As a US American abroad, you may have heard a tax term called a “foreign source income” before. Perhaps you’ve even asked the question “What is foreign source income?” while reading one of our tax guides. Don’t worry – we’re going to make sure we will lay this all out for you.
Foreign source income for Americans abroad is very important to track – and sometimes report – to the IRS every year. It just depends on how much you make. It’s one of those things every American living abroad will need to become aware of when tax season arrives.
Foreign Source Income
If we look at income in general, the IRS classifies it based on where you earn money.
If you are living and working in the United States as a US citizen, Green Card Holder or even as a non-US Person, then your income is US-sourced. Even if you are working for a foreign company while you are in the United States, it is still considered US-sourced income. This is because the money you are receiving is earned while working physically from within the United States.
If you are working abroad (outside of the US) any money that you make is considered foreign-sourced income. Keep in mind, we are talking about earned income (wages, business income) and not passive income, which is a different story.
If the Disney corporation sent you to work for them in Hungary, any money you receive working in Hungary as an American expat will be known and seen as foreign source income to the IRS. Any money received while working physically in another country other than the US is considered foreign source income.
Determining the Correct Source
However, it can get tricky. For example, when you take a business trip to the US for Disney and earn money while you are there. That money will be considered US-sourced income since it was earned from within the States and not abroad. This is important to know.
When tax season hits, you will need to report your worldwide income to the IRS. Plus, you’ll need to be able to differentiate from what is US-sourced income and foreign-sourced income.
Though, just because you have foreign source income does not mean you will be double-taxed. Preventative measures have been put in place with the Totalization Agreements because of this.
Additionally, it’s good to know whether the foreign country you are working in has been approved by the US to not allow double taxation to exist.
Bona Fide Residence Test & Physical Presence Test
Something to keep in mind is that having foreign source income and wanting to exclude it from US taxation means that you will need to qualify for either the physical presence test or bona fide residence test:
For this purpose, foreign earned income is income you receive for services you perform in a foreign country during a period your tax home is in a foreign country and during which you meet either the bona fide residence test or the physical presence test.
- Physical Presence Test: To officially pass this test you need to be outside of the US for 330 full days in a consecutive 12 month period, that must begin or end in the tax year.
- Bona Fide Resident Test: To pass this test, you will need to be a resident in a foreign country and subject to local income taxes for at least a full tax year.
The FEIE and Foreign Tax Credit for Foreign Source Income
In order to utilize the benefits of the Foreign Earned Income Exclusion (FEIE) and Foreign Tax Credit (FTC), your income must be foreign earned/sourced.
The Foreign Earned Income Exclusion (FEIE) allows you to exclude up to a certain amount of foreign earned income from your US taxes. For the coming 2019 tax year, you can exclude up to $105,900. You will need to convert your foreign currency to US dollars to see if you make under the limit. If you earn more, then you can look to also use the Foreign Housing Exclusion.
For the Foreign Tax Credit (FTC) you will need to walk a few steps to avoid double-taxation:
- Identify which income is foreign sourced
- Figure out if your income is general, passive or falls into another foreign tax credit category
- Use Form 1116 to calculate the maximum amount of foreign tax credit you can claim on your federal tax return
- Keep records of any unused foreign tax credit for a future tax year
- If you have US-sourced income from business trips or other reasons, that you believe should be considered foreign-sourced, look at your country’s tax treaty for guidance
How to Report
If you would like to manually file and report your foreign source and worldwide income, you can fill out IRS Tax Form 1040 along with either Form 2555 (Foreign Earned Income Exclusion) or Form 1116 (Foreign Tax Credit).
If you have over $200,000 combined from foreign financial assets, please include Form 8938: Statement of Specified Foreign Financial Assets. You can use Form 8938 to properly disclose and report specified foreign financial assets. Otherwise, the IRS may believe you are looking to “hide” foreign assets and can charge steep penalties.
If you have any questions about your tax obligation to the IRS – do reach out to us at info@taxpartners.ca or by phone at 905-836-8755!