The earned income exclusion for foreign residence.by Knight, Lee G.
As a result of amendments to Sec. 911 included in the 1986 Tax Reform Act, a qualifying individual living abroad can elect to exclude, for taxable years beginning in 1987 and thereafter, an initial $70,000 of foreign earned income1 and the excess of housing expenses over a base amount.2 A "qualifying individual" means an individual whose tax home(3) is in a foreign country and who is either: 1) a U.S. citizen working abroad who meets the bona fide residence test of Sec. 911(d)(1)(A) or the physical presence test of Sec. 911(d)(1)(B); or 2) a U.S. resident alien working abroad who meets the physical presence test of Sec. 911(d)(1)(B).
(1) Sec. 911(1)(B)(ii) defines earned income qualifying for the exclusion to include wages, salaries, professional fees, or other compensation for personal services--other than amounts paid by the United States or its agencies to United States citizens who are government employees or military personnel. If a taxpayer is engaged in a trade or business in which both personal services and capital are material income producing factors, Sec. 911(d)(2) provides that no more than 30% of the taxpayer's share of the net profits are excludable.
(2) The base amount is 1) 16% of the salary of a federal employee at grade level GS-14 multiplied by 2) the number of days of the taxable year that the taxpayer qualified under the bona fide residence test or the physical presence test.
(3) Sec. 911(d)(3) defines the term "tax home" as the qualifying individual's home for purposes of Sec. 162(a)(2)," and Regs. Sec. 1.911-2(b)--consistent with the longstanding Service position under Sec. 162(a)--situates an individual's tax home "at his regular or principal (if more than one regular) place of business or, if the individual has no regular or principal place of business because of the nature of the business, then at his regular place of abode in a real and substantial sense."
The physical presence test unequivocally requires the taxpayer to spend a minimum of 330 full days out of any 12 consecutive months in a foreign country or countries. The foreign residence test, on the other hand, requires the taxpayer to show to the satisfaction of the Service that he/she has been a bona fide resident of one or more foreign countries for an uninterrupted period which includes an entire taxable year. The term "residence," however, has not been defined statutorily, administratively, or judicially. The Tax Court takes the position that each case must be decided on the basis of its own unique facts because the decisions are not harmonious enough to formulate a uniform definition. The Tax Court also states that the taxpayer's burden of proof is greater than usual since the taxpayer has to establish bona fide residence to the Service's satisfaction.
Uncertainty over the meaning of the term "residence" combined with a more stringent burden of proof, obviously leaves the taxpayer in a precarious position. This position, however, can be improved if the taxpayer is made aware of factors the courts have used to determine foreign residency and the consequences of not qualifying for the exclusion. This article provides a checklist of factors that should be helpful to the taxpayer in tax planning.
Overview of Factors Used to Determine Foreign
Although the term "residence" has not be defined in connection with the foreign residency requirements, general legal principles define it as physical presence with intent to stay for a period of time. This can be distinguished from two other terms: 1) domicile--the intent to make a home in the place of physical presence; and 2) sojourn--presence without intent to remain.
The Service in Publication 54, "Tax Guide for U.S. Citizens and Resident Aliens Abroad," states that a taxpayer with a U.S. domicile still may have a bona fide residence abroad. The Service also takes the position that, to the extent practical, the principles of Sec. 871 and the related regulations which guide the determination of residence of aliens should be applied in determining whether a taxpayer is a bona fide resident of a foreign country. Apparently, the Service believes there is enough common ground between residency and tax home of a citizen and an alien to use these factors in determining bona fide foreign residence.
Sec. 7701(b) defines the term "resident alien." Although this section does not change the definition of foreign residence for the purposes of Sec. 911(d)(1)(A), the criteria in the regulations under Sec. 7701(b) provide some insights for the residency question. Proposed Regs. 301.7701(b)(2)(c)(1)(2) list the following factors as relevant to alien individuals trying to prove a closer connection to a tax home in a foreign country: . The location of the individual's permanent home; . The location of the individual's family; . The location of personal belongings, such as automobiles, furniture, clothing, and jewelry owned by the individual and his family; . The location of social, political, cultural, or religious organizations in which the individual has a current relationship; . The location of the individual's personal bank accounts; . The type of driver's license held by the individual; . The country of residence designated by the individual on forms and documents; . The types of official forms and documents filed by the individual, such as Form 1078 (Certificate of Alien Claiming Residence in the United States) or Form W-9 (Payer's Request for Taxpayer Identification Number); and . The location of jurisdiction in which the individual votes.
