Does Foreign Earned Income Exclusion Cover Severance Pay and Unemployment Benefits?

Does the Foreign Earned Income Exclusion apply to severance/unemployment?

Welcome to the Practical Expat Tax Adviser. This series is designed to identify a common crossborder tax question and then provide the practical US tax considerations for the given situation that the standard human can understand. For those of us with less of a life who are more technically inclined, I end the article with a breakdown of the legal support and basis for the considerations provided. Enjoy!

This is not meant to be tax advice for YOUR situation. Find a qualified professional or reach out to me directly for more practical crossborder tax advice.

The Client Scenario: Post-employment income while living abroad

Today’s question is looking at whether severance and/or unemployment income is eligible for the foreign earned income exclusion.

Taxpayer Question

“I’ve been living in Costa Rica for the last several years and have enjoyed the benefit of the Foreign Earned Income Exclusion (FEIE). It saves me about $20,000 in federal tax every year on my U.S. salary income. However, I recently got laid off and will be receiving a severance as well as considering unemployment. Can you give me any advice? How does this affect my FEIE?”

Practical Analysis: Distinguishing between income types

The FEIE has several qualifying factors. In this case, we need to focus on the ‘foreign earned’ part of that qualification and apply that to both the severance income and the unemployment income.

Key FEIE qualification factors

When evaluating whether post-employment income qualifies for the FEIE, we must examine whether each income stream meets the critical "foreign earned income" criteria:

1. Earned Income Test: Is the income considered compensation for services performed?
2. Foreign Source Test: Were the related services performed entirely outside the United States?

What does "Earned Income" really mean?

The IRS has specifically ruled for severance to be considered “earned” income for FEIE purposes. As long as all of the work performed related to the severance was done in a foreign country (i.e., no US work days) then it will be eligible for the foreign earned income exclusion.

Important Consideration: read the details of the severance contract to understand the periods covered. If there are US workdays over the relevant period, those would need to be stripped out from the FEIE calculation as they would not be “foreign”. This proportional allocation keeps as much of the income as possible covered by the FEIE while avoiding the potential for harsh penalties down the road.

Are "Unemployment" benefits considered earned income?

The unemployment income is a different story. The IRS would consider it to be ‘passive,’ meaning it is not directly related to the performance of services. This is a form of government assistance as opposed to compensation for labor.

To summarize, in this situation the FEIE should apply to the severance income but the unemployment income will be subject to U.S. tax as ordinary income. The FEIE is claimed on the severance with the filing of Form 2555 with the annual Form 1040.

Implementation Strategy

Here's the quick guide tax filing guide for Expats who received severance or unemployment:

• Report severance income on Form 2555 alongside your Form 1040 to claim the FEIE benefit
• Report unemployment benefits as ordinary income subject to standard U.S. taxation

Technical Foundation and Legal Framework

Still here? Great, it's time to dig into the technical details!

A lot of a tax accountant’s job is to find the definition of words and apply that to a fact pattern. The tax law is there to give us those definitions, but they do not always jive with what you would expect.

The critical analysis centers on interpreting two key statutory elements: "foreign" and "earned."

Section 911(b)(1)(A) and Reg. Sec. 1.911-3(a)

“the term “foreign earned income” means earned income (as defined in paragraph (b) of this section) from sources within a foreign country (as defined in § 1.911-2(h)) that is earned during a period for which the individual qualifies under

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to make an election. Earned income is from sources within a foreign country if it is attributable to services performed by an individual in a foreign country or countries. The place of receipt of earned income is immaterial in determining whether earned income is attributable to services performed in a foreign country or countries.”

Translation: The country you are physically in when you provide the service determines the source… Not where the customer/client is.

Section 911(b)(1)(A) and Reg. Sec. 1.911-3(a) establish that income qualifies as "foreign" when:

• It derives from sources within a foreign country
• It is attributable to services personally performed in a foreign country
• The individual qualifies under relevant FEIE eligibility tests
• The location where payment is received is immaterial

Section 911(b)(2)(A) and Reg. Sec. 1.911-3(b)

“the term “earned income” means wages, salaries, professional fees, and other amounts received as compensation for personal services actually rendered including the fair market value of all remuneration paid in any medium other than cash”

Translation: Earned income is income derived from the performance of services.

Section 911(b)(2)(A) and Reg. Sec. 1.911-3(b) define "earned income" as:

• Wages, salaries, professional fees, and similar compensation
• Amounts received specifically for personal services actually rendered
• Including all remuneration regardless of payment medium

Applying these definitions to the pattern

Together, these “definitions” essentially tell us that eligible income has to be from the performance of services and you have to be performing those service while physically in a foreign country. Of course, this is all very clear when comparing something like a salary to a dividend, but there are other types of income that do not fall squarely in these rules. Severance and unemployment income are good examples of this.

Fortunately, we have a IRS Revenue Ruling that specifically speaks to the severance. In Revenue Ruling 79-6 the IRS says that this is still “earned” income as long as the payment is in the nature of compensation for past services and does not represent consideration for cancellation of an employment contract or in respect of a noncompete agreement. This is a similar concept to a bonus in that the payment is for prior services rendered.

Although there is not a direct ruling related to unemployment income, this does not seem to fall under the Sec. 911 definition of earned income. The IRS calls out specific types of income such as wages, professional fees, bonuses, and commissions as being earned income. At the same time, Reg. Sec. 1.911-3(c) says that things like pension income and other passive income are specifically excluded. Unemployment income would likely be considered “unearned” income as it does not directly relate to services being rendered.

Conclusion: Strategic Approach to Post-Employment Income

There are other types of income that fall into this grey area such as partnership income or royalty income where it is not so clear at first whether it is “earned” or not. This is an area of tax law where we do actually have a lot of cases and ruling to pull from (re: taxpayers have tried it all). If you are not sure whether your income applies I recommend not making an assumption and finding a professional and/or doing some research.

Specifically, for expats experiencing employment transitions while living abroad - the goal is to:

1. Maximize FEIE Benefits: Apply the exclusion to qualifying severance pay by documenting the foreign nature of your service performance
2. Plan for Tax Liability: Anticipate standard taxation on unemployment benefits
3. Maintain Documentation: Preserve records detailing work locations and severance agreement terms
4. Consider Timing: Evaluate how unemployment benefits might affect your overall tax situation

Understanding these distinctions allows for proactive tax planning during employment transitions, potentially preserving significant tax benefits despite changing income sources.