U.S. Tax Savings Available Through Code Section 911

U.S. citizens residing in Costa Rica who earn compensation for personal services performed in Costa Rica or another foreign country may be eligible to exclude up to $91,400 of earned income from their U.S. gross income in 2009 under Internal Revenue Code Section 911.

The exclusion amount is adjusted each year for cost of living. But whether the exclusion confers any meaningful benefit depends on the amount of Costa Rican taxation on the income, whether the taxpayer has other Costa Rican source income subject to Costa Rican tax, and where the services are performed.

U.S. citizens and tax residents are subject to U.S. federal income tax on all their worldwide income. Some version or other of the exclusion has been in the Internal Revenue Code since 1926, designed primarily to promote foreign investment and trade by U.S. businesses by easing the U.S. tax burden on U.S. persons employed in foreign locales where the cost of living might be higher than in the United States. However, the exclusion can apply even for a U.S. taxpayer enjoying a lower cost of living in Costa Rica.

To be eligible for the exclusion, a U.S. citizen must be a “bona fide” resident of a foreign country or countries for an entire, uninterrupted taxable year, or be present in a foreign country or countries for 330 full days in a consecutive 12-month period (the “physical presence” test). Persons who are resident aliens for U.S. federal income tax purposes can qualify for the exclusion under the physical presence test but cannot qualify under the bona fide resident test unless entitled to the benefit of a U.S. income tax treaty with their country of citizenship if such treaty has a nondiscrimination provision. In either case, the individual’s “tax home” (his or her regular or principal place of business, or if none, then the “regular place of abode”) must also be in a foreign country or countries.

The exclusion applies only to “earned income,” such as salary, wages, fees for professional services and certain other amounts treated as compensation, including self-employment income (but limited if capital is a “material income-producing factor”) and partnership income that is foreign earned income. It may also apply to certain royalties or proceeds of the sale by an artist or composer of his or her work, severance pay, and certain other amounts. The exclusion does not apply to pension and annuity income, social security receipts, payments to U.S. government (or government agency) employees, or amounts paid more than one year after the year in which the services are rendered. Certain foreign housing expenses covered by the employer may also be excluded.

The income must be “foreign source” for U.S. federal income tax purposes, which generally requires that the services be performed outside the United States and in a foreign country or countries. A recent case denied the exclusion for income earned on a cruise ship because it was not earned in a foreign country.

If a U.S. taxpayer wishes to claim the exclusion, he or she must file Form 2555, or Form 2555-EZ if only the earned income exclusion is claimed and certain other conditions are met.

In 2005, Congress restored the “stacking” rule for excluded income, so that other, non-excluded income of the taxpayer is taxed at the U.S. marginal income tax (and alternative minimum tax) rates that would apply if the exclusion were not applicable. Simply put, the overall U.S. federal income tax is computed as if the excluded earned income were included, and then the exclusion is applied. This reduces the benefit of the exclusion; before the 2005 change, income in excess of or not qualified for the exclusion was taxed as if it were the only taxable income.

EXAMPLE: Joe D’Ude, a U.S. citizen moves to Costa Rica on January 1, 2009, and is in Costa Rica for 330 full days in 2009. Joe is much in demand as a surfing instructor, and earns US$90,000 (DUDE!) from giving lessons in Tamarindo. He also receives $20,000 in royalties from a surfboard design improvement he invented and licensed to an Australian board maker. Although Joe might have a different opinion, he is not an artist, so the royalty income is not protected by the Section 911 exclusion. Joe knows he has to file a U.S. federal income tax return, and he is not foolish enough to risk the penalties and potential criminal sanctions of not filing (no wonker, he). Ignoring adjustments, exemptions, credits and deductions, Joe’s 2009 U.S. federal tax will be computed on $110,000, so even though the $90,000 is then excluded, the $20,000 in royalties will be taxed quite a bit more under the stacking rule than if it were his only income.

Using the exclusion also results in disallowance of deductions, credits or other exclusions to the extent allocable to the excluded income. For example, the U.S. foreign tax credit for foreign taxes on the exclusion amount is not allowed. The exclusion is subject to proration for a partial qualifying year.

There are numerous complex U.S. tax rules applying to the exclusion that cannot be covered in a short article like this. U.S. persons who might qualify for the exclusion should consult their U.S. tax return preparers to discuss their eligibility and the ramifications of the election. Costa Rican tax advice should also be sought. In some cases, it may be better to forego the exclusion in favor of the U.S. foreign tax credit.

One particular case in which the exclusion could be more meaningful is where the U.S. taxpayer qualifies as a bona fide resident of Costa Rica, but can earn fees for services provided outside Costa Rica (assuming Costa Rica continues to tax on a territorial basis) and outside the United States. If such fees are not taxed, or only minimally taxed, where the services are provided, then the U.S. exclusion could result in true tax savings. That result, however, is becoming increasingly rare.

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Jason Warner’s practice is twofold (1) advising foreign individuals and privately-held foreign business about the US tax consequences of investing in the US or starting a business here, moving to the US or leaving the US, and dealing with US tax issues when their children move to or leave the US; and (2) advising US individuals and privately held US companies about the US tax consequences of investing outside the US or starting a foreign business activity, and expatriation.

If you would like to communicate with Costa Rica tax expert Randall Zamora and his associate Jason Warner, please use the simple form below:

Andrew Makarik

to@welovecostarica.com

Andrew Makarik is the main editor of WeLoveCostaRica, a fan of this sunny country. He is also a loving husband and a has a lovely daughter. By being a devoted family man and the biggest Costa Rica fan, he wants to make more people feel at home there. WeLoveCostaRica unites people and helps them find new home or a new travel destination. This website is a friendly community where everyone can find not only information, but also new friends and travel pals. Andrew is also passionate about IT and programming, so he himself maintains a friendly atmosphere in this cozy environment of WeLoveCostaRica.com.