Flip-Flopping the Foreign Earned Income Exclusion

Hi, it's Phil and it's the Friday Edition, full of international tax goodness. If you want to stop receiving this, just click the Unsubscribe link at the bottom of the email.

Since we are starting the tax season, let's do a practical topic for those of you living abroad, or those of you preparing income tax returns for people living abroad.

Flip-Flopping the Foreign Earned Income Exclusion vs. Foreign Tax Credit

This week's topic comes from Darlene Ayoub, CPA. She dialed into a recent International Tax Lunch session I did on the Foreign Earned Income Exclusion, and wondered about using the exclusion one year and not using it the next. Lightly edited (for the sake of telling a good story LOL), here is Darlene's question:

If you start doing a tax return for a U.S. person abroad and use the foreign earned income exclusion for a year or more, can you switch to claiming the foreign tax credit?

She called it a "flip-flop", and that's right. One year you might want to use foreign tax credit to reduce the U.S. tax liability, and the next year you might want to use the foreign tax credit because it results in a lower tax bill. She then continues with the question:

My understanding is the IRS doesn't allow this. What are your thoughts on this?

Thanks and I look forward to the next lunch/learn session.

Darlene

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The Quick Answer

No flip-flops:

• You must elect to use the foreign earned income exclusion.
• You can revoke that election (accidentally or deliberately).
• Once you have revoked the election, you cannot make another election to use the foreign earned income exclusion until the 6th year after your last use of the foreign earned income exclusion.

Electing the Foreign Earned Income Exclusion

The foreign earned income exclusion is simple to understand, though needlessly complicated to apply. If you are an American abroad and are eligible (by really truly living abroad, according to needlessly complicated rules), then the first $101,300 (for the 2016 tax year)¹ of earned income (you did work, you got paid) is tax-free to you.²

The way you get this treatment is by choosing it -- making an election, in tax parlance. The way you make the election is by giving the IRS a piece of paper. The piece of paper is Form 2555, which you attach to the tax return you file.³

When you file Form 2555, it means you have chosen to use this method for computing your U.S. income tax liability for all future years, until you revoke the election.⁴

Revoking the Election Deliberately

You can stop using the foreign earned income exclusion, and you tell the IRS that you want to stop by revoking the election. You do that by filing a statement with your tax return for the year that you want to make the foreign earned income exclusion stop.⁵. For instance:

• Example 1: Amended Return. You filed your 2014 tax return claiming the foreign earned income exclusion, but now you realize that was a dumb idea :-) and you want to fix the mistake. You file an amended 2014 tax return with a statement on it saying you elect to revoke the election to claim the foreign tax credit. The revocation is effective for 2014 and future years.
• Example 2: Current Year Return. You have always filed your tax returns claiming the foreign earned income exclusion because you were living in Dubai (no income tax!). But in 2015 you move to Germany (plenty of income tax!) and you decide that for 2015 and future years it makes sense for you to just claim a foreign tax credit on your U.S. tax return. You attach the statement to your 2015 tax return. The revocation is effective for 2015 and future years.

There is nothing magic about the statement you need to attach to your tax return. Here is an idea:

I hereby revoke my election to claim the foreign earned income exclusion, as authorized by T. Reg. § 1.911-7(b)(1), effective starting with the taxable year covered by this tax return.

There's the "flip" part of the flip-flop, Darlene. You can toggle the foreign earned income exclusion off anytime you want, either on the current year tax return or a timely-filed amended tax return.

Revoking the Election Accidentally

You can accidentally revoke your election to use the foreign earned income exclusion. You do this by taking an inconsistent position on your income tax return: you claim the foreign tax credit for the income that is eligible for the foreign earned income exclusion.

The IRS has issued a Revenue Ruling about this:⁶

From January 1, 1984, through February 28, 1986, A was a qualified individual as defined in section 911(d)(1). As of March 1, 1986, A was no longer a qualified individual. A made a valid election to exclude foreign earned income under section 911(a)(1) and claimed the exclusion for the 1984 and 1985 taxable years. In the tax return for the 1986 taxable year, A did not claim the exclusion for which he was eligible for the period beginning January 1, 1986, and ending February 28, 1986. Instead, A reported all gross income earned during the year and claimed a foreign tax credit for foreign taxes paid on foreign earned income. A did not file a statement with his 1986 tax return specifically revoking the section 911(a)(1) election.

