This blog addresses the foreign earned income exclusion rules as they apply to civilian contractors, and other civilian employees, who work in foreign country combat zones. By “civilian,” I am specifically referring to individuals who are not employees of the United States or any agency of the United States.
I. IRC Section 911 Foreign Earned Income Exclusion
Let’s start with some basics. IRC section 911(a)(1) allows a “qualified individual” to exclude his foreign earned income and housing costs from gross income. In the same way that the foreign tax credit limitation limits the foreign tax credit to the amount of U.S. tax attributable to foreign-source income, IRC section 911(b)(2)(D) limits the amount of foreign earned income that may be excluded to an amount adjusted annually for inflation.
For 2014, the maximum amount that could be excluded was $ 99,200. Under IRC section 911(b)(1)(B)(ii), foreign earned income does not include amounts paid by the United States or an agency of the United States to an employee of the United States.
What is a qualified individual? A “qualified individual” is defined as one who has a “tax home” in a foreign country and who is either:
(1) A citizen or resident of the United States, and who is physically present in a foreign country for at least 330 full days during any period of 12 consecutive months (“330 day physical presence”); or
(2) A citizen of the United States, and has been a “bona fide resident” of a foreign country or countries for an uninterrupted period which includes an entire taxable year (“bona fide residence”).
Reducing this to its bare bones, in order to be eligible for the foreign earned income exclusion under IRC section 911, a taxpayer must either:
(1) Have his “tax home” in a foreign country and satisfy the “330 day physical presence” test, or
(2) Have his “tax home” in a foreign country and satisfy the “bona fide residence” test.
Not unlike other key phrases in the Internal Revenue Code, “tax home,” “330 day physical presence,” and “bona fide residence” are definitions with precise meanings. At the risk of overstating the obvious, under both options, the taxpayer must establish that his “tax home” was in a foreign country. However, “330 day physical presence” and “bona fide residence” are alternative requirements.
In other words, a taxpayer may qualify for the foreign earned income exclusion if his tax home is in a foreign country and he satisfies the 330 day physical presence test in that country, even though he is not a bona fide resident of that country. On the other hand, a taxpayer may qualify for the foreign earned income exclusion if his tax home is in a foreign country and he is a bone fide resident of that country, even though he fails the 330 day physical presence test in that country.
Who has the burden of proof? The taxpayer, except as otherwise provided by statute or determined by the Court. See Title 26 App., Rule 142(a).
a. Tax Home
i. In General
For purposes of IRC section 911, “tax home” has the same definition as it does under IRC section 162(a)(2) (relating to traveling expenses while away from home). Under Treas. Reg. § 1.911-2(b), an individual’s tax home is considered to be located either:
• At his regular or principal (if more than one regular) place of business, or
• If the individual has no regular or principal place of business due to the nature of the business, then at his regular place of abode in a real and substantial sense.
To throw in a slight “wrench,” the Internal Revenue Code explicitly states that an individual cannot have a tax home in a foreign country during any period in which his abode is in the United States. See IRC section 911(d)(3).
How do we reconcile these requirements so that they make sense? First, it is necessary to determine whether the taxpayer has a U.S. abode. If so, then he “flunks” the foreign tax home requirement.
But in cases where the taxpayer does not have a U.S. abode, the taxpayer’s tax home is his “regular or principal place of business.” However, if no regular or principal place of business exists, then the taxpayer’s tax home reverts back to his “regular place of abode.”
As you can see, this reasoning is circular. At the same time, the latter (i.e., regular place of abode) is unlikely to be a U.S.-abode, since if we went through the check list in the order recommended above, then we would have known whether the taxpayer had a U.S. abode from the very beginning.
What does this mean for taxpayers who don’t have a U.S. abode and eagerly want to claim the foreign earned income exclusion? In order to satisfy the section 911(d)(3) “foreign” tax home requirement, such taxpayers must establish that their regular or principal place of business is in a foreign country. Absent that, they must prove that their regular place of abode is in a foreign country – any foreign country – under Treas. Reg. § 1.911-2(b).
From this, we can craft a “handy dandy” rule: The limitation does not require that the taxpayer’s abode be in a foreign country, so long as his regular or principal place of business is located there. It only requires that the taxpayer’s abode not be in the United States.
