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Maximize Your Exclusion of Foreign Earned Income Under the Physical Presence Test

Accountants CPA Hartford, LLC: William Brighenti, Certified Public Accountant If your tax home is in a foreign country, in order to exclude all or some of your foreign earned income, you must meet either the bona fide residence test or the physical presence test.  Of course, your tax home is your regular or principal place of business or employment. 

Generally, if you are a bona fide resident of a foreign country for an uninterrupted period (excluding brief or temporary trips for vacation or business) that includes an entire tax year, then you meet the bona fide residence test.  Once you have met this test, then you are a bona fide resident of that country for all years of residence there, including partial years. For instance, if you arrived in the foreign country in the middle of year 1, remained for the entire year 2, and then left in the middle of year 3, then you were a bona fide resident of the foreign country for all of year 2, and half of years 1 and 3.

The problem with meeting the bona fide residence test is that your arrival rarely, if ever, would occur just prior to January 1st, qualifying you for an entire tax year in your first year of residence in the foreign country.  Consequently, in order to exclude your first year’s foreign earned income, the physical presence test is customarily used in the first year of residence in a foreign country in order to qualify for exclusion of foreign earned income.

Generally, to meet the physical presence test, you must be physically present in the foreign country for at least 330 full days during a 12-month period.  For example, if you were physically present in the foreign country from April 15 2009 through April 15, 2011, and you wished to file a tax return for the year 2009 on April 15, 2010, excluding your foreign earned income, you would be able to do so under the physical presence test; however, you would not be able to do so under the bona fide residence test because you were not a bona fide resident of the foreign country for the entire tax year beginning January 1, 2009 and ending December 31, 2009.

The question is—and the purpose of this article—is how would you maximize the exclusion of foreign earned income under the physical presence test.  For instance, assuming you did not leave the foreign country at all during 2009, would you simply multiply the maximum annual exclusion limit of foreign earned income for the year 2009—$91,400—by 261/365 (261/365 representing the “annual rate” of Section 911(b)(2)(A), where 261 is the number of days from April 15th through December 31st and, of course, 365 is the total number of days in the year 2009)?  If you do such, then the maximum amount of foreign earned income that you could exclude from tax would be $65,357.  Is there a way of applying the physical presence test to increase the exclusion of foreign earned income from tax than simply by using the first full day after your arrival date in the foreign country to compute the “annual rate”?

Yes, there is; otherwise, why would I bother to write this article in the first place?  For the year of arrival, you would compute the maximum exclusion as follows:
  1. Count forward 330 days from your first day of physical residence, excluding any vacation and business days in the United States;
  2. Count backward 12 months from the date determined in step 1 above;
  3. Count the total days from the date determined in step 2 above through the end of the tax year;
  4. Multiply the maximum exclusion limit for the applicable tax year by the annual rate, or the number of days determined in step 3 above by the total calendar days in the tax year (either 365 or 366).
If April 15, 2009 were the first full day of residence in the foreign country, the 330th day forward would be March 10, 2010, which would be the last day of the 12 consecutive month period relevant to the tax year 2009.  Counting backward 12 months from that date provides the first date of our exclusion period for 2009:  March 11, 2009.  Counting the total days from March 11, 2009 through December 31, 2009, gives us 297 days for the numerator in our annual rate formula used to compute the maximum allowable exclusion of foreign earned income:  297/365 x $91,400, or $74,372 of maximum excludible foreign earned income.

All other things being equal, and assuming you were single and your foreign earned income exceeded $74,372, by using these four steps to derive the numerator in your annual rate fraction for the computation of your foreign earned income exclusion—rather than simply using your arrival date to derive the numerator in your the annual rate fraction—you would have saved $2,250 in federal income taxes and $451 in Connecticut income taxes.

Now let’s consider your year of departure.  As in the year of arrival, if you were simply to include the number of days you were in the foreign country in that tax year in the numerator of your annual rate for the year 2011, the amount of foreign income eligible for exclusion would be the following, assuming a maximum exclusion of $91,500 for 2011:  105/365 x $91,500 = $26,322.

