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Foreign Earned Income and Housing Exclusion

U.S. citizens and resident aliens are generally taxed on their worldwide income regardless of where the income is earned or received. A U.S. citizen who earns income in a foreign country may also be taxed on that income by a foreign host country, thus leading to double taxation. However, a number of tax provisions provide relief from this inequity, including the foreign tax credit and deduction, the foreign earned income exclusion, and the foreign housing cost exclusion.

Qualifying individuals may elect to exclude from gross income up to $95,100 (in 2012) of foreign earned income, as well as certain employer-provided housing costs. Individuals with self-employment income are also entitled to deduct certain non-employer-provided housing costs. In order to qualify for these exclusions and deductions, an individual's tax home must be in a foreign country and the individual must meet either a residence or physical presence test. The determination of whether a taxpayer qualifies is based on all the facts and circumstances including:

  • the taxpayer's intention,
  • the length of stay in a foreign country
  • the nature and duration of employment,
  • the establishment of a home in the foreign country, and
  • the nature, extent and reasons for temporary absences from the foreign home.

To substantiate eligibility for the foreign earned income and housing exclusion, a taxpayer must have adequate documentation. For instance, travel dates may be verified with U.S. passport information.

Taxpayers may not elect to take both the foreign-earned income and housing exclusions and the foreign tax credit. Also, if a taxpayer claims the foreign earned income exclusion, the taxpayer will not qualify for the earned income credit for that year. The choice between the foreign earned income and housing exclusions and the foreign tax credit depends on which option more effectively reduces taxes. If the taxpayer's foreign earned income is subject to a higher foreign income tax than the U.S. income, it is more advantageous to claim the foreign tax credit.

In selecting the more appropriate option, certain factors must be considered, such as the length and certainty of stay in a foreign country. If a taxpayer working in a high tax country revokes the election, he may not take the election for five years without permission from the IRS and, therefore, would be at a disadvantage if he were transferred to a low tax country. In addition, a "stacking rule" has been added to ensure that U.S. citizens living abroad are subject to the same U.S. tax rates as individuals living and working in the United States. Thus, income that is excluded from gross income is included for determining the applicable tax rate.

Home Office Deductions

Generally, a deduction is not allowed for personal, living, and family expenses, including expenses and losses attributable to a dwelling that is occupied by a taxpayer as a personal residence. The general disallowance rule does not apply to expenses that are allowable as deductions without regard to their connection to a trade or business, such as certain interest, taxes, and casualty losses (subject to their own limits).

However, a taxpayer may take a home office deduction relating to a residence that the taxpayer occupies where:

  • the taxpayer exclusively uses a portion of the residence on a regular basis as a principal place of business for any trade or business;
  • the taxpayer regularly uses the residence as a place of business that is used by patients, clients, or customers in meeting or dealing with the taxpayer in the normal course of the taxpayer's trade or business; or
  • in the case of a separate structure that is not attached to the residence, the taxpayer uses the separate structure in connection with the taxpayer's trade or business.

In the above situations, an allocable portion of expenses attributable to the residence can be deducted.

In the case of an employee, a home office deduction is allowed only if, in addition to satisfying the exclusive and regular use test, the home office is for the convenience of the employer. In addition, expenses allocable to using a portion of a residence on a regular basis as a storage unit for the taxpayer's inventory or product samples can be deducted if the taxpayer is engaged in the trade or business of selling products at retail or wholesale, but only if the residence is the sole fixed location of that business.

Generally, the amount that a taxpayer may deduct for the business use of a home is limited to the gross income derived from the use of the residence for that trade or business, reduced by the deductions that are allowed without regard to their connection with the taxpayer's trade or business (i.e., mortgage interest, property taxes, etc.). If gross income is derived both from the use of the residence and from the use of other facilities, a reasonable allocation (based on the facts and circumstances of each case) is made to determine that portion of the gross income derived from the use of the residence.

The deductions allowable without regard to whether the activity is a trade or business are deducted first. Any remaining gross income may then be reduced (but not below zero) by the remaining allowable deductions. Any disallowed deduction is carried forward indefinitely.

Like-Kind Exchanges

Like-kind exchanges generally result in a postponement of gain recognition for business and investment property owners. The tax savings from participating in a like-kind exchange can be very substantial.

