# A question about oversea income exclusion



## veggie (May 13, 2021)

Apologize in advance if this question has been asked before. I have spent a lot of time reading up and down to find answers. My CPA seems not very familiar with oversea income and tax. I have earned about equal amount salaries both in US and UK last year. 2/3 of my UK income will be excluded by form 2555. However, the UK part greatly increase my US tax liability. I carefully looked at the tax return my CPA prepared. The excluded amount is also used in calculation the US federal tax, then a deduction is calculated on this excluded amount but at a lower tax rate. So it ends up with a pretty big federal tax, far exceeding my usual tax withholding. My CPA claims this is how his software does and can't be wrong. On this return, the AGI doesn't include excluded salary but does include the part of UK income (about 1/3) not excluded. However from what I can tell, this part of non-excluded income wasn't used to calculate federal tax. Does this look right? I had thought that once excluded, the foreign income wouldn't affect US tax rate even though it will appear on tax return. This is my first time dealing with foreign income. Phone calls to IRS didn't give me any answer. Please education me. TIA!


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## Moulard (Feb 3, 2017)

Your thinking was right... once upon a time... but not now.

Before 2006 (if memory serves correct) if you had an income of say 100k, and excluded 90k the remaining to 10k would be taxed as if your gross income was 10k.

Now however, non-excluded income is taxed based on your actual gross income, so that 10k is taxed at the rate applicable for an income of 100k.

Take a look at the Foreign Earned Income Tax Worksheet in the 1040 general instructions (p. 34)

What is not clear from your post is where your US income is sourced or whether it is earned income or not. 
This is important from the perspective of which country has the primary right to tax the income and whether or not you might be better off using Foreign Tax Credits to Offset your US tax liability as opposed to the FEIE.


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## veggie (May 13, 2021)

Hi Moulard, thank you for your reply! My US income is salary with W2. Using some numbers as example:
If I made 80K from US employer and 90USD from UK employer. 60K of the 90K was excluded. On my CPA's return: federal tax is calculated based the tax bracket on 80K+60K=140k then substracting the tax bracket based on the 60K. However the tax rate of 80+60K is higher than that on 60K. End result is that there will be tax on the 60K. Shouldn't the 60K be excluded from federal tax calculation? Would it make more sense that the non-excluded 30k being included in this calculation method? Even though on my CPA's calculation, my current AGI is actually 80K+30K=110K... This is so confusing.


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## Moulard (Feb 3, 2017)

For wages income is sourced based on where you perform the work not who is paying you...

Trying to reverse engineer your circumstances...

you in the UK when working for your UK employer (60k)
you moved to the US, where you continued to work for your UK employer (30k)
then you started to work for a US employer in the US (80k)
If this is right, then 60k can be excluded and 110k would be considered US sourced income and therefore cannot be excluded. 

So your gross income would be 170k, after excuding the 60k your AGI would be 110k 

Long and the short, assuming I have intuited your circumstances correctly and I am not missing something it appears your CPA has it right.


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## veggie (May 13, 2021)

I should have made it more clear. Continue with that example, I worked in the US for half a year and earned USD80k then moved to UK and earned 90KUSD (70KGBP). Tax collected by UK government is 1/3, ouch...

I had thought I only need to pay tax to IRS on the USD80K because the 90K UK income will be either excluded or covered by foreign tax credit since UK tax rate is way higher than US. Therefore, my tax to IRS would be the same regardless that 90K USD UK income. Now on CPA's return:
AGI=80K+30K=110k after about 60k of the 90K excluded through his software.
Federal tax = rate1 x (80+60k)- rate2 x 60k . Rate 1 is around 18%, rate 2 is about 12%. After this calculation, essentially, I own 6% of the 60K to IRS on top of the tax of 80k. This part is very confusing to me. Thank you!



Moulard said:


> For wages income is sourced based on where you perform the work not who is paying you...
> 
> Trying to reverse engineer your circumstances...
> 
> ...


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## Moulard (Feb 3, 2017)

OK...

Unless you meet the bona fide resident rules (which you do not as you have not been in the UK for a full calendar year), the exclusion amount is proportionally reduced based on your time out of the US that is within the tax year.

This means the FEIE is really ineffective means to reduce your tax liability if you moved to the UK mid way through the year and are having to rely on days outside the tax year to meet the physical presence test. Just using an example to to show how ineffective it is...

