This discussion is for Americans working abroad who want to claim the foreign earned income exclusion, but they are late in filing the tax return to do so.
The Foreign-Earned Income Exclusion
Americans living and working abroad can make up to $101,3001 of earned income tax-free. Earned income is what you get paid for working — wages or self-employment income.
This is the foreign-earned income exclusion.2 It is great.
- Your salary = $100,000.
- Your tax = $0.
What’s not to like?
You get this tax benefit by attaching Form 2555 to your income tax return.3
People (not you!) have been known to misunderstand the foreign-earned income exclusion. In their minds, they say “Well, I earn less than $100,000 per year, so I don’t have to file a tax return.”
Not so. You do not get to treat earned income as tax-free unless you do the paperwork: file Form 2555.
We get people fairly frequently who need to fix this problem. They are clearly entitled to the foreign-earned income exclusion, and it saves them a lot of tax. They didn’t file tax returns and claim the foreign-earned income exclusion because they misunderstood the tax law.
Late Elections: The IRS Can Say No
If the Internal Revenue Code gives a taxpayer an election — you can choose some special tax treatment — the general principle is simple: claim that special treatment on a timely-filed tax return.
The filing deadline rules are unnecessarily complex. Sometimes Congress writes a deadline into the Internal Revenue Code. An election must happen by the filing deadline for the tax return. Or maybe the tax election must happen by the filing deadline plus an extension, if you requested an extension to file your tax return. When an election has the deadline hard-wired into the Internal Revenue Code, it is a statutory election.4 The IRS has limited authority to give you a break if you miss the deadline.
But sometimes, Congress just says “the taxpayer can elect this special treatment” and gives the IRS the authority to write the rules for filing deadlines. These are called regulatory elections.5 Because the IRS has the authority to write the rules, there is somewhat more leeway for giving you a break if you miss a deadline.
The election to excludes your foreign-earned income from taxation is a regulatory election. Congress simply said “At the election of a qualified individual . . . there shall be excluded from the gross income . . . .”6 Congress then delegated the details of enforcing this rule to the Treasury Department (of which the IRS is a part).7 Thus, the Treasury Department sets the filing deadlines for when a taxpayer makes the election to take the foreign-earned income exclusion.
There are a host of rules that soften the harsh effect of missing the deadline. The IRS has general rules that deal with relief from deadlines when you blow an election.8 And there are specific rules that apply to the foreign-earned income exclusion and what to do when you are late in claiming it.9
Timely Election for the Foreign-Earned Income Exclusion
Making an election correctly is simple: file Form 2555 as part of a timely-filed income tax return.10 This means you file on or before the deadline that applies to you: April 15 or June 15.
If you apply for an extension of time to file your income tax return (use Form 4868 — or Form 2350 — in the right circumstances), that extended deadline is the one that matters. Get your tax return filed before the extended deadline, have Form 2555 attached, and you have made the election to exclude your foreign-earned income from taxation.
Missed the Filing Deadline?
What happens if you are late? The filing deadline has passed, and you did not file Form 2555 to claim the foreign-earned income exclusion. The default rule is “too bad, you lose” — you do not get to exclude foreign-earned income from being taxed.
But the system has some slack built in. It is designed to encourage you to move fast. The sooner you fix the problem, the safer you are.
Here are the rules.
Nonfilers: One Year Late
If you never filed a tax return and you are filing late, you can claim the foreign-earned income exclusion if you are not too late.
File your original tax return within one year after the actual deadline.11 The IRS will allow the foreign-earned income exclusion to apply, whether you owe tax (or not) after applying the foreign-earned income exclusion.
You are living outside the United States and meet all of the qualifications for the foreign earned income exclusion. Your salary is $50,000 per year. You missed the 15 June 2016 deadline for filing your 2015 income tax return. You file your 2015 income tax return in January, 2017. You attach a properly-prepared Form 2555 to claim the foreign earned income exclusion.
You did not file a timely 2015 income tax return.
However, your late tax return was filed within one year of the 15 June 2016 filing deadline. Therefore, your claim for the foreign earned income exclusion will be accepted.
Note that it does not matter whether you are under audit, have received a notice from the IRS, or owe any Federal income tax. All that is irrelevant. If you get your original tax return on file within one year of the filing deadline, you win.
