Taxpayers living abroad as expatriates are undoubtedly familiar with the numerous burdens the U.S. tax system places on individuals living abroad. To start, numerous disclosures and information returns, such as FATCA and FBAR, lead to a complex and often duplicative web of annual tax filings that a taxpayer is required to make. Aside from these filing burdens, the United States is the only developed nation that taxes on the basis of citizenship rather than on the basis of where the income was earned. As such, the United States has developed certain credits and exclusions intended to minimize the potential for “double taxation.”
However, some claims by taxpayers may be too aggressive and raise the potential for penalties and interest due to improper claims for credits or exclusions. One tax exclusion that is frequently improperly claimed is the Foreign Earned Income Exclusion. The IRS is aware of this fact and targets enforcement to identify this issue. In fact, a U.S. taxpayer living in Israel recently unsuccessfully attempted to claim this tax exclusion on the basis of his foreign residence alone.
Foreign Earned Income Exclusion (FEIE) can permit certain qualifying U.S. taxpayers to exclude part or the entirety of their foreign earned income for U.S. income tax purposes. FEIE also includes the potential for foreign housing exclusions and a foreign housing deduction. While the amount is adjusted for inflation on an annual basis, U.S. citizens could have excluded foreign earnings up to:
While self-employment earning can be used towards the FEIE, but it will not apply to any self-employment tax that may be due.
Before an individual may claim FEIE, he or she should verify that all requirements are met. Generally, the test to determine whether a claim for FEIE is appropriate is two-pronged in nature. First, one must assess as to whether they can qualify as a bona fide resident of a foreign nation. An individual is considered a bona fide resident of a foreign jurisdiction when he or she is a U.S. citizen, or a U.S. resident alien of a nation that has executed a tax treaty with the U.S. and spends an uninterrupted period that includes an entire tax year. However, physical presence is not enough to satisfy this test. The length of your stay and your purpose for being in the foreign nation are factors that will be considered. Alternatively, certain U.S. citizens and residents may be able to qualify through the physical presence test.
In addition, the taxpayer must be able to show that their “tax home” is based in a foreign nation. One’s tax home is routinely considered the principle place of business for the individual. Courts often turn to regular business records and other documents to determine the applicable tax home. Thus, while residence in a foreign nation is required, the determinative factors affecting eligibility for FEIE is bona fide resident status and a tax home in a foreign nation. 26 USC § 911(d)(1).
In a recently adjudicated matter, a taxpayer brought a claim that he could properly claim FEIE solely on the basis of his residence in Israel. Hirsch v. Commissioner, T.C. Summ. Op. 2016-37. In Hirsch, the taxpayer argued that he should be entitled to the FEIE solely on the basis of his residence in Israel. While the court conceded that Hirsh was indeed a bona fide resident of Israel, the committed substantial resources towards determining the taxpayer’s tax home.
In making this determination in Hirsch, the court seems to place significant reliance on routine employment documents held and produced by the taxpayer’s employer, Merrill Lynch. The court focused on a number of factors in these record that suggested the taxpayer’s tax home was actually in the United States. These factors included:
Based on these and other factors, the court determined that the taxpayer’s tax home was actually in the United States. Since the taxpayer was able to satisfy the bona fide resident test but not the tax home test, he was not eligible to claim FEIE.
If the IRS has contacted you regarding potentially improper claims for tax exclusions and tax credits, don’t go through an examination or audit without professional guidance. A tax lawyer can often anticipate audit techniques and develop strategies to meet these challenges. To discuss your concerns in a reduced-rate consultation with an experienced tax lawyer, call the Tax Law Office of David W. Klasing at 800-681-1295 today.