The IRS has been increasingly auditing taxpayers who’ve claimed the foreign earned income exclusion (FEIE). It was identified as a compliance campaign by IRS LB&I last year (link).
It’s easy to see why the IRS would audit this issue. A qualifying individual may exclude up to $104,100 (for 2018) of foreign earned income from U.S. taxation, plus a housing exclusion. In a typical 3 year audit, an adjustment favorable to the IRS could lead to additional taxes (plus penalties and interest) on more than $300,000 of incorrectly-excluded income.
Sometimes FEIE is claimed along with foreign tax credits (although scaled down). Likely the taxpayers with the highest audit potential are those that rotated in foreign countries with no income tax since there would be no foreign tax credits to claim in lieu of the FEIE. Most notably are contractors working in Middle Eastern countries such as Saudi Arabia and UAE. Short-term rotators generally do not qualify for the FEIE – although a series of 1 year rotations may qualify (see Linde v. CIR, T.C. Memo 2017-180).
Foreign Earned Income Exclusion – Qualified Individual
To claim an IRC section 911 exclusion of foreign earned income, the taxpayer must be a qualified individual.
The term “qualified individual” means an individual whose tax home is in a foreign country and who is—
(A) a citizen of the United States and is a bona fide resident of a foreign country or countries for an uninterrupted period which includes an entire taxable year, or
(B) a citizen or resident of the United States and who, during any period of 12 consecutive months, is present in a foreign country or countries during at least 330 full days in such period (aka physical presence test)
So, a taxpayer must have a tax home in a foreign country and must meet either the bona fide residence test or the physical presence test.
For purposes of IRC 911, “tax home” has the same meaning as defined under IRC 162(a). Section 162(a)(2) provides for a deduction for ordinary and necessary expenses paid during the taxable year in carrying on a trade or business, including travel expenses incurred while away from home in the pursuit of a trade or business. For purposes of section 162(a)(2) an individual’s tax home is generally “the vicinity of the taxpayer’s principal place of employment and not where his or her personal residence is located.” Mitchell v. Commissioner, 74 T.C. 578, 581 (1980); see also Rev. Rul. 75-432, 1975-2 C.B. 60.
An individual, however, shall not be treated as having a tax home in a foreign country for any period during which his abode is within the United States. Maintenance of a dwelling in the United States by an individual, whether or not that dwelling is used by the individual’s spouse and dependents, does not necessarily mean that the individual’s abode is in the United States. Sec. 1.911-2(b), Income Tax Regs. This is an important point and is often a reason (albeit erroneously) for the IRS to disallow FEIE. An individual can have a dwelling in the U.S. and not have an abode in the U.S. A taxpayer must show that the ties to the foreign county were “indefinite” and not “transitory.” It helps to have an employment contract stipulating an indefinite assignment.
Bona Fide Residence Test
The bona fide residence test is not well-defined by statute and rests upon questions of fact and existing case law. It’s preferable to qualify for the FEIE under the physical presence test (discussed further below) if possible.
Whether an individual is a bona fide resident of a foreign country is determined by applying by the principles of section 871. Bona fide residence in a foreign country or countries for an uninterrupted period may be established, even if temporary visits are made during the period to the United States or elsewhere on vacation or business.
‘Residence’ generally requires both physical presence and an intention to remain. In Sochurek v. Commissioner, 300 F.2d 34 (7th Cir. 1962), the Court of Appeals for the Seventh Circuit provided the following factors as relevant in determining bona fide foreign residence:
(1) intention of the taxpayer;
(2) establishment of a home in the foreign country for an indefinite period;
(3) participation in cultural and social activities;
(4) physical presence in the foreign country;
(5) nature, extent, and reasons for temporary absences from his temporary foreign home;
(6) assumption of economic burdens and payment of taxes to the foreign country;
(7) status of resident contrasted to that of transient or sojourner;
(8) treatment accorded his income tax status by his employer;
(9) marital status and residence of his family;
(10) nature and duration of his employment; whether his assignment abroad could be promptly accomplished within a definite or specified time; and
(11) good faith in making the trip abroad; whether for purpose of tax evasion.
Other circuits have used varying but similar factors.
Physical Presence Test
Unlike the bona fide presence test, the physical presence test is clearly-defined. An individual qualifies for the PPT if he is a U.S. citizen or U.S. resident alien who has been physically present in a foreign country (or countries) for at least 330 full days during any period of twelve consecutive months, and the individual’s tax home is in a foreign country (or countries) throughout the 330 full days of presence. The term “foreign country” includes both the territorial waters of the foreign country (determined under U.S. law) and air space over the foreign country. The 330 full days need not be consecutive days.
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