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The Foreign Earned Income Exclusion (FEIE) allows qualifying U.S. citizens and resident aliens living abroad to exclude up to $130,000 of foreign earnings from federal income tax. To qualify, you must pass either the bona fide residence test or the physical presence test and file Form 2555 with your return.
The FEIE is one of the most valuable tax benefits available to Americans working overseas. It’s also one of the most frequently audited. The IRS knows that this exclusion is widely claimed, sometimes incorrectly, and the documentation burden falls entirely on the taxpayer. If you can’t prove you met the qualifying tests, the exclusion gets denied – and you’ll owe the full tax, plus interest and penalties going back to the original filing date.
At Ed Parsons CPA, we represent expats and international taxpayers who are under IRS examination or who want to get ahead of potential audit exposure. Here’s what the IRS is actually looking for when it audits a Foreign Earned Income Exclusion claim, and how to protect yourself.
How Much Foreign Income Can You Exclude From U.S. Taxes?
Short answer: For the current tax year, qualifying taxpayers can exclude up to $130,000 in foreign earned income. This amount is adjusted annually for inflation. On top of that, the Foreign Housing Exclusion allows you to exclude certain housing costs above a base amount, subject to location-based limits.
It’s important to understand what counts as “earned income” under the exclusion. Wages, salaries, self-employment income, and professional fees all qualify. Passive income does not. Investment returns, rental income, pensions, Social Security benefits, and payments received as an employee of the U.S. government are all excluded from the FEIE calculation. The IRS pays close attention to how income is categorized on Form 2555, and misclassification is a common audit trigger.
The Two Qualifying Tests the IRS Audits Most Closely
Every FEIE claim depends on passing one of two tests. During an audit, the IRS examiner will focus almost exclusively on whether you genuinely met the requirements of the test you elected. Understanding the difference between them is essential.
| Criteria | Bona Fide Residence Test | Physical Presence Test |
|---|---|---|
| Basic requirement | Established a true residence in a foreign country for an uninterrupted period that includes a full tax year | Physically present in a foreign country for at least 330 full days during any 12-month period |
| Intent matters? | Yes – the IRS evaluates your intention to live abroad indefinitely | No – this is a strict day-count test |
| Short trips to the U.S. | Allowed, as long as they don’t disrupt bona fide residence status | Each day in the U.S. (even partial) counts against the 330-day threshold |
| Common audit focus | Lease agreements, foreign bank accounts, community ties, visa type | Passport stamps, travel itineraries, airline records |
| Best suited for | Long-term expats with deep roots in a foreign country | Contractors, digital nomads, or workers on shorter foreign assignments |
The physical presence test sounds straightforward, but the IRS interprets “full day” literally. If your flight from London lands in New York at 11:58 PM, that entire calendar day counts as a U.S. day. Taxpayers who travel frequently between countries are especially vulnerable to miscounting, and the IRS cross-references passport records and CBP entry data to verify claims.
What Triggers an IRS Audit of Your FEIE Claim?
Not every FEIE filing gets examined, but certain patterns consistently draw IRS attention. Based on what we see working with expat clients at Ed Parsons CPA, these are the most common red flags:
- Large exclusion amounts with minimal foreign documentation. Claiming the full exclusion without attaching supporting evidence on Form 2555 raises questions immediately.
- Maintaining a U.S. home while claiming foreign residence. If you still own or rent a home in the States, the IRS may argue you never truly established bona fide residence abroad.
- Frequent or extended trips back to the U.S. Spending significant time domestically while claiming the physical presence test is the single most common reason for denial.
- Self-employment income from U.S.-based clients. The IRS scrutinizes whether the income was truly “earned” in a foreign country if all your clients are based in America.
- Late-filed returns claiming the exclusion retroactively. If you’ve had unfiled tax returns for multiple years and are now claiming the FEIE on late filings, expect heightened scrutiny.
- Inconsistencies with FBAR or FATCA reporting. If your foreign bank account disclosures don’t align with the income and residency story on your Form 2555, the IRS will notice.
