First of all, obligatory legal disclaimer. I must make it clear that I am not your attorney. The rules outlined below apply differently to everyone based on each individuals’ facts and circumstances. This is not legal advice, etc.
My goal in writing this guide is to provide general information to make you a more well-informed tax payer and to also provide practical tips you can follow to ensure compliance with tax law and possibly help save you tax dollars. With that said, this guide does cover some pretty complex topics. I have included rules from regulations that even most tax lawyers likely would not discover unless doing targeted research for a digital nomad client.
A few years ago I begin writing what would have been my first book all about digital nomad taxes. It never happened - I instead wrote Unf*ck Your Biz - but I decided to turn what I had completed into a blog. Since there was so much juicy, riveting content already, I split it into 5 parts. I'd recommend reading them in order, like chapters in a book. However, if you want to skip ahead you'll find direct links to the other parts below.
The General Rule
The U.S. tax system is widely considered one of the most complex in the world. Unsurprisingly, U.S. international tax law is one of the more complicated areas of U.S. tax. There are different rules that apply to citizens vs. non-citizen residents vs. non-residents. This guide is focused on the rules affecting U.S. citizens living and working abroad. For tax purposes, under most rules, Green Card holders are treated as U.S. citizens, so this guide should prove useful for these individuals as well.
The general rule regarding U.S. tax is that U.S. citizens are taxed on their worldwide income. Throughout this series, this principle will be referred to as the “General Rule.” Let’s state it one more time. The General Rule is that, U.S. citizens are taxed on their worldwide income.
The vast majority of nations only tax citizens on income earned in that respective country. Our tax code makes things a little trickier. This means that a U.S. person living the entire tax year in a foreign country is still subject to U.S. tax. There are many exceptions to the General Rule, but it’s important to understand our baseline. It’s provide the why behind why we need to pay such close attention to the rules.
Before diving into the rules, it’s helpful to understand some tax industry specific terms, which may have different definitions outside of the tax context.
Domestic vs. Foreign Business
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Determining whether a taxpayer is required to file a tax return is a threshold issue. Many nomads falsely believe that they need not file a U.S. tax return if they are abroad for most or all of the tax year. Unfortunately, this is incorrect.
The General Rule requires taxpayers who meet the IRS filing requirement income thresholds to file regardless of how much time they spend in the U.S. For the 2018 tax year, the filing requirement is based solely on the standard deduction. If the taxpayers income is greater than the standard deduction, she is required to file a tax return. The below chart shows the standard deductions for the 2018 tax year. (These amounts change each year with inflation. Do a quick Google to find the current amounts).
Married Filing Joint
Head of Household
Single OR Married Filing Separate
For self-employed taxpayers this is based on gross, not net, income.
This makes sense because if a single taxpayer only has $10,000 in income, the deduction will reduce income to $0. Therefore, tax would be $0 UNLESS, one of the following applies:
- You had net earnings from self-employment of at least $400;
- You owe any special taxes including: alternative minimum tax, additional tax on a “qualified plan,” social security or Medicare on tips not reported to an employer, household employment taxes, and recapture taxes;
- You or your spouse receives health savings account distributions Archer MSA, or Medicare Advantage MSA distributions;
- You had wages from church or qualified church controlled organization;
- You had advanced payments of the premium tax credit or health coverage tax credit.
Even when a taxpayer is not required to file, it is still generally a good practice. Particularly if a taxpayer is owed a refund due to tax withholdings or an available credit. Filing a return also starts the clock on the IRS’ allowable time to go back and audit the return, and filing a return is necessary for deductions and credits that get carried forward.
Perhaps most importantly, filing returns help tax agencies keep tabs on what taxpayers are doing from year-to-year. You may be thinking, I don’t want the IRS keeping tabs on me, but . . .
Foreign Earned Income Exclusion
The FEIE is the major exception (kind of) to the General Rule. The FEIE comes from Section 911 of the U.S. tax code. It allows a person to exclude income earned abroad from their taxable income – for income tax purposes if the person qualifies. Tax payers MUST file a tax return to claim this exclusion.
The FEIE only excludes earned income, like your self-employment income. It does not exclude passive income like capital gains. It also only excludes foreign income, as is probably obvious from the title. Income earned within the U.S. cannot be excluded. Combining these two requirements means that only income earned through your efforts while outside of the U.S. is excludable. The FEIE only exempts income for income tax purposes. Taxpayers must still pay self-employment tax on their self-employment income.
