Tax on Foreign Income of US Citizens or Residents

Foreign Earned Income Exclusion

Individual US citizens and residents are taxed on their worldwide income. However, IRC Sec. 911 provides that qualified taxpayer can elect to exclude foreign earned income up to $80,000 from taxable income. (Read IRS Pub 54 for more details.) The qualifications are:

1. A citizen or resident of the US who has been a bona fide resident of a foreign country for an entire taxable year; or

2. A citizen or resident of US who is present in a foreign country during at least 330 full days during any period of 12 consecutive months.

Additionally, the excludable income must be "earned income", meaning compensation for personal services actually performed in the foreign country when the taxpayer qualifies for bona fid resident or physical presence test.

Qualified taxpayers can elect to take the foreign earned income election by filing Form 2555 with their tax return. However, foreign tax paid will be allocated on total foreign source income, any foreign tax allocated to the excluded foreign earned income cannot qualify a tax credit again. Therefore, taxpayers should consider taking full foreign tax credit rather than the exclusion if the foreign effective tax rate is higher than US.

Note: Dates spent in or income from Cuba, Iraq and Libya do not qualify. (Form 2555 instruction)

Foreign Tax Credit

Generally, taxes paid to foreign governments are deductible in the same manner a US state and local taxes on Schedule A. Alternatively, taxpayers can elect to claim foreign income tax as a credit by filling Form 1116 annually. In most instances, foreign tax credit saves more income tax than a deduction, and also avoids triggering AMT. One caution is that any foreign tax allocated to excluded earned income is not eligible as either deduction or credit.

For example if a qualified US citizen paid $20,000 foreign tax on his foreign earned income of $100,000, and claimed foreign earned income exclusion of $80,000. Then only 20% of foreign tax paid ($4,000 can be taken as a foreign tax credit or deduction).