have a question about form 2555

[whois234]

hi all,

My wife was out of the US, had foreign income, and qualified to use form 2555 exclusion.

I am w2 full-year US resident. Preparing joint return.

But I see in TurboTax/efile calculator that this “excluded” income still taxed.

Per my understanding it’s due to me, having a US w2 income. So it turned from 2555 exclusion to work in a different way.

Instead of taxing on the higher tax bracket (22%) it taxed on the 10% and 12%.

I clearly see in the IRS form 2555 instruction:

https://www.irs.gov/instructions/i2555

Foreign tax credit or deduction.

You can't take a credit or deduction for foreign income taxes paid or accrued on income that is excluded under either of the exclusions. If all of your foreign earned income is excluded, you can't claim a credit or deduction for the foreign taxes paid or accrued on that income. 

But if under current conditions my wife’s income taxed even after using form 2555, maybe I can do the credit of foreign taxes using form 1116?

I looked in instruction and publication 54 and don’t see anything about this scenario.

I even don’t see a sample similar to mine when form 2555 working differently, as I see in my case.

Would be great if someone can suggest it. also would be great if someone can explain and point to any official source why it's happened like that.

Also seems like the same case affecting people who are moving from/to the US in the middle of the year, ie they have foreign and US income in the same year.

[DaveF1006]

It depends. the foreign income exclusion in 2020 is $107,600 per qualifying person.  if your wife's income exceeded the exclusion amount, she can claim a foreign tax credit for the excess. For an example, if she earned $137,600, she can claim a foreign tax credit based on $30,000 worth of income. ($137,600-107,600) Turbo Tax will make this calculation if this is the case. 

You can also work your scenario both ways in Turbo Tax to see which will give you the best return.

1. First use a a scenario where her foreign income is excluded. Remove it the exclusion
2. Next report the income(without the exclusion) but claim a foreign tax credit paid to the foreign country.
3. See which gives the best result.

[whois234]

no-no. I am talking about a simple case, foreign income around 20k$. She has not exceeded the allowed income limit for sure. I tried both calculations and I see that excluding under form 2555 is the best option. She was half of the tax year in a foreign country and her limit smaller than 107k$. But anyway it's much higher than income itself. My question not related to this.

I see that excluded foreign income is taxed doing simple exercise:

1) I am preparing all incomes, w2, etc except her foreign income and see the return amount;

2) I am adding her foreign income and excluding it under form 2555;

3) now the return amount is smaller.

All these cases you mention about being over the limit 107k$, comparing scenarios 1116/2555 - obvious from form 1116 / form 2555 instructions.
I am talking about detail which I see in the calculation but can't find in the official documentation.
I clearly see on both portals calculators are behaving in the same way and mentioned differences almost the same - around 10% from the foreign income.

[DaveF1006]

It depends. You can still test it both ways by either excluding the income or add the income and take the foreign tax credit to see which will give you the best return.

[mm1232]

@DaveF1006 don't know. Seems like what I am writing and you reading - two different things.

I am saying that "excluded foreign income still taxed".

And it's what I am trying to understand - why?

Per my understanding "excluded" income should make no difference on tax liability, whether it's present or absent in the return. I don't know how to explain my question in a better way.

[DaveF1006]

It depends. As I understand, your wife is being taxed on foreign income that she hasn't been able to exclude.  My question is, why not?  Was it for the following reasons? She should be able to exclude her foreign income if she meets the following four requirements. 

• Must have foreign earned income
• Must have a tax home in a foreign country
• Meet either the bona fide residence test or physical presence test.
• Make a valid election to exclude foreign earned income.

My guess is that the reason why income was not excluded is because she did not meet the requirements of the  the bona residence or physical presence test. if this is the case, she should be able to claim a foreign tax credit for the foreign taxes paid to another country. As far as taxation, foreign income is taxed the same as ordinary income. 

[mm1232]

no, it's what I am saying again and again. She meets the requirements. Question not about this.

This "excluded income" still taxed after the exclusion, but at a different tax rate. I clearly see that this income present in 1040 form and has no impact on AGI. But it makes an impact on the tax bill.
It adds around 10% when I am adding to return it and "excluding".

As I mentioned - I tried on TurboTax and efile tax calculators, and I see the same behavior with almost the same numbers.

[DaveF1006]

I think at this point, you may need to consult live help. Please use this link to  Contact Us to connect to live help.

