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The foreign earned income exclusion is one area that US citizens living abroad often know about in some form or another but may not be aware of the impact of either claiming or not claiming the foreign earned income exclusion using form 2555. For more information about form 2555 and some of the common misconceptions, such as whether or not you have to file 1040’s if you’re foreign income is less than a certain amount or why someone would choose not to use the foreign earned income exclusion among other questions, please click here.

It’s a good idea to assess what impact, if any, will be caused by using the foreign earned income exclusion or not using it and whether one option provides more favorable tax treatment. There are simple scenarios where an individual could have saved an extra $2,000 simply by not claiming the foreign earned income exclusion.  In other cases, you may be better off to claim the exclusion and in other cases, there may be no difference.

Let’s look at the following scenario and the impact of either claiming or not claiming the foreign earned income exclusion using form 2555.

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  • Mary is a dual Canadian/US citizen living in Alberta, Canada
  • Mary is a single mother with 2 children, aged 4 and 6
  • Mary has Canadian wages of CAD $70,000 ($64,220 USD) and investment income (interest) of $2,500 ($2,290 USD). She also received $2,400 ($2,200 USD) Universal Childcare Benefit (UCCB).
  • Mary is able to claim the head of household filing status in the United States

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Before taking into account any foreign tax credits, Mary’s tax returns show the following figures:

Canadian T1

Total income- $74,900 ($70,000+2,500+2,400)

Taxes owing- $12,000 (Federal and Alberta tax)

US 1040

Total income $68,710 ($64,220+2,290+2,200)

Taxes owing: $6,600   (federal tax)

Option #1– To claim the foreign earned income exclusion (Form 2555) to exclude the CAD $70,000 of Canadian wages from Mary’s 1040 return.

Using Form 2555 to exclude wages, Mary’s Canadian tax return would look the same as above, however her US tax return would look something like this

US 1040

Total income: $4,490 (64,220+2,290+2,200-64,220)

Taxes owing/refund: nil

In this scenario, by using the foreign earned income exclusion, Mary will pay the $12,000 Canadian tax and have no tax owing/refund on her US 1040. This sounds pretty good, right?

Now let’s look at the same scenario, except that Mary won’t use the foreign earned income exclusion to exclude her Canadian wages from her total US income on her 1040.

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Option #2–  Choosing not to claim the foreign earned income exclusion (Form 2555) to exclude the CAD $70,000 of Canadian wages from Mary’s US tax return.

As mentioned above, Mary’s 1040 with all of the income would look something like this:

US 1040

Total income: $68,710

Taxes owing: $6,600

At this point, Mary can complete form 1116 with her 1040 return which will allow her to get credit for her foreign taxes paid in Canada. Without going into great detail about form 1116 for this purpose, let’s assume that Mary’s $12,000 of tax in Canada allocates in the following way to each type of income:

$70,000 Canadian wages generates $11,220 in Canadian tax

$2,500 interest income generates $400 in Canadian tax

$2,400 UCCB generates $380 in Canadian tax

The total being the T1 income of $74,900 and tax of $12,000, as shown earlier.

Now to the extent that Mary’s US tax on each type of income is less than her Canadian tax on that same type of income (this is a simplification), she will credit for her Canadian tax paid and she will get a foreign tax credit equal to her US tax of $6,600.

To see how this works, assume that the income on the 1040 generates the $6,600 of US tax as follows:

$64,220 USD Canadian wages generates $6,170 in US tax

$2,290 USD interest income generates $220 in US tax

$2,200 USD UCCB generates $210 in US tax

The total being the 1040 income of $68,710 and tax of $6,600, as shown earlier.

As you can tell, you’ve paid much more Canadian tax on each type of income. Since Canada has first right to tax on “Canadian source” income and since all of the income is Canadian source, you will be able to claim the foreign tax credit equal to the lessor of the Canadian tax you paid on each type of income or the actual US tax relating to each. In all cases you have more than enough Canadian tax to cover the US tax liability. (Note: In reality certain types of income gets grouped together in categorizes – General source income, passive source income, re-sourced income- and the tax relating to the income in each category determines the amount of the foreign tax credit, but this example simplifies this)

So when all is said and done, the Canadian still looks the same with the $12,000 of taxes owing on Mary’s T1, however the US tax return now looks like this:

1040

Total income $68,710 ($64,220+2,290+2,200)

Taxes owing: $6,600

Less foreign tax credit: $6,600

Net tax owing: nil

Child tax credit: $2,000

Refund of taxes: $2,000

In this scenario, by not utilizing the foreign earned income exclusion, Mary was actually able to generate a $2,000 refund on her US tax return (due to refundable child tax credits of $1,000 per child).

The issue with claiming the foreign earned income exclusion to remove the foreign wages from the total income for US tax purposes is that Mary no longer qualifies for the child tax credit because she has reduced her income to a point where she has no tax (before foreign tax credits).

In the end, it’s always worthwhile considering whether there is any tax difference with using or not using form 2555 to exclude foreign earned income.

Any questions or comments? Please feel free to drop me a line below or email me directly at tony@hutcheson.ca

 

 

One response to “How not claiming the foreign earned income exclusion saved $2,000”

  1. Beth says:

    Hi there. Nice post. Curious of a few things. I did similar to what you showed in your example as a teacher abroad working in a tax free country. It was more beneficial to leave the income earn overseas taxable to the USA. It gave the child tax credit though not the earned income credit as I was overseas. When I moved to another country with a much higher wage I decided to split my foreign income up. I left only enough taxable to the USA to get the refund on the child tax credit. I excluded the rest. I saw nothing in the tax code that said excluding foreign income required all of it to be excluded. Thoughts? Thanks!

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Tony Theaker

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The information contained in this article is for general use only and should not be viewed as professional advice. Accounting and tax rules and regulations regularly change and individuals should contact a competent professional to obtain accounting and tax advice based on their specific situation.

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