Let’s look at a hypothetical. Jill lived in the U.S. January through March of 2022 and in Germany for the remainder of the year. She earned $12,000 in passive income and $120,000 in earned income. Let’s assume for simplicity that she earned the same amount each months, so these totals are cleanly divisible by 12. How much does Jill have in foreign earned income?
The passive income is not earned. We can disregard that. Jill had $120,000 in earned income, 75% of which was earned while living abroad. Thus, her foreign earned income was $90,000.
In addition to the above two caveats, the FEIE has income limitations. The exclusion is limited to $112,000 per person (in 2022). Any foreign earned income over $112,000 cannot be excluded.
Also note that any of these rules are subject to change. Many tax experts expected drastic changes to the FEIE under the 2018 tax overhaul. Luckily for expats and nomads, the FEIE provisions were largely untouched. Whenever there are whispers of tax law changes in Congress, take note and stay up on what could be changing.
Do Nomads Typically Qualify – The VERY Short Answer
Most Nomads will qualify for the exclusion if they are outside of the U.S. for at least 330 days.
Example of How the FEIE Works to Reduce Income
Let’s say Dora Designer is a U.S. citizen. Dora works at her full-time job for the month of January. Then, she leaves the county and works remotely while traveling the globe. She makes $5,000 in January and $50,000 the rest of the year. Dora’s tax return will show $55,000 of income. She will then complete the FEIE required form to exclude $50,000 of income since it was foreign earned income. The return will then show $5,000 of taxable income.
Dora could not simply report $5,000 of income since she has the burden of reporting all income and then showing why some should be excluded from tax. If Dora took the approach of only showing $5,000 of income, she may wind up in a stressful audit.
The FEIE Baseline Rule
To be eligible to claim a foreign earned income exclusion, a taxpayer must have:
- A foreign tax home; and
- Be a bona fide resident of a foreign country
- Being present in a foreign country for 330 days in 12 months
Now Let’s dive into each of these sub-rules.
Foreign Tax Home
A person’s tax home is his regular or principal place of business. If the individual has no regular or principal place of business due to the nature of the business, that person’s tax home is his “regular place of abode.” The issue with digital nomads is that, by definition and in practice, they have no regular place of abode. One court case found that where an individual has no regular place of business or abode, therefore, having no tax home, that individual is an itinerant whose tax home moves with him from place to place. This is good news for purposes of the FEIE, but not so much for purposes of traveling deductions (discussed further below).
A person does not have a foreign tax home if his abode is in the United States. Determining where one’s abode is, unfortunately, is not so simple. The tax code does not define abode, so courts have looked at different facts to determine where one’s abode is. One case interestingly cites a report from the House Ways and Means Committee to determine the legislative intent of this rule. That report stated that a person in Detroit, Michigan who commutes daily to work in Windsor, Ontario would technically have a tax home in Canada since her principal place of business is in Canada. However, her abode would be in Michigan. The law, specifically the abode rule, disqualifies her from having a foreign tax home. The case continues to state the intent seems to be clear that the abode limitation serves to provide tax benefits only to those who actually incur increased living expenses living abroad. This does not mean that you need live in a country with a higher cost of living.
The landmark cases that determined the taxpayers abode to be in the U.S. involved individuals who worked on oil rigs for a specified period of time in which the employer paid for their housing on the oil rig. Logically, it makes sense for these individuals to be denied the FEIE because they incurred no financial detriment or personal out-of-pocket costs by living outside the U.S. while they maintained residences in the U.S. for their time off.
The second requirement for the FEIE is that a taxpayer either be a bona fide resident of a foreign country (bona fide residence test), or be present in a foreign country for 330 days in 12 months (presence test).
Bona Fide Residence Test
This option is only available to U.S. residents and not resident aliens. To be a bona fide resident of a foreign country a taxpayer must go to that country for an indefinite period and set up permanent quarters. The taxpayer must also reside in that foreign country for an uninterrupted period including an entire tax year (Jan 1 – Dec 31). You may take trips from this new residence, including to the U.S., so long as you intend to return to the new residence.
This test is simpler. It requires taxpayers be abroad for 330 total days. A taxpayer would qualify if she spent, for example, 110 days in Spain, Italy, or France. There are specific rules on what counts as a whole day. To be safe, place to be abroad for 331 or 332 days a year to meet this requirement. Most true digital nomads are going to meet this requirement rather than the Bona Fide Residence Test, since the presence test does not require setting up a permanent establishment in one country.
A digital nomad traveling regularly will likely be an itinerant whose tax home moves with him from place to place. If he stays out of the U.S. for at least 330 days for the tax year, he will qualify for the FEIE.
Taxes are just one aspect to building a healthy and wealthy business.
Dial in some of the others in my free training.
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