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The difference between earned and unearned income for international employees

In order to claim the foreign earned income exclusion you must have worked in a foreign territory when earning income. Any work performed in a foreign country is considered foreign income even if the payments are deposited into a US bank. Discerning between earned income and unearned income for the purposes of filing as an international employee can be difficult to say the least. To make things a bit less complicated, we will take a look at each aspect of foreign taxation and determine the appropriate income status of each by reviewing various sections of the US Tax Code.

In the Tax guide for US, Publication 54, income is defined as compensation for professional services rendered.

Earned income on an international assignment may include any of the following types of compensation:

Bonuses
Commissions
Salaries
Sick leave
Severance pay
Tips
Vacation pay
Wages
Non-Cash income (meal & lodging reimbursements, use of company car, etc.)

Comparable in size to the list of earned income qualifiers, here is the list for unearned income:

Alimony
Annuities
Capital gains
Corporate dividends
Gambling earnings
Interest
Unemployment
Social Security

Other variable income

Not every type of income is as black and white as the previous lists, however. There are numerous types of income which have very specific regulations which vary greatly depending on individual circumstances. For example, rental income is generally viewed as unearned income. In the case of an owner’s or investor’s direct involvement with the business of renting, however, a percentage of rental income not to exceed 30% can be viewed as earned income.

In the field of entertainment actors, actresses, dancers, singers and performers are usually paid directly for services performed or through royalty earnings based on distribution. A carpenter who renders payment for services will undoubtedly have received earned income. Writers and entertainers, however, will only have their royalties regarded as earned income in the event that there is a copyright transfer or a detailed contract was in place to submit a certain amount of literary works.

In regard to corporate income, Section 911(d)(2)(A) clearly defines the difference between earned income and unearned income - even in the event of salary compensation. This section of the United States Tax Code indicates that only reasonable compensation for services is considered earned income. If a CFO, for example, earned $140,000 in a year and the reasonable compensation rate was $85,000, then only $85,000 would be considered earned income. Industry averages for positions are used by the IRS to determine the rate of reasonable income.

While it’s impossible to outline all of the variable businesses and types of income in each industry in one article, we can go over a few basic rules to help you determine whether your income is earned or unearned. In Section 911(d)(2)(B) earned income is defined as any income for which personal services were provided. It also states that any income derived from capital investments is generally considered unearned income; but if there is a net profit from capital investments and you performed work for the corporation through which investments were bought only 30% will be viewed as earned income.

We will provide an example of this situation. If you are a bona fide resident of Afghanistan earning $65,000 and you own a share of Deutsche Bank on the Borse which paid you roughly $25,000 your total earned income would equal the $65,000 you earned as salary. If, however, you performed services for Deutsche Bank your total earned income would equal $68,750 {($25,000x0.15)+$65,000}.

Split year income

There are cases in which foreign earned income is not earned until the following year.In this situation, according to Regulation Section 1.911-3(e)(1) all income earned in the first year must be filed with that year’s taxes – regardless of the time in which compensation was realized. If you are performing services this year for which you do not anticipate receiving compensation until next year, remember that you must claim the foreign earned income on the current year’s tax returns.

It’s important to note, however that Code Section 911(b)(B) has different statutes for compensation received in the 3rd year after work was performed. In this case, the foreign earned income would be claimed in year 3, rather than in year 1.

What’s equally as important to remember is that the previous 2 paragraphs are referring only to foreign earned income – not gross income. Gross income needs to be calculated in the year it was received, despite of the year in which it was earned. For example, if you work in 2012 but will not be paid for your services until 2013 you will not claim your earnings on your 2012 taxes; instead, you will claim them on your 2013 taxes when you file in 2014. If you will not be compensated until 2014 you will claim your income on your 2014 taxes you file in 2015.

As you have just learned, there are a great number of rules and regulations governing the definition of earned and unearned income. It is vital that you familiarize yourself with the specific rules in regard to your profession so that you can get the most out of the tax advantages offered to you as an international employee.