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Unlocking IRS Form 673: Understanding Foreign Earned Income Exclusion

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Unlocking IRS Form 673: Understanding Foreign Earned Income Exclusion

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IRS Form 673 is utilized by US citizens working abroad to claim an exemption from US federal income tax withholding on their foreign-earned income. This form is particularly relevant for those who anticipate being eligible for foreign-earned income and housing exclusions or deductions under section 911 of the Internal Revenue Code, aiding in effective expat tax management.

Functionality of IRS Form 673 for US Expatriates

Form 673 serves as a crucial tool for US expatriates, allowing them to claim an exemption from withholding on foreign earned income, subject to meeting the bona fide residence test or the physical presence test. It is essential for those whose tax home is in a different country and who earn wages while living abroad, providing a means to manage tax withholdings more effectively.

Criteria for Foreign Earned Income

Foreign earned income eligible for consideration under Form 673 includes salaries, wages, or professional fees. This income must be earned during a period where the individual’s tax home is in a foreign country, and they meet either the bona fide residence test, implying a full calendar year in a foreign country, or the physical presence test, which involves being in a foreign country for at least 330 days in a year.

Category Taxable Non-Taxable (up to limit) Notes

IRS Form 673 and Form 2555: A Comparative Understanding

While Form 673 is focused on requesting withholding exemption, Form 2555 is used to report foreign-earned income to claim exclusions. It's important to note that Form 673 is based on the qualifications set forth by Form 2555. Both forms play a significant role in preventing the double taxation of foreign-earned income, an essential consideration for US expats living in a foreign country.

Tax Terms Explained: Withholding, Exclusion, Exemption

Understanding key tax terms is vital for US citizens working abroad:

  • Withholding: This refers to the part of an employee’s wage that is withheld by the employer and paid to the government as a part of income tax obligations.
  • Exclusion: Certain types of income, such as foreign-earned income, are not subject to federal income tax, thereby reducing the amount of taxed income.
  • Exemption: This represents a portion of income that is not taxed. While personal exemptions reduce taxable income, it's important to note their suspension under the Tax Cuts and Jobs Act.

These terms are fundamental in navigating tax obligations for US citizens and resident aliens, particularly those living abroad and dealing with foreign-earned income.

How to Fill Out and Submit IRS Form 673 Correctly

Filling out and submitting IRS Form 673 accurately is vital for US citizens and resident aliens working abroad to claim the appropriate exemptions from US federal income tax on their foreign-earned income.

Step-by-Step Guide for Completing Form 673

  1. Personal Information: Start by providing your full legal name, Social Security number, and complete address, including the name of the foreign country where you reside. This step is crucial for the IRS to identify your tax situation correctly.
  2. Certification of Eligibility: Confirm your eligibility to claim the foreign-earned income exclusion under section 911 of the Internal Revenue Code. Detail your tax home's location, verify your physical presence abroad, and specify your foreign-earned income, including wages earned while living overseas.
  3. Housing Cost Exclusion: If you meet the foreign housing exclusion criteria or deduction criteria, complete this section by estimating your housing expenses. This part is particularly relevant for those living in a foreign country and incurring substantial housing costs.
  4. Exemptions: Enumerate any exemptions you're entitled to, as defined under US tax laws, in Part IV of the form.
  5. Signature: Finally, sign and date the form to validate the information. This step is crucial for the IRS to process your form accurately.

If employed by a US company, hand this form to your employer for withholding adjustment. Remember, the form is not submitted to the IRS. Notify your employer immediately if your eligibility changes during the year.

Submitting of Form 673 to Your Employer

After completing Form 673, you should submit the form to your employer if you work for a US company abroad. Your employer will use this form to adjust your income tax withholdings appropriately. Maintaining a copy of the completed form is important for your records. This step is crucial, as Form 673 is not sent to the IRS but is used by your employer to determine the correct amount of federal income tax to withhold from your pay.

Consequences of Not Filing IRS Form 673

Impact on Tax Withholding and Penalties

Failing to file IRS Form 673, a crucial document for US expatriates, can result in significant tax implications and penalties:

  1. Increased Tax Withholding: Without Form 673, there's a risk that your US employer may withhold more income tax than necessary, impacting your net income. This over-withholding can occur because the employer would need more information to apply the foreign earned income or housing exclusion.
  2. Risk of Additional Taxes: You must file Form 673 to avoid missing out on tax benefits like the exclusion from withholding on foreign earned income, leading to unnecessary financial strain due to additional taxes.

