The Tax Increase Prevention and Reconciliation Act (TIPRA, P.L. 109-122) has made retroactive changes to the foreign earned income and housing cost exclusions that can drastically increase the tax bills of Americans working abroad. The changes applies for tax years beginning after 2005.

While still allowing both the foreign income exclusion and the housing cost exclusion, TIPRA changes the way that both are computed. The Act adds inflation adjustment provisions to the base $80,000 exclusion amount and then offsets that benefit for some taxpayers by limiting the amount of the housing cost exclusion. The Act also creates new limits to the total exclusions so that the exclusions no longer produce tax savings based on the taxpayer's highest tax bracket.

The changes made by the Act will have the most adverse impact on Americans working abroad in low tax areas, such as Bermuda, Hong Kong, Singapore and the Middle East generally. On the other hand, they will have far less impact on Americans working abroad in high taxed European countries. In many cases, employers will pick up the tax increases imposed on their overseas employee's by TIPRA's changes to the foreign exclusions. At the same time, the increased costs for employers may serve to spur them to hire non-Americans for positions currently being filled overseas by Americans. By hiring citizens of countries that don't tax their overseas employees, companies could save the added amounts they pay to Americans to cover their tax burdens, as now increased by TIPRA.

Background. The U.S. generally taxes its citizens and residents on their worldwide income. An election applies to exclude earned income of a qualified individual who has his tax home in a foreign country and is either (i) a U.S. citizen who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year, or (ii) a U.S. citizen or resident present in a foreign country or countries for at least 330 full days in any 12 consecutive month period. This is called the foreign earned income exclusion. Under pre-Act law, the maximum exclusion amount was to have been $80,000 for 2006 and 2007 and indexed for inflation after 2007.

A qualified individual also may elect to exclude certain foreign housing costs paid or incurred by or on his behalf (or claim a deduction where the costs are not paid by the employer). For qualifying taxpayers under pre-TIPRA law, the base housing cost amount above which costs were eligible for exclusion in a tax year was 16% of the annual salary (computed on a daily basis) of a grade GS-14, step 1, U.S. government employee, multiplied by the number of days of foreign residence or presence in the tax year. For 2006 this salary was $77,793, with the result that the 2006 base housing amount was to have been $12,447 for a taxpayer entitled to the exclusion for the entire year.

The combined foreign earned income exclusion and housing cost exclusion cannot exceed the taxpayer's total foreign earned income. In addition, the taxpayer's foreign tax credit is reduced by the amount of the credit attributable to the exclusions.

A taxpayer with excludable income under Code Sec. 911 was subject to tax on his other income, after deductions, starting in the lowest tax rate bracket.

TIPRA's orivusions accelerate inflation adjustments to the foreign earned income exclusion. Under TIPRA, the $80,000 maximum foreign earned income exclusion amount is adjusted for inflation after 2005. (Code Sec. 911(b)(2)(D)(ii), as amended by Act § 515(a)) As a result, the maximum 2006 exclusion is $82,400. However, TIPRA also amended the housing cost amount so that the base housing cost amount is 16% (computed on a daily basis) of the maximum foreign earned income exclusion (the $80,000 amount adjusted for post-2005 inflation) for the calendar year in which the tax year begins (Code Sec. 911(c)(1)(B)(i)), multiplied by the number of days of bona fide residence or presence for which the qualified individual is eligible for the exclusion. Thus, the base housing cost amount is $13,184 ($82,400 × 16%) for 2006.

TIPRA also makes changes in the housing cost exclusion. In addition, TIPRA limited the housing cost exclusion to 30% of the maximum foreign earned income exclusion (computed on a daily basis) for the calendar year in which the tax year begins, multiplied by the number of days of bona fide residence or presence for which the qualified individual is eligible for the exclusion. (Code Sec. Sec . Code Sec. 911(c)) For 2006, the maximum amount of the foreign housing cost exclusion is $11,536: ($24,720 ($82,400 × 30%)) − $13,184 for a taxpayer entitled to the exclusion for the entire year. (The IRS may issue regs or other guidance providing for the adjustment of the 30% limit on the basis of geographic differences in housing costs relative to housing costs in the U.S.) (Code Sec. 911(c)(2)(B))

Under TIPRA, exclusions no longer save tax at taxpayer's highest brackets. Where a taxpayer excludes income under the foreign earned income exclusion or the housing cost exclusion for any tax year, then, notwithstanding the regular income tax or alternative minimum tax rules, the following rules apply under TIPRA. The taxpayer's regular tax is equal to the excess (if any) of: (1) the regular tax that would be imposed for the tax year if his taxable income were increased by the amount of these exclusions for the tax year (Code Sec. 911(f)(1)(A)) over (2) the tax that would be imposed for the tax year if his taxable income were equal to the amount of these exclusions for the tax year. (Code Sec. 911(f)(1)(B)) Similar rules apply in computing the tentative minimum tax for AMT purposes. (Code Sec. 911(f)(2))

Illustration : For 2006, Andrew, a single taxpayer, is entitled to the foreign earned income exclusion and the foreign housing cost exclusion for the entire year. He is entitled to the maximum foreign earned income exclusion of $82,400 and a foreign housing cost exclusion of $10,000. (Andrew has actual housing cost expenses of $23,184 which is $10,000 more than the base housing cost amount of $13,184.) He has taxable income of $17,600 after taking the exclusions into account. Without the exclusions, Andrew's taxable income would be $110,000 ($17,600 + $82,400 + $10,000). Andrew's income tax for 2006 equals the excess of $25,132 (the tax on total taxable income of $110,000) over $20,204 (the tax on the total exclusion of $92,400). Thus, A's total tax for 2006 is $4,928.

Under pre-TIPRA law, Andrew would have been entitled to a foreign earned income exclusion of $80,000, and a foreign housing exclusion of $10,737 (housing cost expenses of $23,184 less the base housing cost amount of $12,447). His taxable income would have been $19,263 ($110,000 less the total foreign exclusions of $90,737). The tax on $19,263 would have been $2,520, or $2,408 less than it is under TIPRA.

RIA Research References: For the foreign earned income exclusion, see FTC 2d/FIN ¶ O-1101 et seq.; United States Tax Reporter ¶ 9114.01 et seq.; United States Tax Reporter ¶ 191,001 et seq.; TG ¶ 30151 et seq. For the exclusion for foreign housing costs, see FTC 2d/FIN ¶ O-1161 et seq.; United States Tax Reporter ¶ 9114.02 et seq.; United States Tax Reporter ¶ 191,028 et seq.; TG ¶ 30158 et seq.

Source: RIA Federal Taxes Weekly Alert (preview) 06/15/2006, Volume 52, No. 24