See that? The taxpayer had a valid election to use the foreign earned income exclusion, then one year arbitrarily did not use that exclusion. Instead, the taxpayer just reported all of the earned income as taxable, and claimed the foreign tax credit on his tax return.

The result? The taxpayer is treated as having revoked the foreign earned income exclusion election by taking a tax reporting position that is inconsistent with the foreign earned income exclusion.

Although the regulations under section 911 of the Code prescribe a method by which a taxpayer may revoke an election to exclude foreign earned income, they do not purport to provide the exclusive method for revoking such an election. Taxpayers are required to revoke their elections and to obtain the consent of the Secretary to reelections to prevent them from abusing the tax benefits provided by section 911 through alternating between electing section 911 benefits and claiming foreign tax credits. Thus, to ensure that the taxpayer cannot abuse the benefits of section 911, the election made under section 911 will be considered revoked because the taxpayer's inclusion of income and the claiming of the foreign tax credit in a subsequent year is inconsistent with that election.⁷

Emphasis added by me.

Making a New Election

After you revoke the foreign earned income exclusion, you must wait to make a new election. You can "flip" the election off, but you can't "flop" back to the foreign earned income exclusion easily. You must either wait a few years, or ask the IRS for permission.

Wait Until the Sixth Year

If you revoke your foreign earned income exclusion election, you cannot make a new election (filing Form 2555 to do so) until the sixth year after the year for which the revocation was effective.⁸ Clunky verbiage, I know.

Example 3

You revoke your foreign earned income exclusion election on your 2015 income tax return. The sixth year after the first year for which the revocation was elected is 2021. This means that the first time you can claim the foreign earned income exclusion is on your 2021 income tax return.

Example 4

You revoke your foreign earned income exclusion by filing an amended income tax return for 2014. The first year that your revocation was effective is 2014. The sixth year after 2014 is 2020. (Count 'em off on your fingers; I did.). The first year you can claim the foreign earned income exclusion is on your 2020 income tax return.

Ask the IRS For Permission to Flop Back Early

If you do not want to wait until the "sixth taxable year following the first year taxable year for which the revocation was effective blah blah blah"⁹ you can ask the IRS for permission to toggle back to the foreign earned income exclusion:

If an individual revoked an election under paragraph (b)(1) of this section and within five taxable years the individual wishes to reelect the same exclusion, then the individual may apply for consent to the reelection. The application for consent shall be made by requesting a ruling from the Associate Chief Counsel (Technical), National Office, Internal Revenue Service, 1111 Constitution Avenue NW., Washington, DC 20224. In determining whether to consent to reelection the Associate Chief Counsel or his delegate shall consider any facts and circumstances that may be relevant to the determination. Relevant facts and circumstances may include the following: a period of United States residence, a move from one foreign country to another foreign country with differing tax rates, a substantial change in the tax laws of the foreign country of residence or physical presence, and a change of employer.¹⁰

The address is long-dead. Look at Publication 54, Chapter 4 for the latest address and other hand-wavey instructions for how to do this. Publication 54 also provides a little warning:

Because requesting a ruling can be complex, you may need professional help. Also, the IRS charges a fee for issuing these rulings. For more information, see Revenue Procedure 2015-1.

This is your clue that maybe the whole effort will not be worth the time and effort.

Conclusion: Flip-Flop Slowly or By Permission Only

The short message for your clients, Darlene, is that they cannot flip back and forth from year to year.

Disclaimer, Etc.

Wherein I disavow any responsibility whatsoever for these words because I'm probably wrong, and tell you that Sturgeon's Law applies to me, too, so you would be a fool to rely on this email. Hire someone (Darlene Ayoub, CPA in Katy, TX, perhaps?) to help you. Or spend the time to figure it out. Your Life + IRS Rules = Right Answer.

See you in a couple of weeks.