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In the Courts: Taxpayer Denied the Foreign Income Exclusion

This article applies to individual taxpayers that may be eligible for the Foreign Earned Income Exclusion and also may have concern as to whether their tax home is a qualifying foreign tax home for purposes of the exclusion.

Abstract: The U.S. Tax Court recently denied a pilot the foreign income exclusion because his principal place of business was deemed to be in the United States, not another country. This article provides background on the exclusion and delves into the details of the taxpayer’s case.

Douglas H. Cutting v. Commissioner, No. 15370-17, Nov. 19, 2020 (U.S. Tax Court)

In the recent case of Douglas H. Cutting v. Commissioner, the U.S. Tax Court denied a pilot the foreign income exclusion because his principal place of business was deemed to be in the United States, not another country. The court’s decision holds an important lesson for those in similar circumstances.

Background on the Exclusion

Foreign earned income is income an individual receives from sources within a foreign country that’s attributable to services that he or she performed. “Qualified individuals” may exclude foreign earned income from their gross incomes so long as their tax homes are in a foreign country and they’re either:

  • Bona fide residents of those countries for an uninterrupted period that includes the entire tax year, or
  • Physically present in a foreign country or countries for a certain period.

An individual’s tax home is considered his or her regular place of business or principal place of business if more than one regular place exists. If no regular or principal place of business exists, the individual’s tax home is his or her regular place of abode in a “real and substantial sense.”

To qualify for the foreign earned income exclusion as a bona fide resident of a foreign country, a taxpayer must offer “strong proof” of bona fide residency in the country. When determining an individual’s bona fide residency, the Tax Court looks at the following 11 factors:

  1. The intention of the taxpayer,
  2. Establishment of the taxpayer’s home in the foreign country for an indefinite period,
  3. Participation in the activities of the taxpayer’s chosen community on social and cultural levels, identification with the daily lives of the people, and general assimilation into the foreign environment,
  4. Physical presence in the foreign country consistent with the taxpayer’s employment,
  5. Nature, extent and reasons for temporary absences from the taxpayer’s temporary foreign home,
  6. Assumption of economic burdens and payment of taxes to the foreign country,
  7. Status as a resident contrasted to that of a transient or sojourner,
  8. Treatment accorded the taxpayer’s income tax status by the employer,
  9. Marital status and residence of the taxpayer’s family,
  10. Nature and duration of employment, as well as whether the assignment abroad could be promptly accomplished within a definite or specified time, and
  11. Good faith in making the trip abroad or whether it appears to be for the purpose of tax evasion.

Facts of the Case

The taxpayer in Cutting was an American citizen living in Thailand. He worked as a pilot for an airline under a contract with the U.S. Department of Defense, flying mostly international routes transporting military personnel and cargo. The taxpayer’s income came primarily from his piloting work.

His employment was governed by a collective bargaining agreement that required him to designate a home base (a primary residence for records purposes) and a gateway travel airport. The taxpayer selected San Jose, California, to be his home base and the San Jose Airport to be his gateway travel airport.

He used his father’s address in San Jose as his mailing address because he didn’t own or lease a residence in the United States during the relevant years. On IRS Form 2555, “Foreign Earned Income,” he stated that he wasn’t a resident of Thailand and didn’t live with any family members abroad.

In Thailand, the taxpayer held only temporary transit and nonimmigrant visas, which expired after 30 days. These visas were renewed automatically each time he left Thailand to work as a pilot, giving him a fresh 30-day period whenever he returned. On at least two occasions, the Thai government denied the taxpayer’s requests to extend his visas. He couldn’t own or lease property in Thailand and didn’t pay any taxes there.

For 2012, 2013 and 2014, he filed as a single taxpayer in the United States and claimed the maximum allowable foreign earned income exclusion under Internal Revenue Code Section 911. The IRS disallowed these exclusions because he hadn’t established either bona fide residence or physical presence in Thailand for those years.

Court’s Decision

The Tax Court, after analyzing the pertinent factors, found that the taxpayer wasn’t a bona fide resident of Thailand and, therefore, couldn’t claim the foreign earned income exclusion.

The court pointed out that most of the 11 determining factors weighed against him. Specifically, there was no evidence that the taxpayer intended to become a bona fide resident of Thailand, nor was there evidence that he’d established a home in Thailand for an indefinite period. Also, nothing showed that the taxpayer tried to assimilate into the Thai culture, though his wife was Thai. He didn’t assume any economic burdens of life in Thailand (such as buying or renting a home) or pay taxes to the government. In addition, he wasn’t a legal resident of Thailand because he had only temporary transit and nonimmigrant visas, and he stated on his Form 2555 that he wasn’t a Thailand resident.

Finally, the court noted that the taxpayer chose San Jose, California, as his principal place of business when he designated it as his home base. Plus, his employer was based in the United States and withheld U.S. taxes from his wages — and, as mentioned, he filed his U.S. tax return as a single taxpayer.

Flight Cancelled

There were two factors in the taxpayer’s favor: he had a physical presence in Thailand, and he spent most of his time there when not working. However, these factors didn’t provide the lift he needed to get his case off the ground. If you intend to claim the foreign income exclusion, work with your CPA to ensure you can provide the evidence needed to withstand an IRS challenge.

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