What to Do If Your FEIE Claim Is Denied?

FEIE stands for Foreign Earned Income Exclusion, which allows eligible U.S. tax expats to exclude a certain limit of their foreign earned income (like wages, salary, bonus, or self-employment fees for personal services) from their US federal income tax. However, you need to satisfy some eligibility requirements to claim it. If you don't fulfill the requirements or provide incorrect or incomplete information on Form 2555, the FEIE claim can be denied. 

But simply because your claim is denied doesn't mean that you will lose the exclusion permanently. You can respond to the denial based on the reason why the IRS denied your claim and whether you can prove that you actually qualify. If your FEIE claim is denied, this blog is for you. We will cover the reason why the IRS might deny a claim and what you should do after that, how to avoid making the same mistakes in the future, and much more. 

What is the FEIE?

The FEIE allows eligible taxpayers to exclude a certain limit of qualifying foreign earned income from their U.S. federal income tax. To apply for the exclusion, you generally need:

• A tax home in a foreign country.
• Foreign earned income from personal services rendered in a foreign country.
• Meet either the bona fide residence test or the physical presence test.

You can claim the FEIE by completing Form 2555 and attaching it to Form 1040 or Form 1040-X (when appropriate). The IRS has the authority to either approve or deny your claim, and there can be many reasons behind the denial. Having said that, let's now look at the reasons why the IRS might deny your FEIE claim. 

Why Might the IRS Deny an FEIE Claim?

Here are some of the common reasons behind the IRS denying your FEIE claim:

Not Satisfying the Physical Presence Test

This is one of the most common reasons behind the IRS denying your FEIE claim. The U.S. carries out a physical presence test to determine whether a taxpayer qualifies for the FEIE. Under the test, you generally need to be physically present in any foreign country for at least 330 full days during a period of 12 consecutive months. 

Although the 330 days need not be consecutive, each qualifying day must be a full day in a foreign country. Hence, if you keep traveling to the United States, it can affect your calculation, and you may fail the test. Similarly, if your travel dates don't meet the requirements, your claim may be denied.

Not Meeting the Bona Fide Residence Test

This is another test that requires you to be a bona fide resident of a foreign country for a continuous period that includes an entire tax year. However, this doesn't mean that you will simply live abroad for a year and will qualify as a bona fide resident. 

The IRS will also consider several other factors to determine whether you qualify. This includes your residence, visa, employment arrangement, family ties, and the purpose of your stay.

Your Tax Home Was Not In a Foreign Country

You need to have a foreign tax home during the relevant qualifying period. You will not qualify for the FEIE claim if your tax home remains in the US, irrespective of whether you spend significant time outside the country. 

Your tax home is generally the general area of your main place of business, employment, or post of duty. For the FEIE tax-home test, the IRS also considers where your abode is located and whether your family, economic, and personal ties indicate that your abode remains in the United States.

Income Was Not Foreign Earned Income

Generally, FEIE applies to income that is earned from personal services performed in a foreign country. This includes salary and wages, professional fees, certain self-employment income, and other compensation received for personal services. It's important to have qualifying income to be eligible to claim the FEIE. 

Investment income (Passive income), such as interest, ordinary dividends, and capital gains, is generally not counted as foreign earned income. Even if you earn this passive income from a foreign source, you cannot consider it when filing for the FEIE. 

Providing Incorrect or Incomplete Information in Form 2555

If you mistakenly make an error or fail to provide complete information on Form 2555, you may face issues with the claim. These errors include:

• Entering the wrong travel dates.
• Using the incorrect qualifying period
• Not providing the required visa information.
• Reporting the wrong amount of foreign earned income.
• Failing to attach Form 2555 to the relevant tax return.

If you claim the physical presence test, ensure you submit the information related to your travel and the qualifying 12-month period. The IRS specifically asks taxpayers to submit these details.

Once you have determined the reason for the denial, the main part begins: responding to the denial. Next, we will discuss the steps to take after a FEIE denial.

What Should You Do After a FEIE Denial?

Follow the steps below if your FEIE claim is denied by the IRS:

Step 1: Read the Notice from the IRS Carefully

When you receive the denial notice, don't just file another return without understanding the problem. Firstly, you must identify the reason why the IRS rejected your FEIE claim. Then, compare the IRS notice with your Form 2555 and supporting records. Check whether the IRS questioned your: 

• Eligibility
• Travel History
• Tax Home
• Documents 
• Foreign Residence
• Information on Form 2555

It's important to understand the reason behind the denial, as it will decide the next step you need to take. 

Step 2: Re-confirm Whether You Are Eligible for the FEIE Claim

To do that, you need to check three key requirements, which are:

• Tax Home: Confirm whether your tax home was in a foreign country.
• Qualifying Test: Determine if you satisfy either the physical presence test or bona fide residence test.
• Earned Income: Check if the income earned from services you personally rendered meets the applicable requirements. 

If you fail to meet any of these requirements, simply making a mathematical correction or fixing a documentation error will not qualify you for the FEIE.

