United States citizens pay tax on their worldwide income. This general rule can result in double taxation–with the United States imposing tax on the same income that was already taxed by a foreign government.
The United States has tax treaties with many countries that help avoid this type of double taxation. The United States also provides a foreign tax credit to help mitigate the impact of double taxation.
Our tax laws also provide an exception for foreign-earned income for individual taxpayers. This exception also saves taxpayers money by preventing double taxation. The Internal Revenue Service (IRS) routinely challenges tax returns that include this exception and it is a common international tax issue.
Defense contractors working at military locations in other countries are frequently involved in these tax disputes. There are a number of court cases that serve to define when defense contractors are eligible for this exception.
The recent Wood v. Commissioner, T.C. Memo. 2021-103 is one of these cases. It addresses whether a defense contractor who does not assimilate into the local community can qualify for the foreign-earned income exclusion.
Facts & Procedural History
This case involves a taxpayer who worked as a defense contractor overseas. She worked in Texas for a period of time before starting her defense contractor career. She maintained a home in Texas that was only used to park her car while she was overseas.
During most of the time involved in this case, she worked at a U.S. military base in Afghanistan. She did so pursuant to one-year temporary contracts. She did not set up a foreign bank account, she did not interact with the local Afghans or learn their language, and she did not purchase a house as she lived on the military base.
She returned to Texas after her temporary work expired. She turned down job opportunities in the United States. She took a job in Afghanistan after being unemployed and living in Texas for much of 2016.
The IRS notified her that she needed to file U.S. income tax returns. She did so by hiring a tax preparer that focuses on international tax returns. The tax returns reported an exclusion for her income given that she worked as an employee in a foreign country.
The IRS audited her tax returns and disallowed the foreign exclusion. Litigation in the tax court ensued. The question was whether the taxpayer qualified for the foreign-earned income exclusion.
The Foreign Earned Income Exclusion
Taxpayers who are United States citizens pay tax in the United States on their income regardless of where the income is earned or where the services are performed.
This basic rule is modified by Section 911. Income generated while working in a foreign country is excluded (it also includes an exemption for foreign housing costs, but those costs are not at issue in this case).
Foreign earned income is “the amount received by such individual from sources within a foreign country or countries which constitute earned income attributable to services performed by such individual during the period….”
The foreign-earned income exclusion is limited to $108,700 of income per person, currently. The amount is adjusted annually based on inflation.
The exclusion is actually an election. As such, to claim the exemption, one has to file income tax returns in the United States to make the election. The exemption is elected by reporting it on Form 2555, Foreign Earned Income, included with a tax return.
Once the taxpayer makes this election, the election continues for subsequent years as long as the taxpayer qualifies for the election in the later years. The taxpayer has to either ask the IRS for permission to revoke the election or no longer qualify by moving back to the United States, etc.
To qualify for the exclusion, one has to meet the “bona fide resident” test or the “physical presence” test.
The Physical Presence Test
To meet the physical presence test the taxpayer has to be a bona fide resident of the foreign county or country for an uninterrupted 12 month period.
The courts have applied the following factors in evaluating whether this test is met:
- intention of the taxpayer;
- establishment of her home temporarily in the foreign country for an indefinite period;
- participation in the activities of her chosen community on social and cultural levels, identification with the daily lives of the people, and, in general, assimilation into the foreign environment;
- physical presence in the foreign country consistent with her employment;
- nature, extent, and reasons for temporary absences from her temporary foreign home;
- assumption of economic burdens and payment of taxes to the foreign country;
- status of resident contrasted to that of transient or sojourner;
- income tax treatment accorded by her employer;
- marital status and residence of her family;
- nature and duration of her employment and whether assignment abroad could be completed more expeditiously; and
- whether residence abroad reflects good faith (as opposed to a tax evasion purpose).
The facts of this case are unique in that the taxpayer could not satisfy many of these factors. Afghanistan is a war zone. The taxpayer was working in the war zone during the course of the war. Thus, she was not allowed to purchase a home in Afghanistan. She had to live on the military base. It would not have been safe to interact with the local people or to assimilate into the local community. She also maintained her home in Texas, even though she did not really live in it.
The IRS determined that these factors showed that the taxpayer was not a foreign resident. The court found these factors neutral.
The court focused on the taxpayer’s intent. The court noted that the taxpayer did not seek employment in the United States when her job ended. She was here temporarily when she was unemployed, but the stay in the United States was temporary.
Given this evidence, the court concluded that the taxpayer was a foreign resident while she worked abroad. This did not apply to the period of time she was unemployed and temporarily resided in Texas. The court considered the physical presence test for this unemployment period.
Facts matter in cases like this, so it’s helpful to pause and consider the facts of similar cases. The Linde v. Commissioner, T.C. Memo. 2017-180 is an example. The Linde case involved a defense contract employee stationed in Iraq. He was employed on temporary one year contracts, like the taxpayer in the present case. Unlike the taxpayer in the present case, the taxpayer in Linde actually interacted with the local Iraqui population and maintained a bank account in Iraq. The taxpayer in Linde also maintained a home in the United States, had a wife and children in the United States, and he spent some of his time off visiting his home and family in the United States. The court found that Linde also qualified for the Section 911 exclusion.
The Acone v. Commissioner, T.C. Memo. 2017-162, case is another example. In that case, the court concluded that an airline pilot who was stationed overseas did not qualify for the exemption. You can read out the Acone case here.
The Physical Presence Test
The physical presence test requires the taxpayer to be physically present in a foreign country for 330 days. This requires the court to consider the taxpayer’s travel history. In this case, the taxpayer had resided in the foreign country for the prior year and several months into 2016, which was the year that she became unemployed and moved to Texas. Thus, the court concluded that the taxpayer met the physical presence test for the first several months in 2016. This requires that the excluded income be pro-rated based on the months she met this test.
The IRS continues to challenge taxpayers who claim the foreign earned income exclusion. Those who make this election should expect to have to defend the election. This includes maintaining travel records and records showing that they integrated into the community in the foreign country, had a foreign bank account, etc.
Advance tax planning can help document these factors and make it easier to defend these elections on audit.