Beware of a trap set for the unwary. This applies to situations where the taxpayer has both an abode and a principal place of business, the locations of which differ, but are nonetheless foreign. For example, suppose that the taxpayer’s abode is located in Timbuktu but his principal place of business is located in France. The rule is that when the taxpayer’s regular or principal place of business is in a foreign country, it doesn’t matter that the taxpayer’s abode is not located in that same country. In other words, abode and principal place of business need not be located in the same country in order for the taxpayer to satisfy the “foreign” tax home requirement.
Instead, all that’s necessary is that the abode not be located in the United States. In the example above, the taxpayer would still satisfy the tax home requirement, despite the fact that his abode and principal place of business are different. At the end of the day, all that matters is that the taxpayer’s abode – here, Timbuktu – is not the United States.
ii. U.S. Abode Supersedes What Might Otherwise Be a Foreign Tax Home
As discussed above, an individual cannot have a tax home in a foreign country during any period in which his abode is in the United States. IRC section 911(d)(3). However, Treas. Reg. § 1.911-2(b) blunts the harshness of this rigid rule:
• “Temporary presence of the individual in the United States does not necessarily mean that the individual’s abode is in the United States during that time”; and
• “Maintenance of a dwelling in the United 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.” In other words, an individual’s abode may not necessarily be in the United States even if the individual maintains a home for his family in the United States.
Both the U.S. Tax Court and U.S. Circuit Courts have weighed in on the “tax home” requirement of section 911 in a number of decisions. The leading court decisions are Bujol v. Commissioner, 53 T.C.M. (CCH) 762 (1987), affd. without published opinion 842 F.2d 328 (5th Cir. 1988) and Lemay v. Commissioner, 53 T.C.M. (CCH) 862 (1987), affd. 837 F.2d 681 (5th Cir. 1988).
In Bujol and Lemay, the taxpayers alternated blocks of time working abroad with blocks of time at home in the United States where their families lived. Specifically, in the Bujol case, the taxpayer alternated working 28 days abroad and returning home to the United States for 28 days. Similarly, in Lemay, the taxpayer spent approximately half of his time with his family in Louisiana.
With respect to the tax home requirement, these courts focused on the requirement that the taxpayer’s abode not be in the United States. For this purpose, the tax court and appellate courts have used the following definition of “abode”:
“Abode” has been variously defined as one’s home, habitation, residence, domicile, or place of dwelling. Black’s Law Dictionary 7 (5th ed. 1979). While an exact definition of “abode” depends upon the context in which the word is used, it clearly does not mean one’s principal place of business. Thus, “abode” has a domestic rather than vocational meaning, and stands in contrast to “tax home” as defined for purposes of section 162(a)(2).
Bujol, 53 T.C.M. at 763.
Using the above definition of abode, most courts have held that the taxpayer had a U.S. abode. As a result, the taxpayers could not exclude their foreign earned income from gross income for U.S. tax purposes. See Harrington v. Commissioner, 93 T.C. 297 (1989); Doyle v. Commissioner, 57 T.C.M. (CCH) 1436 (1989); Lemay v. Commissioner, 53 T.C.M. (CCH) 862 (1987), affd. 837 F.2d 681 (5th Cir. 1988), and Bujol v. Commissioner, T.C.M. (CCH) 762 (1987), affd. without public opinion 842 F.2d 328 (5th Cir. 1988).
Below are a few of the more salient factors that that were instrumental to the courts’ decisions:
• Possession of a U.S. bank account and U.S. driver’s license;
• A U.S. voter’s registration;
• Existence of strong familial, economic and personal ties in the United States and only transitory ties in the foreign country where the taxpayer worked (conversely, IRC section 911 contemplates that transitory presence in the United States would not constitute a U.S. abode).
As a result of determining that the taxpayers in the cases described above had U.S. abodes, these courts dispensed with analyzing the location of the taxpayers’ regular or principal places of business for no other reason than that it was now moot.
After establishing the existence of a tax home in a foreign country, taxpayers must still establish that they satisfy the 330 day physical presence test or the bona fide residence test. These tests will be the subject of Part II of this blog.
Original Post By: Michael DeBlis