# Foreign Earned Income Exclusion vs Foreign Tax Credit



## Nishitokyo2014

Hi all, 

I've got a question for any of you self-employed US expats here in Japan. 

When filing your US federal tax returns, do you take the Foreign Earned Income Exemption or the Foreign Tax Credit? Which is better for a small freelance business? 

Also, if any of you can explain why when taking the FEIE we must pay taxes on our business expenses (the logic behind it), I'd really appreciate it! I can't find any explanation. 

This is an example they give on various websites:

Example 2.(p33)
You are a U.S. citizen, have a tax home in Spain, and meet the physical presence test. You are self-employed and personal services produce the business income. Your gross income was $109,800, business expenses $63,900, and net income (profit) $45,900. You choose the foreign earned income exclusion and exclude $91,400 of your gross income. *Since your excluded income is 83.24% of your total income, 83.24% of your business expenses are not deductible*. Report your total income and expenses on Schedule C (Form 1040). On Form 2555 you will show the following:

Line 20a, $109,800, gross income,
Lines 42 and 43, $91,400, foreign earned income exclusion, and
Line 44, $53,190 (83.24% × $63,900) business expenses attributable to the exclusion.

Deposit	
In this situation (Example 2), you cannot use Form 2555-EZ since you had self-employment income and business expenses.

Any advice would be appreciated.


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## larabell

The part you've marked in bold is pretty easy to explain. Out of the total income in the hypothetical example, $91,400 is not being taxed at all -- it's completely tax-free by virtue of the FEIE. Therefore the portion of the expenses associated with that income isn't tax deductible because no tax was paid on the excluded income in the first place.

It works the same with the Foreign Tax Credit. Since the citizen in the example earned more than the FEIE limit, he can claim a tax credit for any foreign tax paid on the income that was *not* excluded. In other words, 16.76% of the foreign tax paid (100% - 83.24%) may be taken as a credit against whatever tax is due on the US return. However, the tax credit does not apply to foreign taxes paid on the portion of his income which was excluded from US taxes.

It's a simple pro-rated calculation. If half your income is excluded from taxation altogether, half your expenses must also be excluded and half the foreign income you paid cannot be used as a tax credit.


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## Bevdeforges

You may want to post this question in the Expat Tax section (or say the word and I can copy your query over there for you). 

Whether to take the FEIE or the FTC is also one of those things you may want to confer with other overseas taxpayers on. It can come down to how much tax you pay where you are and the timing of those tax payments.
Cheers,
Bev


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## Nishitokyo2014

larabell said:


> The part you've marked in bold is pretty easy to explain. Out of the total income in the hypothetical example, $91,400 is not being taxed at all -- it's completely tax-free by virtue of the FEIE. Therefore the portion of the expenses associated with that income isn't tax deductible because no tax was paid on the excluded income in the first place.
> 
> It works the same with the Foreign Tax Credit. Since the citizen in the example earned more than the FEIE limit, he can claim a tax credit for any foreign tax paid on the income that was *not* excluded. In other words, 16.76% of the foreign tax paid (100% - 83.24%) may be taken as a credit against whatever tax is due on the US return. However, the tax credit does not apply to foreign taxes paid on the portion of his income which was excluded from US taxes.
> 
> It's a simple pro-rated calculation. If half your income is excluded from taxation altogether, half your expenses must also be excluded and half the foreign income you paid cannot be used as a tax credit.


Thank you so much for the fast reply and thoughtful answer! I was expecting to have to wait a week or more!

I guess I'm a little slow learning, but in the example I gave the actual "income" after expenses would have been the "profit" after expenses. That is what the host country is going to tax as would the States if he/she was living there. It doesn't seem just to levy a tax on expenses paid, which is what is happening in the example I provided. Expenses are not income. Is there something I am missing?


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## Nishitokyo2014

Bevdeforges said:


> You may want to post this question in the Expat Tax section (or say the word and I can copy your query over there for you).
> 
> Whether to take the FEIE or the FTC is also one of those things you may want to confer with other overseas taxpayers on. It can come down to how much tax you pay where you are and the timing of those tax payments.
> Cheers,
> Bev


Bev, thank you so much for the quick reply! Yes, definitely, please copy and post my question in the Expat Tax section! 

Cheers!


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## larabell

Ni****okyo2014 said:


> I guess I'm a little slow learning, but in the example I gave the actual "income" after expenses would have been the "profit" after expenses. That is what the host country is going to tax as would the States if he/she was living there. It doesn't seem just to levy a tax on expenses paid, which is what is happening in the example I provided. Expenses are not income. Is there something I am missing?


That's not how FEIE works. You exclude from income, not from profit. Profit is income minus expenses, but... the expenses are considered to apply evenly across all income so if some portion of your income isn't taxed at all, you also have to ignore an equivalent portion of your expenses.

If your business was a separate entity and the "profit" was being passed through to you as "income" then you couldn't deduct the expenses at all because said expenses would have already been accounted for in computing "profit". So I think you're mixing up two different things.


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## Nishitokyo2014

larabell said:


> That's not how FEIE works. You exclude from income, not from profit. Profit is income minus expenses, but... the expenses are considered to apply evenly across all income so if some portion of your income isn't taxed at all, you also have to ignore an equivalent portion of your expenses.
> 
> If your business was a separate entity and the "profit" was being passed through to you as "income" then you couldn't deduct the expenses at all because said expenses would have already been accounted for in computing "profit". So I think you're mixing up two different things.


Again, thanks for the speedy reply!