Lets say you were in the UK for only 200 days in the 2020 tax year then you would only be able to exclude a maximum of 200/366 x 90k = 49,180 USD not the full 90k you earned

For lower income earners who can offset the difference using the standard deduction it doesn't matter... but at higher incomes it definitely becomes problematic.

Additionally, if the amounts you quote are pro-rata salary amounts of what you would be earning in the UK once there for a full year, then you are likely to be above the exemption limit anyways and have to revert to FTCs next tax year regardless.

I would suggest you use foreign tax credits to offset the US tax liability on your UK income rather than the FEIE as it will be far more effective.

To minimize your US tax liability you have two options

Exclude some UK income using the FEIE and then claim a proportionally reduced pro-rata share of UK taxes paid or accrued on the remainder
Revoke the FEIE and claim 100% of the UK taxes paid or accrued on your UK sourced income (up to the amount of US tax owed on that income).
Personally I would choose to go down #2, as you will be able to carry over excess UK taxes for up to 10 years. The only real downside is that once you revoke the FEIE you cannot use it again for 5 years. If you will be in the UK that long then it is of no consequence, but would be an issue if you were to move to a country with tax rates lower than the US within that period.


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## Bevdeforges (Nov 16, 2007)

The term "exclusion" is something of a misnomer here. Plus, the mechanics of the calculation don't actually "exclude" amounts earned overseas. The FEIE threshold has to be apportioned according to the length of time you worked overseas vs. in the US (as do any and all deductions that you may be entitled to against the total income).


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## veggie (May 13, 2021)

Really appreciate your explanation!

For option 1, some income is excluded by FEIE, and tax on the non-excluded part is deducted by Foreign tax credit. 

Seems option 2 makes more sense. Through my research, foreign tax credit only requires 1666 form, not 2555. But my CPA keeps telling me 1666 form can't be used along. I guess AGI will become 80+90k if option is used?



Moulard said:


> OK...
> 
> Unless you meet the bona fide resident rules (which you do not as you have not been in the UK for a full calendar year), the exclusion amount is proportionally reduced based on your time out of the US that is within the tax year.
> 
> ...


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## veggie (May 13, 2021)

Thank you for your explanations. I am trying very hard to understand how the tax is calculated when FEIE is involved. Seems I need to find the right CPA...



Bevdeforges said:


> The term "exclusion" is something of a misnomer here. Plus, the mechanics of the calculation don't actually "exclude" amounts earned overseas. The FEIE threshold has to be apportioned according to the length of time you worked overseas vs. in the US (as do any and all deductions that you may be entitled to against the total income).


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## Bevdeforges (Nov 16, 2007)

veggie said:


> Seems option 2 makes more sense. Through my research, foreign tax credit only requires 1666 form, not 2555. But my CPA keeps telling me 1666 form can't be used along. I guess AGI will become 80+90k if option is used?


That's form 1116.

What I think your CPA may be trying to explain to you is that if your foreign earned income is, for example, $100,000 and the FEIE limit for the year is $110,000, you can't elect to only take the FEIE on, say $70,000 and then use the Foreign Tax Credit on the remaining $30,000.

Now, if your foreign earned income for the year is $150,000 and the limit is $110,000 you CAN take the full $110,000 exclusion and then apply the FTC to the remaining $40,000.

Where things get tricky is when you are dealing with differing tax years (as you do between the US and UK). For US taxes, you have to figure on what you earned during the calendar year, not the UK tax year. And for the UK taxes, you base it on what you earned during the UK tax year (April to April). So it depends very much on when you changed jobs and countries.


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## veggie (May 13, 2021)

Hi Bevdeforges, I start to understand the expat tax a little better. Your example is exactly my question:

"Now, if your foreign earned income for the year is $150,000 and the limit is $110,000 you CAN take the full $110,000 exclusion and then apply the FTC to the remaining $40,000."

Will this excluded $110,000 affect my US tax rate? On my CPA's return, this 110,000 was used to calculated federal tax with a high tax rate and then got deducted at lower tax rate.



Bevdeforges said:


> That's form 1116.
> 
> What I think your CPA may be trying to explain to you is that if your foreign earned income is, for example, $100,000 and the FEIE limit for the year is $110,000, you can't elect to only take the FEIE on, say $70,000 and then use the Foreign Tax Credit on the remaining $30,000.
> 
> ...


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## Moulard (Feb 3, 2017)

veggie said:


> Will this excluded $110,000 affect my US tax rate? On my CPA's return, this 110,000 was used to calculated federal tax with a high tax rate and then got deducted at lower tax rate.


