Under Internal Revenue Code (IRC) Sec. 911, Citizens or Resident of the U.S. Living Abroad, arises Form 2555, Foreign Earned Income which is filed to claim the Foreign Earned Income Exclusion, Housing Exclusion and/ or Housing Deduction.
Form 2555 is an IRS 3 page Form 2555, Foreign Earned Income, broken out by 9 parts:
Form 2555 Part I page 1- General Information-, is used to gather general information about the taxpayer and the foreign assignment and to ensure compliance with the Tax Home Test.
Form 2555 Parts II & III pages 1 and 2- represent the qualification tests.
Form 2555 page 1 bottom Part II- Taxpayers Qualifying under the Bona Fide Residence Test- addresses the Bona Fide Resident Test.
Form 2555 page 2 top Part III- Taxpayers qualifying under the Physical Presence Test- addresses the Physical Presence Test.
Form 2555 page 2 Parts IV All Taxpayers- breaks out the different types of foreign earned income eligible for the Foreign Earned Income Exclusion.
Form 2555 Part VI page 3- Taxpayers Claiming the Housing Exclusion and/ or Deduction- states the Qualified Foreign Hosing costs, the Housing cap and the Housing Norm or base. Part VI then goes on to calculate the actual Housing Exclusion, or if self-employed transfers the applicable Housing amount to Part IX to be used for the Housing Deduction.
Form 2555 Part VII page 3-Taxpayers Claiming the Foreign Earned Income Exclusion- calculates the applicable full year or prorated Foreign Earned Income Exclusion
Form 2555 Part VIII page 3- Taxpayers Claiming the Housing Exclusion, Foreign Earned Income Exclusion or Both- amalgamates the Foreign Earned Income Exclusion and the Housing Exclusion together to send the total amount to Form 1040 line 7, Schedule 1 – Part I Line 8
Form 2555 Part IX page 3- Taxpayers Claiming the Housing Deduction- calculates the Housing Deduction and transfers it to Form 1040 line 8a, Schedule 1- Part I Line 22 Adjusted Gross Income.
There are three ways U.S. expats can avoid double taxation while abroad on a foreign assignment: The Foreign Earned Income Exclusion; the Foreign Housing Exclusion- (if employed) or/ and the Foreign Housing Deduction – (if self-employed); all found on Form 2555- Foreign Earned Income and the Foreign Tax Credit.
To qualify for the Foreign Earned Income Exclusion, a taxpayer must meet two tests: 1) all taxpayers must meet the Tax Home Test and then meet either 2) a) the Bona Fide Residence Test or b) the Physical Presence Test.
The Foreign Earned Income Exclusion found on Form 2555 is an elective per spouse tax break on foreign income that is earned while residing and working abroad outside the U.S.
In partial years residing abroad- years expatriating from the U.S. or repatriating back to the U.S.- the Foreign Earned Income Exclusion is pro-ratable based upon the number of days in that calendar year residing abroad over 365 (366 leap year) days.
‘Earned income’ in Foreign Earned Income
Earned income is generally wages or self-employed income, but not pension, annuity, social security benefit, or U.S. government wage income. Earned income may also include business profits, royalties and rents, but certainly excludes income from property such as interest, dividend and capital gain income, and excludes other income such as alimony, prizes and gambling winnings.
‘Foreign’ in Foreign Earned Income
Foreign Earned Income is non- U.S. sourced earned income. The sourcing of Earned income is dependent on where the related services are physically performed, by workdays. Wages, bonuses and options are always allocable between U.S. and Foreign workdays, whereas other types compensation items related specifically to only foreign workdays are treated as 100% foreign always (IRS Revenue Ruling 69-238), such as: Quarters (Housing), Home Leave, Education Allowances, Cola’s, Moving expenses and Tax Equalization or Protection.