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Did you know if you are working and living abroad you can exclude from taxation your foreign income under IRS Section 911(a)? You just have to pass one of two tests: The Bona Fide Residence Test or the Physical Presence Test. If youqualify under one of these two tests then you are good….that is, until the IRS comes to see you and commences aForeign Income Exclusion Audit. So if you are abroad, or plan to be, and are going to be earning income there, stay tuned to TaxView with Chris Moss CPA Tax Attorney to see what tax traps the Government has waiting for you when the IRSForeign Income Exclusion Audit team comes knocking on your door. Before you leave town learn how to create the facts and evidence you need to fight back an IRS Foreign Income Exclusion Audit….and win….on TaxView with Chris Moss CPA Tax Attorney.
Americans earning income abroad have since 1926 been allowed to exclude from taxable income under 911(a) but only if they were a “bona fide non-resident” of the United States for at least a year. To qualify as a “bona fide non-resident” though you also need to establish a residence in the foreign country which is not always the same as your permanent home or domicile and for IRS purposes you must make a valid and timely election under Regulations 1.911-7(a)(2). This is easier said than done as Ms. McDonald found out in a just released decision from US Tax Court this week in Nancy McDonald vs IRS US Tax Court August 25, 2015 which illustrates how important it is to make a valid and timely election to take advantage of the foreign exclusion.
The facts are relatively complex in that McDonald was living abroad and did not file a tax return in 2009. The IRS prepared a substitute tax return and then issued a notice of deficiency. McDonald the filed the 2009 return two years late claiming foreign earned income exclusion. The IRS audited and disallowed the exclusion claiming McDonald failed to make a valid election under 1.911-7(a)(2). McDonald appealed to US Tax Court in McDonald v IRS US Tax Court (8/25/2015) claiming she made a valid election or in the alternative the election requirements were unreasonable and not specifically authorized by law.
The Court notes the IRS promulgated regulations, even though Congressional law is silent on when and how to make the election. You can chose from four alternative timing methods to make the election three of which involve Form 2555: 1. Attach From 2555 to your income tax return timely filed 2. Attach Form 2555 with your return filed by amendment. 3. AttachForm 2555 with your the original return filed within one year after the due date and 4. Attach Form 2555 with your return filed after the deadline provided that you owe no federal tax including the exclusion and file Form 2555 before the IRS catches you OR in lieu of Form 2555 print on the top of the tax return “filed pursuant to Section 1.911-7(a)(2)(i)(D).
McDonald argues that if she had simply included on the top of the first page the required statement she would have made a valid election and owe no tax, in effect, that her omission of this statement should be excused because only the regulations, not Congressional law make this a requirement and that the requirements are unreasonable. Judge Gustafson opines “…it is true that the Code Section 911(d)(9) makes no mention of the timing of the election but rather provides the Secretary shall prescribe such procedures…” The Court therefore concludes that the regulation provides taxpayers with four alternative methods by which they can timely elect the exclusion. The fact that the Secretary could have chosen longer periods within which to permit the election is of no consequence, because the alternative methods with four varying periods are reasonable. IRS Wins McDonald Loses.
So now that you have made a valid election, as Hermine Dinger found out, you must work for a foreign company or government that has no connection with an American company or business or US Military or US Military Agency. Hermine Dinger thought she was able to exclude the income earned from ADD, the German authority of the Minister of Internal Affairs that administered payroll for civilian employees of the US Army. The IRS audited and disallowed her exclusion. Dinger appealed to US Tax Court in Dinger v IRS US Tax Court (8/ 6/ 2015) claiming she was paid by a German Government office. The Court easily found for the Government finding that Dinger worked for the United States even though the ultimate source of her income was foreign.
Our final case illustrates how difficult it is to qualify living abroad under Section 911(a), as Joe Evans found out in Evans v IRS US Tax Court (1/20/2015). Evans worked in Russia in the oil industry and filed tax returns from 2007-2010 prepared by Bradley Borden, a tax professional, claiming that his tax home was Russia. The IRS audited all 4 years disallowing the foreign earned income exclusion claiming Evans was not a bona fide Russian resident. Evans appealed to US Tax Court in Evans v IRS US Tax Court (1/20/2015)
The Court notes that Section 911(d)(3) carves an exception out in that if a person has a home or an “abode” within the United States during his foreign residency Evans cannot establish that his tax home is in a foreign country, citing Jones v Commissioner 927 F.2d 489 (5th Cir. 1991). Evans had invariably some connections with the foreign country in which he works, but if his ties to the United States are stronger, we have held that his “abode” remains in the United States citingHarrington v Commissioner 93. T.C. 297 (1989). Unfortunately for Evans, he still was registered to vote in his home state of Louisiana, possess a Louisiana Driver’s license and had a Louisiana bank account.
Judge Lauber easily finds for the Government showing that Congress limited the benefits of Section 911(d)(3) to discourage folks from incurring duplicative costs of maintaining distinct US and foreign households citing again Jones v Commissioner 927 F.2d 489 (5th Cir. 1991). IRS wins Evans loses.
In conclusion, if you are planning to work abroad and want to take advantage of Section 911(a) Foreign Income Exclusion, first, before you leave the United States make sure you retain the services of a tax attorney to plan out your tax strategy so that you not only legally elect the exclusion, but you have the contemporaneous evidence created to insert into your next tax return before you leave the country so that the Government will have on record your election. Second, if in the very likely event you get audited by the IRS retain that same tax attorney to defend you so she can apply the law to your unique set of facts and circumstances that she helped create for you years earlier. Finally sit back and relax wherever you are in the world as you win your IRS Foreign Income Exclusion Audit with a bullet proof protected tax return.
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Chris Moss CPA Tax Attorney