Hello.
I can pass the 330 day residency test, I think I pass the tax home
test, but it's not clear whether I pass the foreign earned income
test.

I have a business here in Thailand where I sell products over the
internet largely to Americans and ship them the goods direct from
here.  The definition the IRS uses regarding business profits and
earned income is where the sale takes place.  But where exactly does
my sale take place?  In Thailand, since that's where I am with the
product? In America, since that's where the website is hosted and the
customer is based?

California still wants me to pay sales tax on sales to customers in
California since I have a slight business presence there (my family
handles my mail, including a check or two a day that arrives).  If
California considers these sales to warrent California taxes (rightly
or wrongly), perhaps sales to any American customer count as US sales?

My situation seems to be a grey area and I would like to have a solid
answer on this.  I will likely hire a tax professional to guide me
through my pretty complicated tax situation, but I would like to get
at least this one tax question figured out.

Hi dancalio,

The short answer to your question is, the object of filing a 1040 is
to make a declaration of how much income you earned (foreign or
otherwise). Your residency tests will determine if you are eligible
for the foreign exclusion or not.

Following are excerpts I've taken from the IRS 2003/1040 "Forms and
Instructions for Overseas Filers" (I will assume you are a U.S.
citizen).

FORM 2555
Foreign Earned Income

"If you are a U.S. citizen... living in a foreign country, you are
subject to the same U.S. income tax laws that apply to citizens living
in the United States. But if you qualify, use Form 2555 to exclude a
limited amount of your foreign earned income."

"You qualify for the tax benefits available to taxpayers who have
foreign earned income if both 1 and 2 apply.
1. You meet the tax home test. 
"Your tax home must be in a foreign country throughout your period of
bona fide residence (330 days). Your tax home is your regular or
principal place of business...regardless of where you maintain your
family residence. If you do not have a principal place of business
because of the nature of your business, your tax home is your regular
place of abode (where you live)."
2. You meet either the bona fide residence test OR the physical presence test."

>>>You qualify for no. 1 because you are living and doing business in
a foreign country.
>>>You qualify for no. 2, the physical presence test. as you already stated.

Remember, you are filing a 1040 with the IRS to declare *your* income,
and you are including Form 2555 because you and your business are in a
foreign country. It doesn't matter that most of your customers are in
the States - you and your business (and products) are in Thailand.  So
you will fill out form 2555, entering all of your business income (in
U.S. dollars) you earned minus allowable deductions. You will subtract
the exclusion from your total foreign earned income in Part VII.

FORM 1040
U.S. Individual Income Tax Return

In line "Other Income": write "form 2555" in the blank space provided
and write your allowable exclusion within parenthesis in the space
provided. For example, let's say you made $100,000 and your allowable
exclusion is $80,000. You would put ($80,000) under "Other Income" and
$20,000 under "Business Income" (attach Schedule C). Your total income
would be $20,000 plus any other income you may have received
(interest, dividends, etc).

>>>>>>

FORM 2555
http://www.irs.gov/pub/irs-pdf/f2555.pdf

FORM 2555 INSTRUCTIONS
http://www.irs.gov/pub/irs-pdf/i2555.pdf

FORM 1040
http://www.irs.gov/pub/irs-pdf/f1040.pdf

Services Available Outside the United States: 
HOW TO ORDER PACKAGE 1040-7 for Overseas Filers:
"During the filing period (January to mid-June), you can get the
necessary federal tax forms and publications from U.S. Embassies and
consulates. You can request Package 1040?7 for Overseas Filers, which
contains special forms with instructions and Publication 54.
Also during the filing season, the IRS conducts an overseas taxpayer
assistance program. To find out if IRS personnel will be in your area,
you should contact the consular office at the nearest U.S. Embassy."
http://www.irs.gov/publications/p54/ch07.html

I hope I've been able to help to clear this up for you. If you have
any questions, or if I've misunderstood you, please post a
clarification request *before* closing/rating my answer and I'll be
happy to assist you further.

Thank you,
hummer

I used my own knowledge and experience plus IRS forms I have in-hand.
I also searched the IRS for the forms and instructions.

