In this video, we walk through 5 TCP practice questions about calculating the foreign-earned income exclusion. These questions are from TCP content area 1 on the AICPA CPA exam blueprints: Tax Compliance and Planning for Individuals and Personal Financial Planning.
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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Calculating the Foreign-Earned Income Exclusion
The FEIE allows U.S. citizens and resident aliens who are living and working in a foreign country to exclude a portion of their income earned abroad from U.S. income tax. The intention behind this is to mitigate double taxation of income earned overseas. This figure is adjusted annually for inflation.
Eligibility Criteria
To qualify for the FEIE, an individual must meet all three of the following criteria:
- Tax Home: Their tax home must be in a foreign country. A tax home is generally defined as the main place of employment or business during the tax year, irrespective of where the family home is located.
- Bona Fide Residence Test or Physical Presence Test: The taxpayer must satisfy either the bona fide residence test or the physical presence test.
Bona Fide Residence Test
This test applies to individuals who are bona fide residents of a foreign country or countries for an uninterrupted period that includes an entire tax year. Various factors are considered to determine bona fide residence, including:
- Intention or purpose of staying abroad
- Length and nature of the stay
- Establishment of a home in the foreign country
- Participation in community activities
- Nature of employment and the terms of the contract
- Taxpayer’s compliance with foreign country’s residence laws
Physical Presence Test
To meet this test, the taxpayer must be physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months. The 330 days do not need to be consecutive, but they must be full days, excluding the days of arrival and departure.
Calculating the Exclusion:
Standard Calculation
If the taxpayer meets either the bona fide residence or the physical presence test for the entire tax year, they can exclude the maximum amount set for that year.
Example:
Taxpayer: Sarah
Location: France
Income: $120,000
FEIE Limit: $112,000
- Eligibility: Sarah meets the bona fide residence test.
- Exclusion: She can exclude up to $112,000 of her earned income.
- Taxable Income: $120,000 – $112,000 = $8,000
Result: Sarah’s taxable income on her U.S. tax return is $8,000, with the remainder excluded under the FEIE.
Prorated Exclusion
If the taxpayer does not meet the test for the full year (e.g., changed employment or moved during the year), the exclusion amount can be prorated. The formula for proration is:
Prorated Exclusion = (Number of Qualifying Days in Tax Year / 365) x Maximum Annual Exclusion
Example:
Suppose a taxpayer earns $120,000 in salary and meets the physical presence test for 250 days of the tax year, with the maximum exclusion for the year being $108,700.
- Calculate the prorated exclusion: (250 days / 365 days) x $108,700 = $74,452
- Calculate the taxable income: $120,000 salary – $74,452 exclusion = $45,548
Implications for Gross Income
The FEIE reduces the portion of the taxpayer’s gross income that is subject to U.S. income tax. It is essential to note that the exclusion only applies to earned income from employment or self-employment activities conducted abroad. It does not apply to passive income such as dividends, rental income, capital gains, or income earned from the U.S. while working remotely in a foreign country.