These factors should be equally applicable to a taxpayer trying to prove bona fide foreign residence. As the proposed regulations state, however, these factors are not the only ones to be considered. The courts also have developed and applied various factors for determining bona fide foreign residence.
Borrowing from general legal principles, the Tax Court in Heinzelman v. Commissioner held that intent was the primary factor to consider in determining residence. The Seventh Circuit in Sochurek v. Commissioner, however, studied all related cases and found that other courts had used a variety of factors. From these factors, the Seventh Circuit selected the following as ones that "may not be present in every situation but if...appropriate should be properly considered and weighed": . Intention of the taxpayer; . Establishment of his home temporarily in the foreign country for an indefinite period; . Participation in the activities of his chosen community on social and cultural levels, identification with the daily lives of the people and, in general, assimilation into the foreign environment; . Physical presence in the foreign country consistent with his employment; . Nature, extent, and reasons for temporary absences from his temporary foreign home; . Assumption of economic burdens and payment of taxes to the foreign country; . Status of resident contrasted to that of transient or sojourner; . Treatment accorded his income tax status by his employer; . Marital status and residence of his family; . Nature and duration of his employment; whether his assignment abroad could be promptly accomplished within a definite or specified time; . Good faith in making his trip abroad; whether for purposes of tax evasion.
The Tax Court subsequently adopted these factors in Dawson v. Commissioner. However, because the factors overlap (e.g., the taxpayer's intent is part of several factors) and not all factors are present in every case or weighted the same, the issue of bona fide residence continues to be a question of fact. Making the taxpayer aware of how these and other factors (such as those listed in the proposed regulations) have been applied by the courts neverthless is a necessary, although not always sufficient, step for satisfying the bona fide foreign residency requirement.
Establishment of Permanent Attachment Via Foreign
The taxpayer generally must establish a permanent attachment to a foreign country to show that he has been a bona fide resident of that country. The Tax Court explained this guideline in Jellinck v. Commissioner:
although "residence" does not require a permanent
house, or even a definite and settled abode, it does
require that that taxpayer have some degree of permanent
attachment for the country of which he is an alien,
and it has been said that it is this degree of permanence
of an individual's attachment for a country in which he
is at some time physically present which determines
whether he is a domiciliary, a resident, or a transient of
Applying these principles in Ferrar v. Commissioner, the Tax Court held that the taxpayer-actor was a transient, and, thus, was not entitled to the benefit of Sec. 911. The evidence presented did not establish the degree of permanent attachment to any of the countries in question that would have allowed the court to conclude that the taxpayer was a bona fide resident of any one of them. For example, the taxpayer was in India solely for the purpose of the filming of a portion of a single motion picture and had no other connection that would establish any kind of permanent attachment. What the evidence better supported was the position that the taxpayer was no more than a mere transient and intended to pursue his career wherever the opportunity presented itself- -in the United States or in foreign countries.
The Tax Court in Larsen v. Commissioner, however, found that the taxpayer had the requisite permanent attachment to establish bona fide residence for the tax year in question, 1949, because of an intent to make a career of foreign employment. The taxpayer initially executed a standard form employment contract that could be terminated at his option at the end of 18 months. From the outset, however, he intended to remain in the foreign country where he worked and received his salary for as long as he was needed to complete his job. He had left no personal property in the U.S. and, upon completion of one job, fully expected to move to another foreign job with the same employer. Although the taxpayer technically terminated his first contract in November 1949 when he returned to the U.S., the court determined that this trip was merely a vacation and that the termination was only a device for obtaining transportation. Both the taxpayer and his employer had understood that he would return, and most of his belongings were left in the foreign country based upon his expectation. The temporary absence, therefore, did not interrupt the period of foreign residency.