---

Request for Answer Clarification by dancalio-ga on 13 Sep 2004 08:32 PDT

Hello hummer,

Thank you for your quick and detailed  response. But I think I need to
double check a thing or two with you. I'm not sure you really
responded to the heart of my question regarding the specific nature of
my business income.

You say "Your residency tests will determine if you are eligible
for the foreign exclusion or not.".  I understand the residency and
tax home requirements already. However, there is more to it than that
considering I have a business.  The case of simple "personal services"
performed abroad is easy, but business profits are not so easy.

The IRS defines income from business profits as being foreign or not
depending on where the actual sale occured. I can't find the link on
the irs site right now but I just saw it recently.

Business taxes for sales that occur in America I think ARE taxable. 
If I lived in Thailand all the time but owned a retail store in
America that would be business profits earned in America.  So what
about selling over the internet?  The situation would be more clear
cut except for the fact that California clearly treats my sales to
California residents as California sales since I have a small office
in California.  If California can treat sales to California residents
as  California sales why wouldn't the US government treat sales to US
customers as US sales?

Perhaps I'm just making a dumb point but I need to make sure my case
is rock solid in this important matter.  Also, I was wondering what
sort of tax background you have.  I have other tax questions I need
help with and perhaps you could help me with those as well.

Thanks for the clarification,
Daniel

---

Request for Answer Clarification by dancalio-ga on 13 Sep 2004 09:06 PDT

Ahh, here's the link I was talking about:
http://www.irs.gov/businesses/small/international/article/0,,id=96414,00.html

Notice what it says about how business income depends on "where sold
allocation".  This is the heart of my question.

Please help me make sense of this considering my situation.

Bonus: Also on this page, they talk about dividends depending on type
of corporation (foreign or US).  I'll throw in a $2 tip if you could
tell me what this means regarding S-Corporations.  I was considering
setting up my business as S Corporation (registered in California). 
Outside the salary I would pay myself, does this mean that any profits
I get would be considered as US based and thus I couldn't use them for
the foreign earned income exclusion?

Thanks.

---

Clarification of Answer by hummer-ga on 13 Sep 2004 11:32 PDT

Hi Daniel,

You are not making a dumb point and you are not alone in trying to
figure this out.

"I sell products over the internet largely to Americans and ship them
the goods direct from here."

Income is taxed based on its source and where the services are
performed. You are performing services in Thailand and therefore your
income is outside the U.S.  I think it may be confusing because you
think of your income as coming from the U.S. (the money you receive
from your customers), but in fact, the services you perform in
Thailand are the source of your income.

The following link explains U.S. Source Income - it has a different
orientation than your situation but the definition of U.S. Source
Income is the same.

An explanation of "U.S. Source Income":
US TAX FOR ALIENS: Publication 519: US Tax Guide for Aliens:
Chapter 2, page 11:
"A nonresident alien usually is subject to U.S. income tax only on
U.S. source income (services performed in the U.S)."
Table 2?1, page 11: 
Summary of Source Rules for Income of Nonresident:
 A. Factor Determining Source:
  1. Salaries, wages, other compensation: Where services performed
  2. Business income: Personal services:  Where services performed
Chapter 2, page 12: 
"All wages and any other compensation for services performed in the
United States are considered to be from sources in the United States."
"If your compensation is for personal services performed both inside
and outside the United States, you must figure the amount of income
that is for services performed in the United States."
http://www.irs.gov/pub/irs-pdf/p519.pdf

"Business taxes for sales that occur in America I think ARE taxable. 
If I lived in Thailand all the time but owned a retail store in
America that would be business profits earned in America.  So what
about selling over the internet?  The situation would be more clear
cut except for the fact that California clearly treats my sales to
California residents as California sales since I have a small office
in California.  If California can treat sales to California residents
as  California sales why wouldn't the US government treat sales to US
customers as US sales?

The sales are not occurring in the U.S.  Forget about the internet for
a moment and pretend your customers were calling you on the phone.
They call you up to order your widget and you take their credit card
info, package it up, go to your local post office in Thailand, and
post the parcel to the U.S. You just performed all of those services
in Thailand and therefore you are eligible for the foreign exclusion.

