How To Report Deductions(p33)

If you exclude foreign earned income or housing amounts, how you show your deductions on your tax return and how you figure the amount allocable to your excluded income depends on whether the expenses are used in figuring adjusted gross income (Form 1040, line 38) or are itemized deductions.

If you have deductions used in figuring adjusted gross income, enter the total amount for each of these items on the appropriate lines and schedules of Form 1040. Generally, you figure the amount of a deduction related to the excluded income by multiplying the deduction by a fraction, the numerator of which is your foreign earned income exclusion and the denominator of which is your foreign earned income. Enter the amount of the deduction(s) related to excluded income on line 44 of Form 2555.

If you have itemized deductions related to excluded income, enter on Schedule A (Form 1040) only the part not related to excluded income. You figure that amount by subtracting from the total deduction the amount related to excluded income. Generally, you figure the amount that is related to the excluded income by multiplying the total deduction by a fraction, the numerator of which is your foreign earned income exclusion and the denominator of which is your foreign earned income. Attach a statement to your return showing how you figured the deductible amount.

You are a U.S. citizen employed as an accountant. Your tax home is in Germany for the entire tax year. You meet the physical presence test. Your foreign earned income for the year was $114,370 and your investment income was $11,555. After excluding $91,500, your AGI is $34,425.

You had unreimbursed business expenses of $1,500 for travel and entertainment in earning your foreign income, of which $500 was for meals and entertainment. These expenses are deductible only as miscellaneous deductions on Schedule A (Form 1040). You also have $500 of miscellaneous expenses that are not related to your foreign income that you enter on line 23 of Schedule A.

You must fill out Form 2106. On that form, reduce your deductible meal and entertainment expenses by 50% ($250). You must reduce the remaining $1,250 of travel and entertainment expenses by 80% ($1,000) because you excluded 80% ($91,500/$114,370) of your foreign earned income. You carry the remaining total of $250 to line 21 of Schedule A. Add the $250 to the $500 that you have on line 23 and enter the total ($750) on line 24.

On line 26 of Schedule A, enter $689, which is 2% of your adjusted gross income of $34,425 (line 38, Form 1040) and subtract it from the amount on line 24.

Enter $61 on line 27 of Schedule A.

You are a U.S. citizen, have a tax home in Spain, and meet the physical presence test. You are self-employed and personal services produce the business income. Your gross income was $109,900, business expenses $63,900, and net income (profit) $46,000. You choose the foreign earned income exclusion and exclude $91,500 of your gross income. Since your excluded income is 83.26% of your total income, 83.26% of your business expenses are not deductible. Report your total income and expenses on Schedule C (Form 1040). On Form 2555 you will show the following:

• Line 20a, $109,900, gross income,
• Lines 42 and 43, $91,500, foreign earned income exclusion, and
• Line 44, $53,203 (83.26% × $63,900) business expenses attributable to the exclusion.

Assume in Example 2 that both capital and personal services combine to produce the business income. No more than 30% of your net income, or $13,800, assuming that this amount is a reasonable allowance for your services, is considered earned and can be excluded. Your exclusion of $13,800 is 12.56% of your gross income ($13,800 ÷ $109,900). Because you excluded 12.56% of your total income, $8,026 (12.56 % of your business expenses), is attributable to the excluded income and is not deductible.

You are a U.S. citizen, have a tax home in Brazil, and meet the physical presence test. You are self-employed and both capital and personal services combine to produce business income. Your gross income was $146,000, business expenses were $172,000, and your net loss was $26,000. A reasonable allowance for the services you performed for the business is $77,000. Because you incurred a net loss, the earned income limit of 30% of your net profit does not apply. The $77,000 is foreign earned income. If you choose to exclude the $77,000, you exclude 52.74% of your gross income ($77,000 ÷ $146,000), and 52.74% of your business expenses ($90,713) is attributable to that income and is not deductible. Show your total income and expenses on Schedule C (Form 1040). On Form 2555, exclude $77,000 and show $90,713 on line 44. Subtract line 44 from line 43, and enter the difference as a negative (in parentheses) on line 45. Because this amount is negative, enter it as a positive (no parentheses) on line 21, Form 1040, and combine it with your other income to arrive at total income on line 22 of Form 1040.

You are a U.S. citizen, have a tax home in Panama, and meet the bona fide residence test. You have been performing services for clients as a partner in a firm that provides services exclusively in Panama. Capital investment is not material in producing the partnership's income. Under the terms of the partnership agreement, you are to receive 50% of the net profits. The partnership received gross income of $228,740 and incurred operating expenses of $88,490. Of the net profits of $140,250, you received $70,125 as your distributive share.

You choose to exclude $91,500 of your share of the gross income. Because you exclude 80% ($91,500 ÷ $114,370) of your share of the gross income, you cannot deduct $35,396, 80% of your share of the operating expenses (80% × $44,245). Report $70,125, your distributive share of the partnership net profit, on Schedule E (Form 1040), Supplemental Income and Loss. On Form 2555, show $91,500 on line 42 and show $35,396 on line 44. Your exclusion on Form 2555 is $56,104.