To maximize your exclusion of foreign earned income in your year of departure, you would figure the maximum exclusion in a manner similar to that used in figuring your maximum exclusion in your year of arrival, except in the opposite direction:
  1. Count backward 330 days from your last day of physical residence, excluding any vacation and business days in the United States;
  2. Count forward 12 months from the date determined in step 1 above;
  3. Count the total days in your year of departure from January 1 through the date determined in step 2;
  4. Multiply the maximum exclusion limit for the applicable tax year by the annual rate, or the number of days determined in step 3 above by the total calendar days in the tax year (either 365 or 366).
If April 15, 2011 were the last full day of residence in the foreign country, the 330th day backward would be May 21, 2010, which would be the first day of the 12 consecutive month period relevant to the tax year 2011.  Counting forward 12 months from that date provides the last date of our exclusion period for 2011:  May 20, 2011.   Counting the total days from January 1, 2011 through May 20, 2011, gives us 140 days for the numerator in our annual rate formula used to compute the maximum allowable exclusion of foreign earned income:  140/365 x $91,500, or  $35,096 of maximum excludible foreign earned income.

Once again, all other things being equal, and assuming you were single and your foreign earned income exceeded $35,096, by using these four steps to derive the numerator in your annual rate fraction for the computation of your foreign earned income exclusion—rather than simply using your departure date to derive the numerator in your the annual rate fraction—you would have saved $1,425 in federal income taxes and $439 in Connecticut income taxes.

All in all, all other things being equal, and assuming you were single and your foreign earned income exceeded the calculated excludible amounts, by using the respective four steps to derive the number of days you are physically present in your years of arrival and departure instead of simply basing their derivations on the dates of arrival and departure results in this specific example in federal income tax savings of $3,675 and Connecticut income tax savings of $890, or total income tax savings of $4,565.  Of course, different savings in income taxes would result in different circumstances; however, the employment of the above-mentioned methodologies would ensure the maximum exclusion of foreign earned income and maximum tax savings. 

The obvious question is, why are you allowed to include days prior to your arrival and subsequent to your departure in the numerator of your annual rate factor?  There are several reasons.  First, you are required to be in the foreign country 330 days, not 365 days.  Secondly, you are allowed to choose any 12 consecutive months of your required year of residency, whether or not that year pre-dates or post-dates your dates of arrival and departure, respectively.  Thirdly, your period of physical residence for the purpose of computing your annual rate is not strictly limited by arrival or departure dates.  As a result, by using these four-step procedures in determining the beginning and ending dates of your physical presence in the foreign country, you can add as much as 35 or 36 days to the numerator in your annual rate fraction, or 10% of the maximum annual exclusion limit.  Since taxpayers claiming the foreign earned income exclusion are taxed at the much higher marginal tax rates that would have applied had they not claimed the exclusion, the tax consequences of not maximizing one's exclusion can be significant.

This article is provided for informational purposes and is not intended to be construed as legal, accounting, or other professional advice.  For further information, please consult appropriate professional advice from your attorney and certified public accountant. 

Have a tax, a QuickBooks, or an accounting question?  Please feel free to submit it under "Comments" on our blog, Accounting, QuickBooks, and Taxes by William Brighenti, Certified Public Accountant, Accountants CPA Hartford, LLC.  For information and assistance on any tax, QuickBooks, or accounting issue, please visit our website:  Accountants CPA Hartford, LLC.

If and only to the extent that this publication contains contributions from tax professionals who are subject to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, the publisher, on behalf of those contributors, hereby states that any U.S. federal tax advice that is contained in such contributions was not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose.  The above tax advice was written to support the promotion or marketing of the accounting practice of the publisher and any transaction described herein.  The taxpayer recipients of this offering memorandum should seek tax advice based on their particular circumstances from an independent tax advisor.

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