Greetings again, digital nomads. This week we’ll go back to basics: the foreign earned income exclusion. Form 2555.
I’m going to show you an element that is almost universally ignored by everyone. They’re probably right to ignore the problem, but it is important to know that a problem exists, and why you can safely ignore it. This week’s episode is buried, in other words, somewhere in Donald Rumsfeld’s brain. I aim to take an known-unknown and make it a known-known, so you can then ignore it with impunity.
Qualifying For the Foreign Earned Income Exclusion
Everyone you talk to about this topic jumps up and down and fairly shouts with glee about rainbows and unicorns and lollipops because … yeah, well, actually the foreign earned income exclusion is pretty sweet.
The first $100,200 of earned income (for 2015) can be exempted from U.S. income tax. More earned income can be excluded from U.S. income tax on top of that (for housing expenses). Use Form 2555 attached to a filed tax return to do this. (NOOB WARNING: you have to file a tax return to claim this exclusion. It does not automatically apply to you.
The next topic of conversation usually involves math and travel. How many days did you spend outside the United States? The number 330 gets mentioned a lot. Brows are furrowed. Much pondering. At least that’s the way it works for digital nomads. Oh, you might note a hand-wave in the general direction of bona fide residency (with no discussion of what that really means). But then everyone will start talking about 330.
But there are two words that no one seems to say. Tax home.
You do not qualify for the foreign earned income exclusion unless you know what those words mean, know what the IRS thinks they mean, and know that your tax home is where the IRS wants your tax home to be. The IRS is Mama. When Mama’s happy, EVERYBODY is happy. When Mama’s not happy, ain’t NOBODY happy.
Let’s make Mama happy.
And before I go on, let me translate that for the tax geeks among you.1
You must be a “Qualified Individual” to use the foreign earned income exclusion.2
There are two things that must be true in order for you to be a Qualified Individual:
- Your tax home must be outside the United States;3 and
- You must EITHER
a. be a U.S. citizen and a bona fide resident of a foreign country4 OR
b. you must be a U.S. citizen or resident alien (green card holder, “count the days” resident, or tax resident by election) and be outside the United States for **the right number of days** over a defined time period using a gratuitously overly-complex mathematical exercise that has the number 330 in it.5
The reason why everyone loves to talk about 330 days is because there is certainty. Yes, it is a stupidly over-complicated idea to understand and apply to your life. But you can figure it out.
No one wants to talk about the meaning of “tax home” because it is one of those defined pieces of jargon in the Internal Revenue Code that is poorly (at best) defined by the government. They tell you what they want, but they don’t tell you what they really mean. Your random Purveyor of Tax Expertise wants to look smart, hence discussions of math rather than trying to define the undefined.
The foreign earned income exclusion rules say that your tax home (for the purpose of the foreign earned income exclusion) has the same meaning as it does when you’re thinking about taking a tax deduction for travel expenses.6
The rules for taking a deduction for travel expenses7
are not exactly a model of clarity and have been hotly litigated by the IRS and taxpayers for decades. It’s an Itchy and Scratchy Show out there, people.
Here’s what the IRS has to say about the idea of “tax home” (which you must have if you want the foreign earned income exclusion):
Tax home. For purposes of paragraph (a)(i) of this section, the term “tax home” has the same meaning which it has for purposes of section 162(a)(2) (relating to travel expenses away from home). Thus, under section 911, an individual’s tax home is considered to be located at his regular or principal (if more than one regular) place of business or, if the individual has no regular or principal place of business because of the nature of the business, then at his regular place of abode in a real and substantial sense. An individual shall not, however, be considered to have a tax home in a foreign country for any period for which the individual’s abode is in the United States. Temporary presence of the individual in the United States does not necessarily mean that the individual’s abode is in the United States during that time. Maintenance of a dwelling in the United States by an individual, whether or not that dwelling is used by the individual’s spouse and dependents, does not necessarily mean that the individual’s abode is in the United States.8
I can hear you now. “Da fuhhhhhhhh?”
Let’s break it down.
No U.S. Home; You’re Always On the Move
If you are permanently on the move–traveling the way I like to travel, with everything in one backpack–there is a pretty clear answer. The IRS says that your home is where you are, because that is where you are working: from Chiang Mai, out of your backpack.9
There are a lot of court cases that support this position. The court cases are in the context of “Dear IRS, I want to take a deduction for travel expenses under Section 162(a)(2)”. Where someone is an itinerant worker (truck drivers are a classic example
WARNING PDF), the IRS takes the position that the tax home follows the person. Since the person is working at the same location as his tax home, the IRS denies a business expense deduction for travel away from home.
You like that conclusion by the IRS. If you are spending 90 days in Bali followed by two months in Thailand and then you’re off to Vietnam for nine months, your tax home is where you are. Since that tax home is outside the United States, you qualify for the first of the two legs that must be satisfied in order to qualify for the foreign earned income exclusion. Go play the 330 game now.
