Self-Employed Professionals and Foreign Income – Part 3

Foreign Earned Income

To claim the foreign earned income exclusion or the foreign housing deduction (only when paid from self-employed earnings), you must have foreign earned income.   Foreign earned income generally is income you receive for services you perform during a period in which you meet both of the following requirements:

  • Your tax home is in a foreign country.  (Covered in Part 1 of this series).
  • You meet either the bona fide residence test or the physical presence test.  (Covered in Part 2 of this series).

As a self-employed professional, your foreign earned income includes your professional fees earned and business profits.   The source of your earned income is the place where you perform the services for which you received the income.  Foreign earned income is income you receive while working in a foreign country.  Where and how you are paid has no effect on the “source” of the income.  For example, income you receive for work done in Austria is income from a foreign source even if the income is paid directly to your bank account in the United States.

Royalties received by a writer, author or illustrator are earned income if they are received:

  • For the transfer of property rights of the writer in the writer’s product, or
  • Under a contract to write a book or series of articles.

Such royalties are reported on Schedule C for the self-employed writer, author or illustrator.

Foreign Earned Income Exclusion

Your foreign earned income exclusion is limited to your foreign earned income minus your foreign housing deduction.  You may be able to exclude up to $95,100 in 2012 ($97,600 in 2013) of your foreign earned income.  For 2012, you cannot exclude more than the smaller of:

  • $95,100, or
  • Your foreign earned income for the tax year minus your foreign housing deduction.

EXAMPLE:  You are a self-employed professional living and working in a foreign country and meet the bona fide residence or physical presence test.  Your net earnings (profit) from self-employment (after all business expenses) shown on Schedule C is $105,000.  You are allowed to deduct your foreign housing deduction of $9,084 (see Foreign Housing Deduction Example below) from this amount leaving a balance of $95,916.  Of this amount, you would be allowed to exclude $95,100, leaving only a balance of $816 subject to income tax on your U.S. Form 1040. Your personal exemption, allowed on your U.S. Form 1040, would offset this amount.

Income tax

Income tax (Photo credit: Alan Cleaver)

Foreign Housing Deduction

As a self-employed professional, you are allowed a foreign housing deduction to the extent these expenses were paid for by your self-employment earnings.  As with the foreign income exclusion, your tax home must be in a foreign country and you qualify as a bona fide resident or meet the physical presence test.

The Floor and the Ceiling

Your housing amount is the total of your housing expenses (such as rent, utilities, property insurance, rental of furniture and accessories, and residential parking) for the year minus the base housing amount.   The computation of the base housing amount is tied to the maximum foreign earned income exclusion.  The amount is 16% of the exclusion amount (computed on a daily basis), multiplied by the number of days in your qualifying period that fall within your tax year.  For 2012, the maximum foreign earned income exclusion is $95,100 per year; 16% of this amount is $15,216 or $41.57 per day.   To figure your base housing amount if you are a calendar-year taxpayer, multiply $41.57 by the number of your qualifying days.  Subtract the result from your total housing expenses (up to the applicable limit) to find your foreign housing deduction amount.

Your qualified housing expenses are generally limited to 30% of the maximum foreign earned income exclusion (computed on a daily basis), multiplied by the number of days in your qualifying period that fall within your tax year.  For 2012, the standard ceiling would be $28,530 ($95,100 times 30%), or $77.95 per day.  If you live in a high-cost locality, you will be allowed a higher ceiling amount.  The limits for high-cost localities are listed in the instructions for Form 2555.

EXAMPLE:  Your qualifying period includes all of 2012.  During the year, you spent $24,300 for your housing.  You did not live in a high-cost locality.  Since your actual housing expenses do not exceed the standard limit ($28,530), your actual housing costs ($24,300) minus the base housing amount ($15,216), or $9,084, will be your foreign housing deduction.

The housing deduction cannot be more than your foreign earned income minus your foreign earned income exclusion.  You can carryover to the next year (and the next year only) any part of your housing deduction that is not allowed because of the limit.  Situations involving married couples (both having foreign earned income) or involving separate households in a foreign country or countries will require further computations.  This series presents the requirements and benefits for a single, self-employed person.

As a self-employed professional, you will file Form 2555 with your annual return.  You are not eligible to use Form 2555-EZ.

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In Part 4, the conclusion to this series, I will review where items are reported on your return, discuss how self-employment taxes are handled, and provide some helpful resources.  

