Exceptions to the Bona Fide Residence and Physical Presence Tests

When American citizens live and earn income abroad, they generally must pay income taxes on their foreign income to the country in which they work and live. As they are still American citizens, they are also legally required to file tax returns with the United States.

However, the Internal Revenue Service (IRS) permits citizens who live and work abroad to exclude from their income an amount that is adjusted annually for inflation under the tax code’s international tax exclusion. The amount that can be excluded was: $108,700 for 2021 and $112,200 for 2022. The effect is that they are not forced to pay taxes twice on the excluded portion of their foreign earned income.

There are two tests in the Internal Revenue Code that are used to determine a person’s eligibility for this exclusion:

• The bona fide residence test: In order to qualify for the foreign earned income exclusion, a person must meet 4 criteria under the bona fide residence test:
  • The person must be a U.S. citizen or a U.S. resident alien living in a country that is as a party to a tax treaty with the US;
  • The person must have a residence in a foreign country;
  • The person must live in the foreign country for the entire tax year, meaning typically from January 1 through December 31 of a single year. Short trips or vacations to the U.S. are permitted;
  • The person must not have any plans to move back to the U.S. in the foreseeable future.
• The physical presence test. The physical presence test requires that a person be physically present in a foreign country or countries for at least 330 full days during a period of 12 consecutive months. The 330 days during which the person is outside the U.S. do not need to be consecutive.

Both tests are designed to determine if an American citizen or resident alien working and living abroad really lives outside the U.S. long enough to justify allowing them to exclude the allowed amount of their annual foreign earned income. Taxpayers only need to satisfy one of these tests to qualify for the foreign earned income tax exclusion.

People who qualify for the foreign earned income exclusion are also likely to qualify for the foreign housing deduction, which can also help them reduce their tax liability. The foreign housing exclusion and deduction is an allowance for taxpayers who live and work in a foreign country to exclude any amount that their employer allocates to them to cover costs related to housing. The exclusion applies regardless of whether the expenses are paid directly to the taxpayer or paid on their behalf.

To qualify for the foreign housing exclusion and deduction, taxpayers must meet the same time requirements as those required for either the bona fide resident or physical presence tests. There are some technicalities to the foreign housing exclusion and deduction that are not relevant here. A person who receives money from their employer as a housing allowance should consult a qualified U.S. tax attorney for advice.

Both citizens and resident aliens of the U.S. may make use of the foreign earned income exclusion. According to the tax code, a person’s reason for being abroad is not relevant to this test. However, if a family emergency, illness, or employer directive causes the taxpayer not to be present in the foreign country, these reasons are not enough to excuse the taxpayer’s failure to be present in a foreign country for the required 330 days.

Furthermore, a “day” is considered a full 24 hours. So the days on which a person arrives in and departs from a foreign country do not count toward the 330 days.

A person may travel between foreign countries during their time abroad, but any time spent in the U.S. while in transit, such as during a layover between flights, does not count towards the person’s 330 days, if it is less than 24 hours.

In addition, a person needs to understand that they must still consider that U.S. Social Security and Medicare taxes continue to apply to wages that a person is paid for services performed as an employee in a foreign county. There is a long list of rather complicated conditions that must apply to create the obligation for a taxpayer to make Social Security and Medicare withholdings. So, again, a person should seek the advice of a qualified tax lawyer

Are There Exceptions to the Bona Fide Residence and Physical Presence Tests?

There are two exceptions to the requirements of the bona fide residence and physical presence tests for international tax purposes. They are as follows:

• Waiver of Time Requirements;
• U.S. Travel Restrictions.

The income a person receives as military or civilian income while they are stationed abroad is not considered foreign earned income by the U.S. government.

What Is the Waiver of Time Requirement?

Both the bona fide residence test and the physical presence test usually contain minimum time requirements. However, minimum time requirements can be waived if the taxpayer must leave a foreign country because of:

• War;
• Civil unrest; or
• Similar adverse conditions.

The taxpayer may still qualify for the foreign earned income exclusion If they can demonstrate that they would have met the requirements of the physical presence test had it not been for the adverse conditions that forced them to leave their foreign domicile.

Furthermore the taxpayer would also have to show that they had a tax home in that country and were a bona fide resident of the country at the time circumstances forced them to leave. If they can meet this requirement, they may still make use of the foreign earned income exclusion.

What Else Do I Have to Show for This Requirement?

A person also must be able to show that they reasonably could have expected to meet the minimum time requirements if not for the adverse conditions. To qualify for the waiver, a person must in reality have had their tax home in the foreign country and be a bona fide resident of, or be physically present in, the foreign country on or before the beginning date of the waiver period.

What Does the IRS Mean by U.S. Travel Restrictions?

If a person lives in a foreign country in violation of U.S. travel restrictions, they will not qualify as a person who is a bona fide resident of a foreign country. They would not qualify for the physical presence test either. This is because income from sources within such countries does not qualify as foreign earned income.

Housing expenses in that country while a person lives there in violation of the law cannot be included in calculating the amount of a foreign housing deduction. The only country to which this restriction applies is Cuba, excluding the United States Naval Base at Guantanamo Bay.

Do I Need a Lawyer?

The law concerning exclusions and deductions for income earned in a foreign country can be complicated. Of course, you do not want to make mistakes on your income tax returns as this can lead to receiving unpleasant communications from the IRS.

So, it is a really good idea to consult an experienced tax lawyer who can help you with foreign earned income. Your tax lawyer can give you reliable advice as to whether you qualify for the special exclusions and deductions for foreign earned income.