Tax Court Denies Foreign Exclusion for State Department Local Hire Civilian Employee
In a decision that continues the trend of the IRS and courts focusing on the foreign earned income exclusion, the Tax Court ruled against a State Department local hire civilian who claimed the exclusion and was then flagged by the IRS for an audit of the issue.
Basics of the Foreign Earned Income Exclusion
Provided that an individual can satisfy either the bona fide residence test (substantive change in residence based on facts and circumstances) or the physical presence test (present in a foreign country for 330 full days during any period of 12 consecutive months) and is able to establish a tax home in a foreign country, such individual can exclude from income a portion of his or her “foreign earned income” under Section 911 of the Internal Revenue Code.
The general rule is that a “tax home” is located in the vicinity of the taxpayer’s regular or principal (if more than one regular) place of business or employment, regardless of where you maintain your family home. The “tax home” rule is subject to an important overriding exception – an individual is not considered to have a tax home in a foreign country for any period during which the individual’s “abode” is in the United States. “Abode” has been variously defined as one’s home, habitation, residence, domicile, or place of dwelling.
The foreign earned income exclusion amount is adjusted annually for inflation. For tax year 2018, the maximum foreign earned income exclusion is up to $103,900 per qualifying person. If filing individuals are married and both work abroad and meet either the bona fide residence test or physical presence test, each one can choose the foreign earned income exclusion.
What is foreign earned income?
Foreign earned income is generally pay for personal services performed overseas, such as wages, salaries, or professional fees. It does not include passive income items, such as dividends, royalties, rent, pensions, and capital gains.
It also does not include amounts paid by the United States or an agency thereof to an employee of the United States or an agency thereof.
O’Kagu v. Commissioner (151 T.C. No. 6)
As a brief background, this case involved a U.S. citizen who worked for the State Department at the U.S. consulate in Frankfurt, Germany. His job description was security equipment technician and he was referred to as a “local hire civilian employee” in his employment documents.
The taxpayer claimed the foreign earned income exclusion based on the argument that he was not truly a U.S. Government employee, because he was excluded from certain perquisites afforded to other U.S. Government employees, and he was in fact required to be a resident of and have a work permit and bank account in Germany. He furthered argued that as a technical matter, he was employed under 22 USC 2669(c) (the statute allowing the State Department to hire employees), which has been construed by courts to mean that State Department employees are “employees of the federal government for purposes of any law not administered by [the Office of Personnel Management].”
The Tax Court rejected the taxpayer’s arguments, concluding that his local presence and work prerequisites did not preclude his employee status, and that as a technical matter, Section 911 containing the foreign exclusion is not a law administered by the Office of Personnel Management, but rather it is part of the Internal Revenue Code administered by the Secretary of the Treasury. Therefore, the taxpayer should be considered an employee of the U.S. government for purposes of Section 911 and should therefore not be allowed to claim the exclusion.
The Takeaway for U.S. Expats
In light of the continuing trend of the IRS and courts focusing on the foreign earned income exclusion, it’s important for expats to have solid justification for their FEIE claims.
At Expat Tax Professionals, our experts have extensive experience in utilizing all of the tax benefits available to U.S. expats, including the FEIE, foreign tax credits, foreign housing exclusion, treaty benefits, and more.
We have helped many expats significantly reduce or eliminate their U.S. tax obligations using one or more of these benefits. We are ready to help you with your U.S. tax filings. Contact us today!
By Joshua Ashman, CPA & Nathan Mintz, Esq.