Section 911: What Employers of Expats Should Know

An employee qualifies under the bona fide residence test by establishing a genuine, indefinite residence in a foreign country for a full tax year, which is a facts-and-circumstances test looking at intent and ties to the foreign country, not just a day count. Alternatively, they qualify under the physical presence test by being physically present in a foreign country or countries for at least 330 full days during any twelve-month period, which is purely mechanical and doesn't require any intent to stay. An employee on a short-term rotation who travels back to the US frequently may fail both tests, while someone genuinely relocated and settled abroad typically passes the residence test easily.

The exclusion applies to foreign earned income, wages and self-employment income for services actually performed abroad, and there's a separate housing exclusion or deduction on top of it for qualifying housing costs above a base amount. Say your employee's annually adjusted exclusion limit lets them exclude a large majority of a moderate expat salary: income above that limit is still taxed normally, and investment income, US-source income, and certain deferred or supplemental pay generally don't qualify for the exclusion at all regardless of where the employee lives.

Even though the exclusion is claimed on the employee's personal return, you as the employer still generally have withholding and reporting obligations on their wages unless a specific exemption applies. Many employers adjust withholding for a qualifying expat employee once they've filed the appropriate exemption certificate, but that adjustment isn't automatic just because the employee tells you they'll qualify. Get documentation of their qualifying test before changing withholding, not just a verbal assurance, since you're on the hook for correct withholding regardless of how their personal return eventually turns out.

Some states don't conform to the federal foreign earned income exclusion at all, meaning an employee can exclude the income federally and still owe state tax on the same wages if they maintain sufficient ties to that state. This catches employees and employers by surprise constantly: the federal exclusion feels like the whole answer, but if the employee's state of residence or domicile doesn't recognize it, there's a second tax bill that federal planning never touched. Check the specific state's conformity rules before assuming an expat assignment is tax-clean across the board.

An employee who starts the year on assignment abroad but returns to the US before completing either test's full qualifying period may lose the exclusion for that year entirely, or need to requalify under a different test, depending on the specific facts. A pulled-forward return date because of a family emergency, a project ending early, or a company recall can all break qualification, so if an assignment's timeline changes mid-year, that's worth flagging to a tax advisor immediately rather than assuming everything works out at filing time. Build a check-in at the midpoint of any planned assignment specifically to confirm the qualifying test is still on track.

Keep a simple record for every expat employee from day one: the assignment start and expected end date, the specific country or countries involved, and which test you expect them to qualify under. If a physical presence test is the plan, track their actual travel days against the qualifying window as the year goes, not retroactively from expense reports and calendar guesses months later. That single habit turns a stressful year-end scramble into a five-minute confirmation.

Record these details for every expat employee from day one:

• The assignment start date and the expected end date.
• The specific country or countries involved in the assignment.
• Which test you expect the employee to qualify under, bona fide residence or physical presence.
• Actual travel days against the qualifying window, if physical presence is the plan.
• The withholding certificate on file, gathered before you change any withholding treatment.