For U.S. persons living abroad, the foreign earned income exclusion (“FEIE”) under Section 911 of the Internal Revenue Code provides a significant measure of tax relief against the U.S. government’s unique system of citizenship-based taxation.
If you’re able to establish that your tax home is outside the U.S. and can satisfy either the bona fide residence test or the physical presence test, you can exclude from income a portion of your income earned overseas. To claim this exclusion, you must file a U.S. federal income tax return (Form 1040) and attach Form 2555.
In this blog, we review key limitations on the foreign earned income exclusion, including those particularly relevant for self-employed expats.
General Limitation on Exclusion Amount
The most basic limitation on the exclusion for foreign earned income is, of course, the maximum exclusion amount, which is indexed for inflation each year.
For the 2022 tax year, the maximum amount is $112,000, and this will increase to $120,000 for the 2023 tax year.
Limitation Due to Expenses of Self-Employed Expats
Perhaps less-well known is the rule under Section 911(d)(6) of the Code, which states that no deduction from gross income (e.g., for business expenses) is allowed to the extent such deduction is allocable to or chargeable against gross income excluded by the foreign earned income exclusion.
Mechanically, this rule is implemented not by requiring an adjustment to the allowable deductions on Schedule A of the taxpayer's income tax return, but by requiring that the amount of disallowed deductions be subtracted from the exclusion amount that flows from the Form 2555 to the “Other Income” line of the taxpayer's Form 1040.
So, for instance, in a simplified case, a self-employed expat with a foreign business that generates revenues of $1 million, but net profits of $500,000 due to deductible business expenses, should generally have their foreign exclusion cut by 50 percent.
Limitation Due to Nature of Business of Self-Employed Expats
This limitation is particularly relevant for self-employed expats and relates to the concept that the exclusion applies only to earned income, which generally includes wages for personal services. Under Section 911(d)(2)(B) of the Code, in the case of a taxpayer engaged in a trade or business in which both personal services and capital are material income-producing factors, a reasonable allowance as compensation for the personal services rendered by the taxpayer, not in excess of 30 percent of his share of the net profits of such trade or business, can be considered earned income.
So, for instance, in another simplified case, a self-employed expat with a foreign sales business that generates revenues of $100,000, only $30,000 would be considered earned income that could be excluded under the foreign earned income exclusion.
While this rule is less relevant for-service based businesses, self-employed expats with sales-oriented businesses should be particularly mindful of the 30-percent limitation.
Effect on Income Tax Rate Due to Stacking Rule
While not a limitation, per se, it’s important for those weighing the foreign tax credit versus the foreign earned income exclusion to consider the so-called “stacking” rule. Section 911(f) of the Code imposes this rule under which individuals claiming the foreign earned income exclusion are subject to the same marginal rates of tax as individuals with the same level of income who are not eligible for (or do not elect to claim) the exclusion. In other words, the exclusions are no longer treated as coming “off the top” of an individual's income.
Like the other limitations, calculation of the stacking rule can be complex, as it is affected by other credits and deductions taken by the self-employed expat. Careful consideration should be taken when claiming the foreign earned income exclusion in order to ensure that it’s claimed correctly and achieves the most efficient outcome on the tax return.