Internal Revenue Service
Revenue Ruling
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smRev. Rul. 75-86
1975-1 C.B. 242
Sec. 911
IRS Headnote
U.S. citizen employed abroad; excludable income computation. Examples are given to show the computation of U.S. citizens' earned foreign income excludable from gross income under section 911(a) of the Code, and deductions allocable to the excluded income, in situations involving sole proprietors and partners who receive fees from services in excess of the maximum exclusion, income from services and capital in excess of the maximum exclusion, and expenses in excess of income.
Full Text
Rev. Rul. 75-86
Advice has been requested as to the method of determining the amount of earned income that is excluded from gross income under section 911 of the Internal Revenue Code of 1954. Advice is also requested as to the method of determining deductions that are allocable to or chargeable against excluded earned income and disallowed under the last sentence of section 911(a).
Section 911(a) of the Code provides that earned income of certain United States citizens from sources without the United States shall not be included in gross income. Section 911(c) provides that the amount so excluded for any taxable year shall not exceed an amount which shall be computed on a daily basis at an annual rate of $20,000 in the case of an individual who qualifies under section 911(a), except that the amount shall be $25,000 in the case of an individual who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire year, but only with respect to that portion of such taxable year occurring after such individual has been a bona fide resident of a foreign country or countries for an uninterrupted period of three consecutive years.
The last sentence of section 911(a) of the Code provides that an individual shall not be allowed, as a deduction from his gross income, any deductions (other than those allowed by section 151, relating to personal exemptions) properly allocable to or chargeable against amounts excluded from gross income under section 911.
In applying section 911 of the Code, the maximum amount of earned income that may be excluded is $20,000 (or $25,000 if applicable) of gross income. If the total earned income exceeds the amount thus excludable, the amount of deductions disallowed under the last sentence of section 911(a) shall be an amount which bears the same ratio to the total of such deductible items properly allocable to or chargeable against such earned income as the amount of earned income excluded from gross income bears to total earned income. These conclusions are illustrated in the following examples.
Example 1. A is a United States citizen who has been a bona fide resident of foreign country Z for a period that includes the current taxable year and an uninterrupted period of the three prior consecutive years. Since taking up residence in Z he has been operating a business in that country, as a sole proprietor. Capital was not a material income producing factor. In the year under consideration his fees received for services rendered in country Z were $100,000 and he incurred expenses of $48,000 in earning the fees.
Under section 911(b) of the Code $100,000 is earned income. The amount of gross income that is excluded under section 911(c) is $25,000. Since deductions from gross income which are properly allocable to or chargeable against amounts excluded from gross income are not allowable under the last sentence of section 911(a), a part of the deductions, in the proportion that exempt income bears to all gross income, are disallowed. The amount of taxable income is therefore computed as follows:
Earned income $100,000
Exclusion 25,000
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Included income $ 75,000
Expenses attributable to excluded income
(not allowable) 25/100 X $48,000 = $12,000
Expenses attributable to included income
(allowable) 75/100 X $48,000 = $ 36,000
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Taxable income $ 39,000
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Example 2. B is a United States citizen who has been a bona fide resident of foreign country Y for a period which includes the current taxable year and an uninterrupted period of the three prior consecutive years. Since entering Y he has been performing services for clients as a partner of a firm rendering services. The other members of the partnership, C and D, also reside in Y and all of the business of the partnership is done in Y. Under the terms of the partnership agreement, the net profit of the partnership is distributed in accordance with the interest of the partners in the firm, 50% to B, 30% to C and 20% to D. In the year under consideration the firm derived gross income from fees of $200,000 from country Y. In earning the fees, expenses of $80,000 were incurred in country Y. Of the net profits of $120,000, $60,000 was distributed to B as his distributive share.
As in Example 1, expenses must be allocated in the proportion that B's exempt income bears to his total income as follows:
B's share of total earned income $100,000
Exclusion 25,000
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$ 75,000
B's expenses attributable to excluded
income (not allowable) 25/100 X $40,000
= $10,000
B's expenses attributable to included
income (allowable) 75/100 X $40,000 = $ 30,000
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Total taxable income $ 45,000
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Example 3. E is a United States citizen who has been a bona fide resident of foreign country X for the current year and for the uninterrupted period of the three prior consecutive years. Since he arrived in X, E has owned and operated, as a sole proprietor, a retail store. The business is one in which both personal services and capital are material income producing factors. In the year under consideration, E's gross income (gross receipts minus cost of goods sold) was $300,000 and his expenses were $100,000. A reasonable allowance as compensation for personal services performed by E was $60,000.
Section 911(b) of the Code provides that in the case of a taxpayer engaged in a trade or business in which both personal services and capital are material income producing factors, a reasonable allowance as compensation for personal services, not in excess of 30% of his share of the net profits of such trade or business, shall be considered as earned income. In this case a reasonable allowance as compensation for personal services is $60,000, which is 30% of net profits. The figure 30% of net profits merely sets a maximum limitation on the amount of the gross income that can be considered earned income. Once the amount of earned income has been determined, expenses must be allocated in the proportion that the exempt income bears to total income as follows: Total income $300,000
Excluded earned income 25,000
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Included gross income $275,000
Expenses attributable to excluded income
(not allowable) 25/300 X $100,000
= $8,333.34
Expenses attributable to included income
(allowable) 275/300 X $100,000 = $ 91,666.66
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Taxable income $183,333.34
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Example 4. F is a United States citizen who has been a bona fide resident of foreign country W for an uninterrupted period that includes only one entire taxable year. Under section 911(c)(1) of the Code the maximum amount that is excludable from F's gross income is therefore $20,000.
Since arriving in W, F has been operating a business in which both personal services and capital are material income-producing factors. During the current year the business had gross income of $60,000 and expenses of $90,000. A reasonable allowance as compensation for the personal services rendered by the taxpayer is determined to be $30,000. See Anne M. B. Brewster, 55 T.C. 251 1970), aff'd 30 A.F.T.R. 2d 72-5774 (C.A.D.C. 1972), which holds, in part, that the 30 percent limitation contained in section 911(b) of the Code is a limitation on the amount to be treated as "earned income" only in situations where there are net profits.
Accordingly, F's expenses allocable to the excluded earned income must be disallowed and the deductible loss from the business determined as follows:
Excluded gross income $20,000
Gross income not excluded $40,000
Expenses attributable to excluded gross
income (not allowable) 20/60 X 90,000
= $30,000
Expenses not attributable to excluded
gross income (allowable 40/60 X $90,000 $60,000
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Net loss from business ($40,000 less
$60,000) ($20,000)
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