Correcting Mistakes on Form 673

If errors are made on a previously submitted Form 673, it's essential to address them promptly:

  • Obtain a New Form: Download Form 673 from the IRS website.
  • Complete with Correct Information: Fill out the form accurately, ensuring all details about foreign-earned income and housing costs are correct.
  • Sign and Submit: After thorough verification, sign, date, and submit the corrected form to your employer to adjust your tax withholdings appropriately.

It's important to address these errors quickly to prevent misinterpretations or complications with the IRS.

Benefits of Filing IRS Form 673

Filing Form 673 offers several advantages for US citizens working in a foreign country:

  • Tax Savings: Claiming the applicable exemptions on foreign-earned income can lead to significant tax savings.
  • Prevents Over-withholding: It helps to avoid overpaying taxes, thus preventing the need to wait for a tax refund after filing your annual income tax return.
  • Facilitates Financial Planning: Understanding your tax obligations upfront aids in more accurate budgeting and financial planning for expats.

Filing Requirements for Form 673

Form 673 isn't mandated to be filed annually but should be updated and resubmitted to your employer in case of significant changes in income or personal circumstances. This form plays a crucial role in informing your employer about your eligibility for foreign income exclusions, thereby adjusting the amount of federal income tax to be withheld.

Claiming Exemption from US Income Tax Withholding

To claim an exemption from US income tax withholding on wages earned abroad, US expatriates must carefully follow these steps:

  • Obtain Form 673: Accessible on the IRS website.
  • Fill Out Accurately: Provide all necessary personal information, including details about foreign earned income and estimated housing cost exclusion.
  • Submit to Employer: Hand over the completed form to your employer, enabling them to adjust your tax withholdings accordingly.
  • Update as Necessary: If your circumstances change, such as returning to the US or changing income, update and resubmit the form.

By understanding and appropriately managing Form 673, US expatriates can navigate the complexities of foreign income tax, ensuring compliance and optimizing their financial obligations.

Crucial Factors to Consider When Claiming Exemption from Withholding on Foreign Earned Income

Properly understanding and claiming an exemption from withholding on foreign earned income is essential for US expatriates. Here are the key factors to consider.

Residency Tests for Exemption Eligibility

  1. Bona Fide Residence Test: This test evaluates if you've been a resident in a foreign country for a full calendar year without interruption. It's critical for those filing Form 673 and seeking exemption from withholding on foreign earned income.
  2. Physical Presence Test: Checks if you've been physically present in a foreign country for at least 330 days in a 12-month period, a crucial factor for qualifying for the exemption.

Type of Income and Exclusions

  • Income Eligibility: The exemption mainly applies to income earned for services performed in a foreign country, like salaries and professional fees, vital for expats earning while living abroad.
  • Foreign Earned Income Exclusion (FEIE): Assess your eligibility for FEIE, which allows a portion of your foreign earned income to be excluded from US federal income tax.

Other Tax Considerations

  • Foreign Tax Credit: Consider if you're eligible for a credit or deduction for foreign taxes paid on foreign source income.
  • Foreign Housing Exclusion: This can potentially exclude specific housing expenses, based on your foreign tax home's location.
  • Tax Treaty Benefits: While tax treaties don't exempt foreign-earned income, they often offer a credit for foreign taxes paid.
  • Filing Requirements: Typically, you would need to file Form 2555 or 2555-EZ with your tax return to claim these benefits.

Foreign Earned Income Eligible for Exclusion

The FEIE allows US citizens and resident aliens living abroad to exclude up to $108,700 of foreign-earned income from their US income tax. To qualify, your income must include salaries, wages, or professional fees, and you must meet either the bona fide residence test or the physical presence test. To qualify:

  • Income Types: Includes salaries, wages, and professional fees, but excludes US government pay and other non-eligible income types.
  • FEIE Limits: As of 2021, up to $108,700 of foreign-earned income is eligible for exclusion for those meeting the bona fide residence test or the physical presence test.

Qualifying for Foreign Housing Exclusion

To be eligible for the foreign housing exclusion:

  • Tax Home and Expenses: Your tax home must be in a foreign country, with incurred housing expenses.
  • Employer Requirement: This exclusion does not apply if the US government employs you.

Filing Taxes: Exclusion vs. Withholding on Foreign Earned Income

Understanding the difference between FEIE and Foreign Tax Withholding is crucial:

  • FEIE: Beneficial for US expats in countries with lower tax rates, as it excludes a specific amount from US taxes.
  • Foreign Tax Withholding: Advantageous in countries with higher tax rates, as it involves claiming a credit or deduction for taxes withheld.