Step 3: Gather Supporting Documents

If you believe the mistake is not on your side, but the IRS', gather relevant documents to support your position. Some useful documents may include:

• Flight records
• Passport stamps
• Airline itineraries
• Pay statements
• Employee letters
• Travel calendars
• Immigration records
• Foreign utility bills
• Foreign tax records
• Employment contracts
• Foreign lease agreements
• Visa or residence documents 

Having accurate records of your travel is specifically important if you claim the physical presence test. This is because your eligibility for the test is determined based on the number of qualifying full days you spend abroad. 

Step 4: Respond to the IRS if Requested

The IRS notice may request that you submit documents or provide information. If that's the case, follow the instructions and respond by the deadline mentioned on the notice. Explain your point clearly and submit supporting documents to prove your position instead of sending irrelevant paperwork.

When responding, make sure your response clearly addresses the reason the IRS questioned your FEIE claim. 

Step 5: Rectify the Return if There Was an Error

If your FEIE claim was denied due to an error in your original return, you must correct it. For example, assume the denial happened because you entered wrong travel dates on Form 2555. So, you must identify the correct qualifying period and then recalculate the exclusion. 

To claim the FEIE, you must use Form 2555 and attach it to Form 1040 or Form 1040-X, as required by the IRS. People often end up in a situation where they might not have qualified when they originally filed but become eligible later. In such a case, you can file an amended return. That said, let's discuss whether you can still file an FEIE.

Can You Claim FEIE Later?

Yes, you may be able to claim an FEIE later in certain situations. According to the IRS, a taxpayer who filed before they satisfied the physical presence and bona fide residence test can later file Form 1040-X. They can attach it to their Form 2555 after meeting all the qualifying requirements. 

For example, assume you moved abroad during the year. However, you had not yet completed the required qualifying period by the time your tax return was due. So, in this case, you can file your return but without applying for the exclusion. Later, when you satisfy the applicable test, you may file an amended return to claim the FEIE. 

What if, even after waiting, I don't qualify for the FEIE? Well, in that case, avoid forcefully adding the exclusion to your return. There is another option available to reduce double taxation. Next, let's understand what happens if you cannot qualify for FEIE. 

What if You Cannot Qualify for FEIE?

As mentioned above, if you don't meet the FEIE requirements, don't try to include the exclusion on your return just because you want to. If you wish to reduce the risk of double taxation, you may use other available options, such as FTC. 

For example, if you have paid the qualifying foreign income taxes, you may consider the Foreign Tax Credit (FTC) option. FTC is not the same as FEIE; hence, it has its own eligibility requirements and limitation rules. If you are a U.S. taxpayer living in another country, such as India, where foreign income may be subject to local taxation, understanding this can be important for you. 

Further, if you qualify and apply but your claim is denied, you have the option to appeal. However, you cannot simply appeal at any time for any reason. If you are sure that the mistake is on the IRS's side and you have documents to prove your position, you may proceed further. Let's discuss more about this in detail.

Can You Appeal a FEIE Denial?

If you disagree with the IRS's determination, you may have the right to request reconsideration or appeal, depending on the type of IRS action and notice you received. You do not need to assume that an appeal is available only when the IRS made a factual mistake. Review the notice carefully, follow its appeal instructions, and act within the applicable deadline.

Submitting an appeal, amended return, or new Form 2555 is not automatically the correct answer. Instead, the correct response is to reply directly and provide the supporting documents. Further, let's understand how to prevent FEIE-related issues in the future. 

How to Avoid FEIE Problems in the Future?

Major FEIE-related issues can be prevented by keeping good records. You should keep a year-round travel log that reflects:

• Date you left the United States and entered a foreign country. 
• Date you returned to the United States.
• The countries you visited.
• Number of full foreign days

Also ensure you keep evidence to support your foreign tax home and employment. Compare your travel calendar with your passport and flight records before you start filing Form 2555. Your entire 330-day calculation can be affected even by a small error in the date. Hence, good recordkeeping and accurate calculation are very important. Lastly, let's look at a quick checklist to avoid facing denials with your FEIE claim.

Quick Checklist to Avoid FEIE Denial

Before you respond to the IRS, you must take the following steps:

• Review the reason for denial from the IRS
• Verify your foreign tax home and foreign earned income
• Confirm whether you qualify for the FEIE
• Check your travel dates and qualifying days
• Review Form 2555 for any errors or missing information
• Collect supporting documents and records
• Check the deadline to respond to the IRS
• If FEIE is not available, consider using the foreign tax credit (FTC) option.

To Conclude

Just because your FEIE claim is denied doesn't automatically mean you're exempt from claiming it again. Instead, identify why your claim was denied or why the IRS questioned your exclusion. After that, verify your tax home, income, qualifying test, and information on Form 2555.

If you determine that the denial happened due to an error or missing documentation, you may rectify it by providing evidence to support your claim. Moreover, after checking everything, if you don't qualify, check whether another provision applies to you, such as the foreign tax credit (FTC). 

If you wish to avoid issues before filing FEIE, the best way is to keep accurate travel and income records or connect with an expert at Savetaxs. We have an entire team of experts who can help you claim the FEIE. Also, identify the reason and respond if your claim is denied. Our team can help you determine whether you qualify for the exclusion and help you adhere to the rules. Contact us right away as we are actively working 24/7 across all time zones.