Applying the Foreign Earned Income Exclusion to International Waters
For many U.S. expats, the key mechanism for preventing double income taxation is the foreign earned income exclusion (FEIE), a U.S. expat tax basic concept. The FEIE allows income earned abroad to be excluded on the U.S. income tax return, up to the annual exclusion amount ($107,600 in 2020). This means that the expat’s income up to this amount will be taxed only once – in the expat’s country of residence.
As its name denotes, the foreign earned income exclusion requires the U.S. person’s earned income to be “foreign”, meaning sourced in a foreign country. Simply put, income earned inside the U.S. does not qualify while income earned in a foreign country does qualify.
In this blog, we explore a third scenario – where income is not earned in the United States, nor is it earned in a foreign country, but rather in international waters, a significant area of the world that is not under the territory of any one particular country.
Applying the FEIE to this scenario is particularly relevant for those with ocean jobs and other careers on the water, such as merchant marines, or those who travel regularly or live in international waters (commonly known as seasteading).
International Waters and the Physical Presence Test
The physical presence of an individual can impact an expat’s ability to claim the FEIE in two potential ways – first, it affects one’s ability to qualify for the FEIE, and second, it affects the amount of the exclusion that can be claimed.
In terms of qualification, a U.S. individual must pass either a bona fide residence test or a physical presence test. The more objective “physical presence” test is passed if the individual is present in a foreign country for 330 full days during any period of 12 consecutive months.
In this regard, U.S. courts have ruled that days of presence in international waters do not count as days of presence in a foreign country. In most cases, therefore, those who live or work a significant amount of days in international waters must demonstrate that they are otherwise bona fide residents of a foreign country in order to qualify for the FEIE.
We note in this regard, that in response to the coronavirus pandemic, the IRS recently announced that qualification for the FEIE will not be impacted as a result of days spent away from a foreign country due to the pandemic based on certain departure dates. You can read more about this leniency here.
International Waters and the Work Day Limitation
In terms of exclusion amount, if the individual passes the bona fide residence test, the amount of the exclusion is limited to the percentage of work days while physically present in the foreign country over the entire work days during the tax year.
In this regards, U.S. courts have ruled that days of presence in international waters are considered “bad” days, meaning they increase the work day limitation (which lowers the exclusion amount).
The Case of Mr. Wilson in International Waters
The Tax Court last addressed the issue of applying the FEIE to international waters in a case called Wilson v. Commissioner, T.C. Summary Opinion 2016-19. In the Wilson case, the taxpayer was a resident of Mexico who worked as a ship’s engineer in the merchant marine. His only employment during the tax years at issue was as an engineer on board oceangoing container ships.
The Tax Court found that the Mr. Wilson was in fact a bona fide resident of Mexico so he qualified for the FEIE. However, the Court also found that Mr. Wilson’s FEIE amount should be limited because of the fact that he worked many days in international waters.
The record showed that Mr. Wilson worked in international waters for 134 days during 2009 and 124 days during 2010. During 2009, Mr. Wilson worked a total of 175 days, so that 23% (41 divided by 175) of his income was exempt from U.S. taxation. During 2010, Mr. Wilson worked a total of 146 days, so that 15% (22 divided by 146) of his income was exempt from U.S. taxation.
The Takeaway for U.S. Expats
The foreign earned income exclusion is a key tool for U.S. expats when it comes to filing taxes. The exclusion may look simple, but a number of nuances to the rules make claiming the FEIE more complex than at first blush.
If you are a U.S. expat and want to maximize your foreign earned income exclusion, we’re here to help! Contact us for more information.