I've searched for a suitable link that would spell it out and here is
the closest I came:
International Tax Issues in Global e-Commerce:
"For the entrepreneur who is willing to reside nearly full time (more
than 329 days per year) in a foreign tax haven country such as the
Bahamas, Bermuda or Nevis, the US tax system permits the US person to
exclude up to $76,000 per taxpayer (for the year 2000) of earned
income while living outside the US. This exclusion is also available
to the self employed. Any excess earnings are subject to U.S. taxes.
If your spouse actively works in the business, you could get a double
tax exemption ($152,000) for 2000. This exemption is scheduled to
increase by $2,000 per year until it reaches $80,000 in 2002."
http://www.rpifs.com/ecommerce/ecommercetaxes.htm

Don't confuse CA sales tax (or other "remote tax" charged by other
states) with Federal Income Tax - they are two different birds
altogether.

Another way to look at it - do you pay income tax to Thailand? The
foreign income exclusion was put in place so U.S. citizens wouldn't
have to pay tax on the same income to two different countries. Ask
yourself if Thailand considers that you are earning income there. If
you are earning x dollars in Thailand, how can you also be earning the
same x dollars in the U.S.?

Foreign Earned Income (FEI) Exclusion:
http://www.txcpa.net/fei_exclusion.htm

In regards to my qualifications, I'm not a tax consultant but my
situation was very similar to yours for many years (and I never had
any trouble with the IRS 8-)

If you're still unsure, please let me know and I'll have another go.
Sorry, I can't help you with the s-corporation question.

hummer

---

Clarification of Answer by hummer-ga on 17 Sep 2004 10:01 PDT

Hi dancalio,

Thank you for your nice note, I appreciate it. However, it bothers me
that you aren't completed satisfied yet so I have been trying to find
a link for you. How's this?

"The place where you perform the services is what defines your income
as foreign, not where or how you are paid."

Topic 855 - Foreign Earned Income Exclusion ? What Qualifies?
"If you live and work abroad, you may qualify to exclude all or part
of your foreign earned income from United States income tax. Foreign
earned income is defined as wages, salaries, professional fees, and
other amounts received as compensation for personal services performed
in a foreign country, during the time your tax home is in a foreign
country, and you meet either the bona fide residence test or the
physical presence test. *The place where you perform the services is
what defines your income as foreign, not where or how you are paid.*
For instance, income received for personal services performed in
France is foreign earned income, even if the employer is American and
your pay is deposited in an American bank. Wages paid by the U.S.
government to its employees are not eligible for the exclusion.
However, amounts paid to independent contractors by the U.S.
government may be eligible for the exclusion."
http://www.irs.gov/taxtopics/tc855.html

Hoping that helps -
hummer

---

Request for Answer Clarification by dancalio-ga on 26 Sep 2004 09:45 PDT

Hi Hummer,

I noticed you posted a response so I'll just respond as long as you're
still around.

I understand the point of it being dependent upon where personal
services are performed regardless of where and who pays you.  But the
IRS makes a specific point differentiating between "personal services"
and "business income" at this link:

http://www.irs.gov/businesses/small/international/article/0,,id=96414,00.html

Please look at this link and see what I'm talking about.  

I have business income, do I not?  So I need to determine the source
of the income based on where the item is sold, no?  So the question,
which I'm not sure has much legal precedent, is where exactly does my
sale take place?

You argue that where the sales take place is irrelevant since the
"personal services" are clearly being performed in Thailand.  My case
would be easy and I wouldn't have to come to google questions if I
were, say, an engineer hired by Halliburton to do work over here.  But
I have a business, so perhaps the "personal services" side of it
doesn't even apply to me.  If "personal services" fully describes my
situation, then why would the IRS make the point about "business
income" as opposed to "personal services" at the link I showed you?

So the burden of your argument that I qualify for the exclusion would
be to prove either:
a) "Business income" doesn't apply to me, and "personal services"
fully describes my situation.

or

b) "Business income" applies to me, but the "Where Sold
Allocation" as the IRS describes it is fully in Thailand.