Documentation the IRS Expects You to Have
The burden of proof sits with you, not the IRS. If you cannot substantiate your claim with records, the exclusion will be denied. Here’s what a well-prepared expat taxpayer should have organized and accessible:
- Copies of your passport showing entry and exit stamps for the relevant tax year
- Foreign lease or mortgage agreements proving your overseas housing arrangement
- Utility bills, bank statements, and insurance policies from your country of residence
- Employment contracts or business registration documents from the foreign jurisdiction
- Visa or residency permit documentation showing your legal status abroad
- A detailed travel log tracking every day spent inside and outside the U.S.
The IRS doesn’t require you to submit all of this with your return, but you absolutely need it ready if your filing is selected for examination. Taxpayers who work with a qualified tax resolution CPA before filing significantly reduce their exposure, because the documentation is organized properly from the start.
Under audit for your FEIE claim? Don’t respond to the IRS without professional guidance.Talk to Ed Parsons CPA – Call (786) 265-8578
What Happens If the IRS Denies Your FEIE?
When the IRS disallows a Foreign Earned Income Exclusion, the consequences go beyond simply paying the tax you originally excluded. Here’s what you’re looking at:
- Full federal tax on the previously excluded income. If you excluded $130,000 and the claim is denied, that entire amount gets added back to your taxable income for the year in question.
- Accuracy-related penalties. Under IRC Section 6662, the IRS can assess a 20% penalty on the underpayment attributable to negligence or substantial understatement of income.
- Interest from the original due date. Interest accrues from the date the tax was originally due, not from the date of the audit determination. On a large balance, this adds up quickly.
- Downstream collection consequences. An unpaid balance from a denied FEIE can escalate through the standard IRS collection process, from notices to liens to levies. If the balance grows large enough, you could eventually face a final notice of intent to levy or even passport revocation under the seriously delinquent tax debt program.
The good news is that an audit denial isn’t the end of the road. You have the right to appeal through the IRS Independent Office of Appeals, and if that fails, to petition the U.S. Tax Court. Having professional representation during the audit itself, however, is the most effective way to prevent a denial from happening in the first place.
The Streamlined Filing Option for Expats Who Are Behind
If you’ve been living abroad and haven’t filed U.S. returns or claimed the FEIE for prior years, the IRS Streamlined Filing Compliance Program may offer a path to get compliant without penalties. This program is specifically designed for taxpayers whose failure to file was non-willful, meaning it wasn’t intentional tax evasion.
Under the streamlined procedures, qualifying expats can file three years of delinquent income tax returns and six years of FBARs with no late-filing penalties. It’s one of the most generous compliance programs the IRS offers, but it requires careful preparation and honest disclosure. Errors in the streamlined submission can lead to the IRS rejecting the application and opening a standard examination instead.
Frequently Asked Questions
Can the IRS audit my FEIE claim from a prior year?
Yes. The IRS generally has three years from the date you filed to audit a return. However, if the exclusion resulted in a substantial understatement of income (more than 25% of gross income omitted), the statute extends to six years. For fraudulent returns, there is no time limit.
Do I still need to file a U.S. tax return if all my income is excluded under the FEIE?
Yes. U.S. citizens and resident aliens are required to file a federal return regardless of where they live or earn income. The FEIE is claimed on Form 2555 attached to your return. Failing to file is a separate compliance issue that can result in penalties and loss of the exclusion itself.
What if I qualify under both the bona fide residence test and the physical presence test?
You only need to meet one test to claim the exclusion. However, if you qualify under both, the bona fide residence test generally provides stronger audit protection because it doesn’t depend on an exact day count and allows more flexibility for U.S. visits.
Can I claim the FEIE and the Foreign Tax Credit at the same time?
Not on the same income. You can claim the Foreign Tax Credit on income that isn’t covered by the FEIE exclusion, but you cannot double-dip by excluding income and also taking a credit for taxes paid on that same income.
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Ed Parsons CPA – IRS Tax Resolution for U.S. Expats Who Need Clarity, Not ConfusionCall (786) 265-8578 | Schedule a Consultation.