36.2 What Is Foreign Earned Income?
For exclusion purposes, foreign earned income includes salaries, wages, commissions, professional fees, and bonuses for personal services performed while your tax home is in a foreign country and you meet either the foreign residence test or the physical presence test; see 36.3. Earned income also includes allowances from your employer for housing or other expenses, as well as the value of housing or a car provided by the employer. It may also include business profits, royalties, and rents, provided this income is tied to the performance of services. Earned income does not include pension or annuity income, payments for nonqualified employee trusts or nonqualified annuities, dividends, interest, capital gains, gambling winnings, alimony, or the value of tax-free meals or lodging under the rules in 3.12.
Foreign earned income does not include amounts earned in countries subject to U.S. government travel restrictions.
Courts have agreed with the IRS that income earned in Antarctica, in international waters, and in international airspace is not earned in a foreign country and thus cannot qualify for the exclusion.
U.S. government pay ineligible.
If you are an employee of the U.S. government or its agencies, you may not exclude any part of your pay from your government employer. Courts have agreed with the IRS that U.S. government workers were U.S. employees even though they were paid from sources other than Congressionally appropriated funds. If you are not an employee of the U.S. government or any of its agencies, your pay is excludable even if paid by a government source. You are not considered a U.S. government employee if you work for a private employer that has contracted with the government, provided you are under the employer’s control and supervision, you are paid by the employer, and no U.S. government agency would be liable for your salary if your employer defaulted.
Under a special law, tax liability is waived for a civilian or military employee of the U.S. government killed in a military action overseas; see 35.6.
Profits from sole proprietorship or partnership.
If your business consists solely of services (no capital investment), 100% of gross income is considered earned income. If services and capital are both income-producing factors, the value of your personal services, but no more than 30% of your share of the net profit, is considered earned income. Net profit is reduced by the deduction for the employer-equivalent portion of self-employment tax (12.2) before figuring your 30% share.
If you do not contribute any services to a business (for example, you are a “silent partner”), your share of the net profits is not earned income.
If you do not have a net profit, the portion of your gross profit that represents a reasonable allowance for personal services is considered earned income.
The partnership agreement generally determines the tax status of partnership income in a U.S. partnership with a foreign branch. Thus, if the partnership agreement allocates foreign earnings to partners abroad, the allocation will be recognized unless it lacks substantial economic effect.
Caution
Fringe benefits.
The value of fringe benefits, such as the right to use company property and facilities, is added to your compensation when figuring the amount of your earned income.
Royalties.
Royalties from articles or books are earned income if you receive them for transferring all of your rights to your work, or you have contracted to write the articles or book for an amount in cash plus a royalty on sales.
Royalties from the leasing of oil and mineral lands and from patents are not earned income.
Reimbursement of employee expenses.
Do not include reimbursement of expenses as earned income to the extent they equal expenses that you adequately accounted for to your employer; see 20.31. If your expenses exceed reimbursements, the excess is allocated according to the rules in 36.6. If reimbursements exceed expenses, the excess is treated as earned income.
Straight commission salespersons or other employees who arrange with their employers, for withholding purposes, to consider a percentage of their commissions as attributable to their expenses treat such amounts as earned income.
Reimbursed moving expenses.
Reimbursements of moving expenses are not reported as income if you adequately account to your employer for the expenses; see 12.8.
A reimbursement is taxable if received under a non-accountable plan or for moving expenses that are not deductible (12.3) or that you deducted in an earlier year. However, for purposes of claiming the earned income exclusion, the reimbursement may be considered to have been earned in a year other than the year of receipt. This is important because an exclusion is allowed only for the year income is earned. If the move is from the U.S. to a foreign country, the reimbursement is considered foreign earned income in the year of the move if you qualify under the foreign residence or physical presence test for at least 120 days during that tax year. Reimbursement of moving expenses from one foreign country to another is considered foreign earned income in the year of the move, if you qualify under the residency or physical presence test at the new location for at least 120 days during the tax year. If you do not meet one of these tests in the year of the move, the reimbursements are earned income that must be allocated between the year of the move and the following tax year.
A taxable reimbursement for a move back to the U.S. is considered income from U.S. sources if you continue to work for the same employer. If you move back to the U.S. and take a job with a new employer or if you retire and move back to the U.S. and your old employer reimburses your moving expenses under a prior written agreement or company policy, the reimbursement is considered to be for past services in the foreign country and qualifies as foreign earned income eligible for the exclusion. The reimbursement is considered earned in the year of the move if you qualified under the residency or physical presence test (36.5) for at least 120 days during the tax year. Otherwise, the reimbursement is allocated between the year of the move and the year preceding the move. See IRS Publication 54 for details.