When Foreign Earned Income Exclusion Isn’t Enough: State Tax Risks for US Expats With Clients Back Home
- Dec 3, 2025
- 4 min read
US expats who claim the Foreign Earned Income Exclusion (FEIE) often discover that “decoupled” states can still tax their foreign earnings, especially when self‑employed with a client base anchored in one state.
Federal FEIE vs. state nonconformity
At the federal level, FEIE lets qualifying expats exclude a substantial amount of foreign earned income using Form 2555, reducing or eliminating U.S. federal income tax on that income. However, FEIE is a federal provision; states are not required to follow it, and several either ignore it or require an add‑back of excluded income when computing state taxable income.
Some “sticky” states are notorious here. States like California, Hawaii, Massachusetts, New York, Colorado, and South Carolina either do not recognize FEIE or otherwise give little or no relief for foreign earned income, meaning wages or self‑employment income excluded federally may remain fully taxable at the state level if you are still considered a resident. In practice, federal FEIE planning does nothing for those state returns unless you’ve truly broken residency.
Residency “stickiness” and decoupled states
For expats, the fundamental state question is not “Do I claim FEIE?” but “Am I still a resident of that state under its own law?” Sticky states like California, New York, Virginia, South Carolina, and New Mexico have residency rules that often keep you in the tax net unless you sever domicile and document a clear move.
Decoupled states that do not follow FEIE compound the problem: even after years abroad, if they still treat you as a resident, they can tax your worldwide earned income including what you excluded federally. This is especially harsh in years when you pay foreign tax to your host country but the state gives no matching foreign tax credit, leading to true double taxation.
Self‑employment, client concentration, and nexus
For self‑employed expats delivering services cross‑border, the analysis adds a business‑nexus layer. States are not bound by federal treaty concepts and can assert income tax on “state‑sourced” business revenue if you have sufficient connection (nexus) even when you live abroad.
Key risk factors include:
A large share of your client base in one state, especially if contracts are governed by that state’s law, you market specifically to that state, or regularly perform work “in” that state via travel.
Use of in‑state agents, employees, or contractors, an in‑state mailing address, or physical facilities (even storage, shared office, or a co‑working membership).
Many service states apportion income based on where the “benefit of the service” is received. If most of your clients are in, say, California or New York, those states may argue that a significant portion of your self‑employment income is state‑sourced, regardless of your physical location. FEIE does not shield that from state tax in nonconforming states.
Practical planning points for expat sole proprietors
Clarify your state residency status first
Review your last state of residence’s domicile and statutory‑resident tests, and document a clean break if you intend to end residency (lease termination, sale of property, change of driver’s license, voter registration, no dependents or spouse remaining, etc.).
In high‑risk states (California, New York, Virginia, South Carolina, New Mexico), consider a written memo or contemporaneous file for your move date, ties retained, and ties cut to defend nonresident status later.
Separate “residency” from “business nexus”
Even as a nonresident, you may owe tax on state‑sourced business income in states where you have sufficient nexus.
Map your clients by state, look at each state’s market‑based sourcing or cost‑of‑performance rules, and identify where the benefit is considered received so you can evaluate nonresident filing obligations.
Understand that FEIE is federal only
Assume no FEIE relief at the state level unless you confirm conformity in that specific state’s statutes or instructions (and many popular expat states do not conform).
Run parallel computations: one using federal FEIE, and one adding back FEIE for each nonconforming state where you might be a resident or have nexus, to see the real cash‑tax impact.
Coordinate with foreign tax credits and entity structure
If you’re in a decoupled state and a high‑tax foreign jurisdiction, the FEIE‑first approach may backfire by eliminating federal foreign tax credits you could have used to offset state tax in a credit‑friendly state.
For significant, recurring income into a single state market, consider whether operating through an entity (e.g., S‑corp or foreign corporation with carefully managed U.S. PE and state nexus) improves your state posture under that state’s corporate rules.
Get state‑specific advice before scaling
Once you know that 60–80% of your clients are in one decoupled state, treat that state as a primary tax stakeholder and read its nonresident and apportionment rules as carefully as you read §911.
Because each sticky state has its own quirks (safe harbors, voluntary disclosure programs, statute rules), a short state‑specific consult can often prevent years of compounded exposure.
Bottom line for US expats using FEIE
Claiming FEIE solves only the federal side of the equation; it does nothing by itself to disconnect you from a decoupled state, and it does not protect self‑employment income whose market is heavily concentrated in one state. The real work is (1) terminating residency in sticky states where possible, and (2) managing business nexus and sourcing so that your cross‑border practice isn’t inadvertently anchored, for state tax purposes, in the very jurisdiction you thought you’d left.
When in doubt, consult with a cross-border tax professional who is well-versed in both individual and business tax questions.