Ok, so it seems I'm mixing up income and profit. So, just to be sure, if someone who works for a company is paid a $50k salary, they pay no US taxes using FEIE, but a person who runs a small business and generates a gross income of $100k but has expenses of $50k must pay taxes not only the amount above the FEIE ($97,600) but also on the $50k of expenses they had? What could possibly be the logic behind that? Is it to prevent people from starting businesses? Both people only take home $50k of which they both have to pay local (Japanese) taxes on.

My understanding is if a small business/self-employed person was operating in the States, they would only pay taxes on the profit after expenses (assuming the expenses were allowed). They would be allowed to deduct their expenses before calculating their tax liability. They would not pay taxes on the full gross income generated by the company. Am I incorrect in this assumption?

Again, thanks for taking the time to reply to my questions!


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## larabell

I'm not sure why you think you'd be paying taxes on the $50K of expenses.

Assuming the income from your "business" is being treated as personal income, and rounding the FEIE to $90K to make the calculations easier, you would be able to exclude all but $10K of your income from US taxation. Because you're only being taxed on 10% of your total income, you can only deduct 10% of your expenses -- which would be $5K. Your net taxable income becomes $5K (the excess $10K over your FEIE exclusion minus 10% of your expenses). You would pay tax on $5K (although, if I remember right, you might have to pay at the marginal tax rate for $100K).

Granted, paying US tax on $5K is different from not paying anything at all but all you would have to do is structure your business so only the $50K over expenses becomes personal income. In fact, it might work that way already (as I recall, Schedule C has you compute the profit from a business and then copy the difference over to your personal 1040, no?). I've filed Schedule C before but never as an expat.

Anyway... if the difference is significant to you, you really should be talking to a tax expert.


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## Nishitokyo2014

larabell said:


> I'm not sure why you think you'd be paying taxes on the $50K of expenses.
> 
> Assuming the income from your "business" is being treated as personal income, and rounding the FEIE to $90K to make the calculations easier, you would be able to exclude all but $10K of your income from US taxation. Because you're only being taxed on 10% of your total income, you can only deduct 10% of your expenses -- which would be $5K. Your net taxable income becomes $5K (the excess $10K over your FEIE exclusion minus 10% of your expenses). You would pay tax on $5K (although, if I remember right, you might have to pay at the marginal tax rate for $100K).
> 
> Granted, paying US tax on $5K is different from not paying anything at all but all you would have to do is structure your business so only the $50K over expenses becomes personal income. In fact, it might work that way already (as I recall, Schedule C has you compute the profit from a business and then copy the difference over to your personal 1040, no?). I've filed Schedule C before but never as an expat.
> 
> Anyway... if the difference is significant to you, you really should be talking to a tax expert.


Larabell, again, thank you so much for all your input! Are you an accountant?

The more I dig into this the more complicated it is and completely unfair a system it appears to be.

Apparently you CANNOT take the FULL deduction if you have business expenses. Your FEIE is REDUCED by a percent that is generated by dividing the FEIE by total income. Then the business expenses are multiplied by the percent generated. From there the total FEIE is REDUCED (adjusted) by that amount. And finally you have to pay the difference between your total income minus the ADJUSTED FEIE.

So, for example if someone with a small business has a total GROSS income of $100K and business expenses of $40K, the IRS will divide the FEIE deduction ($97,600) by total GROSS income which equals 97.6%. Then the total expenses are multiplied by that percent which equals $39,040. Then the FEIE is REDUCED by $39,040 to equal $58,560. And finally the total GROSS income is reduced by the new ADJUSTED FEIE to equal $41,440. This is the amount that is TAXABLE at a rate of 28% which equals $11,603. 

This is a huge difference from the person with an equivalent salary of $60,000 who doesn't have to pay anything using the FEIE.

This is what appears to have happened to me last year (of course, different numbers). If you (or anybody) can tell me that I've made a mistake, I would really love to hear it. And, if there is a better way of dealing with this any advice would be appreciated!


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## larabell

I got the following from About.com:

"Self-employed persons working abroad may claim the foreign earned income exclusion and the foreign housing deduction. Both the income exclusion and the housing deduction will be calculated based on your net income as figured on Schedule C or Schedule F."

What I believe that means is that you take your gross income minus whatever business expenses you incurred to produce that income and that becomes your net income. From net income you would then subtract the FEIE exclusion. If anything is left, you're taxed on that.

I don't follow your description and it doesn't match what little I know about FEIE. But, then again, I'm not an accountant. You really should be talking to one.


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## Nishitokyo2014

larabell said:


> I got the following from About.com:
> 
> "Self-employed persons working abroad may claim the foreign earned income exclusion and the foreign housing deduction. Both the income exclusion and the housing deduction will be calculated based on your net income as figured on Schedule C or Schedule F."
> 
> What I believe that means is that you take your gross income minus whatever business expenses you incurred to produce that income and that becomes your net income. From net income you would then subtract the FEIE exclusion. If anything is left, you're taxed on that.
> 
> I don't follow your description and it doesn't match what little I know about FEIE. But, then again, I'm not an accountant. You really should be talking to one.


Larabell, I can't say thank you enough. You've been wonderful in replying to my queries. 

Unfortunately, the example I provided above is exactly how my accountant in the States filed my taxes. This is why I came to this site hoping to find others who have a similar situation to mine and can provide advice on how to navigate the ridiculous US tax code. If my accountant is wrong, I need to figure out what is correct. 

Thanks again for all your help!!!


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