By Vernon K. Jacobs,
CPA
& J. Richard Duke,
J.D., LLM
| Foreign Earned
Income Exclusion
By Vernon K. Jacobs,
CPA |
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This is a huge tax break for certain self employed people who have “portable trades” or businesses. It’s also a great break for employees who have jobs that involve extended international assignments and who don’t have to spend a lot of time in the corporate offices.
U.S. persons who work and live for at least a full year in a foreign country may exclude up to $92,400 of earned income - or self employment earnings - from U.S. taxes in 2006. (This amount will be indexed to keep pace with inflation.) To the extent that the foreign country imposes tax on income earned in the their country, this is not a way to avoid taxes entirely. The key is whether the country in which you work and live imposes substantially less taxes than what you would have to pay in the U.S. And, in a few cases, you may be able to create a job for yourself in a tax haven country where there is no tax on your earnings.
For example, a couple who were writers and self-publishers moved to the Bahamas for two years. Their publishing business was a U.S. corporation that continued to publish and sell their books and newsletters. They each received compensation of $70,000 a year for two years while working in the Bahamas in the early nineties. Their salaries were deductible by their U.S. corporation the same as when the couple worked in the U.S. After piling up $280,000 of tax free earnings, they returned to the U.S. For them, two years in paradise was more than enough.
The pre-97 law permitted individuals who
worked and lived abroad to
exclude up to $70,000 a year of earnings each year from U.S. taxes.
That’s now been increased $92,400 per
year for 2006.
This exclusion is an alternative to the foreign tax credit , which is often a better choice for those who work in high tax foreign countries. The exclusion is more beneficial for those who work in low tax countries.
It isn’t necessary that you live in the
same foreign country for the
entire time. You can move from country to country. The test is that you
must live and work abroad for at least 330 days out of 12 consecutive
months to
qualify for the full exclusion. Time spent traveling between countries
is counted as time spent working in a foreign country. The exclusion is
only available after the U.S. person has lived offshore for at least
330
days out of any full year.
Other income realized or earned while working abroad is still subject to U.S. tax. Any earnings in excess of the exclusion, any capital gains, interest, dividends, royalties or other income is subject to U.S. taxes.
For those who are self employed and don’t own a corporation, the exclusion is based on self employment earnings when capital is NOT a material income producing factor. Where capital is material, only 30% of the profits will count as compensation for the exclusion.
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