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Stake your claim to a foreign income exclusion

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in Small Business Tax

Are you—or one of your family or friends—being shipped overseas for job-related reasons? It’s important to know that income earned while working abroad is still subject to U.S. income tax. But Americans can take advantage of several tax breaks that aren’t available to the folks back home.

Advice: Don’t overlook the tax exclusion for compensation earned on foreign soil. The foreign income exclusion applies to earned income such as salary, wages and bonuses. It does not include dividends, interest, capital gains rental income and the like.

Here’s the whole story: If you qualify, you can exclude from U.S. income tax up to $80,000 of foreign-earned income in 2006. If you’re out of the United States for part of the tax year, you must prorate the exclusion.

For example, a foreign resident for 300 days of the year can exclude about 82.2 percent of the income (300 days divided by 365 days) for a maximum exclusion of $65,753 (82.2 percent of $80,000).

To qualify, you must be a U.S. citizen, maintain a tax home in a foreign country and meet either the foreign residence test or the physical presence test. For this purpose, your tax home is generally the location of your principal place of employment, not necessarily the place where you live.

Foreign residence test. This test requires you to be a bona fide resident of a foreign country for an uninterrupted period of an entire year. The IRS will consider the following factors to determine if your claim is legit:

• The type of living quarters you occupy (e.g., hotel or rented home).
• The length of time your family resides with you.
• The length of the uninterrupted period you live outside the United States.
• The nature of your work abroad.
• Whether you maintain a home in the United States and, if so, any rental agreements.

Once you’ve met this test for the entire year, your qualification dates back to the first day you established foreign residence. Occasional trips to the U.S. for business or pleasure won’t taint your status.

Physical presence test. You must be physically present in a foreign country for a full 330 days during any consecutive 12-month period. It doesn’t matter what your intentions are or whether any special circumstances exist.

The IRS is a stickler on the full day requirement. If you spend part of the day traveling to or from the United States, it doesn’t count. You must spend the entire 24 hours in the foreign country.

Tip: Keep a travel log with your other important tax records. Supplement the log with airline tickets, stamped passports and other evidence of arrival and departure dates.

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