American Expats Beware: That Cruise Might Cost You Thousands in Taxes
Every year, hundreds of US expats with online jobs gather in South America for a 14-day cruise across the Atlantic. These self-professed “digital nomads” hope to catch some rays with like-minded individuals who also manage to travel around the globe by working remotely. The cruise is generally affordable, and many of them even see it as an investment into their business network. What they don’t realize is that they might be throwing away as much as $17,000 in tax breaks.
Digital nomads are just one subset of expats who have found a way to take advantage of a tax exemption known as the Foreign Earned Income Exclusion (FEIE). This tax break allows expats to exclude up to $101,300 (in 2016) of their foreign earnings from US income tax if they are in a foreign country for 330 days in a 12-month period. This could equate to just over $17,000 per year in tax savings for someone taking the full exclusion. Clearly, this is a massive financial benefit for those Americans living abroad, especially for individuals who rely on the decreased tax obligation to fund their travels.
So what’s the problem?
Here’s the catch: the rule states that an individual qualifies for the FEIE under the Physical Presence Test by being, “physically present in a foreign country,” for 330 days. It does not say that you need to simply be outside of the USA. This tiny nuance means that the time Americans spend in international waters will actually count against them. If a US expat visits home for a couple of weeks and then goes on a two-week cruise, all of a sudden they could potentially lose their FEIE benefits and owe income tax on their foreign earnings for that year. Even if an American misses the target by just a single day, he or she will still owe income tax on all of their earnings.
In fact, the IRS makes this very clear in Publication 54 (Tax Guide for US Citizens and Resident Aliens Abroad). The publication outright states, “…the time you spend on or over international waters doesn’t count toward the 330-day total.” Unfortunately, the IRS won’t care that you spent your time gorging yourself on a cruise’s buffet rather than reading up on the relevant tax law.
Don’t worry, it gets worse. Any income earned while in international waters will not be exempt under the FEIE, even if an expat still meets the Physical Presence Test. This means that when an American decides to open up their laptop and work while aboard a cruise ship, then any income earned will be subject to US income tax.
What to do about it?
This begs the question: what can be done? There is a chance that expats who missed the 330-day mark can still qualify for the FEIE under a second metric, the Bona Fide Residence Test. This allows expats who have permanently relocated from the United States and have established long-term homes in foreign countries to also claim the FEIE. Additionally, Americans abroad can also pursue other methods of reducing their tax liabilities. For example, US expats can claim Foreign Tax Credits for taxes paid to foreign countries. Of course, this is a problem best solved preemptively by carefully managing how many days are spent in the US and in international waters.
Needless to say, this is a mistake that can be easily avoided simply by having an understanding of the rules. All expats should chat with a CPA or qualified tax professional if they are unsure whether or not they qualify for special expat tax breaks. If you’re not sure where to start, Wayfare Accounting LLC specializes in US expats and can help you stay on track. US tax law is exceedingly tricky, especially within an international context, and it is always better to be safe than sorry (and $17,000 poorer)!