Deborah C. Wood v. Comm’r; T.C. Memo. 2021-103 | August 18, 2021 Lauber, J. | Dkt. Nos. 23239-18, 23260-18

Short Summary:  The IRS determined that Wood, a government contractor who earned all her income on a U.S. military base in Afghanistan, owed roughly $95,000 in income tax deficiencies, plus additional tax and accuracy-related penalties. Wood petitioned the tax court, which mainly found in her favor. The court held that she qualified for section 911(a)(1)’s “foreign earned income” exclusion and that she was not liable for a late-filing addition to tax under section 6651(a)(1) because she was serving in support of the military in a combat zone during the relevant time.

Key Issues: The two requirements for qualifying for the foreign earned income exclusion turn on a variety of factors. Here, the taxpayer’s somewhat unique work circumstances easily qualified her for the exclusion.

Primary Holdings:

Section 61(a) provides that gross income means “all income from whatever source derived.”  Section 911(a)(1) provides that a “qualified individual” may elect to exclude from gross income, subject to certain limitations, “foreign earned income.” 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.” Sec. 911(b)(1)(A).

There was no dispute that Wood’s compensation for her work as a contractor in Afghanistan was “foreign earned income.” The issue was whether she was a “qualified individual” and eligible to exclude that compensation from her gross income. The court agreed with Wood that she was.

There are two requirements to qualify for this exclusion: “First, she must either be a ‘bona fide resident’ of one or more foreign countries or be physically present abroad for a specified period. Sec. 911(d)(1). Second, she must show that her ‘tax home is in a foreign country.” Sec. 911(d)(1) (flush language).” Wood at 11-12.

To establish bona fide foreign residency, the taxpayer must provide “strong proof” (more than a preponderance) of that residence. Courts look at a number of factors, including: “(1) intention of the taxpayer; (2) establishment of her home temporarily in the foreign country for an indefinite period; (3) 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; (4) physical presence in the foreign country consistent with her employment; (5) nature, extent, and reasons for temporary absences from her 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) income tax treatment accorded by her employer; (9) marital status and residence of her family;(10) nature and duration of her employment and whether assignment abroad could be completed more expeditiously; and (11) whether residence abroad reflects good faith (as opposed to a tax evasion purpose).” Wood at 12-13 (citations omitted).

In reviewing Wood’s testimony and other evidence at trial to analyze these factors, the court also considered the unique circumstances of a government contractor in Afghanistan. Factors that might have ordinarily weighed in the government’s favor, were neutral at best, in those circumstances. For example, Wood maintained a Texas driver’s license as a condition of her employment. Likewise, doing her banking locally in Afghanistan would have been impractical, if not impossible. Participation in the local community was similarly impossible; she was not permitted to leave the base where she was stationed.

Based on its analysis of these factors, the court held that Wood was a bona fide resident of Afghanistan during 2012-2015. Wood was not a bona fide Afghanistan resident in 2016; she lived in her house in Texas from April (after losing her job) until December (when she returned to Afghanistan for a different contractor). She did, however, qualify for the exclusion (for part of the year) via the 330-day physical presence requirement. This requires that the taxpayer, “during any period of 12 consecutive months, * * * [be] present in a foreign country or countries during at least 330 full days in such period.” Sec. 911(d)(1)(B).” Id. 17-18.

The second requirement for the foreign earned income exclusion is to show that the taxpayer’s “tax home is a foreign country.” Sec. 911(d)(1). As the court noted, this inquiry overlaps with the first requirement.

The court concluded that Wood met both requirements for the exclusion for tax years 2012-2015 and part of 2016. The court also found that Wood was not liable for any additional tax or penalty for her late filing based on extensions for taxpayers serving in support of U.S. Armed Forces in a combat zone.

Key Points of Law:

Proof of bona fide foreign residency requires strong evidence, more than a preponderance. The inquiry is fact-intensive.

Insight: Wood’s fairly unique circumstances (government contractor in Afghanistan) limit the application of this case. The court would likely review the relevant factors differently for a government contractor stationed elsewhere (for example, Europe), and very different for taxpayers earning income abroad in less restrictive circumstances.