Your discussions clarifying the "personal services" side of things, as
in your last response, really seems to miss the point.  I understood
that side of things quite well even before coming to ask for help here
at google.

Thanks for all the help hummer.

-Daniel

---

Clarification of Answer by hummer-ga on 26 Sep 2004 10:17 PDT

Hi Daniel,

Monday I will call the IRS on the phone, explain your situation and
let you know what they have to say, ok?  In case they ask, what kind
of products do you sell? Do you make them yourself? If not, where are
they made? If you can think of anything else that they may ask, let me
know. I'll do the best I can for you.

Regards,
hummer

---

Clarification of Answer by hummer-ga on 26 Sep 2004 11:32 PDT

Daniel, do your customers order your products on your website using a
secure order form?  Then you pick up their orders in Thailand and
process their credit card there?  Do you have a business account with
a credit card company or are you using PayPal or something like that? 
Is your business registerd in Thailand? Just trying to anticipate
questions. hummer

---

Request for Answer Clarification by dancalio-ga on 28 Sep 2004 10:24 PDT

Wow, hummer, you're going beyond the call of duty.  It's not necessary.

But, if the call is free and you're interested for interests sake, I
would appreciate if you could ask them.  I can't call without it being
long distance from where I am.

Let me try to clarify things a bit.
I purchase the jewelry wholesale from local manufacturers in Thailand.
I take orders on my internet website and they pay with paypal 90% of
the time and send me a check/money order the rest of the time. I ship
the items out from here in Thailand.  If the customer has to mail me
something, I use my parent's address in San Diego and my parents keep
me up to date.

---

Clarification of Answer by hummer-ga on 28 Sep 2004 11:55 PDT

Hi Daniel,

Well, I tried, but the 1-800 number was only valid Jan - Apr., so I
tried again to find a good link for you. Try this one:

In regards to "Foreign Earned Income"
"Foreign earned income generally is income you receive for services you perform."
"Earned income. This is pay for personal services performed, such as
wages, salaries, or professional fees. The list that follows
classifies many types of income into three categories. The column
headed Variable Income lists income that may fall into either the
earned income category, the unearned income category, or partly into
both." See chart

In regards to "Source of Income"
"The source of your earned income is the place where you perform the
services for which you received the income. Foreign earned income is
income you receive for working in a foreign country. Where or how you
are paid has no effect on the source of the income. For example,
income you receive for work done in Austria is income from a foreign
source even if the income is paid directly to your bank account in the
United States and your employer is located in New York City."

In regards to "business income" versus "personal service", the
personal service you perform for your business counts as "earned
income".
"Income from a sole proprietorship or partnership.   Income from a
business in which capital investment is an important part of producing
the income may be unearned income. If you are a sole proprietor or
partner and your personal services are also an important part of
producing the income, the part of the income that represents the value
of your personal services will be treated as earned income."
http://www.irs.gov/publications/p54/ch04.html#d0e3332

So, given that you pass the residency test, and you have foreign
earned income for personal services performed for your business in a
foreign country, I am confident that you can claim the exclusion. It
doesn't matter whether you are performing the personal services for
somebody else's company or your own - you're doing it outside the
U.S.. It also doesn't matter where your customers are.

Is that any clearer?  Have I wacked you over the head enough? 8-)
hummer

Researcher did a good job.  There was one angle to the question, about
the location of business profits as opposed to "services performed"
that I'm not sure was totally clarified, but perhaps I'm just seeing
complication where it doesn't really exist.

I have not read all the discussion above but in regard to your
original question: as a general rule, for a sale, the source of income
depends on where title to the goods passes. If you sell the item and
the customer owns it before you ship it, the title passes where you
are. If it is yours until the customer receives it in the US (title
passes here) then it is US source. If you have a US office and that
office participates in the selling, then the income from the sale is
likely US source even if the title to the goods passes abroad.

Also note, for the foreign earned income exclusion if you have
business income and both personal services and capital are material
factors in producing the income from the business, then for the
foreign earned income exclusion, the part treated as income from
services cannot exceed 30 percent of the net profits of the business.

Hi taxbear.

Thanks for your knowledgeable insight into this conversation.  You
have picked up the crux of the problem.

