Good News for US Expatriates Earning Income Overseas

In a recent tax court case ruling, the taxpayer was deemed to qualify for the foreign earned income exclusion, was able to exclude his wages and or self-employment income earned
overseas. The court held that the taxpayer met the required tests. The foreign earned income exclusion allows US citizens earning income abroad to exclude up to $102,100 of their wages or income from self-employment as long as certain criteria are met.

In this case, the taxpayer is a United States citizen who worked and lived in Iraq in the employer provided residence with the intent to remain in Iraq until retirement. The taxpayer’s spouse resided in the United States during the same period. Notwithstanding the taxpayer’s ties to the United States, including a US-based spouse and a home in the US, the court determined the taxpayer’s tax home was in Iraq.

Tax Issues

The issues before the court were as follows: whether the taxpayer was a qualified individual entitled to exclude portions of the wages earned overseas under the foreign earned income exclusion provisions, and whether the taxpayers were entitled to deductions for unreimbursed employee business expenses claimed on Schedule A as Itemized Deductions for the same years. Interestingly, the following relevant tax issues may apply to similar cases for foreign income exclusion situations:

Travel to the US – The taxpayer was required by the employer to take 30 days off every 90 days (later, every 120 days), during which time he flew to the United States by way of Kuwait and often Europe.

Bank Accounts – The taxpayer’s bank account was maintained at the Armed Forces Bank, although the taxpayer worked for a subsidiary of the Blackstone Group – a private entity. The
bank account was maintained in Alabama but the taxpayer clarified at trial that although the armed forces account was accessible from Alabama, the account was not opened or maintained in Alabama.

Driver license – the taxpayer did not own a car overseas nor did he have a non-US driver license. He did occasionally drive employer provided vehicles and had access to one.

Foreign income taxes – the taxpayer did not pay the taxes in Iraq, although for many of the periods in question the employer withheld Iraqi income taxes from the taxpayer’s paycheck.

Burden of proof : as a rule, the IRS’s determinations of tax liability as indicated on Notice of Deficiency are presumed correct. Therefore, the burden of proof rests with the taxpayer. In other words, the taxpayer bears the burden of proving that the IRS determinations are incorrect. There’s an exception, however, under which the burden of proof can be shifted to the IRS only as to the factual issues that are relevant to the taxpayer’s tax liability.

The Interesting Part – The Foreign Earned Income Exclusion

As usual, the tax code dictates that “all income from whatever source derived” is taxed to United States citizens in the US unless a specific exclusion applies. Such exclusions are generally
narrowly construed and the taxpayer must clearly establish the adherence to such exclusion rules. One such exception is known as foreign earned income exclusion. To be entitled to the exclusion a “qualified individual” must satisfy two criteria. First, the taxpayer must be an individual whose tax home is in a foreign country. Next, the taxpayer must either be a bona fide resident of one or more foreign countries for an uninterrupted period that includes an entire taxable year or be physically present in a foreign country or countries during at least 330 days in any 12 month period. The latter is also known as the “physical presence test”. Given the taxpayer’s travel schedule, the taxpayer admittedly did not meet the second test. Therefore, the taxpayer had to prove that his tax home was in Iraq and that he was a bona fide resident of Iraq.

Interestingly, the tax home is defined as the “vicinity of the taxpayer’s principal place of employment” and not where his personal residence is located. Case history seems to indicate that the fact of ownership of a home in the United States, whether or not used by the taxpayer’s spouse and family does not necessarily establish that the taxpayer’s abode is in the United States. The case law becomes really interesting in that the decisions tend to rely on the strength of ties between the foreign country and the United States. There seems to be a consensus that so long as the taxpayers ties to the United States remain strong, the courts have held that the abode remained in the United States, especially if the ties to the foreign countries were limited.

The court found that the taxpayer’s economic and social life was centered in the foreign country. The court considered such factors as accepting promotion in the foreign country income derived exclusively from the foreign country economic ties that grew stronger over the years in Iraq including the opening of a bank account there, accepting a promotion from his employer in the use of free time for making physical improvements to his Iraqi residence. In addition, social life such as visiting local markets and restaurants, socializing with fellow contractors, all contributed as proof of effort to create and maintain personal life in Iraq.

Analysis of the ruling and the related tax case law seems to indicate that the courts consider many factors to determine one’s ties to the foreign country for the “bona fide residence test”. Such factors have to do with physical presence or a foreign country, economic and social ties, intent as to the future residence, maintenance of one’s  living quarters such as improvements in anticipation of continued residence as well as the maintenance of banking and social relationships.

Despite the IRS arguments that the taxpayer’s abode was in Alabama because he visited his family who lived there, he owned a home there, maintained an Alabama driver license as well as an active voter registration, the court disagreed citing the taxpayer’s desire to remain in Iraq indefinitely as well as the collective effects of other efforts he has made to create a personal life in Iraq.

Despite the victory on the first issue, the disallowed unreimbursed employee expenses and deductions for travel and business expenses, the court found the evidence insufficient to establish a business purpose as to the “unreimbursed” nature of certain expenses. Such expenses were disallowed.

Tax Planning Takeaway

The bona fide tax residence in the foreign country versus residence in the United States seem to be a sub zero game. Secondly, all factors from banking to ownership of real estate to physical presence to frequency of travel to location in physical contact with one’s family to promotions, travel habits, as well as economic and social life in the foreign country all seem to weigh on the termination of what constitutes bona fide residence. Moreover, the bona fide residence in a foreign country for an uninterrupted period of time may be established even if the taxpayer makes temporary visits to the United States on vacation or business.

We recommend US taxpayers residing or working overseas to maintain proof of the economic and social life, travel schedules, proof of foreign and United States expenses, as well as the record keeping of the exact travel and physical presence dates both in the foreign country and other countries as well as the United States.

Sources:
Linde. T.C. Memo. 2017-180
Ustaxcourt.gov

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