FEIE and IRS Audits: What NRIs Should Be Prepared For

For U.S. citizens and qualifying resident aliens, including green card holders, who live and work abroad, the Foreign Earned Income Exclusion (FEIE) can reduce U.S. federal income tax on qualifying foreign earned income. However, to claim this exclusion, you need to fulfill the tax home and the set of eligibility rules and properly report the exclusion on Form 2555.

If you are using the physical presence test PPT, you need to have accurate travel records handy, as you generally need to meet the 330-day threshold for time spent abroad in a 12-month period. When you are claiming the FEIE, it does not automatically mean that it is an audit; the IRS will ask you for proof of your income, tax home, travel history, and eligibility.

In this blog guide, we will understand what may attract the questions from the IRS, what records you need to keep, and what to expect when your FEIE claim is reviewed.

However, Here is a Quick Note For the NRIs and the FEIE

The FEIE, or Foreign Earned Income Exclusion, is a US federal tax provision, not an Indian residency benefit. It is specifically applicable to eligible US citizens and resident aliens, including green card holders, who have foreign-earned income that meets the applicable requirements.

Being an NRI under Indian tax law does not by itself determine FEIE eligibility. A U.S. citizen or qualifying U.S. resident alien living in India may claim the FEIE if they meet the U.S. tax-home requirement and either the Bona Fide Residence Test or Physical Presence Test.

Is The FEIE Automatically An IRS Audit Risk?

No, the FEIE is not automatically an IRS audit risk. Instead, the FEIE is a US tax benefit provided by US law; claiming it does not automatically mean your return will be audited.

However, the IRS may request documentation if it has questions about whether you qualify or whether the information required on the return is consistent. Hence, to excel in this, good recordkeeping is important. Further, the recommendation is to maintain the records that support the item reported on your tax return and keep them for the applicable period of limitations.

As an NRI, this is quite important because FEIE claims generally encompass international travel, foreign employment, Indian income, foreign accounts, and other reporting requirements.

What Is Here Can Trigger A Closer Look

The following are the reasons that can trigger a closer look:

Weak Travel Documentation

If you are able to claim the physical presence test, know that your travel history is one of the most essential pieces of evidence.

Details such as your passport, flight reservation records, and personal travel log must match the dates listed in Form 2555. The IRS, however, needs to qualify the period and the information associated with departure and arrival when the PPT is used.

Unclear Foreign Tax Home

Your FEIE claim needs to be consistent with your actual working and living circumstances. Further, ensure you have the documents ready that will help establish where you lived and worked. These documents could include a lease, utility records, employment documents, and other evidence associated with your foreign tax home.

Too Much Time In The US

If you take occasional trips to the US or even extended trips, it can be harder to fulfill the PPT, the Physical Presence Test. This is because you need at least 330 days in foreign countries during a qualifying 12-month period. Just ensure that you maintain a record of every US entry and departure rather than relying on memory.

Foreign Account & Income Reporting Mismatches

An NRI who is also a US person may have certain reporting obligations for the bank accounts held in India and other foreign financial assets. The FATCA, however, requires foreign financial institutions to report the information related to certain US account holders, and the IRS also has its own foreign asset reporting requirement.

Your IRS tax return, FBAR, Form 8938, and all the other US-associated filings need to be consistent with your financial records.

Claiming FEIE Without Any Supporting Income Records

Keep all employment contracts, bank records, salary statements, Form W-2 or equivalent foreign payroll records, and self-employment documentation, wherever applicable.

The total amount you have earned outside the USA, as reported on the return, must always be supported by your records.

Foreign Self-Employment With US Connections

The NRIs who are working self-employed need to maintain records that must show their services were performed and how their business income was earned.

If you are self-employed and have a US-based client, that does not mean the income earned from that client is US-sourced. Because where the services were performed and the nature of the business matter. Hence, ensure you maintain the proper documentation.

What Proof Should NRIs Keep For An FEIE Claim?

For NRIs to maintain a good and complete documentation file, they must include:

• Records associated with the passport and immigration.
• The flight tickets and the boarding passes.
• Airline travel history
• A day-by-day complete travel calendar
• The foreign lease and the housing records
• The foreign bank statements
• Utility bills and other evidence of foreign residence.
• Self-employment records, if applicable.
• The Form 2555 calculations and supporting worksheets.
• Copies of filed US tax returns.
• Records supporting foreign taxes paid.
• FBAR and Form 8938 records, if applicable.

Good records make it easier to prepare an accurate return and respond if the IRS sends a notice or examines the return.

How Far Back Can The IRS Go

Though the tax assessment timeline for general federal income tax is three years, the period is extendable under certain exceptions.

For example, the period can generally extend to a year where more than 25% of gross income is omitted. Further, the IRS provides a six-year rule for certain income attributable to a specific foreign financial asset when the omission exceeds $ 5,000.

Further, there are special circumstances in which the assessment period will remain open indefinitely. Those instances can be fraudulent returns or situations where a valid return was never filed.

This is because the international reporting rules will create a separate and different compliance issue. NRIs must avoid assuming that keeping records for only three years is always enough.

Let us understand this with an example:

What Will Happen During The FEIE Review

The following steps may have been included in the IRS review prior to return processing:

IRS Notice: You will receive a written notice explaining what information is requested in the documents.

Document Request: Further, the IRS will require you to provide the supporting documents to support your FEIE eligibility and income-related dates or the tax year.

Response: After the IRS reviews your return, you will be required to provide all documents supporting the information reported on your return.

Resolution: After reviewing your response and supporting documentation, the IRS may accept the reported treatment, request additional information, or propose an adjustment.

The sole purpose here is to respond accurately and within the deadline that is mentioned in the IRS notice.

Quick Checklist

The following is a quick checklist to follow to maintain compliance:

• You need to first confirm that you are eligible to claim the FEIE.
• Determine whether you qualify under the Bona Fide Residence Test or the Physical Presence Test.
• Maintain clear travel records.
• Keep all your travel documents ready, such as your boarding pass and flight records.
• Keep documentation supporting your foreign tax home, such as employment records, lease agreements and utility records.
• Keep a clear record of your self-employment and employment history.
• Reconcile the foreign income to your US return with your financial records.
• You need to review the Form 8938 and FBAR requirements separately.
• Keep copies of your Form 2555 and your finished income tax return.
• Retain and keep handy all the supporting documents for the applicable IRS recordkeeping period.

The Bottom Line

The FEIE, that is, the foreign earned income exclusion, is a worthy and valuable tax benefit for qualifying resident aliens, green card holders, and citizens of the United States living and working abroad. The FEIE affects your US federal income tax by reducing it on qualifying foreign earned income.

As an NRI living or working in the USA, the simple habit to adopt is to keep track of your travel documents, your foreign tax home, maintain your income records, and ensure that your international reporting is consistent. The Form 2555 further requires you to provide specific information about your period of qualification and the travel. This is needed because reconstructing the details years later will create unnecessary difficulty.

Be proactive in such matters and do not wait to be served with an IRS income tax notice to know that your important records are missing. Build a strong foundation for your documentation throughout the year, and review your FEIE eligibility before filing.

Further, Savetaxs can help NRIs review FEIE eligibility, prepare international tax filings, and identify potential reporting issues before they turn into a costly affair. Savetaxs offers professional NRI and US expat tax assistance.

Connect with us as we serve our NRIs 24/7 across all time zones.