I have the item here in Thailand, the customer pays for it, and I send
it out.  Since the customer has already paid for it while it's still
in Thailand would this seem like a good argument that the sale takes
place here? I wish there were something more black and white in the
IRS literature I could just quote in case there were any questions.

And let me make a note about the "office" in San Diego. The "office"
in San Diego does not "participate" in the selling in an important
way.  The "office" consists of my parents' house where I receive some
checks and returns so my customers don't have to deal with sending by
international mail. The vast majority of payments are through
electronic mediums like Paypal.

With regards to capital being a factor, I don't think that really
applies to me, does it?  I have thought about this angle of the income
exclusion before and I think it applies to someone who, say, builds a
widget factory abroad and works there as the manager.  A significant
part of his income would be coming from the widget factory capital
investment itself as opposed to his management services so this is
where the 30% profit cap comes from. I buy and sell products, so I
guess this could be considered as "capital" being a "material factor".
 But considering I work 80 hours a week on the business -- i.e.
"personal services" -- connecting the customers with the product, I
think it would be absurd to classify my business under the 30% rule.

Thanks for your knowledgeable insight taxbear.
-Daniel

Daniel,

You must have foreign EARNED income to qualify. Selling goods won't
generate earned income but if you provide services to the business,
the value of your services is earned income (but it cannot exceed 30%
of net income, and it may be less than that).

Re the 'capital' part, this is a question of fact. Note that the
courts have stated the following:

"Moreover, capital is ordinarily a material income-producing factor if
the operation of the business requires substantial inventories or
substantial investments in plant, machinery, or other equipment. On
the other hand, capital is not a material income-producing factor
where the gross income of the enterprise consists principally of fees,
commissions or other compensation for personal services" (Rousku v CIR
56 TC 548)

Given that you sell inventory rather than provide services (say as an
engineering consultant etc) it seems to me that this impacts you.

Hi taxbear,

I'm afraid I must disagree - income made from a business *is* earned
income. He will fill out the schedule for business income, including
income & expenses, and put his Net Business Income on his 2555 just
like anybody else. He *does* provide a service, for example, packaging
and mailing the items.

Regards,
hummer

Hummer, 

Here's an example from the IRS website that might help.

Example 1.

You are a U.S. citizen and meet the bona fide residence test. You
invest in a partnership based in Cameroon that is engaged solely in
selling merchandise outside the United States. You perform no services
for the partnership. At the end of the tax year, your share of the net
profits is $80,000. The entire $80,000 is unearned income.

Example 2.

Assume that in Example 1 you spend time operating the business. Your
share of the net profits is $80,000, 30% of your share of the profits
is $24,000. If the value of your services for the year is $15,000,
your earned income is limited to the value of your services, $15,000.

Hi taxbear,

"I purchase the jewelry wholesale from local manufacturers in Thailand.
I take orders on my internet website and they pay with paypal 90% of
the time and send me a check/money order the rest of the time. I ship
the items out from here in Thailand.  If the customer has to mail me
something, I use my parent's address in San Diego and my parents keep
me up to date."

Yes, ofcourse, a partnership would normally reduce your earned income,
whether you are in the States or elsewhere and that would show up on
the Business Income Form. Without going back and reading all of the
posts here, I don't recall that a partnership ever entered into it
(his parents aren't partners in the business, if that is what you are
thinking). Daniel has a business in Thailand, he does the work, and he
is entitled to the exclusion. The original question was about whether
the fact that his customers are in the U.S. disqualifies him for the
exclusion and the answer is, they do not effect his exclusion in the
least.

Regards,
hummer

I appreciate the latest discussion guys.  Well, I had thought I had
this pretty much figured out and I could save the $450 on the
international tax professional, but now I'm not so sure.  Let me just
make a few points.

1.taxbear wrote:"You must have foreign EARNED income to qualify.
Selling goods won't generate earned income but if you provide services
to the business,
the value of your services is earned income (but it cannot exceed 30%
of net income, and it may be less than that)."