The income that is not excluded is not taxed, but the remainder is taxed at the rate that would have applied if it was all taxable income.
This is what I was trying to explain earlier in the thread.. Using Bev's 150k, exclude 110k and FTCs of 40k..
Lets presume the tax rate at an income of 150k is 30% and the tax rate at an income of less than 50k is 20%
The tax owned on the $40k is not 20% but rather 30% .. so 12k of tax not 8k of tax.

As to Foreign Tax Credits, there are two primary approaches you can use to deal with the difference in tax year (I deal with this every year with the Australian 1 July- 31 June tax year)

The first is to use a cash basis, and you simply ignore the differences in tax years. In the case of Australia, I file my tax return in say October, and the notice of assessment I get tells me the tax I actually owed on 1 July for the previous Australian tax year. So basically I report income received for say the 2020 the calendar year, but tax paid for the 19-20 Australian fiscal year. While much simpler, the differences between tax year and income year can be more problematic if you income is highly variable or there are significant exchange rate changes.

The second is to use an accrual basis, and use the tax withheld on your income as the basis for accrual and you reconcile against any refund either before you submit your return or file an amended return to account for any additional tax paid or refund.

I recommend people use the simpler cash basis until such time as a circumstances mean that they will owe US tax, at which point swap to an accrual basis and use that from that year onwards (you can move from cash to accrual but not from accrual to cash)

The only other "gotcha" with FTCs is that you are required to complete (but not necessarily submit) AMT form 6251 and if your income is over the exemption amount run a parallel set of FTCs using the AMT tax rate and not the general tax rate.


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## veggie (May 13, 2021)

Really appreciate your effort!

Using my example:
Lived in the US and made USD80k then moved to UK on July 1 and earned 90KUSD (70KGBP). Tax collected by UK government is 1/3.
On my CPA's return, without the UK income, my federal tax is, say, 14.4k. With the UK income counted in, my federal tax jumped to 20.4K, even though the FEIE (60K) and FTC are all used (I saw both 2555 and 1116 forms). Could this happen? 

I had thought that with FEIE and FTC being used, my tax liability to IRS won't be affected regardless of this 90K income from UK, since the UK tax rate is quite a bit higher than the US. 

I went through the return, and realized the increase came from this calculation:
Federal tax = rate1 x (80+60k)- rate2 x 60k . Rate 1 is around 18%, rate 2 is about 8%. The excluded amount is playing a roll here.

FTC is definitely a more straightforward approach....




Moulard said:


> The income that is not excluded is not taxed, but the remainder is taxed at the rate that would have applied if it was all taxable income.
> This is what I was trying to explain earlier in the thread.. Using Bev's 150k, exclude 110k and FTCs of 40k..
> Lets presume the tax rate at an income of 150k is 30% and the tax rate at an income of less than 50k is 20%
> The tax owned on the $40k is not 20% but rather 30% .. so 12k of tax not 8k of tax.
> ...


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## Moulard (Feb 3, 2017)

As it happens, I had a bit of time to kill... and being in a generous mood, I reinstalled some older tax software I have... and modeled your Tax return using the FEIE + FTCs vs just using FTCs...

Thisis based on... US income 80k, UK income 90k, UK taxes Paid 33,333 physically present in the UK for 183 days

Caveat, that this was done in about 15 minutes and using 2019 software ...but I hope it will be instructive of the impact of your choice (or your accountants choice) to use FEIE.

FEIE exclusion + FTCs for the UK income not excluded

Gross Income of $170k USD
FEIE - rules mean you can exclude a max of 53,095 of your UK income. (assuming physically in the UK for 183 days in 2020 given you state you arrived on 1 July) so you have $36905 in unexcluded foreign income
Reduces your taxable income to 104705 after the standard deduction and thus a potential tax liability of $25,262 before you take FTCs into consideration
Using the FEIE means you have exclude 58.99% of your foreign income and thus have to reduce the foreign taxes available to use from 33,333 to 13,669
After you split the standard deduction between US and UK income you have a foreign taxable income of $30446 out of a gross taxable income of $104725.. ie 29.0779% of your taxable income is foreign
Through the magic of mathematics this means you can utilize $7,128 of foreign tax credits
Resulting in a US tax liability of $17,916 and a carryover amount of $6541

Now, if you revoked the FEIE and use only FTCs

You still have a gross income of $170k USD but your AGI is now 170K USD
After the Standard deduction you have a taxable income of $157,800 and a potential US tax liability of $33,027 before taking FTCs into account
This time however, because you have not excluded any income, you have a foreign taxable income of $83,541
But the other side of that coin is that you can now utilize $16,966 of your foreign taxes
Which leaves you with a US tax liability of $15,542 and a carryover amount of $16367

Long and the short, I would recommend you get your Accountant to do the sums only using the FTCs - something a good one should have done regardless.


