What is Foreign Earned Income?
For U.S. taxpayers living or working abroad, the term foreign earned income comes up frequently. But what exactly makes income "foreign," and what makes it "earned"?
The answer is important because foreign earned income may qualify for special U.S. tax treatment, including the Foreign Earned Income Exclusion (FEIE).
It Is About Where You Work
One of the most important things to understand is that foreign earned income is determined by where you perform the work, not where your employer or client is located and not where the money is deposited.
For example, suppose a U.S. citizen moves to Spain and continues working remotely for a U.S. company. The employee's wages for services performed while working in Spain are foreign earned income, even though the employer is an American company and the employee is paid in U.S. dollars into a U.S. bank account.
Likewise, a self-employed consultant living abroad may have foreign earned income from services performed outside the United States, even when the consultant's clients are located in the United States.
What Does "Earned" Mean?
Foreign earned income generally means compensation received for personal services you perform in a foreign country.
It can include:
- Wages and salaries
- Professional fees
- Commissions
- Bonuses
- Certain allowances or reimbursements
- Self-employment income from services performed abroad
The key idea is that you are receiving the income because of work or services you performed.
What Is Not Earned Income?
Not all income received while living overseas is foreign earned income.
Income that generally does not qualify includes:
- Interest
- Dividends
- Capital gains
- Pensions and annuities
- Social Security benefits
- Most passive rental income
These types of income may still have U.S. tax consequences, but they generally are not considered earned income for purposes of the Foreign Earned Income Exclusion.
Living Abroad Does Not Automatically Make Your Income Foreign Earned Income
Simply moving to another country does not mean that all of your income becomes foreign earned income.
For example, a retiree living in Portugal who receives a pension, Social Security benefits, dividends, and investment income does not suddenly have foreign earned income simply because those payments are received while living in Portugal.
On the other hand, if that same person begins consulting and performs the consulting work while living abroad, the consulting income may be foreign earned income.
Foreign Earned Income Does Not Automatically Mean Tax-Free Income
This is another important distinction.
Having foreign earned income and being eligible to exclude foreign earned income are two different things.
U.S. citizens and resident aliens remain subject to U.S. taxation on worldwide income. A taxpayer with foreign earned income may be able to use the Foreign Earned Income Exclusion, foreign housing provisions, the Foreign Tax Credit, or a combination of tax provisions to reduce double taxation.
Eligibility for the Foreign Earned Income Exclusion has additional requirements, including having a foreign tax home and meeting either the Bona Fide Residence Test or the Physical Presence Test.
The exclusion also is not automatic. Generally, it is claimed by filing Form 2555, Foreign Earned Income, with the taxpayer's federal income tax return.
Self-Employed Taxpayers Need to Be Especially Careful
A qualifying self-employed taxpayer may claim the FEIE on qualifying foreign earned self-employment income. However, the FEIE generally reduces regular U.S. income tax, not self-employment tax. A Social Security totalization agreement may affect the self-employment tax result in some countries.
The Bottom Line
Foreign earned income is income you earn by performing work or services in a foreign country.
The location of your employer, your clients, your bank account, or the currency in which you are paid does not by itself determine whether income is foreign earned income.
Once you determine that income is foreign earned income, the next question is whether you qualify for the Foreign Earned Income Exclusion or whether another provision, such as the Foreign Tax Credit, would produce a better tax result.
The article is meant for informational purposes only. Please contact me directly to discuss how this applies to your individual tax situation.