This seems to be contradicted by the income classification information found here:

http://www.irs.gov/businesses/small/international/article/0,,id=96414,00.html

At this link, business income from goods sold qualifies as foreign
earned income depending on "where sold allocation".  Clarification of
this is why I started this google question.

2. Whether I fit into the capital side of things is, I think, somewhat
complicated.

It seems like the intent of the law is to make sure that you get the
exclusion on work YOU do as opposed to work YOUR MONEY does.  They
don't want you making a business investment, whether in a new factory
or "substantial inventories", which pays off in tax free money. Under
the intent of the law, considering all the constant work I put into
the business -- e.g., customer service, marketing, website design,
finding product, market research, expansion into new markets and ideas
-- I think this wouldn't apply to me.

Under the letter of the law it's not clear whether it applies to me. 
a. It would seem absurd for it to hinge on the technicality of whether
I maintain "substantial inventories" or not.  If absolutely necessary,
I could maintain a much smaller inventory and pick up the goods from
the manufacturers as needed. Obviously, the nature of my work and
business wouldn't change, but I wouldn't have much in the way of
inventory anymore.

b. What exactly does "substantial invetories" mean anyway?  On my
gross sales revenue of $100, the inventory cost of the actual products
is only about $5. I create the value by running the business.  Say I
was in the paper clip business.  I bought them for 1 cent a piece, I
had thousands of them, and through my business ingenuity, I was able
to sell them for $10,000 a pop to art museums; would this be
"substantial inventory" capital and thus put me in the same category
as the guy who puts down $200,000 to set up the widget factory?

Or what if I sold paperback books I wrote? Say I sold them door to
door and spent 8 hours a day walking around the suburbs trying to sell
my book.  In this case, the inventory costs would likely be similar to
mine ($5 for $100) yet I don't think the IRS would put him in the 30%
of profits capital caveat.

3. If I turned my business into an S Corporation and paid myself a
salary up to $80,000 for my services (as I think I could justify)
wouldn't this clearly be bonafied "foreign earned income"? If I could
run the same business under such a basic technical restructuring and
qualify, doesn't it seem like the nature of my business as it is now
should also qualify?

4. For what it's worth, HR Block says I do qualify for the $80,000
exclusion and gave no caveats about the capital 30% rule.  This was
the $20 online question service they offer.

5. Hummer, I am in your debt for all your attention paid to this
matter. About your last comment, I could be wrong, but I think the
fact of the example being a partnership is beside the fact.  The point
is about business income and capital investment and you could replace
"partnership" with "sole proprietership" and taxbear's point wouldn't
change. I know this because I remember reading these examples or
examples like them in the irs publications and their point was just
about business income in general vis a vis capital.

Thanks,
Daniel

Dear Daniel,

Thank you for the update, I'm glad to hear everything is beginning to
fall into place for you. As you know, I have a personal interest in
your question and it has been frustrating for me not to be able to
nail the answer in black & white. Just regarding your original
question about where your sales take place, I am 100% positive that
you qualify for the $80,000 exclusion and I'm happy to hear H&R Block
agrees with me.

Good luck with your business,
hummer

Daniel,

The link you provided does not contradict my point. The link simply
discusses whether something is foreign SOURCE income or US source
income. As has been previously discussed, for income from sales this
depends on where the title to the goods passes.

The question in your case remains whether capital plays a material
role. In some cases this is very obvious. For example, if I am a
consulting engineer then clearly my business is really about me
selling my personal services and capital plays no role. In other cases
it is less obvious. Your example of writing and selling a book is a
good one. In this case you are receiving a return for your personal
services in writing the book. This is quite different to buying copies
of someone else's book from one place and selling them to customers.

I gave you a quotation from a leading court decision that might (or
might not) help. The full text of the IRS literature regarding earned
versus unearned might also help and is as follows:

Earned and Unearned Income 
Earned income was defined earlier as pay for personal services
performed. Some types of income are not easily identified as earned or
unearned income. Some of these types of income are further explained
here.

Income from a sole proprietorship or partnership.   Income from a
business in which capital investment is an important part of producing
the income may be unearned income. If you are a sole proprietor or
partner and your personal services are also an important part of
producing the income, the part of the income that represents the value
of your personal services will be treated as earned income.

