The foreign earned income exclusion is only available from income that is earned, such as income from salary and employment. It is not eligible for passive type investment income. The tax law in this area, like most areas of U.S. tax law is excessively complex in the restrictions and requirements that exist in the law.
The foreign earned income exclusion (“FEIE”) is a completely different concept from the foreign tax credit (“FTC”).
The foreign tax credit requires the USC or LPR to reflect the non-U.S. source income on their tax return along with the non-U.S. income tax paid. The FTC then allows a credit to be calculated to reduce the amount of U.S. tax, which may reduce it to zero. In addition, any excess FTC amounts (i.e., where greater taxes were paid outside the U.S. as compared to the U.S. tax) can be carried forward or carried back under a set of specified rules.
In contrast, the FEIE, simply excludes the entire amount of the “earned” income from taxation in the U.S.
There is also a very different tax form used for the FTC as compared to the FEIE. See USCs and LPRs Living Outside the U.S. – Key Tax and BSA Forms
One basic requirement for the FEIE is that a U.S. income tax return must be filed, in order to elect and obtain the tax treatment to exclude the income from taxation. In addition to filing a U.S. tax return, the taxpayer must meet the residency tests and file IRS Form 2555, Foreign Earned Income
One common misunderstanding, is that a FEIE is always better than a FTC. This is not always true. The following spreadsheet reflects “earned” income in the form of salary. The taxpayer also has three other different types of income; dividend income, interest income and long-term capital gain from the sale of real estate.
As the example demonstrates, the USC or LPR living outside the U.S. has a higher tax burden in their country of residence on long-term capital gain, as compared to the tax on the earned income. Hence, in this particular case, the taxpayer will probably be better off by not electing to exclude the salary income from taxation under the FEIE. Instead taking a foreign tax credit for all income specifically including the salary income, i.e., “earned income” should produce a lower over-all U.S. income tax burden.
I will demonstrate in a later post the actual difference between how the FEIE and FTC produces a different result in the above example.