Andy Powers-A Professional who cares..About YOU!
Civilian Contractors Assigned Abroad-Middle East & Elsewhere
Note that this article is written as Congress is debating to repeal the Section 911 Earned Income Exclusion
Since the onset of Operation Enduring Freedom and Operation Iraqi Freedom I have received numerous questions from both independent contractors and employees of government civilian contractors assigned abroad. The questions and emails have steadily increased since the IRS issued its policy memorandum regarding whether or not these workers’ tax homes were considered to be abroad or in the U.S. Internal Revenue Code Section 911(d)(3) states that a person who has an abode in the United States shall not be considered to have a tax home in a foreign country, and based on that the IRS memo stated that it will challenge many tax returns filed that claim the benefits of the foreign earned income exclusion under Section 911 if they consider the person not to have a foreign tax home.
This memo was issued after the IRS saw numerous tax abuses by foreign contractors, large and small. Larger companies, such as KBR and B&R were attempting to avoid paying social security tax on people who worked for them in Kuwait, Iraq and Afghanistan. First they treated workers who otherwise would have been considered as employees for purposes of payroll tax withholding as independent contractors. They had the workers sign an agreement stating that they were not employees of the companies, but rather self employed contractors, and issued a Form 1099MISC reporting payments made to them. The IRS challenged many of these and determined that as these workers were under the direct supervision of the “employers” that they should be treated as employees subject to withholding of income and social security tax, and that the employer should have paid into the social security tax fund. Having lost that tax avoidance scheme they then set up foreign subsidiaries to employ the workers. Under the law at the time, employees of all foreign corporations or LLCs were not subject to U.S. tax withholding or social security tax. Once this was uncovered, changes were made requiring U.S. companies who relocated or hired U.S. persons to work for their wholly owned foreign subsidiary to withhold U.S. taxes.
Then there is the issue of the IRC Section 911 foreign earned income exclusion (FEIE). I have seen all types of inaccuracies and abuses, and so has the IRS. These range from tax preparers who are totally out of touch with the tax laws claiming a deduction on Schedule C of individual self employed contractors for “Combat Zone Exclusion” equal to the FEIE (which had the affect of reducing income subject to self employment tax) to taxpayers claiming to be bonafide residents of Iraq, Kuwait and Afghanistan for an entire calendar year and thus entitled to the maximum FEIE, even though they clearly maintained an abode in the U.S. where their family resided, where the taxpayer stayed sometimes 5 or 6 months out of the year while they were on leave. These people lived on military bases or employer compounds, were not considered to be residents by the local country and were not subject to foreign income tax laws of the foreign country. Clearly this is not the intention of Section 911 and these taxpayers were not entitled to the FEIE.
However then there is the taxpayer who gets caught in the midst of all this. He/she is clearly on assignment for an indefinite period of time, may be single, does not return to the U.S. except for possibly a few weeks out of the year, and should otherwise be entitled to claim the FEIE pursuant to the physical presence test. In view of the IRS memo if the taxpayer did not give up their U.S. drivers license or other ties to the U.S. (as they were American’s first and expatriates second) the question is raised as to whether they maintained a foreign tax home (FTH), and if Section 911(d)(3) regarding a U.S. abode should deny them the opportunity of claiming the FEIE. Faced with this, the IRS instructs in Publication 54 that if the taxpayer is assigned overseas for 12 months or less, that person does not have a FTH. Now many of these workers have annual contracts with “evergreen clauses”, meaning that they are 12 month employment contracts that automatically renew unless it is broken by either the employer or the employee.
IRS POSITION on 12 MONTH RENEWABLE CONTRACTS
The IRS, in Publication 54, states that if the initial assignment is for 12 months or less then the taxpayer does not have a FTH and is not entitled to claim the FEIE. However if the assignment is renewed and the length of the foreign assignment is extended then beginning in the 13th month, the taxpayer is then considered to have a FTH, and the FEIE begins AT THAT TIME. This means that even if the person is abroad for 4 years, if they have a 1 year renewable contract, they are denied the FEIE benefits during the first year.
SOLUTION
A simple solution to this is for the employment agreement to be an 18 month (or greater than 1 year) assignment, with a renewable clause, as the IRS position is that the governing factor is “intent”. If the taxpayer intends to live in a foreign country for more than one year, the period is considered to be “indefinite” beginning with the first day of the assignment. Once the intension to remain abroad for more than a year, with the possibility that it could be extended, the indefinite nature of the assignment entitles the taxpayer to be considered as having a FTH during the first year of the assignment, and if that person qualifies by spending at least 330 of any consecutive 365 day period outside the U.S. then the taxpayer should qualify for the FEIE during that period, subject to the rules for determining the maximum FEIE allowed for the tax year.
It is important to note, however, that in the case of persons working as civilian employees or contractors in areas such as the middle east, where they live on employer or government compounds and are not considered as being residents subject to tax by the local tax authorities, that it is clear that the taxpayer DOES NOT qualify as being a bonafide resident of that country, and must adhere to the 330/365 day physical presence test in order to qualify for the FEIE. However, should local (foreign) law determine that the person is a tax resident and subject to foreign income tax, and not exempt under any tax treaties with the U.S. that state that the person is not to be considered a resident of the foreign country and therefore not subject to local income tax, that person should be considered as being a bonafide resident of the foreign country, whereby the limitations of the physical presence test would not apply.
SUMMARY AND CONCLUSION
Whether or not a U.S. person qualifies under IRC Section 911 for the FEIE will be determined based on the facts and circumstances of the situation. Of paramount importance is planning. The person accepting the assignment should not assume that it is a “gimme” that he or she can exclude all or a portion of their compensation, as is often mistakenly assumed by many people accepting such contracts. The prudent thing to do is to understand the nature of the assignment in advance, get an employment agreement that has an initial assignment period greater than one year with a renewable clause, and position one’s self as not maintaining an abode in the U.S. It is important to note that the mere fact that a person’s family remains in the U.S. is not a decisive factor in determining that the taxpayer maintains an abode in the U.S., especially in situations where there exists a hazard risk or other conditions that prevent the family from relocating with the taxpayer. What is important, however, are things like the intended period of assignment, whether the person is subject to local tax laws, if they mingle with the local residents, etc. Remember, pre-assignment planning is of paramount importance.
Note that this article is written as Congress is debating to repeal the Section 911 Earned Income Exclusion