The good news is that you may qualify to exclude all or part of your foreign earnings from your taxable income.

Foreign earned income (meaning salaries and wages, commissions, bonuses, professional fees and tips) is income you receive for services you perform in a foreign country. It doesn’t matter whether your are paid by a U.S. employer or a foreign employer, as long as your tax home is in a foreign country.

Generally, your tax home is your regular or main place of business or post of duty, regardless of where you maintain your family home. It includes the entire city or general area in which your business or work is located.

To qualify for a foreign earned income exclusion you must also meet either the bona fide residence test or the physical presence test.

The characteristics usually qualifying you as a bona fide resident include establishing a home and settling in that country with some degree of permanence.

For the bona fide residence test you must be a bona fide resident of a foreign country for an uninterrupted period that includes one full tax year.

You qualify for the foreign earnings exclusion only if your tax home is in a foreign country throughout your period of residence or your 330 days of physical presence.

The amount of foreign wages and salary you can exclude per year is limited to your actual foreign wages or the annual maximum dollar limit, whichever is less. Starting with tax year 2006, the foreign earned income exclusion is adjusted each year for inflation. For 2010 the foreign earned income exclusion is up to $91,500 and for 2011 it’s up to $92,900.

Any taxes owed for the remaining income will be paid at the tax rates that would have applied without having claimed the exclusion.

You can also exclude amounts paid by your employer for housing. These include any amounts paid directly to you or on your behalf for housing, rent, education for your children, or tax equalization ("gross up" payments).

The amount of the housing exclusion is 16% of the foreign earned income exclusion amount.

You can claim the income exclusion, the housing exclusion, or both, as long as you don’t exclude the same amount twice.

If you are self-employed working abroad, you may claim the foreign earned income exclusion, but you’ll need to use the foreign housing deduction instead of the exclusion. Both the income exclusion and the housing deduction will be calculated based on your net income as figured on Schedule C. So, calculating the right amount of the exclusion depends on figuring your business income accurately.

The housing deduction (which can be calculated on Form 2555) is reported on Form 1040 Line 36. The foreign housing deduction reduces your regular tax liability but does not reduce your self-employment tax liability.

If you claim the exclusion, you will not be able to claim a deduction or credit on your U.S. income tax return for the foreign income tax on your earned income. 

The foreign tax credit applies to passive foreign income (unearned income), or investment income such as interest and dividends.

For example, if you have diversified your investment portfolio to include investments in other countries, you may have incurred taxable income in one or more foreign countries.

The foreign tax that was paid on these dividends or distributions is reported in box 6 of Form 1099-DIV – Dividends and Distributions, that you receive from your investment fund manager, or on Form 1099-INT in the case of interest income. 

If you are in a partnership, or a shareholder in an S corporation you can claim the credit for your proportionate share of foreign income taxes paid or accrued by the partnership or S corporation and passed along to you. These amounts should be reported on Schedule K-1. 

As a beneficiary of a trust or estate, you can claim the credit based on a proportionate share of the foreign tax on the trust or estate.

You can also claim foreign real property taxes as an itemized deduction on Schedule A of Form 1040.

There is an interesting piece of news for taxpayers who, in the past, failed to disclose foreign accounts or report foreign income, to take advantage of the IRS new Offshore Voluntary Disclosure Initiative.

Announced early February this year and available for a limited time only, this special initiative is designed to bring offshore money back into the U.S. tax system and help people with undisclosed income from hidden offshore accounts get current with their taxes. Taxpayers participating in the new initiative must file all returns and pay any taxes, interest and accuracy-related penalties due by Aug. 31, 2011.

Taxpayers hiding assets offshore who do not come forward will face far higher penalty scenarios as well as the possibility of criminal prosecution.

As far as corporations are concerned, well, there’s no need for us to concern ourselves with that, what happens offshore stays offshore! Income earned abroad by U.S. corporations is not taxed in the U.S. unless or until the income is repatriated, such as by payment of dividends to a parent corporation.