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## Bevdeforges (Nov 16, 2007)

One other "gotcha" (or potential "gotcha") with using the FTC is that you have to apply the taxes paid according to the type of income taxed. So, if you have any sort of bank interest or investment income, the FTC on that has to be calculated separately from the FTC on your salary income. For someone with significant "passive income" from investments or bank accounts or other sources, this means a separate form 1116 for each type of income. 

Where this can foul people up is if you have "tax free" holdings in your country of residence. The US rarely recognizes these as "tax free" for US purposes, so you may have 0 foreign taxes to credit against your US tax obligation. This, unfortunately, may apply to some sorts of savings-based retirement accounts and therefore can negate the whole retirement savings benefits for US citizens.


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## Moulard (Feb 3, 2017)

Yup...and you always have to complete and maintain a separate set of FTC calculations using the AMT tax rate.

At one point I was looking down the barrel of 6 FTC forms (regular and AMT versions of passive, general, and resourced by treaty)

The treatment of concessionally taxed retirement accounts is problematic regardless -- one clearly needs to be mindfull of a whole bunch of things.

But at least for the OP, UK-US pension is far nicer on pensions that many other treaties.


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## veggie (May 13, 2021)

Hi Moulard, you are indeed so generous and patient. Thank you. You know more than my CPA about expat tax. He only keeps telling me how wonderful his tax software is which costs him 15k yearly so it can't be wrong... I asked him to do the return using FTC only. He said his software only allows income entered by 2555 form.

One more thing, if you haven't uninstalled your software, what the US tax liability is once the UK income is taken away?



Moulard said:


> As it happens, I had a bit of time to kill... and being in a generous mood, I reinstalled some older tax software I have... and modeled your Tax return using the FEIE + FTCs vs just using FTCs...
> 
> Thisis based on... US income 80k, UK income 90k, UK taxes Paid 33,333 physically present in the UK for 183 days
> 
> ...


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## Moulard (Feb 3, 2017)

veggie said:


> He said his software only allows income entered by 2555 form.


I am going to bite my tongue on this one and simply say that it is time to get yourself another CPA. One who is better versed and prepared to support the myriad of issues faced by expats.

Or, given you have a head for numbers, you can always do it yourself. Your income is above the free-file limit, but those providers will e-file a self prepared return for you for a fee. 



veggie said:


> what the US tax liability is once the UK income is taken away?


Unless you are happy to sign a fraudulent return, you cannot simply "take away" your UK income.

The US taxes its citizens and permanent residents on their global income. Therefore your UK income is part of your US tax liability.

You have two primary tools at your disposal to reduce the double taxation that will result because the UK will have the primary right to tax your UK income.

FEIE (form 2555)
FTCs (form 1116)
Given your circumstances, with both of these, you *will *end up paying a higher rate of tax on your US income than would be the case if you only reported your US income on your tax return.


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## veggie (May 13, 2021)

Moulard said:


> I am going to bite my tongue on this one and simply say that it is time to get yourself another CPA. One who is better versed and prepared to support the myriad of issues faced by expats.


Hi, Moulard, yes, I am in touch with an expat CPA now even though I already paid the first guy....




Moulard said:


> Unless you are happy to sign a fraudulent return, you cannot simply "take away" your UK income.
> 
> The US taxes its citizens and permanent residents on their global income. Therefore your UK income is part of your US tax liability.
> 
> ...


No, of course NOT going to do a a fraudulent return. My only question from the very beginning is whether the UK income will affect amount of tax to IRS... I had thought that due to the tax treaty between UK and US, there would be no double taxation. Thus, even my UK income is reported on the tax return, tax collected by IRS will be the same in my situation. I am just kind of shocked to see on my CPA's tax return, my tax liability jumped so much. So I am wrong. 

Thank you again for your explanations and suggestions!


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## Moulard (Feb 3, 2017)

Tax treaties are not about prevention of double taxation but rather about dividing the spoils.

The issue in your case is that your UK income pushes you into a higher tax bracket, and thus your US income gets taxed at this higher rate. 
This is compounded by the fact that FEIE is not really effective unless you have been outside the US for an entire year.