Avoiding Double Taxation: US Income Tax vs. Foreign Income Tax

To mitigate double taxation:

  • Foreign Tax Credit and FEIE: Use these to minimize US tax liability on foreign income.
  • Tax Treaties and Deductions: Leverage these to reduce taxes paid in foreign countries.
  • Incorporation and Entity Selection: Consider the benefits of incorporating abroad and choosing the right entity.
  • Relocation: Moving to countries with territorial tax systems can help avoid double taxation.

Each individual's tax situation is unique, requiring careful consideration and often the guidance of a tax professional to navigate these complex regulations effectively.

Common Misconceptions About IRS Form 673

Understanding the nuances of IRS Form 673 for US expatriates is crucial to ensure compliance and optimize tax benefits. Let's address some common misconceptions about this form.

Misconception 1: Complete Tax Obligation Release

Form 673 pertains only to exemptions on certain types of income earned abroad, such as wages earned while living in a foreign country. It does not exempt individuals from all US tax obligations like social security tax, medicare tax, or some state taxes.

Misconception 2: Applicability to US Citizens Only

While primarily used by US citizens, resident aliens planning to leave the US for an extended period can also utilize Form 673 to claim an exemption from withholding on foreign-earned income.

Misconception 3: One-Time Submission

Form 673 must be submitted for each tax year you claim the Foreign Earned Income Exclusion, not just once.

Misconception 4: All-Inclusive Foreign Income Exemption

Form 673 applies specifically to earnings like wages and salaries from working for a US company abroad. It does not cover other income types like rental, dividend, pension, or interest income.

Misconception 5: Universal Applicability for Overseas Workers

Only some US expats working abroad are eligible for a tax exemption using Form 673. Eligibility is based on criteria like the Physical Presence Test or Bona Fide Residence Test.

Misconception 6: Simplistic Calculation

Calculating the exemption amount on Form 673 can be complex, involving a thorough understanding of tax codes and laws, especially when considering the foreign-earned income eligible for exclusion.

Misconception 7: Equivalence to Form 2555

Forms 673 and 2555, while related to foreign-earned income, serve distinct purposes. Form 2555 claims foreign earned income exclusion, while Form 673 is about exemption from withholding.

Misconception 8: Inflexibility Post-Submission

It is possible to amend Form 673 during the year if there are significant changes in the assumptions stated in the original form.

Misconception 9: Filing with Tax Return

Form 673 is submitted to your employer for withholding calculation, not with your individual tax return.

Misconception 10: Penalty for Non-Submission

While there's no direct penalty for not filing Form 673, failure could result in over-withholding of your income.

IRS Form 673 and Federal Income Tax: Clearing the Misunderstandings

Form 673 is essential for US expatriates to inform their US employer of their eligibility for foreign-earned income exclusion. However, it's not a blanket exemption from federal income taxes and needs to be refiled annually. It is particularly effective for those who qualify for the foreign earned income exclusion, which can be claimed via Form 2555 or 2555-EZ along with your tax return. Understanding the conditions for the Bona Fide Residence Test or the Physical Presence Test is crucial for eligibility.

Misconceptions Around Income Tax and Form 673

  1. Foreign Earned Income Exclusion: It's important to differentiate between the exclusion, which requires filing Form 2555, and the withholding exemption, which Form 673 addresses.
  2. Form 673 for Employees Only: It's designed for employees, not self-employed individuals.
  3. Annual Filing Requirement: Each year's eligibility must be reassessed and Form 673 refiled if necessary.
  4. Consult a Tax Professional: Given the complexities, seeking advice from a tax expert ensures accurate filing and compliance.

Annual Tax Return Filing and Professional Advice

Even with Form 673 filed with your employer, filing an annual tax return with the IRS is mandatory. This includes claiming the foreign earned income exclusion, for which you must fill out and submit Form 2555. The complexities of tax laws, especially when dealing with foreign income and exclusions, often necessitate consulting with a tax professional or cross-border financial advisor for accuracy and compliance.

By meticulously following these steps and consulting with experts as needed, you can effectively manage the intricacies of IRS Form 673 and ensure compliance with US tax laws while working abroad. This process is essential to navigate tax obligations effectively and to maximize potential tax benefits for US expatriates.

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published

December 19, 2023

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Antonio Del Cueto, CPA

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