Life as an American living abroad can conjure idyllic notions of painting en plein air in Paris or negotiating a last minute deal in Brussels. Not so idyllic, however, is the reality of filing U.S. tax returns from overseas. One of U.S. taxpayers living abroad is avoiding double-taxation of income by both the U.S. and the host country. Achieving this goal can be a confusing and complicated task and there can be many issues such as obtaining documentation, meeting various qualification requirements and the timing of when tax payments are made.
Avoiding Double-Taxation with the Foreign Earned Income Exclusion
To address double-taxation, income tax treaties exist between the U.S. and about seventy other countries. Additionally, a U.S. taxpayer may qualify for one or more of a number of tax benefits created under the Internal Revenue Code to lessen or remove exposure to double-taxation. One of the most powerful of those can be the foreign earned income exclusion (FEIE).
The FEIE permits a U.S. taxpayer who has earned foreign income for services performed to exclude that income from being taxed by the U.S. There is an inflation-adjusted limit to the amount of income which may be excluded, and the cap for 2017 is $102,300. Generally, the type of income which may be excluded consists of wages, salaries, and/or professional fees.
Qualifying Residency Tests. Claiming the FEIE, isn’t automatic. First, a taxpayer must show they are a qualified individual for the purposes of the FEIE. This requires meeting the tax home test and either the bona fide residence or physical presence test. These tests, when met, demonstrate foreign residency on behalf of the taxpayer. The tax home test is based on facts and circumstances, but the other two tests are based on time spent in the host country.
Foreign Earned Income Exclusion Election. The second hurdle for FEIE is that the taxpayer must make an election on IRS Form 2555 (or 2555-EZ) in order to apply the exclusion against their foreign earned income. As previously stated, the FEIE is not automatic. The taxpayer must take the affirmative step of timely filing Form 2555 or else the exclusion may be lost. This is not a tax benefit you want to lose. Many people with foreign income and who meet the first step, misunderstand this requirement and don’t file, thinking they have no income to report due to the FEIE.
Timely Election on Form 2555 to Claim the Foreign Earned Income Exclusion
How do you make sure you don’t lose your eligibility to claim the FEIE? Generally, there are four methods by which a taxpayer may make a timely election. The first three are straightforward, the fourth can be confusing:
1. File Form 2555 with a timely filed U.S. income tax return.
- “Timely Filed.” This includes any extensions to file the return. U.S. taxpayers residing overseas generally are eligible for four extensions of time:
– An automatic extension to June 15th to file and pay (interest may apply);
– An extension until October 15th by filing Form 4868;
– A discretionary two-month extension to December 15th by submitting a letter to the IRS; and
– An extension of time time to meet the qualifying residency tests by filing Form 2350.
2. The election can be made with an amendment to a timely filed return.
- There is a timeframe for filing amendments under Section 6511(a). The amended return must be filed within three years of the filing of the original return or two years from when payment was made, whichever is later.
3. With an original return filed within one year after the due date of the return.
- Extension periods do not apply.
- This timeframe does not constitute an extension to file a return; it is just a timeframe to accommodate making a valid FEIE election.
What If You Don’t File Within the Timeframes Listed Above?
The fourth method to claim the election for the foreign earned income exclusion is more complicated. If you do not claim the election under the three methods above, you can still make the election by filing Form 2555 with a federal income tax return, if:
- No federal income tax is owed after taking the exclusion into account.
In Chief Counsel Memorandum Number 200226010, the IRS clarified that examiners should not be looking at the total tax line (line 63) on Form 1040, but at whether the taxpayer has a refund or a balance due.
This means that any taxes withheld or paid and any credits should be offset against the federal income tax liability to determine whether the taxpayer “owes no federal income tax”. Therefore, if the taxpayer has a refund or no balance due, they can claim the FEIE.
- Federal income tax is owed by the taxpayer, but the taxpayer files Firm 1040 along with Form 2555 BEFORE the IRS discovers that the taxpayer has failed to make an election for FEIE.
- If the taxpayer qualifies for under the provisions of the fourth method, they must type or print on the first page of Form 1040: “Filed Pursuant to Section 1.911-7(a)(2(i)(D).”
This second situation under the fourth method requires a closer look.
Discovery by IRS of Failure to Make the FEIE Election: The Redfield Case.
The important word here is “discovers” –what does this mean? Recently, in Redfield v. Commissioner, T.C. Memo. 2017-71 (2017), a taxpayer found out that the meaning favors the IRS. In that case, the taxpayer, a former U.S. Marine had left the Corps after serving twelve years, including tours in Afghanistan, as a disabled veteran. The facts indicate that he suffered from memory loss and post-traumatic stress. After a period of recuperation, he took a civilian contract position in Afghanistan, believing he was well-enough to complete his assignment. Instead, his condition worsened and he had to return back to the United States.
The taxpayer did not file a timely return and did not make a timely FEIE election. After more than three years from the return’s due date, the IRS prepared a substitute return and assessed a tax deficiency of more than $50,000 and other additions to tax. The taxpayer responded by filing a delinquent return four months later and claiming the foreign earned income exclusion on Form 2555. However, after applying the FEIE, he still owed tax of more than $6,000.
The IRS disallowed the taxpayer’s FEIE claim and the Tax Court upheld this disallowance. The Tax Court held that when the IRS prepared the substitute tax return for the taxpayer, they had discovered that the return had not been filed and that the FEIE election had not been made. The substitute return was evidence of the discovery. This was not the first time the Tax Court had ruled that the preparation of a substitute return constituted discovery that a taxpayer failed to make a timely FEIE election.
The Tax Court was not unsympathetic to the taxpayer. It recognized the taxpayer’s military service and that he did not leave the military unscathed. However, the Tax Court found it was had no other option than to uphold the timely election requirement. They expressed regret but the requirements came from regulations issued by the Secretary of the Treasury under authority delegated by Congress and the Tax Court’s prior construction of these regulations. They did point out that the taxpayer’s circumstances for delinquent filing could be relevant to the determination of penalties and additions to tax.
The best practice is always going to be to timely file your FEIE election. It’s important to understand that it is a tax election and not automatic. As seen in the Redfield case, if taxpayers owes tax of any amount after considering the FEIE and the IRS discovers the taxpayer’s failure to take a valid election, the election is lost. There’s no reasonable cause argument which can recover the election, as seen in the unfortunate outcome in the Redfield case.
 The foreign earned income exclusion amount for 2016 is $101,300.
 See Treas. Reg. 1.911-7(a)(2)(i)(D).
 See McDonald v. Commissioner, T.C. Memo. 2015-169 (2016).
If you need assistance determining your foreign earned income exclusion and making a timely election, the tax attorneys at M. Robinson and Company have experience with international tax issues affecting U.S. taxpayers; we may be able to assist you. Please feel free to contact us at 617-428-6900 with questions. The material in this publication does not constitute legal advice. It is intended for general information purposes only.
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