Nature and Duration of Stay
An indefinite duration of projected stay or employment in a foreign country generally indicates residence, whereas employment for a limited undertaking does not indicate residence. The courts have borrowed this factor from the regulations that are used in determining whether an alien is a resident of the U.S. Reg. Sec. 1.871-2(b) provides:
An alien actually present in the United States who is not
a mere transient or sojourner is a resident of the United
States for purposes of the income tax. Whether he is a
transient is determined by his intentions with regard to
the length and nature of his stay. A mere floating intention,
indefinite as to time, to return to another country
is not sufficient to constitute him as a transient. If he
lives in the United States and has no definite intention
as to his stay, he is a resident. One who comes to the
United States for a definite purpose which in its nature
may be promptly accomplished is a transient; but, if his
purpose is of such a nature that an extended stay may
be necessary for its accomplishment, and to that end the
alien makes his home temporarily in the United States,
he becomes a resident, though it may be his intention at
all times to return to his domicile abroad when the
purpose for which he came has been consumated or abandoned.
Consistent with these regulations, a resident of a foreign country must show: 1) a floating intention--indefinite as to time--to return to the U.S.; 2) no definite intention as to the length of stay in the foreign country; or 3) an extended stay necessary from the outset to accomplish the objective of the employment. An ultimate intention to return to the U.S. once the purpose of employment has been consummated or abandoned in a foreign country is not incompatible with residency status. If the employment objective can be accomplished in a short period of time, however, the taxpayer may be found to be a transient. Temporary assignments, therefore, are not regarded as sufficient to constitute a foreign residence.
The Meaning of "Temporary" to the Service
In Rev. Rul. 60-189, the Service ruled that periods in excess of one year generally would not be reviewed as temporary assignments. Subsequently, in Rev. Rul. 83-82, the Service distinguished between a temporary and an indefinite assignment on the basis of expected duration, actual duration, and other factors related to the U.S. home. If the taxpayer's time abroad is, or is expected to be, for less than one year, all the facts and circumstances must be examined to determine the nature of the stay. If the time abroad is, or is expected to be, for at least two years, the duration is considered indefinite regardless of other facts and circumstances. Assuming that the individual's abode is not located in the U.S. in this latter case, the taxpayer is considered to have a foreign tax home and can elect the Sec. 911 exclusion.
The nature of stays abroad that are expected to and do last at least one year, but less than two years, also are presumed indefinite. The Service, however, can rely on Rev. Rul. 83-82 to rebut this presumption if it can show that: 1) the individual will return to the U.S. home after the assignment is completed; and 2) the U.S. home is the taxpayer's regular place of abode in a real and substantial sense.
Whether the U.S. home is the regular place of abode depends upon the answers to the following questions: . Did the taxpayer use the U.S. residence for lodging
while working in that area just prior to leaving for the
assignment abroad, and did the taxpayer continue to
maintain work contacts (i.e., the taxpayer has merely
taken a leave of absence or a sabbatical) in the area of
the U.S. residence? . Are living expenses duplicated because of the assignment
abroad? . Do family members continue to live in the U.S. residence,
or is the U.S. residence used frequently by the
taxpayer for lodging while employed abroad? A positive response to all three of these questions means that the taxpayer's regular place of abode is located in the U.S. If only two questions are answered in the affirmative, all the facts and circumstances must be examined to determine tax home. A positive response to no more than one of the questions means that the taxpayer has a foreign abode or residence and, thus, is considered to be abroad indefinitely.
The Meaning of "Temporary" to the Courts
The leading case involving the nature and duration of the stay factor is Johnson v. Commissioner. The taxpayer, Johnson, was a U.S. citizen who went to Greenland to work as a mechanic under a contract that did not exceed one year. Johnson, however, intended to stay until the job was completed, and, thereafter, to work wherever the company's work was situated. He remained in Greenland for more than two years, entering into a second contract for not more than six months' work, but a $500 bonus if he remained the full six months. In the second contract, Johnson was described as "of Duluth, Minnesota."
While in Greenland, Johnson lived in barracks provided by his employer and was furnished both food and lodging without cost. His wife and son, however, remained residents in his home in Duluth. Johnson never intended to relinguish his U.S. citizenship, and he returned to his Duluth home upon completion of his work.
Both employment contracts provided for Johnson's transportation back to Duluth--the first, if he worked as long as the contractor desired, and the second, if the employment was not terminated because of failure, neglect, or refusal to work; insubordination; improper work; or false representation of a criminal record. Johnson met the stipulations and, thus, his transportation back from Greenland was paid for by his employer.
The Tax Court held that Johnson was not a bona fide resident of Greenland. The court found that his intention to return to the U.S. was fixed and definite, except as to time. His work assignment clearly was temporary in nature, since his employer could have discharged him without penalty or he could have quit without penalty if he had so desired.
