in the United States and partly in a foreign country, determine the amount of U.S. source income using the method that most correctly shows the proper source of your income.

In most cases you can make this determination on a time basis. U.S. source income is the amount that results from multiplying your total pay (including allowances, reimbursements other than for foreign moves, and noncash fringe benefits) by a fraction. The numerator (top number) is the number of days you worked within the United States. The denominator (bottom number) is the total number of days of work for which you were paid.

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 for work done in the United States during the year.

Number of days worked in the United States during the year (30) ÷ Number of days of work during the year for which payment was made (240) × Total income ($88,800) = $11,100.

Your U.S. source earned income is $11,100.

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. These types of income - specifically, income from sole proprietorships, partnerships, corporations, stock options, pensions, annuities, royalties, rents, and fringe benefits - are further explained here. Income from sole proprietorships and partnerships is generally treated differently than income from corporations.

Trade or business - 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.

Trade or business - 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 Canada. 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:

1. For the transfer of property rights of the writer in the writer's product, or
2. 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.

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, you must add the fair market value of that right to your pay. 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.

1. Straight-commission salespersons.
2. 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.

1. The expenses covered under the plan must have a business connection.
2. The employee must adequately account to the employer for these expenses within a reasonable period of time.
3. 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:

1. Any reimbursements of, or payments for, nondeductible moving expenses,
2. Reimbursements that are more than your deductible expenses and that you do not return to your employer,
3. 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
4. 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 your tax home is in a foreign country and you qualify under the bona fide residence test or physical presence test for 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 2001 that you were being transferred to a foreign country. You arrived in the foreign country on December 15, 2001, and you qualify as a bona fide resident for the remainder of 2001 and all of 2002. Your employer reimbursed you $2,000 in January 2002 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 last year (the year of the move), the reimbursement is considered pay for services performed in the foreign country for both 2001 and 2002.

You figure the part of the reimbursement for services performed in the foreign country in 2001 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 2002.

This computation is used only to determine when the reimbursement is considered earned. You would report the amount you include in income in 2002, 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 under either the bona fide residence test or the physical presence test 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 under the bona fide residence test or the physical presence test for 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, 2002, 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 2002, 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 2002 (the year of the move), the includible reimbursement is considered pay for services performed in the foreign country for both 2002 and 2001.

You figure the part of the moving expense reimbursement for services performed in the foreign country for 2002 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 2001. You report the amount of the includible reimbursement on your Form 1040 for 2002, 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 2002, 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.

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