Capital a factor.   If capital investment is an important part of
producing income, no more than 30% of your share of the net profits of
the business is earned income.

  If you have no net profits, the part of your gross profit that
represents a reasonable allowance for personal services actually
performed is considered earned income. Because you do not have a net
profit, the 30% limit does not apply.

Example 1.

You are a U.S. citizen and meet the bona fide residence test. You
invest in a partnership based in Cameroon that is engaged solely in
selling merchandise outside the United States. You perform no services
for the partnership. At the end of the tax year, your share of the net
profits is $80,000. The entire $80,000 is unearned income.

Example 2.

Assume that in Example 1 you spend time operating the business. Your
share of the net profits is $80,000, 30% of your share of the profits
is $24,000. If the value of your services for the year is $15,000,
your earned income is limited to the value of your services, $15,000.

Capital not a factor.   If capital is not an income-producing factor
and personal services produce the business income, the 30% rule does
not apply. The entire amount of business income is earned income.

Example.

You and Lou Green are management consultants and operate as equal
partners in performing services outside the United States. Because
capital is not an income-
producing factor, all the income from the partnership is considered earned income. 

Income from a corporation.   The salary you receive from a corporation
is earned income only if it represents a reasonable allowance as
compensation for work you do for the corporation. Any amount over what
is considered a reasonable salary is unearned income.

Example 1.

You are a U.S. citizen and an officer and stockholder of a corporation
in Canada. You perform no work or service of any kind for the
corporation. During the tax year you receive a $10,000 ?salary? from
the corporation. The $10,000 clearly is not for personal services and
is unearned income.

Example 2.

You are a U.S. citizen and work full time as secretary-treasurer of
your corporation. During the tax year you receive $100,000 as salary
from the corporation. If $80,000 is a reasonable allowance as pay for
the work you did, then $80,000 is earned income.

(source: http://www.irs.gov/publications/p54/ch04.html#d0e3332)

Daniel,

An extra reference for you. See point (vii) especially given your
earlier question about books:

Earned income does not include: (i) dividends; (ii) disguised
dividends to shareholders who perform services for the company; (iii)
interest; (iv) capital gains; (v) alimony payments; (vi) gambling
winnings; and (vii) income from the sale of property (unless the
property was created through the individual's personal services, such
as a book or a work of art). Code Sec. 911(d)(2)(A); Robida, Daniel v.
Com., (1972, CA9) 29 AFTR 2d 72-1223, 460 F2d 1172, 72-1 USTC ¶9450 ;
Rev. Rul. 80-254, 1980-2 C.B. 222; IRS Pub No. 54 .

(Source: http://www.anderson-tax.com/Executives/Page%2012.htm)

Sorry, but an executive's income is not the same as business income.
Daniel owns his own business and will fill out the income/expenses
schedule for businesses. The net income on that schedule will be used
on Form 2555.
Using your example, if Daniel ran a bookstore, he would not be
eligible for the exclusion - that just isn't true.

Regards,
hummer

Hummer, 

The definition of earned income above is generic. It does not matter
that Daniel is not an executive. The two examples provided (also
above) from the IRS website explaining the situation for someone
engaged in merchandising are consistent with this definition. I know
that you would like to defend your earlier position but please review
the information carefully and I think you will come to the same
conclusion.

There's really no point in arguing. I don't stand to gain anything at
all from this discussion and I merely contributed information that I
believe is helpful to this situation. If Daniel is not interested, he
is certainly welcome to ignore it. However just because information is
inconvenient or not the answer you would like it to be, does not make
it wrong.

I enjoyed talking it over with you and good luck with your future research.

Dear taxbear,

I'm sorry if I offended you, I didn't mean to. I don't feel that I'm
really defending my answer as a researcher (I'd be the first to admit
that I erred), but rather just worried that Daniel will give up on the
idea of the exclusion when the chances are good that he is eligible to
claim it. I think when he fills out all of his tax forms in the new
year, it will become clear what to do.

Likewise, I enjoyed our little discussion and I'll look forward to
seeing your future posts on GA questions - researchers need to be kept
on their toes 8-)

Sincerely,
hummer