Checkpoint Contents Federal Library Federal Editorial Materials WG&L Journals Practical Tax Strategies/Taxation for Accountants (WG&L) Practical Tax Strategies 2009 Volume 82, Number 04, April 2009 Recent Developments INCOME EXCLUSION UNLIKELY FOR CIVILIAN CONTRACTORS IN FOREIGN COMBAT ZONES, Practical Tax Strategies, Apr 2009

PERSONAL

INCOME EXCLUSION UNLIKELY FOR CIVILIAN CONTRACTORS IN FOREIGN COMBAT ZONES

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The IRS has issued a Generic Legal Advice memorandum, AM 2009-003, 2/9/09, that addresses the foreign earned income exclusion rules regarding civilian contractors, or other civilian employees, who are not employees of the U.S. or an agency and who work in foreign country combat zones. The memorandum also discusses whether the combat zone exclusion is available to these employees.

Section 911(a)(1) allows a qualified individual to exclude his or her foreign earned income and housing cost amount from gross income up to the applicable exclusion amount adjusted annually for inflation ($87,600 in 2008; $91,400 in 2009). Foreign earned income does not include amounts paid by the U.S. or a U.S. agency to an employee of the U.S. or agency. A qualified individual is someone who has a tax home in a foreign country and who is either:

(1) A U.S. citizen or resident who is physically present in a foreign country for at least 330 full days during any period of 12 consecutive months (330 day physical presence test). (2) A U.S. citizen who establishes to the satisfaction of the Secretary that he or she has been a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year (bona fide residence test).

A tax home, for Section 911 purposes, is an individual's tax home for purposes of Section 162(a)(2). Specifically, a tax home is either the individual's regular or principal place of business, or, if the individual has no regular or principal place of business because of the nature of the business, his or her regular place of abode in a real and substantial sense. An individual is not treated as having a tax home in a foreign country for any period for which his or her abode is in the U.S. An individual's abode is not necessarily in the U.S., for purposes of Section 911(d)(3), if the individual maintains a dwelling in the U.S., such as a home for his or her family. That is, Section 911(d)(3) requires only that the taxpayer's abode not be in the U.S.

The IRS reviewed a several cases that examined the terms tax home and abode, and found that the courts defined abode as one's home, habitation, residence, domicile, or place of dwelling, and as standing in contrast to tax home for purposes of Section 162(a). Using that definition, the courts generally concluded that taxpayers had a U.S. abode if they spent blocks of time in the U.S.; maintained U.S. bank accounts; held U.S. driver's licenses and voter registration; and had strong familial, economic, and personal ties to the U.S. and only transitory ties in the foreign country where the taxpayers worked. As such, the taxpayers could not exclude their foreign earned income from gross income for U.S. income tax purposes.

The IRS noted that the courts generally have not addressed any issues about the taxpayers' regular or principal places of business. In situations where U.S. abode is not at issue, the IRS added, in order to satisfy the tax home requirement, taxpayers need to address the issue about whether employment involving alternating blocks of time qualifies as regular or principal places of business. If not, the taxpayers need to prove that their abode is in a foreign country.

After establishing that they have a tax home in a foreign country, taxpayers must establish that they also meet either the 330-day

physical presence test or the bona fide residence test. For purposes of the physical presence test, the taxpayer must establish that he or she is a U.S. citizen or resident who is

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physically present in a foreign country for at least 330 full days during any period of 12 consecutive months. Reg. 1.911-2(d)(2) provides that the 330 full days need not be consecutive and may be interrupted by periods during with the taxpayer is not present in a foreign country.

The burden is on the taxpayer to prove that he is physically present for 330 days in a foreign country or countries during the relevant 12-month period by providing acceptable proof, which includes, but is not limited to, passport entries, official records of employment in the foreign country, or other reliable documentation that proves presence.

Reg. 1.911-2(c) provides rules for determining bona fide residence. Under that regulation, an individual with foreign earned income is not a bona fide resident of a foreign country if the individual claims to be a nonresident of that foreign country in a statement submitted to that country's authorities, and the individual's earned income is not subject, by reason of nonresidency, to that country's income tax. The IRS notes that if the foreign country's tax law specifically exempts the earned income of nonresidents who are present for the sole purpose of working in the foreign country's combat zone, then it should not be necessary to pursue an inquiry into whether the individual submitted a statement to the authorities in the country.

Alternatively, the determination of whether a U.S. citizen is a bona fide resident of a foreign country requires an analysis of all the facts and circumstances. The courts have construed the requirement that the taxpayer establish bona fide residence to the satisfaction of the Secretary as imposing a strong proof standard on taxpayers to demonstrate residence in a foreign county. (By contrast, tax home status requires taxpayers to satisfy only a preponderance of the evidence standard.)

The IRS reviewed court opinions for guidance on determining bona fide residence, and found that the courts focused on the following factors:

l The taxpayer's intention.

l Establishment of a home temporarily in the foreign country for an indefinite period.

l Participation in the activities in the community on social and cultural levels, identification with the daily lives of the people, and, in general, assimilation into the foreign environment.

l Physical presence in the foreign country consistent with the taxpayer's employment.

l The nature, extent, and reasons for temporary absences from the foreign home.

l Assumption of economic burdens and payment of taxes to the foreign country.

l Status of a resident of the foreign country as contrasted to that of a transient or sojourner. l The treatment of the taxpayer's income tax status by his employer.

l Marital status and residence of the taxpayer's family.

l Nature and duration of employment; whether the assignment abroad could be promptly accomplished within a definite or specified time.

l Good faith in making the trip abroad; whether for purposes of tax evasion.

The IRS concluded that as a general matter, in light of bona fide residence factors, it would be difficult for civilian contractors, and other civilian employees, who are not employees of the U.S. or a U.S. agency, working in foreign country combat zones to meet the bona fide residence test under Section 911.

Finally, the IRS stated that civilian contractors or other civilian employees were not entitled to the gross income exclusion provided in Section 112(a) for compensation paid to noncommissioned U.S. Armed Forces personnel serving in a combat zone or hospitalized as a result of wounds, disease, or injuries incurred while serving in a combat zone. Only compensation paid by the U.S. Armed Forces to members of the Armed Forces can be excluded under Section 112.

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