Have a U.S. Tax Home; Always On the Move
Key: if you have a permanent residence in the United States, this result may change. Rent it out to be safe. Go read Deamer v. Commissioner
. The taxpayer had a house in New York but rented it out while he was on the move. That was sufficient for the IRS and the Court to say that the house was not his “tax home”.
Bottom line: rent out the house, and you will have no problem claiming that your tax home (for foreign earned income exclusion purposes) is where your backpack is. As you shade toward more and more use of that home, your claim of tax home = backpack becomes more tenuous. This really will not be a problem for you, however – if you spend too much time in your home in the United States, you will blow up the magic 330 formula thereby eliminating the foreign earned income exclusion.
Keeping a rented apartment in the United States can be the same thing as a tax home.
My gut says that except in extraordinary circumstances a digital nomad is living and working abroad and would be considered an itinerant worker by the IRS. If the foreign earned income exclusion is questioned, it will not be due to the tax home question. The IRS will raise the 330 days question, because it is fun and the decision is a clean win/lose decision.
Where Trouble Lies
The trouble lies in the confluence of the bona fide residence test and the existence of some sort of fixed base in the United States.
If you have some sort of fixed base in the United States (business or residence) and you are claiming the foreign earned income exclusion because of the 330 day test, it is far easier for the IRS to challenge you on the math rather than challenge you on the location of your tax home. If you have a fixed base in the United States you are likely to have visited it a lot, thus blowing yourself up by spending too much time in the USA. If you didn’t spend too much time in the USA (related to your fixed business or residence base) then it is pretty good evidence that your tax home is elsewhere.
So the risk lies with those of you who claim to have a tax home outside the United States and you use the bona fide residence test to qualify for the foreign earned income exclusion. I’m not going to talk about what it means to be a “bona fide resident” of another country. That’s FunTime for AnotherTime. Let’s just say you qualify. E.g., you have P.R. status in Singapore but you spend all of your time jetting about on Air Asia and relatively little time in Singapore.
The reason this has a higher potential for blowing up in your face is that you can qualify under the bona fide residence test for the foreign earned income exclusion and spend a decent number of days in the USA. The 330 rule doesn’t matter to you. So now you have some sort of visible stake in the ground (a business base or a home base) and you are spending decent amounts of time there and showing visible ties to that location.
- Generally, your tax home is your place of employment. So if you have a business connection to the USA in some fashion, there is a risk that the “place of employment” is that location. You will be denied the foreign earned income exclusion, but as a lovely party gift the IRS will allow you (maybe) to deduct meals and other travel expenses for business travel away from home. Or maybe not. Maybe they will say the travel was not business related so no travel expense deductions for you and go stick your nose in a dead bear’s bum.
- But if you have no fixed place of employment (as would be true for a digital nomad, because you work where your brain and your MacBook Pro happen to be), then your tax home is your abode.10 Now you are sitting there with a lovely permanent resident visa for another country as well as a lovely home that you are maintaining in the United States. Meanwhile you bought the 90 day pass from Air Asia and are flying all over the place. Where’s your abode?
Oil rig workers have consistently been shut down in claims for foreign earned income exclusion based on “where is my tax home” reasoning. (Also because “in a foreign country” requirements are not satisfied if the oil rig is in international waters, so the income earned is not foreign source income that is eligible for exclusion. But that’s another Friday Edition, right?)
In my experience, digital nomads generally do not rely on the “bona fide residence” test to claim the foreign earned income exclusion. And those that do qualify for claiming the bona fide residence methodology usually (not always, though) spend enough time outside the United States to qualify via the “Magic 330” formula, too.
So this is likely to be a more theoretical than real problem for those of you living the life. People like me would have a problem. A business with an office ‘n people and a house with a mortgage and kids in school etc. Where’s your abode at now, Phil? Probably Pasadena looks pretty good to the IRS even if I sat happily in Ubud for 14 months. (Meh. I can make it work. I’m a tax lawyer. See you in Ubud.)11
Conclusion: Probably No Trouble
Yeah. So you know how I mocked all those people who tell you about everything except the tax home requirement? Maybe they are smarter than me. The tax home requirement is necessary but not sufficient for claiming the foreign earned income exclusion.
For those of you who are unencumbered by operating businesses and houses with mortgages, the tax home requirement will not be a problem. All those people telling you to tattoo “330” on the back of your hand are right.
For the rest of you, put a little bit of forethought into this “tax home” thing, especially if you using the “bona fide residence” hook to claim the foreign earned income exclusion. It shouldn’t be a terribly difficult thing to solve. But give it 15 minutes of thought, will ya?
Congratulations. You are now living in Donald Rumsfeld’s Land of Known Knowns.
You know the routine by now: don’t be dumb, this isn’t legal advice, hire someone competent. And go read Bill Murray’s response to the question “What is it like to be you?
”. Calmed me right down, that did.
See you next week. Send me an email or let’s go get coffee. We don’t even have to talk tax. I’m lonely.