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## veggie (May 13, 2021)

Bevdeforges said:


> One other "gotcha" (or potential "gotcha") with using the FTC is that you have to apply the taxes paid according to the type of income taxed. So, if you have any sort of bank interest or investment income, the FTC on that has to be calculated separately from the FTC on your salary income. For someone with significant "passive income" from investments or bank accounts or other sources, this means a separate form 1116 for each type of income.
> 
> Where this can foul people up is if you have "tax free" holdings in your country of residence. The US rarely recognizes these as "tax free" for US purposes, so you may have 0 foreign taxes to credit against your US tax obligation. This, unfortunately, may apply to some sorts of savings-based retirement accounts and therefore can negate the whole retirement savings benefits for US citizens.


Thank you for the heads up!


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## veggie (May 13, 2021)

Moulard said:


> Tax treaties are not about prevention of double taxation but rather about dividing the spoils.
> 
> The issue in your case is that your UK income pushes you into a higher tax bracket, and thus your US income gets taxed at this higher rate.
> This is compounded by the fact that FEIE is not really effective unless you have been outside the US for an entire year.


Yes, things seem to make sense now. California is more painful because FEIE isn't even recognized here. Ouch!


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## Moulard (Feb 3, 2017)

CA is definitely a "sticky" state when it comes to residency status particularly in term of breaking domicile.

If you have left the state permanently when you moved to the UK and you have abandoned any intention to return to CA then you could well have broken domicile. That being the case, you can file as a part year resident of CA. 

Its really going to boil down to intent.


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## veggie (May 13, 2021)

Moulard said:


> CA is definitely a "sticky" state when it comes to residency status particularly in term of breaking domicile.
> 
> If you have left the state permanently when you moved to the UK and you have abandoned any intention to return to CA then you could well have broken domicile. That being the case, you can file as a part year resident of CA.
> 
> Its really going to boil down to intent.


Googled up this "part year resident of CA". This seems to be a good thing to me...


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## veggie (May 13, 2021)

I googled around and found something called the "stacking rule". This explains everything. Tax on the FEIE is calculated at higher rate and sheltered amount is calculated at the lowest rate. End result is tax liability on the FEIE amount. This is indeed double taxation. Anyways I got the idea now. 

"Calculation of U.S. tax liability (stacking rule) If you claim the FEIE, your income tax is figured using a special calculation called the “stacking rule,” which causes the exclusions to be less beneficial than other deductions or exclusions of the same amount would be. Like many countries, the United States has progressive tax rates, which means that the higher a person’s taxable income is, the higher his rate of tax. In the U.S., each level of tax is referred to as a “bracket,” with higher levels of income subject to higher tax rates, while income in the lower brackets continues to be taxed at the lower rates. For example, in 2016, a single taxpayer with taxable income of USD 75,000 will pay tax of 10 percent on the first USD 9,325 of income, 15 percent on income in excess of USD 9,325 up to USD 37,950, and 25 percent on income over USD 37,950. The taxpayer would be referred to as being in the 25-percent tax bracket, and would know that his next dollar of income would be taxed at 25 percent. The same applies to deductions – if the taxpayer were to have an additional deduction of USD 100, he would know that because he was in the 25-percent bracket, the benefit of that deduction would be to lower his tax by 25 percent of the deduction, or USD 25. *However, the FEIE is less valuable than other deductions and exclusions, due to the stacking rule, which causes the FEIE to offset income that is taxed in the lowest brackets, rather than in the highest brackets. In our example above, if the taxpayer had a deduction of USD 30,000, it would offset income that would be taxed at 25 percent. However, if the taxpayer had a FEIE of USD 30,000, it would shelter income that would be taxed at 10 and 15 percent.* The stacking rule is applied by figuring the tax on your taxable income without taking the foreign earned income and housing cost exclusions into account. Next, the tax is figured on the amount of your total foreign earned income and housing cost exclusions (at the appropriate graduated tax rates and with no other deductions taken into account), as if the amount of the exclusions was your taxable income. Finally, the difference between the two amounts is your actual U.S. tax liability for the year"



Moulard said:


> CA is definitely a "sticky" state when it comes to residency status particularly in term of breaking domicile.
> 
> If you have left the state permanently when you moved to the UK and you have abandoned any intention to return to CA then you could well have broken domicile. That being the case, you can file as a part year resident of CA.
> 
> Its really going to boil down to intent.


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