What is "Temporary"?
The Tax Court's holding that Johnson's work in Greenland was temporary even though it continued for more than two years appears to conflict with the Service's position in Rev. Rul. 83-82. Had the ruling been in effect when Johnson was decided, the Service apparently would have conceded residency to Johnson since the time abroad was at least two years. The factors considered by the court in Johnson, however, continue to be relevant if the actual or expected duration is less than two years.
Residence of Taxpayer's Family
The residence of the taxpayer's family has been a contributing factor in several cases, but in Baehre v. Commissioner, it was controlling. The taxpayer, Baehre, was a U.S. citizen who went to Canada pursuant to an employment contract. Approximately 10 days after Baehre arrived in Canada, he moved from his hotel room into an apartment and arranged for the arrival of his wife and two children. Baehre's family moved--with all of their possessions, including furniture and automobile--to Canada with an intent to reside there for an indefinite period. Baehre and his family maintained no home other than the Canadian apartment for a period of two years. The family also took part in various community activities during the two year period. On the basis of the family's residence in Canada, the court concluded that Baehre was a bona fide resident of Canada for the purpose of the Sec. 911 exclusion.
Assimilation into the Foreign Environment
Participation in a foreign country's cultural and social life--e.g., following local customs, not living apart in a separate U.S. enclave, speaking the language of the country, enrolling the children in local schools, and taking an active role in school affairs--generally indicates residence in the foreign country. On the other hand, not making an effort to become integrated in the local society, failing to study the foreign country's language, or having few or limited local attachments or contacts evidences that the taxpayer is not a resident of a foreign country.
Assimilation into the foreign environment was a critical factor in Schoneberger v. Commissioner. The taxpayer, Schoneberger, was a pilot based in New York who flew primarily international flights. Insofar as the demands of his employment allowed, Schoneberger began to spend all of his time in France. To prove bona fide residence there, he showed his efforts to become assimilated into the French environment. Schoneberger occupied an apartment under a one-year lease in France and purchased furniture for it. Additionally, he studied the French language, dated a French woman whom he considered marrying but who wanted to remain in France, and participated in activities with this woman's family. Schoneberger's testimony indicated that family activities were deemed an important aspect of French social life. Early in his stay in France, Schoneberger had opened a checking and savings account in Paris and had acquired French credit cards. He also had acquired a residency card which he believed was necessary for purchasing an apartment.
Largely because of this assimilation in the French environment, the Tax Court found that Schoneberger intended to remain in France for an extended, yet indefinite, period of time. The court did not draw any negative inferences from the fact that Schoneberger did not belong to any civic or social organizations in France because he had never belonged to such organizations in the U.S. In other situations, however, the courts may use participation in civic organizations and other obscure local contacts--e.g., opening of savings and checking accounts, purchase of major durable goods such as an automobile--to evidence the taxpayer's claim of foreign residence.
Acquisition of Living Quarters Abroad
A taxpayer who chooses and maintains his own quarters at his own expense adds to his proof for bona fide foreign residency. The court's rationale generally has been that a taxpayer who is required, or even volunteers, to live in barracks or lodgings provided and paid for by his employer does not have all the liberties and privileges of a foreign citizen--i.e., the right to select a place of residence and complete responsibility for its maintenance.
In Van Yost v. Commissioner, the Tax Court found it significant that the taxpayer had to acquire his own apartment after being assigned to an offshore drilling rig anchored outside the territorial waters of Singapore. Likewise, in Ross v. Commissioner, the Tax Court found foreign residency largely because the taxpayer arranged to rent an apartment and purchase furniture in Mexico City. At the completion of her employment, the taxpayer remained in Mexico to search for jobs on motion picture films.
Good Faith in Making Trip Abroad
The Sec. 911 exclusion is not available to the taxpayer unless his trip abroad is bona fide--i.e., the trip abroad is made in good faith and not for purposes of tax avoidance. The courts may use a number of factors, including some of those previously discussed, to determine whether the taxpayer's actions are bona fide. For example, in Croyle v. Commissioner, the Tax Court ruled that the taxpayer was not a bona fide resident of France because he: 1) did not make any efforts to become assimilated into the French environment; 2) did not apply for a French visa; 3) did not pay French income taxes; 4) maintained extensive ties with the U.S.; and 5) maintained U.S. bank accounts. Moreover, the court was not convinced that the taxpayer's decision to live in Paris and commute to New York, where he reported for international assignments as a pilot, was not motivated by tax avoidance reasons.
