People who live and work outside the United States may be able to exclude all or part of their foreign-source wages and self-employment income from the federal income tax through a provision called the foreign earned income exclusion. To qualify for the foreign earned income exclusion, a person needs to:
- Work and reside outside the United States, and
- Meet either the Bona Fide Resident or Physical Presence tests.
Persons may also be eligible to to exclude an additional amount for housing using the foreign housing exclusion or deduction.
Types of Income to Which the Foreign Earned Income Exclusion AppliesThe foreign earned income exclusion applies only to income arising from performing services either as an employee or as an independent contractor. "The term 'earned income' means wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered (Internal Revenue Code section 911(d)(2)(A)). Thus, wages and self-employment income may qualify for the foreign earned income exclusion. Other types of income cannot be excluded using this provision.
From Which Tax is Income Excluded?The foreign earned income exclusion functions to exclude earned income from the federal income tax. The foreign earned income exclusion does not exclude income from Social Security or Medicare taxes. Thus, the foreign earned income exclusion does not reduce the self-employment tax, which is the mechanism by which self-employed persons pay in the Social Security and Medicare taxes.
Further, self-employed persons are eligible to take the foreign housing deduction instead of the foreign housing exclusion. There's more details at Self-Employment & Foreign Exclusions.
How does the Foreign Earned Income Exclusion Impact the Tax Calculation?Since 2006, taxpayers claiming the foreign earned income exclusion will pay tax at the tax rates that would have applied had they not claimed the exclusion. In other words, the federal income tax is calculated by first calculating the amount of income tax on income without taking the foreign earned income exclusion into account, and then subtracting the tax as calculated on the amount of foreign earned income that is excluded. The result is the amount of the federal income tax liability. To facilitate this calculation, taxpayers use the Foreign Earned Income Tax Worksheet found in the Instructions for Form 1040 (it's located on page 40 of the 2012 Form 1040 Instructions).