Claiming the Foreign Earned Income Exclusion when Filing a Late Return
The Foreign Earned Income Exclusion lets US expats exclude the first around $100,000 (the exact figure rises a little each year) of their earned income from US taxes.
It’s a great choice for many expats who earn less than this threshold, and sometimes a good option for expats who earn above the threshold too.
To claim the Foreign Earned Income Exclusion, expats have to file form 2555 with their annual US tax return. Form 2555 requires expats to prove that they live abroad.
They must do this either using the Bona Fide Residence Test, which requires them to prove that they are a permanent resident in another country, or the Physical Presence Test, which requires them to prove that they were outside the US for at least 330 days during the tax year (or a 365 day period that coincides with the tax year).
Many expats however, thinking that the Foreign Earned Income Exclusion exempts them from paying US taxes, incorrectly assume that they don’t have to file a US tax return. This assumption means that they have to file a late return and claim the Foreign Earned Income Exclusion in retrospect.
When can expats file the Foreign Earned Income Exclusion late?
The IRS rules allow some leeway at least for expats in this situation. They stipulate that the Foreign Earned Income Exclusion can be claimed:
– as part of a timely filed return, including any extensions
– as part of a return that is amending a timely filed return
– as part of a late filed return filed within one year of the original due date of the return (not counting any extensions)
After a year though, expats may still file a late return and claim the Foreign Earned Income Exclusion so long as they do so before the IRS discovers the absence of the return and contacts them.
“The foreign earned income exclusion is voluntary. You can choose the foreign earned income exclusion and the foreign housing exclusion by completing the appropriate parts of Form 2555.” – the IRS
The Redfield decision
Expats who wait until the IRS contacts them before filing late returns shouldn’t expect leniency from the IRS, as demonstrated by the recent Redfield decision.
Damon Redfield is a former US marine who left the military in 2010, He subsequently worked as a civilian contractor in Afghanistan briefly before returning to the US. He didn’t file a tax return though relating to the time he spent as a civilian abroad until the IRS contacted him in 2014, at which point he filed a late return and claimed the Foreign Earned Income Exclusion.
The IRS disallowed his late claim though, as they had already contacted him, and a court confirmed their decision in August this year, leaving Redfield liable to pay not just tax on the income he earned in 2010, but interest and penalties too, all of which would have been avoided had he filed and claimed the Foreign Earned Income Exclusion before the IRS contacted him.
Expats who need to catch up with their US tax return filing are better off filing at the earliest opportunity, before the IRS contacts them. In 2014, the IRS introduced a way for expats to catch up with multiple years US tax filing without facing penalties called the Streamlined Procedure.
To catch up using the Streamlined Procedure, expats must file their last 3 tax returns and, if required, their last 6 FBARs (Foreign Bank Account Reports, for expats with over $10,000 in total in foreign bank and investment accounts at any time during a tax year), and self-certify that their previous failure to file was non-willful.
When catching up using the Streamlined Procedure, expats can claim the Foreign Earned Income Exclusion (and/or any other exemptions available to expats), so in most cases become compliant without owing the IRS a penny.