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.

Self-Employed Professionals and Foreign Income – Part 1

Reporting Foreign Income Required

If you are a United States citizen with income from sources outside the United States (foreign income), you must report all such income on your tax return unless it is exempt by United States law.  This is true whether you reside inside or outside the United States and whether or not you receive a Form W-2 (if an employee) or Form 1099 (self-employed) from the foreign payer.  This applies to earned income (such as wages, commissions, professional fees and author royalties) and unearned income (such as interest, dividends, capital gains, pensions and rents).

The United States taxes the worldwide income of U.S. citizens, resident aliens and domestic corporations, without regard to whether the income arose from a transaction or activity originating outside its geographic borders.

Qualifying for the Foreign Earned Income Exclusion

If you are a U.S. citizen or a resident alien of the United States and you live abroad, you may qualify to exclude from income up to $92,900 (2011 amount) of your foreign earnings. In addition, you can exclude or deduct certain foreign housing amounts.

Requirements:

To claim the foreign earned income exclusion, you must meet all three of the following requirements:

  1. Your “tax home” must be in a foreign country.  More about your tax home below.
  2. You must have foreign earned income.
  3. You must be one of the following:
  • A U.S. citizen who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year.
  • A U.S. resident alien who is a citizen or national of a country with which the United States has an income tax treaty in effect and who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year.
  • A U.S. citizen or a U.S. resident alien who is “physically present” in a foreign country or countries for at least 330 full days during any period of 12 consecutive months.

“Tax Home” in a Foreign Country

To qualify for the foreign earned income exclusion, your tax home must be in a foreign country throughout your period of bona fide residence or physical presence abroad (terms explained below).  Your tax home is the general area of your main place of business or employment regardless of where you maintain your family home.  Your tax home is the place where you are permanently or indefinitely engaged to work as an employee or self-employed individual (which could be the office in your home).

You are not considered to have a tax home in a foreign country for any period in which your abode (“abode” has been variously defined as one’s home, habitation, residence, domicile, or place of dwelling) is in the United States. However, your abode is not necessarily in the United States while you are temporarily in the United States.  Your abode is also not necessarily in the United States merely because you maintain a dwelling in the United States, whether or not your spouse or dependents use the dwelling.

What is a “Foreign Country?”

A foreign country includes any territory under the sovereignty of a government other than that of the United States.  Residence or presence in a U.S. possession (American Samoa, Guam, Mariana Islands) does not qualify you for the foreign earned income exclusion.  You may, however, qualify for an exclusion of your possession income on your U.S. return.  Residents of Puerto Rico and the U.S. Virgin Islands cannot claim the foreign earned income exclusion or the foreign housing exclusion.

In Part 2, we will review the bona fide residence and physical presence tests (you must meet one).

Writers and Foreign Travel Expenses – Part 2

By Gary A. Hensley

In Part 1, I reviewed the requirements to nail down the “entirely for business” foreign travel expense deduction.  In Part 2, I will cover the “primarily for business” foreign travel expense deduction, foreign conventions, and cruise ships.

Primarily for Business

If you travel outside the United States primarily for business but spend some of your time on other activities and you do not meet any of the four exceptions listed in Part 1 (to qualify for “entirely on business”), you generally cannot deduct all of your travel expenses.  You can only deduct the business portion of your cost of getting to and from your destination.  You must allocate the costs between your business and other activities to determine your deductible amount.  You must allocate your travel time on a day-to-day basis between business days and nonbusiness days.  The days you depart from and return to the United States are both counted as days outside the United States.

To figure the deductible amount of your round trip travel expenses, use the following fraction:  the numerator is the total number of business days outside the United States and the denominator is the total number of business and nonbusiness days of travel.

Your business days include:

  • any day you spend traveling to or from a business destination;
  • any day your presence is required at a particular place for a specific business purpose;
  • any day that your principal activity during working hours is the pursuit of your trade or business;
  • any day you are prevented from working because of circumstances beyond your control; and
  • weekends, holidays, and other necessary standby days if they fall between business days.

Example:  Your tax home is New York City.  You travel to London, where you have a business appointment on Friday.  You have another appointment on the following Monday.  Because your presence was required on both Friday and Monday, they are business days.  Because the weekend is between business days, Saturday and Sunday are counted as business days.  This is true even though you use the weekend for sightseeing, visiting friends, or other nonbusiness activity.

