The Foreign Earned Income Exclusion and Self-Employed Americans Abroad

This is for the self-employed Americans living abroad who want to enjoy some of that tax-free goodness that comes from the foreign earned income exclusion.Perhaps you are a digital nomad -- an American abroad earning a living online by building websites. You have not organized your business as a corporation. You are a sole proprietor.You live at the intersection of Schedule C (PDF) and Form 2555 (PDF).

The Answer

Watch out for "gross" and "net" income. It is easy to assume (because it is logical) that the foreign earned income exclusion applies to net income. Not so.As soon as a self-employed person grosses more than the exclusion amount for the year, there is an assurance of income tax and self-employment tax no matter what the net profit really is -- unless you are in rounding error territory.

The Foreign Earned Income Exclusion and Form 2555 Generally

American citizens and green card holders must file tax returns and pay income tax, no matter where they live and where they work.The foreign earned income exclusion¹ says that a certain amount of "foreign earned income" will not be taxed for Americans living and working abroad. The amount of "foreign earned income" that is not taxed is $101,300 for 2016² and $102,100 for 2017.³"Earned income" is money you make by providing services to people. That includes the money a self-employed person receives for building websites. Earned income if "foreign" if, when you did the work, you were in a foreign country.⁴There are some procedural requirements you must satisfy: you really truly live outside the United States, basically.⁵ Let's assume you have those requirements covered.You claim this tax benefit by filling in Form 2555 and attaching it to your income tax return.

How Schedule C Works

A self-employed person reports income and business expenses on Schedule C.Start with Line 1 ("Gross Receipts") which includes all of the money you received from doing business during the year. Make a few adjustments, and you have Gross Income on Line 7.Then, deduct business expenses, do some simple subtraction, and you have Net Profit on Line 31. This is what your business profit is for the year.Net Profit gets taxed twice:

• You pay income tax on Net Profit.
• In addition, you take that number to Schedule SE and calculate self employment tax.

How the Foreign Earned Income Exclusion Works on Schedule C

Let's say you generate $150,000 of gross revenue (your customers paid you this much money) and you had $50,000 of business expenses. And let's stay with our example: you are a digital nomad, working out of your MacBook Pro in a cafe somewhere in Chiang Mai.⁶Before taking into account the foreign earned income exclusion, your Schedule C looks approximately like this:

Line	Description	Amount
1	Gross Receipts	150,000
7	Gross Income	150,000
28	Total Expenses	-50,000
31	Net Profit	100,000

The random self-employed digital nomad (or indeed almost anyone who uses common sense) would think "Oh cool. I made $100,000 in 2016, and the foreign earned income exclusion is $101,300 for 2016. That means I made less than the exclusion cap so I am not going to pay any income tax."Wrong-o.

The Exclusion Applies to Gross Income, Not Net Profit

The problem arises because the foreign earned income exclusion takes away gross income from being taxed. That is income before expenses. Net profit is income after expense. Here you go:

"At the election of a qualified individual . . . , there shall be excluded from the gross income of such individual, and exempt from taxation under this subtitle, for any taxable year . . . ."⁷

Well, you think. Not so bad. I deduct the maximum foreign earned income exclusion for 2016 from my gross income on Schedule C, and that will take me from profit to loss for the year:

Line	Description	Amount
1	Gross Receipts	150,000
7	Gross Income Before Foreign Earned Income Exclusion	150,000
7	Less Foreign Earned Income Exclusion	-101,300
7	Gross Income After Foreign Earned Income Exclusion	48,700
28	Total Expenses	-50,000
31	Net Profit	-1,300

"Cool!" You exclaim. "I have no taxable income, and better yet, I am not going to pay any self-employment tax either. I ran at a loss for the year."Wrong-o.

The Exclusion Wipes Out Some of Your Business Expense Deductions

If you have income that is taxed, you can take a deductions for the expenses incurred in earning that income.If the income is not taxed, you cannot take a deduction for the expenses incurred in earning that untaxed income.It's kinda beautiful in its symmetry, isn't it? If the income is taxed, you can reduce the income by the expenses incurred. If the income is not taxed, you can't claim the expenses as a tax deduction.

"No deduction . . . shall be allowed to the extent the deduction . . . is properly allocable to or chargeable against amounts excluded from gross income under section 911(a)."⁸

To figure out how much of the business expenses are not tax-deductible, you need to create a fraction:

Foreign Earned Income Exclusion Claimed / Gross Income

For our example, the amount is $101,300 divided by $150,000 = 0.6753.In our example, we have $50,000 of business expenses that are tax-deductible, before considering the foreign earned income exclusion. But 67.53% of those business expenses were incurred to generate gross income that is not taxed. That means $50,000 x 67.53% = $33,765 of business expenses are NOT tax deductible. That leaves $50,000 - $33,765 = $16,235 of business expenses that ARE deductible.

The Result: Net Profit (and Taxable Income) of $32,465

The result, then is a Schedule C calculation that looks like this:

Line	Description	Amount
1	Gross Receipts	150,000
7	Gross Income Before Foreign Earned Income Exclusion	150,000
7	Less Foreign Earned Income Exclusion	-101,300
7	Gross Income After Foreign Earned Income Exclusion	48,700
28	Total Expenses Before Reduction for Reg. § 1.911-6(a) Disallowance	-50,000
28	Add Back Expenses That Are Not Deductible	33,765
28	Total Expenses After Reduction for Reg. § 1.911-6(a) Disallowance	-16,235
31	Net Profit	32,465

The $32,465 of net profit carries over to Form 1040, Line 12, and from there it gets taxed along with your other income. It also flows over to Schedule SE, where your self-employment tax is computed.Not entirely suck-free, is it?

