Summary: We’re noticing a lot of claims for foreign earned income for spouses of foreign affairs and defense agency employees, some of which may place the taxpayers at increased audit risk. The case law here is unclear and but some claims have been disallowed. We recommend taxpayers proceed carefully with the exemption.
The related credit for foreign taxes paid is much less controversial as it is based on clearly established fact: The income was earned overseas and taxed by the host country. This credit reduces tax due to the U.S. government dollar-for-dollar. If the host country is a high or medium tax rate country, this credit may yield a greater relief for the taxpayer than the foreign earned income exclusion (FEIE).
Many foreign affairs and national security agency personnel who have accompanying spouses are tempted to claim foreign earned income for their spouses’ income when the spouses aren’t employed by a U.S. government agency. It’s clear to most taxpayers in this situation that in cases of U.S. government employment, the FEIE is not available to either the taxpayer or the spouse.
Among the common references are the self-prepared tax software interviews (like TurboTax) and the American Foreign Service Association (AFSA) tax guide. The software interviews gloss over the significance of establishing a “tax home” in the host country as does the AFSA guide. Here is the AFSA text discussing the FEIE:
Foreign Earned Income Exclusion
The Tax Cuts and Jobs Act of 2017 did not change the laws governing the FEIE. As such, taxpayers living and working overseas may be eligible for this exclusion, but not if they are employees of the U.S. government. In 2018, the first $103,900 earned overseas as a (non-USG) employee or self-employed person may be exempt from income taxes but not self-employment taxes.
To receive this exclusion the taxpayer must:
(1) Establish a tax home in a foreign country, which is the general area of the taxpayer’s “main place of business, employment or post of duty.” (In other words, where the taxpayer is “permanently or indefinitely engaged to work as an employee or self-employed individual.”) and
(2) Either (a) meet the “bona-fide residence” test, which requires that the taxpayer has been a bona-fide resident of a foreign country for an uninterrupted period that includes an entire tax year, or (b) meet the “physical presence” test, which requires the taxpayer to be present in a foreign country for at least 330 full (midnight-to-midnight) days during any 12-month.
Our advice in these cases is to think about claiming the exemption very carefully. Why? While it is easy to meet one of the two “step two” tests (bona-fide or physical presence), they fail to qualify for the FEIE in the first step, the establishment of a tax home. Let’s focus on the language AFSA provided: “permanently or indefinitely engaged.” Family member assignments are fixed-term and temporary unless taxpayers can demonstrate that the spouse does not intend to accompany the U.S. government employee as s/he moves through the series of temporary and fixed-term assignments that constitute a foreign service career. Of additional significance is that the U.S. employee maintains domicile in the USA in one of the states, DC, or territories, and the tax court will need compelling evidence that the spouse is not a member of the same household and intends to remain in the host country or otherwise overseas, unrelated to the U.S. employee’s temporary assignment. The facts that the spouse is in the host country on U.S. orders, living in U.S. funded housing, and with household goods and family members that were transported at U.S. government expense may be compelling to the tax court. The facts that the spouse has not established residency in the host country due to diplomatic status, entry on a diplomatic visa in a U.S. government diplomatic passport are also likely to be problematic. Additionally, the tax court is the only legal venue in which the burden of proof lies on the defendant.
Can these defects be overcome? Certainly. For a relatively airtight case, the spouse needs to demonstrate that her/his presence in the host country is not tied to the temporary U.S. assignment of her/his spouse. There are many ways to do this, but they are rare unless the intention of the spouse really is to establish a tax home in the foreign country. We’ve seen a few examples of this, particularly later in foreign service careers where the spouse really is establishing a tax home to which the U.S. government employee intends to return once s/he retires. In those cases, the spouse intends to stay in the host country when the U.S. employee departs for the next assignment. Provisions exist for residing in housing not provided by the U.S. government and other easy-to-show actions (residency permits most notably and frequently coordinated by the employer in the host country).
The intent of the FEIE is to allow U.S. taxpayers who have established tax homes overseas to exclude income upon which they are paying local taxes as part of living in their new, non-U.S., abodes. In these cases, U.S. taxpayers should always examine the foreign tax credit at the same time to see which provides them the greater benefit — both cannot be claimed simultaneously.
If the foreign earned income was subject to host country taxation and the taxpayer is electing the FEIE rather than the lesser foreign tax credit, this strengthens the taxpayer’s claim. This is because the spouse clearly has a tax home in the host country.
In a series of cases, the tax court found that DOD contractors working overseas were not eligible for the FEIE. In response, Congress added a specific provision qualifying them for the FEIE by statute, a provision that does not extend beyond the DOD contractor population.
Having read though all this, we want to point out that in any particular interaction with the IRS, a situation similar to a visa interview pertains: The IRS agent’s understanding of the rules will be more important than the rules themselves, though the taxpayer has the ability to challenge that understanding through additional filings and recourse to the U.S. Tax Court. We’ve seen cases where these claims have not been challenged and any individual claimants “mileage may vary.”
If you have questions, feel free to comment here or at our Twitter or Facebook links.