Self-Employed Professionals and Foreign Income – Part 2


In Part 1, I reviewed the tax reporting requirements for reporting foreign income and started the discussion about the foreign earned income and housing exclusions available.

To qualify for the foreign earned income exclusion, you must be (1) a bona fide resident of a foreign country for an uninterrupted period that includes an entire tax year or (2) be physically present in a foreign country for at least 330 full days during any period of 12 consecutive months.

Bona Fide Residence Test

To meet the bona fide residence test, you must have established a bona fide residence in a foreign country.  Your bona fide residence is not necessarily the same as your domicile.  Your domicile is your permanent home, the place to which you always return or intend to return.

EXAMPLE:  You could have your domicile in Boston, MA and a bona fide residence in Edinburgh, Scotland, if you intend to return eventually to Boston.  The fact that you go to Scotland does not automatically make Scotland your bona fide residence.  If you go there as a tourist, or on a short business trip, and return to the United States, you have not established bona fide residence in Scotland.  But if you go to Scotland to work for an indefinite or extended period and you set up permanent quarters there for yourself, you probably have established a bona fide residence in a foreign country, even though you intend to return eventually to the United States.

Determination

Questions of bona fide residence are determined according to each individual case, taking into account factors such as your intention, the purpose of your trip, and the nature and length of your stay abroad.  To meet the bona fide residence test, you must show the IRS that you have been a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year (for example, all of calendar 2012).  The IRS decides whether you are a bona fide resident of a foreign country largely on the basis of facts you report on Form 2555 (which you attach to your Form 1040 for the year you claim this status). IRS cannot make this determination until you file Form 2555.

Uninterrupted Period Including Entire Tax Year

To meet the bona fide residence test, you must reside in a foreign country or countries for an uninterrupted period that includes an entire tax year.  An entire tax year is from January 1 through December 31 for taxpayers who file their income tax returns on a calendar year basis.  You can leave the foreign country for brief or temporary trips back to the United States or elsewhere for vacation or business.  To keep (or establish for the first time) your status as a bona fide resident of a foreign country, you must have a clear intention of returning from such trips, without unreasonable delay, to your foreign residence or to a new bona fide residence in another foreign country.

EXAMPLE:  You arrived with your family in Lisbon, Portugal, on November 1, 2010.  Your assignment is indefinite, and you intend to live there with your family until your company (or self-employment activities) takes you back to the United States or another foreign country.  You immediately established residence there.  You spent April 2011 at a business conference in the United States.  Your family stayed in Lisbon.  Immediately following the conference, you returned to Lisbon and continued living there.  On January 1, 2012, you completed an uninterrupted period of residence for a full tax year (2011) and you meet the bona fide residence test.

[FLASHING LIGHTS]  IMPORTANT POINT!

Once you have established bona fide residence in a foreign country for an uninterrupted period that includes an entire tax year, you are a bona fide resident of that country for the period starting with the date you actually began the residence and ending with the date you abandon the foreign residence. Your period of bona fide residence can include an entire tax year plus parts of 2 other tax years.

EXAMPLE:  You were a bona fide resident of Lisbon from March 1, 2010, through April 14, 2012.  On April 15, 2012, you returned to the United States.  Since you were a bona fide resident of a foreign country for all of 2011, you were also a bona fide resident of a foreign country from March 1, 2010, through the end of 2010 and from January 1, 2012, through April 14, 2012.  This means you can apply the foreign earned income and housing exclusions to your foreign earned income in 2010, 2011 and 2012.    This would allow you to go back and amend your 2010 return (in 2012) to claim the exclusions that were not available to you before the filing deadline for that year.  [See my previous post “Correcting Mistakes AFTER You Have Filed.”]

Physical Presence Test

The alternative to the bona fide residence test is the physical presence test to qualify for the exclusions.

You meet the physical presence test if you are physically present in a foreign country or countries 330 full days during a period of 12 consecutive months.  The 330 days do not have to be consecutive.  Any U.S. citizen or resident alien can use the physical presence test to qualify for the exclusions.

The physical presence test is based only on how long you stay in a foreign country or countries.  This test does not depend on the kind of residence you establish, your intentions about returning, or the nature and purpose of your stay abroad.

330 Full Days

Generally, to meet the physical presence test, you must be physically present in a foreign country or countries for at least 330 full days during a 12-month period.  You can count days you spent abroad for any reason. You do not have to be in a foreign country only for employment or self-employment purposes.  You can be on vacation.  A full day is a period of 24 consecutive hours, beginning at midnight.

How To Figure the 12-Month Period

There are four rules you should know when figuring the 12-month period.

  1. Your 12-month period can begin with any day of the month.  It ends the day before the same calendar day, 12 months later.
  2. Your 12-month period must be made up of consecutive months.  Any 12-month period can be used if the 330 days in a foreign country fall within that period.
  3. You do not have to begin your 12-month period with your first full day in a foreign country or end it with the day you leave.  You can choose the 12-month period that gives you the greatest exclusion.
  4. In determining whether the 12-month period falls within a longer stay in the foreign country, 12-month periods can overlap one another.

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Parts 1 and 2 have covered the eligibility rules to take advantage of the foreign earned income and housing exclusions.  Part 3 will cover the mechanics of taking these exclusions on your return and the forms used.

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