Nonfilers: More than One Year Late
What if you are seriously late? You have not filed a Federal income tax return for several years. You want to clean things up, and the foreign earned income exclusion will, you discover, completely eliminate U.S. income tax on your income.
If you are more than one year late in filing your tax return (with Form 2555), the question of whether you can force the IRS to accept your late Form 2555 or not depends on:
- whether you owe Federal income tax; and
- how fast you are in filing your tax return.
Original Return More than One Year Late and You Owe No Tax
If you are filing your Federal income tax return more than one year late and, after applying the foreign earned income exclusion, you owe no Federal income tax, then the IRS cannot reject you. The foreign-earned income exclusion is yours for the taking.12
You are living outside the United States and meet all of the qualifications for the foreign earned income exclusion. Your salary is $50,000 per year. You have no other income.
You missed the 15 June 2015 deadline for filing your 2014 income tax return. You file your 2014 income tax return in January, 2017. You attach a properly-prepared Form 2555 to claim the foreign earned income exclusion. Your Federal income tax liability is zero.
You are more than one year past the filing deadline for your 2014 income tax return, but you owe no income tax. Therefore, you can claim the foreign earned income exclusion.
You might have been discovered by the IRS and be under audit. It does not matter: if, when you file your original tax return, you have zero income tax liability, you can claim the foreign-earned income exclusion. You still win.
Original Return More than One Year Late and You Owe Some Tax
What if you are filing a tax return for the first time for a tax year, and, after applying the foreign earned income exclusion, you will still owe some tax? Now, it’s a race:
- If you file your tax return before the IRS finds you, the foreign-earned income exclusions is yours.
- If the IRS finds you before you file your tax return, the foreign-earned income exclusion is denied.
Here is what the Regulations say. A taxpayer may make an election more than a year late if:13
“The taxpayer owes federal income tax after taking into account the exclusion and files Form 1040 with Form 2555 or a comparable form attached before the Internal Revenue Service discovers that the taxpayer failed to elect the exclusion.”
The implication is clear: no procrastination.
The Meaning of “Zero Federal Income Tax”
The Form 1040 you file must show that you owe zero Federal income tax or get a refund.
“Federal income tax” means income tax (and alternative minimum tax). It does not include self-employment tax, social security tax, or any other type of tax. It makes total sense. The foreign earned income exclusion only eliminates earned income from income tax. It does not eliminate, for instance, self-employment tax.14
Apply the foreign earned income exclusion, and calculate your Federal income tax liability (and yes, that includes AMT). Ignore the “other taxes” (Lines 57 – 62, Form 1040). Apply all of the withholding taxes, estimated payments, foreign tax credits, etc. that you can muster. Do you owe tax or get a refund? If yes, then you can to claim the foreign earned income exclusion.15
“IRS Discovers” and Speed
It’s a race. How do you know whether your tax returns have been “discovered” by the IRS? You might not, until it is too late. What if you the IRS sent you a notice and you did not receive it? Were you too late? You will not know until you file your late tax return, claiming the foreign earned income exclusion. Silence from the IRS means you filed before they found you, and you succeeded in claiming the exclusion.
Amended Tax Returns and a Late Form 2555
What if you filed your income tax returns on time, but later learned about the foreign-earned income exclusion? You now want to file amended income tax returns, claim the foreign earned income exclusion, and (probably) get a nice tax refund.
Timely Amended Return After Timely Original Return
If you filed a timely original tax return and you file your amended income tax return within three years, then you may claim the foreign earned income exclusion.16
Technically, the time frame for filing the amended tax return is “within the period prescribed in section 6511(a)”. This is the statute of limitations for claiming a tax refund:
Claim for credit or refund of an overpayment of any tax imposed by this title in respect of which tax the taxpayer is required to file a return shall be filed by the taxpayer within 3 years from the time the return was filed or 2 years from the time the tax was paid, whichever of such periods expires the later, or if no return was filed by the taxpayer, within 2 years from the time the tax was paid. Claim for credit or refund of an overpayment of any tax imposed by this title which is required to be paid by means of a stamp shall be filed by the taxpayer within 3 years from the time the tax was paid.17
Amended Tax Return After Late Original Return
If your original income tax return was late and you want to file an amendment to claim the foreign earned income exclusion, your ability to file Form 1040X with Form 2555 to claim the foreign earned income exclusion will depend on whether Federal income tax will be due after you file the amended return. These are the same rules as apply to the original tax return: if no Federal income tax liability exists, you may elect to receive the foreign earned income exclusion18 and if Federal income tax liability exists, you need to beat the IRS (you file before they find you) in order to claim the foreign earned income exclusion.19
This is a rare occurrence.