Compare This to Forming a Corporation: Zero Tax (Yay)

Just for kicks, compare this to the oft-discussed but rarely used strategy of "form a foreign corporation". The idea is that an American abroad will form a foreign corporation and be its sole employee. The corporation earns the income and pays the American abroad a salary that is tax-free because of the foreign earned income exclusion.Let's go back to our first example: business operations for 2016 generated $150,000 of gross income, with $50,000 of business expenses, for a net profit of $100,000 per year before paying a salary to the sole employee. The company pays a salary of $100,000 to our self-employed digital nomad. Here's how it looks:

Description	Amount
Gross Income	150,000
Less Business Expenses	-50,000
Less Salary to Employee	-100,000
Net Profit for the Corporation	0

The $100,000 salary paid to the employee is entirely tax-free because it is less than the $101,300 foreign earned income exclusion cap for 2016. All of the business expenses are deductible in calculating the foreign corporation's profit, because the business expenses belong to the corporation -- not the American abroad self-employed sole proprietor digital nomad taxpayer person.Unfortunately, the Federal government's jihad⁹ on its citizens' foreign financial activities has made it almost impossible for Americans abroad to get bank accounts for themselves or for corporations that they form. For this reason (and others), many people look at the "set up a corporation" idea, shed a silent tear, and move on.But I'm not bitter.

The Number for Zero Income Tax = The Exclusion Cap for the Year

For the digital nomads (and other self-employed Americans abroad) the magic number to look at is Line 7. If it is less than the foreign earned exclusion amount for the year, then you will pay zero income tax. Your expenses will not matter.Let's pretend you grossed $100,000 in 2016, and you had $50,000 of business expenses. Here is how Schedule C will look for you:

Line	Description	Amount
1	Gross Receipts	100,000
7	Gross Income Before Foreign Earned Income Exclusion	100,000
7	Less Foreign Earned Income Exclusion	-100,000
7	Gross Income After Foreign Earned Income Exclusion	0
28	Total Expenses Before Reduction for Reg. § 1.911-6(a) Disallowance	-50,000
28	Add Back Expenses That Are Not Deductible	50,000
28	Total Expenses After Reduction for Reg. § 1.911-6(a) Disallowance	0
31	Net Profit	0

You will only exclude $100,000 of gross income from tax because of the foreign earned income exclusion. The reason is that you are allowed to exclude foreign earned income from taxation up to the cap amount for the year. Or, if your gross income is higher than the cap, you are limited to the cap amount.

Self-Employment Tax: The Exclusion Doesn't Work

You might eliminate your income tax liability with the foreign earned income exclusion. You cannot, however, use the foreign earned income exclusion to reduce your self-employment tax.Self-employment tax is a percentage of "self-employment income."¹⁰Self-employment income means "net earnings from self-employment derived by an individual".¹¹"Net earnings from self-employment" means gross income from self-employment minus allowable deductions.¹² Critically for our purposes, however, gross income is not reduced by the amount of foreign earned income exclusion under IRC § 911.

"The term 'net earnings from self-employment' means the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member; except that in computing such gross income and deductions and such distributive share of partnership ordinary income or loss--

(11) the exclusion from gross income provided by section 911(a)(1) shall not apply."

Let's go back to our example of a digital nomad who has $100,000 of gross income (payments from customers for services rendered) and $50,000 of business expenses.There will be zero income tax for this person:

Line	Description	Amount
1	Gross Receipts	100,000
7	Gross Income Before Foreign Earned Income Exclusion	100,000
7	Less Foreign Earned Income Exclusion	-100,000
7	Gross Income After Foreign Earned Income Exclusion	0
28	Total Expenses Before Reduction for Reg. § 1.911-6(a) Disallowance	-50,000
28	Add Back Expenses That Are Not Deductible	50,000
28	Total Expenses After Reduction for Reg. § 1.911-6(a) Disallowance	0
31	Net Profit	0

But for self-employment tax, Line 31 will show $50,000 of net profit, which will be subjected to the self-employment tax:

Line	Description	Income Tax Amount	SE Tax Amount
1	Gross Receipts	100,000	100,000
7	Gross Income Before Foreign Earned Income Exclusion	100,000	100,000
7	Less Foreign Earned Income Exclusion	-100,000	0
7	Gross Income After Foreign Earned Income Exclusion	0	100,000
28	Total Expenses Before Reduction for Reg. § 1.911-6(a) Disallowance	-50,000	-50,000
28	Add Back Expenses That Are Not Deductible	50,000	0
28	Total Expenses After Reduction for Reg. § 1.911-6(a) Disallowance	0	50,000
31	Net Profit	0	50,000

The net profit of $50,000 for self-employment tax purposes on Line 31 will be passed through to Schedule SE, where it will be subjected to tax at 15.3%.¹³ Meanwhile, the net profit on Line 31 is zero for income tax purposes, so no income tax will be imposed.