A like-kind exchange is an alternative to triggering capital gains by selling property. The sale of property at a gain results in tax payments on the gain. A like-kind exchange, on the other hand, allows you to avoid gain recognition through the exchange of qualifying, like-kind properties. The gain on the exchange of like-kind property is effectively deferred until you sell the property you receive. The IRS allows this tax-deferred transaction because it recognizes that since your economic position remains the same (you have merely exchanged one property for another) and that you should not have to incur taxable gains. You will, however, have to recognize gain on any money or unlike property that you receive in the exchange.

Only certain property qualifies for like-kind treatment. To qualify, both the property you give up and the property you receive must be held by you for investment or for productive use in your trade or business. Buildings, rental houses, land, trucks, and machinery are examples of property that may qualify.

Moreover, cars, light-duty trucks, and cross-over vehicles have been determined by the IRS to qualify as like-kind business property that can be exchanged tax-free under the like-kind exchange rules. The vehicles are like-kind even if they are in different asset classes under the depreciation rules.

Like-kind exchanges provide a valuable tax planning opportunity if:

  • You wish to avoid recognizing taxable gain on the sale of property that you will replace with like-kind property;
  • You wish to diversify your real estate portfolio (for instance) without tax consequence by acquiring different types of properties with the exchange proceeds;
  • You wish to participate in a very useful estate planning technique (continued like-kind exchanges allow you to permanently avoid recognition of gain); or
  • You would generate an alternative minimum tax liability upon recognition of a large capital gain in a situation where the gain would not otherwise be taxed.

Choice of Business Entities

What are the primary advantages of an LLC over a C corporation?

The ability of an LLC to elect to be treated as either a pass-through entity or as a corporation makes the LLC a more flexible form of business organization than a C corporation. LLCs that elect to be taxed as pass-through entities are not subject to tax at the entity level. Instead, the LLC income and loss flow through to the members who pay the tax. In contrast, C corporation's earnings are taxed once at the corporate level, and again at the shareholder level when the already taxed earnings are distributed as dividends. Members of LLCs that elect pass-through status may also use LLC losses to offset their current income, while C corporation's losses may not be deducted by their shareholders. Unlike C corporations, LLCs may be less costly to organize and maintain and they do not have to follow corporate formalities, such as shareholders meetings, etc. (IRS Publication 1066; IRS Publication 541, Partnerships).

What are the primary advantages of an S corporation over a C corporation?

One advantage of an S corporation is that the pass-through regime results in only one level of tax on the S corporation's earnings. In contrast, a C corporation's income is generally taxed twice, once at the corporate level when it is earned, and again at the shareholder level when the already taxed income is distributed to the shareholders as dividends. Another advantage of the S corporation is that its losses flow through to the S corporation shareholders who can use them to offset their current income. The C corporation's losses, on the other hand, cannot be deducted by the shareholders on their tax returns (Instructions to Form 1120S).

What are the primary disadvantages of an LLC compared to a C corporation?

LLCs with a pass-through tax regime have some disadvantages when compared to C corporations. LLC's earnings that flow through to individual members are generally subject to higher income tax rates than earnings of a C corporation. In addition, LLC members are taxed on their share of LLC income even if such income is not actually distributed to them. In contrast, C corporation's income is taxed to the shareholders only if and when it is distributed to them in the form of dividends. Moreover, C corporations are allowed a dividends-received deduction that is not available to LLCs taxed as pass-through entities (IRS Publication 1066; IRS Publication 541, Partnerships).

What are the primary disadvantages of an S corporation compared to a C corporation?

A disadvantage of the S corporation is that, compared to the C corporation, it has limitations with respect to the type and number of shareholders and the classes of stock that it can issue. The lack of such limitations in the C corporation makes it more flexible than the S corporation with respect to raising capital. The C corporation stock is also easier to transfer because of the absence of any shareholder-type limitations. In addition, the income of a C corporation may be subject to a lower tax liability because the individual S corporation shareholders' tax rates are generally higher than the corporate tax rates (Instructions to Form 1120S).

What are the check-the-box regulations?

The check-the-box regulations establish an elective regime for entity classification. They provide a mandatory classification for federal tax purposes for some organizations and a procedure for electing such a classification for other organizations. Under the check-the-box rules, a business entity with two or more members is classified as either a partnership or a corporation, and entities with one member are either classified as a corporation or are disregarded altogether.

Unless the entity elects otherwise, a domestic eligible entity is a partnership if it has two or more owners. An entity is disregarded as an entity separate from its owner if it has a single owner. An eligible entity may elect to be classified as other than its default classification or to change its classification by filing Form 8832, Entity Classification Election, with the IRS Service Center designated on the form.