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Foreign source income and bona fide resident test

Investors and owners of foreign-based businesses frequently ask about the possibility of using the $100,800 exclusion and/or foreign tax credit against income earned from overseas companies.

The typical scenario is this: a taxpayer has a company which is based in the Cayman Islands, Trinidad, Isle of Man, etc. The taxpayer earns active income from this investment (as opposed to capital gains distributions or tax-free returns of capital). This income must be reported on the individual’s US 1040 (unless, of course, the income is being put through a domestic c corp, s corp, or partnership). Can the foreign-earned income exclusion be used to limit the tax to income only above $100,800?

Unless the taxpayer qualifies as a bona fide resident of the foreign country or meets the physical presence test (explained below), he will have to report the full amount of the proceeds on his individual return as self-employment income using schedule C. The good news about filing in schedule C is that it is relatively easy to do and that you may offset this income with expenses used to obtain it. In other words, travel costs, business expenses, and home-office expenses are deductible against this schedule C income.

Bona fide resident test:

  • Lived and established a residence in the country for the entire taxable year

Physical presence test:

  • Must be physically present in the foreign country for at least 330 full days during the 12 month period

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