Conventions Held Outside the North American Area

You cannot deduct expenses for attending a convention, seminar, or similar meeting held outside the North American area unless:

  • The meeting is directly related to your trade or business, and
  • It is as reasonable to hold the meeting outside the North American area as in it.

If the meeting meets these requirements, you must also satisfy the rules for deducting expenses for business trips in general, covered in Part 1 (“entirely for business”) or above under “Primarily for Business.”

The following factors are taken into account to determine if it was “reasonable” to hold the meeting outside the North American area:

  • The purpose of the meeting and the activities taking place at the meeting.
  • The purposes and activities of the sponsoring organizations or groups.
  • The homes of the active members of the sponsoring organizations and the places at which other meetings of the sponsoring organizations or groups have been or will be held.
  • Other relevant factors you may present.

Cruise Ships – $2,000 annual limit 

Cruise Ship - Celebrity Infinity

You can deduct up to $2,000 per year of your expenses of attending conventions, seminars, or similar meetings held on cruise ships. All ships that sail are considered cruise ships.

You can deduct these expenses only if all of the following requirements are met:

  1. The convention, seminar or meeting is directly related to your trade or business.
  2. The cruise ship is a vessel registered in the United States.
  3. All of the cruise ship’s ports of call are in the United States or in possessions of the United States.
  4. You attach to your return a written statement signed by you that includes information about:
  • The total days of the trip (not including the days of transportation to and from the cruise ship port),
  • The number of hours each day that you devoted to scheduled business activities, and
  • A program of the scheduled business activities of the meeting.

5.  You attach to your return a written statement signed by an officer of the organization or group sponsoring the meeting that includes:

  • A schedule of the business activities of each day of the meeting, and
  • The number of hours you attended the scheduled business activities.

The cruise ship deduction is limited and requires signficant documentation attached to your return to substantiate it.  Another byproduct; these attachments may preclude e-filing your return.

Writers and Foreign Travel Expenses – Part 1

By Gary A. Hensley

Entirely on Business

If you travel abroad entirely on business as a writer, author, illustrator or literary agent, all of your travel costs are deductible; however, meal and entertainment costs are still subject to the 50-percent limit.  If your trip is considered to be entirely business, then even if some time is spent sightseeing or on other personal activities,  all of your transportation expenses are still deductible.

There are special rules for determining whether your trip is considered to be entirely for business.  You are treated as having spent your entire trip on business if you meet any of the following four rules:

1.  No substantial control.  Your trip is considered entirely for business if you did not have substantial control over arranging the trip.  The fact that you control the timing of your trip does not, by itself, mean that you have substantial control over arranging your trip.  You do not have substantial control over arranging your trip if you:

  • Are an employee who was reimbursed or paid a travel expense allowance,
  • Are not related to your employer, and
  • Are not a managing executive.

A self-employed person generally has substantial control over arranging business trips so it is virtually impossible to satisfy this rule.  However, you may fall within one of the other rules below.

2. Outside United States no more than a week.  Your trip is considered entirely for business if you were outside the United States for a week or less, combining business and nonbusiness activities.  One week means 7 consecutive days.  In counting the days, do not count the day you leave the United States, but do count the day you return to the United States.

3. Less than 25% of time on personal activities.  Your trip is considered entirely for business if:

  • You were outside the United States for more than one week, and
  • You spent less than 25% of the total time you were outside the United States on nonbusiness activities.  For this purpose, count both the day your trip began and the day it ended.

Example:  You fly on Sunday from New York to London. where you spend 14 days on business and 5 days on personal matters.  You spend one day flying in each direction.  Your total time abroad is 21 days (14 days for business, 5 days for personal activities, and 2 days for travel).  Since the time you spent on nonbusiness activities is less than 25 percent of the total travel time abroad (5 days personal/21 days total), you may treat the trip as entirely business.  Therefore, the entire cost of the airfare is deductible.  You treat the days of travel as business days so that 16/21 of the lodging and meal costs (subject to the 50% limit on meals) are deductible.

4. Vacation not a major consideration.  Your trip is considered entirely for business if you can establish that a personal vacation was not a major consideration, even if you have substantial control over arranging the trip.

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Part 2 will cover foreign expenses incurred “primarily for business” as compared to “entirely,” foreign conventions and cruise ships.