Deferred Earned Income and the Foreign Earned Income Exclusion
U.S. Expats can generally exclude their foreign earned income such as wages, salaries, professional fees, and other amounts received for compensation (up to $102,100 in 2017) from U.S. income tax by use of the Foreign Earned Income Exclusion as long as certain residence or physical presence requirements are met.
However, what happens when a U.S. Expat receives foreign earned income a year or multiple years after the services were rendered?
IRS Regulations state that foreign earned income attributable to services performed in the prior year are excludable from gross income in the year of receipt to the extent that the income could have been excluded in the year earned.
However, IRS Code Section 911(c)(4) states if compensation is received after the close of the tax year following the tax year in which the services were performed then they are not eligible for the earned income exclusion. This rule applies even if the amounts received are back wages which would have been excludable if they had been paid at the proper time.
U.S. Taxpayer living overseas who qualifies for the foreign earned income exclusion for all years is hired to perform services for $90,000 in wages per year by Company X. Unfortunately, due to cash flow constraints Company X only pays the Taxpayer $10,000 per year in wages. This continues for 5 years. In year six Company X pays the Taxpayer back-wages, totalling $400,000 ($80,000 deferred per year x 5 years), plus $90,000 in current year wages. The Taxpayer’s foreign earned income exclusion for year six is $170,000 calculated as follows:
Back Wages received attributable to services performed in year 5 that would have been excludable if received in year 5.
Year 6 earned income:
Total = $170,000
Therefore, the taxpayer as non-excludable income of $320,000 in year six.
The IRS has expressed sympathy for taxpayers in court cases for these situations, but unfortunately, the timing of receipt is clearly stated in the code as a requirement for exclusion.
A possible solution to this problem would for the taxpayer to receive another form of property (such as stock or other assets) in lieu of cash as compensation in years 1-4.
As always, when in doubt, contact your tax preparer to ensure proper reporting. Feel free to reach out to us at firstname.lastname@example.org.