Tax Code Background
Internal Revenue Code Section 911(a) provides that a qualified individual may elect to exclude his or her foreign earned income from gross income, subject to limitations set out in Sec. 911(b)(2). To be entitled to this exclusion, a taxpayer must be:
- An individual “whose tax home is in a foreign country,” and either:
- A “bona fide resident” of one or more foreign countries (bona fide foreign residence test), or
- Physically present in such country during at least 330 full days in a 12-month period (foreign physical presence test).
An individual’s status as a bona fide resident of a foreign country depends on the facts and circumstances of the case. The U.S. Court of Appeals for the Seventh Circuit (the relevant appellate court in this case) has identified 11 factors (the Sochurek factors) as relevant to an analysis of bona fide residency, outlined in greater detail below.
The term “tax home” means, in the case of an individual, “such individual’s home for purposes of Code Sec. 162(a)(2).” Under Sec. 162(a)(2), a person’s home is generally considered to be the location of his or her regular or principal place of business.
However, Sec. 911(d)(3) also provides that an individual won’t be treated as having a tax home in a foreign country for any period for which his or her abode is within the United States. That is, an individual whose “abode” is within the United States cannot establish that his or her “tax home” is in a foreign country.
Although the term “abode” isn’t defined by Sec. 911 or the applicable regulations, the Tax Court has held that it generally means the country in which the taxpayer has the strongest economic, familial and personal ties.
Service in Iraq
In Wentworth, the taxpayer was a Wisconsin native who joined the U.S. Marine Corps Reserves in 2000 after graduating from high school. He began college at the University of Wisconsin that fall but was eventually called to active duty from May 24 to December 31, 2002. The taxpayer resumed his studies upon his return, and then was again called to active duty from June 1, 2004, to May 31, 2005. During the second tour of duty, he spent six months and 16 days in Kuwait and Iraq and “developed a fondness for the Iraqi people he met.”
In March 2006, the taxpayer left Wisconsin and returned to Iraq to work in the private sector, providing security services to U.S. military personnel through April 2007. During this time, he returned to the United States once for 10 days.
In 2009, the taxpayer was hired for a position to provide security services to U.S. State Department personnel, primarily in Iraq. From May 15, 2009 through April 22, 2011, his deployment schedule was generally 105 days on duty (which was occasionally extended) followed by 35 days off, during which he was required to leave Iraq. (Travel costs were covered by his employer.)
He listed his home of record as a friend’s home in Tennessee, which he chose because he had started taking online courses at Middle Tennessee State University and enjoyed country music. Had he not been required to leave Iraq, he would have stayed there.
When on duty, the taxpayer worked six days per week for at least 12 hours per day. He was required to live in the International Zone of Baghdad, Iraq, and his living quarters and meals were provided at no cost to him during his on-duty periods. He interacted with Iraqi people who lived and worked in the area, regularly ate lunch with the Iraqi police and bought goods from Iraqi vendors.
The taxpayer left Iraq on April 20, 2011, and then voluntarily ended his employment. While in Iraq, he decided to pursue a different career path in the petroleum industry in northern Iraq. He continued his courses at Middle Tennessee State University and earned a bachelor’s degree in geoscience in December 2012. Then he earned a certificate in geographic information systems from the University of Wisconsin in May of 2014. However, he ultimately chose not to pursue employment in Iraq because of new dangers in areas that he had previously considered safe.
On his tax returns for 2010 and 2011 (the years at issue), the taxpayer, on the advice of a CPA, claimed the foreign earned income exclusion. For 2010, he reported $140,782 in wages and claimed a foreign earned income exclusion of $91,500. The corresponding amounts for 2011 were $63,208 and $28,520. Federal tax was withheld both years, and he paid no income tax to Iraq.
The IRS determined that the taxpayer was ineligible for the foreign earned income exclusion and determined deficiencies for both years.
The Tax Court found that, while the taxpayer didn’t satisfy the physical presence test, he was nonetheless a bona fide resident of Iraq during the years at issue. The court analyzed the facts of the case under the following Sochurek factors:
Intent. The Tax Court found the taxpayer’s testimony that he intended to remain and work in Iraq both sincere and supported by objective evidence, including the employment opportunities he chose to pursue. This factor favored the taxpayer.
Establishment of home for indefinite period. The court found that there was an expectation that his employment would continue indefinitely, and that his employer-provided housing eliminated the need for him to secure his own. This factor favored the taxpayer.
Activities and assimilation. The court found only limited evidence of the taxpayer’s activities and interactions with Iraqi people and culture outside of his work. But it also acknowledged that he had little time or opportunity for social activities. This factor was slightly adverse to the taxpayer.
Physical presence. During his employment, the taxpayer spent more days in Iraq than in the United States, so this factor favored him.
Temporary absences. The nature, extent and reasons for the taxpayer’s temporary absences from Iraq — namely, the fact that they were required by his employer — weighed slightly in his favor.
Economic burdens and taxes. The taxpayer didn’t incur additional expenses in Iraq because his meals and housing were provided at no cost, and he didn’t pay income tax to Iraq, so this factor was adverse to him.
Legal status. While his legal status under Iraqi law was unestablished, the taxpayer’s presence was such that he was more than transient. This factor was neutral.
Employer’s tax treatment. The taxpayer’s employer withheld federal tax from his wages, but he could have opted to not have taxes withheld. This factor was also neutral.
Marriage and family. The taxpayer didn’t have a spouse or children during the years at issue, but his parents were in the United States and he stayed with a friend in Tennessee on each return, so this factor was slightly adverse to him.
Nature and duration of employment. The taxpayer worked six days per week for at least 12 hours per day doing serious and dangerous work. This weighed in his favor.
Good faith vs. tax evasion. The Tax Court found no bad faith or tax evasion motive, noting that the taxpayer timely and accurately reported his income and sought the advice of a CPA with experience dealing with foreign earned income. This factor favored him.
Home, Tax Home
The Tax Court then determined that the taxpayer’s “tax home” during the years at issue was Iraq. His principal place of employment was there, and the court found that ties to the United States weren’t strong enough to find that his “abode” remained in the United States.
Specifically, he didn’t have a spouse or children at the time, and he didn’t stay with his parents when he visited. The facts that he had a U.S. driver’s license and bank account were insufficient to establish an abode in the United States.
The Tax Court noted that its consideration of the taxpayer’s ties to Iraq took into account “the unique circumstances of his work and the nature of the region.” He worked long hours and had limited time for a social life, and he wouldn’t have left at all during the years at issue if not required to do so by his employer.
Accordingly, because the taxpayer’s tax home was in Iraq and he was a bona fide resident of Iraq, he was a “qualified individual.” Therefore, he was entitled to claim the foreign earned income exclusion for the years at issue.
The Facts Matter
Here, the taxpayer’s overall course of conduct showed that he was a bona fide resident of Iraq and that his “tax home” was in Iraq. Pertinent facts include that he repeatedly sought employment opportunities in Iraq, returned to the United States only as required by his employer and had limited ties to the United States. But, with just a few minor differences in his situation, the Tax Court decision could have gone the other way.
If you’ve spent substantial time working and living abroad recently and are unsure whether you’re eligible for the foreign earned income exclusion, work closely with your CPA to fully understand this potentially valuable tax break.