Foreign earned income filers, here’s an interesting approach

I work with a number of clients who claim the foreign earned income exclusion, allowing them to exclude up to $91,500 of income earned while living and working overseas (plus part of housing costs in some situations). If you don’t claim this (or know anybody who does), you can safely assume you’ll have no interest in the rest of this post.

I recently came across a blogger who lives overseas and made an interesting argument that he believed the IRS was wrong to disallow the Making Work Pay Credit to individuals whose entire “earned income” was excluded by the foreign earned income exclusion. I find his argument interesting, but ultimately disagreed with his position because it seems to hinge on the idea that income can be simultaneously included and excluded from gross income. (There’s far more to it than that, and tax nerds can read pretty much the entire lengthy exchange here.)

But that got me thinking, and I did realize another possible approach ex-pats might take in order to claim the $400 ($800 if married filing jointly) credit. So taxpayers living abroad can choose to qualify for the Foreign Earned Income Exclusion under either the Bona Fide Resident test or the Physical Presence test. Under the Physical Presence test, if you’re physically present in a foreign country for 330 full days out of a 12 month period, you can exclude the foreign income earned during that period up to the limit (currently $91,500).  You can choose any 12 month period you want; it doesn’t have to be the tax year. And it doesn’t matter if the 12-month periods overlap–the 12 month period could extend into another tax year and have no effect on what’s excluded in any other year. In Publication 54, the IRS advises taxpayers to choose the 12 month period that gives them the most benefit.

So, if a taxpayer is living abroad and doesn’t get back to the US very often or for very long, they could choose any 12 month period they want as long as there is at least some overlap with the tax year. Choosing a period other than the tax year would have the effect of reducing the amount of income that’s excluded under the foreign earned income exclusion. So a taxpayer could choose a 12 month period that doesn’t exclude ALL foreign earned income, but only leaves enough income “included” in gross income to maximize the Making Work Pay Credit, but not enough that it exceeds the standard deduction and exemption. In other words, they wouldn’t have enough income recognized that they would owe any federal tax…but they would have enough income to get the Making Work Pay Credit.

Here’s an example: Taxpayer lives overseas and earns $54000. Normally, the taxpayer would just exclude the whole amount. But, the taxpayer could choose a 12 month period that only covers half the tax year, limiting their exclusion to $45,750. That leaves $8,250 in taxable earned income. Based on this, the taxpayer would get the full $400 Making Work Pay Credit. And a taxpayer using the standard deduction, and claiming an exemption for himself, would get a deduction for over $9,000, leaving no taxable income. No tax owed. $400 credit received.

Let me just say I’m not advising anybody to do this. All of my foreign clients are either excluded from Making Work Pay due to high AGI, or they already qualify because they lived in the US part of the year and have eligible earnings. I would want to do a little more research before actually advising anybody to take this position. But I can’t think of any reason it wouldn’t work and be perfectly legal.

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