[mm1232]

I don't have paid account for live help. I thought someone from the community can point on someplace in pub 54 or instruction 2555 where this "magic" explained.

Also, I have two colleagues who faced the same issue. They just paid this lower tax on "excluded" foreign income. One of these two calculated manually and didn't add such taxation and received notice from the IRS that they updated the calculation holding additional tax on "excluded" foreign income.

Turbotax/efile calculator seems like know why it should be like that. I am trying few days to get support from efile team, but they said the same thing I am reading here.

[AmyC]

It sounds like your tax return has some items that use nontaxable income when calculating a credit. This happens with some credits. See 5 Things You Should Know about Refundable Tax Credits.  Have you checked your return before and after adding the income to see what is actually changing?

Do a print preview before and after so you can compare side by side. The nontaxable income can also be used to calculate sales tax for those in the US.

@mm1232

[mm1232]

hi, thx for coming into the discussion.

Yes, I did.

so here is how I found this:

1) I entered most of the return info. IE w2 income, dividends etc...

2) I saved all return forms in pdf.

3) I added foreign income

4) I excluded foreign income under 2555 as wife eligible

5) I saved all return info again and compared side by side.

Here is the outcome I see analyzing the first pages of the form 1040

1) I clearly see that foreign income is present in the second pdf, as it's a special mark on line 1 as FEC and value I entered as foreign income;

2) AGI is the same on both pdf's; 

3) Foreign income excluded in the second pdf. I see it as a value like that (value). The same as I have for foreign income

4) Here is a surprise, tax bills are different on line 16. And it's bigger in the pdf where I see all info related to foreign income.

No other changes I did except entering foreign income and excluding it

I see a difference in 12% in tax bills between these 2 pdf's

I see some page in return named "Foreign Earned Income Tax Worksheet - Line 16"

And there I see computation with FEC amount. Calculated tax there - 10%. But tax bill diff - 12%.

It's the second magic thing related to foreign income and exclusion.

[AmyC]

See Publication 54, page 24 for items affected by the exclusion.

Do you have deductible IRAs? You have to have more items in your tax return that are being affected. Something else is changing. Can you see your actual forms to know what is changing instead of just the summary?

If you exclude income under the foreign earned income exclusion or the foreign housing exclusion, you must add back the excluded amounts in determining your compensation for purposes of the IRA limits.  Likewise, for purposes of determining the IRA limits, do not reduce your compensation by any foreign housing deductions.

@mm1232  

[mm1232]

no ira or anything related to retirement. Amount of foreign income like in three times smaller than the limit. Limit itself smaller than max 107k, as she was abroad not a full year. No housing expenses. Just foreign income, less than 20k$.

My theory on why this taxation appeared, cos exclusion from the income doesn't mean exclusion from taxation in some specific cases. And w2 US income makes my case-specific.

W/o this it would go in a regular way - excluded income and excluded taxation.

But I don't see any confirmation on this on 2555 instruction or pub 54.
Answering your question - I have foreign passive income, which I am reporting under custom 1099 and crediting foreign tax under form 1116. Some US dividends and stock selling for small amounts.

And I also see that this "excluded" taxation goes not on my highest tax bracket 22%, but on 12%. Strange that not 10%

[handan]

I think the issue is that even if the foreign earned income is excluded, it is still added for purposes of calculating marginal (and hence average) tax rates. In a hypothetical example with hypothetical tax rates: Let's say you have $50,000 income from the US and you would be taxed on that at 12% (on average). If you also have $30,000 income from abroad and exclude it, you are still only taxed on the $50,000 income from the US, but at a higher rate, because you are taxed at the marginal tax rate starting at $30,000 now. It's as if you earned $30,000 first and that was tax-free, but the marginal (and hence average) tax rate for the $50,000 income from the US is calculated considering that you earned a total of $80,000. 

[mm1232]

hm, you seem right. I saw something like that on state return. I even saw the name of it "sticky tax rate".

I see the diff between tax bills 12% of the foreign income.

The income of my wife lowers then the limit by 10% - $19,750.

IE, what was taxed before adding foreign income by 10% after "pushing up" become taxed by 22%; ie 22% - 10% = 12% in addition.

And the sum of that is the same, as the sum of foreign income. That's why I was under the impression, that I was taxed on foreign income. But it was wrong.

Seems like I was taxed on US income "under higher tax bracket" but the sum was the same as foreign income.

Yes, it seems correct. Thx for that idea 🙂