There is a lot of talk about the Foreign Earned Income Exclusion (FEIE) and the Foreign Tax Credit (FTC) in the US expat community, but not much is said about how the income is classified. The IRS tax rules for both the FEIE and FTC stipulate that the income being excluded or used for the credit needs to be foreign earned income. So what is foreign earned income exactly?
What Is Foreign Earned Income?
Generally, the IRS classifies income by where it is earned. So if you are living and working abroad, then your income is considered to be foreign earned income, even if you are being paid by a US company.
The opposite is true as well. If you are working in the US, your earnings are considered to be US earned income. This is true no matter who pays your salary, whether it is a US company or a foreign company.
What Qualifies as Foreign Earned Income for Businesses?
If you own your own business and the primary income comes from personal service (such as lawyers and doctors), the source of the income is wherever the services are performed. So if you work from a foreign country, your income will be foreign earned.
For businesses whose primary income comes from selling products (like a store or direct sales business), the source of the income will depend on whether you purchase or produce the items you sell. If the company purchases the items it sells from a foreign country, the income is foreign earned. If the company produces the items it sells, then the country where the items are produced is the source of the earned income.
Passive or Unearned Income
Passive income is any income that you are not “working” to earn. This type of income includes interest, dividends, capital gains, rental property income, retirement income, etc.This category of income is a bit more complicated to determine whether it is considered US or foreignearnedincome. Here is a chart to help:
| Type of Income | Source of Income |
| Interest | Residence of the payer – If outside the US, then the income is considered to be foreign.If from the US, then the income is US earned. |
| Dividends | Location of the corporation – Foreign corporations produce foreign earned dividends. US corporations produce US earned income. Where the company is incorporated determines if it is foreign or US (note: some foreign earned dividends may be considered US earned if the corporation is partially owned by US shareholders). |
| Rents | Location of the property – If the property is located outside the US, then the income is foreign earned. If the property is within the US, it is considered US earned income. |
| Royalties – Natural resources (Oil, Gas, etc.) | Location of the corporation – Foreign corporations produce foreign earned dividends. US corporations produce US earned income. |
| Royalties – Patents, Copyrights, etc.(Intellectual Property) | Where the property is used – If the patents or copyrights are used outside the US, it is foreign earned income. If the royalties are from intellectual property used inside the US, then it is US earned income. |
| Sale of Property – Real Estate (Land and buildings) | Location of the property – If the property is located outside the US, then the income is foreign earned. If the property is within the US, it is considered US earned income. |
| Sale of Property – Personal (Any property that is not land or building) | Location of the seller’s tax home – A tax home is where the taxpayer primarily lives and works. |
| Pensions and retirement income (Not including Social Security) | Location of where the services were performed to earn the pension/retirement income |
| Scholarships/Fellowships | Generally, the residence of the taxpayer determines whether scholarships are considered to be foreign or US earned. Residences outside the US are considered to be foreign earned, and residences within the US are considered to be US earned. |
Why You Need To Know The Difference
How does foreign earnedincome affect your US taxes? Well, like a lot of things, it depends upon your tax situation as a whole. All your worldwide income must be reported on your tax return, including foreign earnedincome as well as US earnedincome. This does not mean that you will pay tax on this income though. There are several tax treatments that can be applied to a return that has foreign earnedincome, either excluding the income from taxation (the FEIE) or preventing you from being double taxed on it (the FTC).
Everyone’s tax situation is different. If you have foreign earnedincome on your tax return, you should make sure to consider all the possibilities that are available to you to mitigate any potential tax difficulties.
Have More Questions About Your Sources of Income?
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As an expert in international taxation and expatriate tax matters, my expertise spans the complexities of the United States tax system for expatriates. I have a comprehensive understanding of the Foreign Earned Income Exclusion (FEIE) and the Foreign Tax Credit (FTC), crucial provisions for U.S. citizens living and working abroad. My knowledge extends to the classification of income according to IRS regulations, particularly in relation to the determination of foreign earned income.
The IRS classifies income based on where it is earned, distinguishing between foreign earned income and US earned income, crucial for taxation purposes. Foreign earned income includes earnings acquired while living and working abroad, irrespective of whether the payment comes from a US or foreign company. Conversely, US earned income encompasses earnings acquired while working within the United States, regardless of the employer's origin.
Understanding the classification of foreign earned income for businesses is pivotal. For service-oriented businesses, income sources are linked to the location where services are provided. For product-oriented businesses, the determination of the income's source relies on whether items are purchased or produced.
Additionally, passive or unearned income, such as interest, dividends, rental income, and royalties, requires careful consideration. The classification of such income as US or foreign earned hinges on specific criteria, including the location of the payer, property, corporation, or the usage of intellectual property.
The differentiation between foreign and US earned income is crucial for tax implications. All worldwide income, including foreign earned income, must be reported on tax returns. However, various tax treatments like the FEIE or FTC can exclude or prevent double taxation on foreign earned income.
Understanding the nuances of these tax provisions is essential for expatriates to optimize their tax situations effectively. Seeking professional guidance from expat-expert CPAs or IRS Enrolled Agents can ensure proper compliance with tax obligations and the utilization of available strategies to mitigate tax liabilities for those with foreign earned income.
In summary, the IRS tax code's complexity, especially concerning expatriate taxation, requires a nuanced understanding of income classification, deductions, and credits. For expats navigating their tax obligations, seeking specialized assistance is prudent to navigate the intricacies of the U.S. tax system's international aspects effectively.
