Exclusion or credit: the choice American founders abroad get wrong

The United States taxes its citizens and green card holders on worldwide income wherever they live. Two mechanisms stop that producing double taxation, and they work in opposite directions:

• The foreign earned income exclusion removes a capped amount of foreign *earned* income from your US taxable income entirely.
• The foreign tax credit leaves the income taxable and gives you a dollar-for-dollar credit for foreign income tax paid on it.

Most people abroad hear about the first and never seriously evaluate the second. For a founder living in a country with real income tax, that is usually the wrong way round.

Qualifying at all

The exclusion requires a tax home abroad plus one of two tests:

• Physical presence — 330 full days outside the United States in any rolling 12-month period. Mechanical, countable, and available to anyone including a perpetual traveller.
• Bona fide residence — residence in a foreign country for an uninterrupted period including a full tax year, judged on facts rather than days. Harder to establish, more flexible once established, and generally unavailable if you have told that country you are not resident there.

The credit has no such tests. It is available to anyone who paid foreign income tax on foreign-source income.

Which one wins

The three traps

1. The five-year lock

Once you elect the exclusion it continues automatically until revoked. If you revoke it, you cannot elect it again for five tax years without the IRS's consent — which is requested through a private ruling and is neither quick nor free.

That matters because circumstances change. A founder who elects the exclusion while in Dubai, then moves to Germany and switches to the credit, then returns to a zero-tax country, has locked themselves out of the exclusion for the return leg. Decide it as a multi-year position, not a single-year optimisation.

2. You cannot credit tax on excluded income

The two reliefs do not stack on the same dollar. Foreign tax paid on income you excluded is not creditable, and the credit on the remainder is computed after an allocation that reduces it. Claiming both carelessly is one of the most common return errors in this population, and it is the kind that produces a notice years later.

3. Neither touches self-employment tax

What the credit gives you that the exclusion does not

1. 1Carryforward. Unused foreign tax credits carry back one year and forward ten. Living in a high-tax country builds a bank of credits that can shelter later US tax — including, sometimes, on a liquidity event.
2. 2No cap. The credit scales with income. The exclusion stops at a fixed figure however well the year goes.
3. 3Coverage of every income type. Dividends, interest, gains and rent are all inside the credit and all outside the exclusion.
4. 4No day counting. No 330-day test, no risk of a family emergency costing you the relief.

The credit's cost is complexity: income has to be sorted into separate baskets, the limitation is computed per basket, and the form is genuinely fiddly. That is a preparer's fee, and for most founders it is smaller than the tax the exclusion leaves on the table.

Two things to do regardless

• File. The exclusion and the credit are both claimed on a return. Owing nothing does not remove the obligation to file, and the exclusion is forfeitable if the return is late enough. The same is true of the information returns, which carry far larger penalties than the tax ever would.
• Keep the day count. Whichever route you choose, the record of where you were is what supports it — the same record that supports your residence position in the country you actually live in.

The exclusion is the famous one. The credit is usually the profitable one. The choice is worth an hour with a spreadsheet and a five-year view, because it is the one you cannot casually reverse.