You would only be filing amended tax returns if you screwed up on the original tax returns, and you want a refund. This means that you would need to beat the IRC §6511(a) deadline in order to receive the tax refund (three years from filing or two years from making the tax payment).
You would be unlikely to file an amended tax return if you owe more tax, although I can see this happening in rare cases (you need to amend your tax return for other reasons, so while you are fixing other problems you claim the foreign earned income exclusion, which partially — but not entirely — softens the blow of additional tax due).
Magic Words You Must Use
In some cases you must put magic words on your income tax return in order to make a late claim for the foreign earned income exclusion. The following situations require you to write “Filed Pursuant to Section 1.911-7(a)(2)(i)(D)”20 at the top of page 1 of Form 1040:
- You are more than one year late in filing a tax return and you have no Federal income tax liability or you are getting a refund;21 or
- You are more than one year late in filing a tax return, you owe Federal income tax, and you file your tax return before the IRS finds you.22
Note: if you do not write those words on the top of your Form 1040, you lose.23
The foreign earned income exclusion is useful for Americans living and working abroad — it reduces U.S. income tax liability. It is especially valuable for Americans who cannot (for whatever reason) use the foreign tax credit.
Don’t panic if you screwed up in years past. If you are a nonfiler, fix the problem. File those tax returns. Odds are that you will be able to successfully claim the foreign-earned income exclusion. If you filed a tax return and did not claim the foreign earned income exclusion, prepare and file an amended tax return to claim a tax refund.
As usual, I must invite the credulous to treat anything they read on the internet with deep suspicion and horror. This stuff you are reading right now is wildly wrong and probably inapplicable to your life. Please go hire a tax pro to help you. Or do it yourself. Maybe things will work out, maybe they won’t. A competent human, with enough time and patience, can figure this stuff out. Maybe that’s you. Just don’t blame me if things go sideways.
If this topic is of interest, check out the post we did on what abode means for foreign earned income.
See you in a couple of weeks.
- For calendar year 2016. Rev. Proc. 2015-53, § 3.32. For 2017, the maximum foreign earned income exclusion is $102,100. Rev. Proc. 2016-55, §3.34. ↩
- IRC §911. ↩
- Regs. §1.911-7(a)(1). ↩
- Regs. §301.9100-1(b). ↩
- Regs. §301.9100-1(b). ↩
- IRC §911(a). ↩
- IRC §911(d)(9). ↩
- Look for your salvation at Regs. §§ 301.9100-1 through 301.9100-3. ↩
- Regs. §1.911-7. ↩
- Reg. §1.911-7(a)(2)(i)(A). ↩
- Regs. §1.911-7(a)(2)(i)(C). ↩
- Regs. §1.911-7(a)(2)(i)(D)(1). ↩
- Regs. §1.911-7(a)(2)(i)(D)(2). ↩
- Self-employed people often learn this too late, to their dismay. Self-employment income on Schedule C will be hit with income tax and self-employment tax (see Schedule SE — warning: PDF). The foreign earned income can take care of the income tax problem, but will not eliminate the self-employment tax. ↩
- CCA 200226010. ↩
- Regs. §1.911-7(a)(2)(i)(B). ↩
- IRC §6511(a). ↩
- Regs. §1.911-7(a)(2)(i)(D)(1). ↩
- Regs. §1.911-7(a)(2)(i)(D)(2). ↩
- Regs. §1.911-7(a)(2)(i)(D)(3). ↩
- Rev. §1.911-7(a)(2)(i)(D)(1). ↩
- Rev. §1.911-7(a)(2)(i)(D)(2). ↩
- McDonald v. Commissioner, T.C. Memo 2015-169. ↩