Temporary Absences from Foreign Residence
A period of bona fide residence generally must be continuous and uninterrupted for an entire taxable year. Once the taxpayer establishes bona fide residence in a foreign country or countries, however, temporary absences (e.g., personal or business trips to the U.S. or elsewhere) from the foreign country will not jeopardize the taxpayer's Sec. 911 exclusion. A temporary absence is one that interrupts a continuous stay in a foreign country to which the taxpayer intends to return. A final departure, on the other hand, exists when the taxpayer abandons his foreign residence.
Tax Court Holdings
On the temporary absence issue, the Tax Court has held that foreign residency is not lost when a taxpayer: 1) returns to the U.S. to arrange to move his family; or 2) vacations in the U.S. and confers with his employer about improving his foreign employment position. If the taxpayer returns to the U.S. after receiving terminal pay or during a period of unemployment, however, the continuous period of foreign residence is broken. The period also is broken if the taxpayer has his overseas employment terminated while he is back in the U.S. on a business trip (even though he begins his search for reemployment abroad immediately). In all of these latter situations, the taxpayer lacks a definite job abroad to return to once his U.S. visit is completed.
Two-Fold Test of Fifth Circuit
In Carpenter v. United States, the Fifth Circuit established a two- fold test to determine if bona fide foreign residency ends when a taxpayer's visit to the U.S. comes at the end of a move from one foreign country to another or from one job to another job within the same foreign country. First, are there reliable indicia that the taxpayer's return abroad is reasonably certain as to fact and as to time? Second, how long was the taxpayer in the U.S. between stays or jobs abroad? If the first test is not passed (i.e., reliable indicia of return are not provided), the second part is irrelevant.
The Fifth Circuit suggested consideration of two key factors in determining the reasonable certainty of the taxpayer's return to the foreign country: . Extent of the taxpayer's preparations, before his return to the U.S., for assuming his new employment position or for moving to his new foreign residence. . Whether the taxpayer has a specified date for his departure from the U.S. for his new job or residence.
The court felt that application of these factors depended on whether the taxpayer was self-employed or employed by another. Where the taxpayer is employed by another, the existence of a specific job assignment that is accepted by the taxpayer before returning to the U.S. and that calls for a return to duty in the foreign country within a specified time period is strong evidence of continuing a bona fide foreign residence. For a self-employed taxpayer, on the other hand, maintenance of a bona fide foreign residence is indicated by: 1) proof of an agreement for a new business venture requiring the taxpayer's presence in a foreign country on or before a certain date; 2) proof that the taxpayer's departure from the U.S. is reasonably within his own control and not contingent upon the efforts of another or the vicissitudes of war or other elements beyond his control; and 3) the taxpayer's establishment of residence in a different foreign country before returning to the U.S.
The taxpayer in Carpenter failed the certainty of return test because the date for his departure from the U.S. for his second foreign job was indefinite. The court, therefore, did not consider whether his 10 month stay in the U.S. after his first foreign job was too long to evidence an intent to return to his foreign residence.
Effect of Taxpayer's Death
An uninterrupted period which includes an entire taxable year generally has been interpreted as a 12 month tax year, running from January 1 through December 31. The courts, however, have split on the question of whether a short year (less than 12 months) caused by the taxpayer's death meets the entire taxable year requirement. The Tax Court has held that it does meet the requirement, whereas a district court has held that it does not. The district court denied the Sec. 911 exclusion on this basis.
The taxpayer has the burden of establishing that he is a bona fide resident of a foreign country, and foreign residency is a question of fact. The Tax Court has stated that the taxpayer's burden of proof is greater than usual, since he has to establish a bona fide foreign residence to the satisfaction of the Service.
The factors discussed in this article to determine bona fide foreign residence are not exclusive. Moreover, no single factor is conclusive, and the Tax Court has observed that intent is the primary factor to be considered in determining residence. Nonetheless, the tax adviser must make the taxpayer who accepts employment abroad aware of the factors in other cases so that every factor within his particular facts and circumstances can be met. The checklist of factors provided in Exhibit 1 should aid in this process and provide a basis for tax planning.
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