Foreign Earned Income Exclusion Denied - Case Study
Interpretation of the Foreign Earned Income Exclusion
A tax court recently found that a contractor of Korean Air could not claim the foreign earned income exclusion. The court concluded he was not a bona fide South Korean resident for the purposes of claiming the exclusion.
The pilot in this case, Robert Hudson, flew for a US airline before becoming eligible for retirement and beginning his pension payments. The pension plan allowed him to take another job after retirement. He took the opportunity to continue his flying career with Korean Air since they had a policy allowing him to maintain his seniority.
- Hudson was hired via a third party recruiter, by Korean Air, as a contractor (as opposed to being an employee or Korean Air or the recruiter) As part of this offer, he agreed to accept South Korea as his home base.
- The contract term was five years, matching closely the period of time until the required retirement age. Hudson planned on filling the full term before returning to the US. However, he retired early due to failing a flight physical.
- While working for Korean Air, he lived in Incheon. He registered as an alien in South Korea, living at the Hyatt Hotel which the airline owned, and at the company’s expense. He brought many large suitcases containing his belongings each time he stayed.
- While flying for the airline, he spend a significant amount of his time in the country. But, he did take off nine days each month, usually in blocks of time, and also had 24 days of vacation each year. During most of the time he had off work he came back to the US to spend time with his spouse in either Arizona or Minnesota where they had homes. On occasion, his wife would fly to meet him at layover locations.
- The fee for Hudson’s services was paid to the contract agency, which was responsible for paying him his salary. Each year, he received a tax statement from the Korean government that noted his “nonresident” status, which was in agreement with Hudson’s view of himself as being a registered alien who is paying taxes to Korea rather than a permanent South Korean resident. Before signing the employment contract, his attorney’s advice was that the contract would make him a Korean Air employee.
- On Hudson’s tax returns from 2007 to 2010, and with a professional tax preparer’s advice, he used the foreign earned income exclusion to exclude his Korean Air salary from his income. For his taxes in 2011 and in 2012, he used a different tax professional (a CPA in Minnesota) who prepared the returns for him. He also sought advice from an attorney concerning the foreign earned income exclusion. Again, he concluded he was allowed to claim the exclusion.
The IRS did not accept the claim of FEIE under Bona Fide Residency. Their reasoning was that he did not establish a physical presence or live there as a bona fide resident during those tax years. In addition, the IRS found that he owed self-employment taxes. Hudson took the case to Tax Court.
What the Law Says
The Section 911(a) exclusion allows “qualified individuals” to exclude their “foreign earned income” from their gross income. The definition of foreign earned income is "the amount received by such individual from sources within a foreign country or countries which constitute earned income attributable to services performed by such individual." Section 911(d) defines a qualified individual as someone whose tax home is located in another country, and is either physically present for a period of time in the country or who is a bona fide resident of the country.
What the Court Said
The Tax Court’s decision was that Hudson could not claim the foreign income exclusion. In the case, Hudson’s argument was that he was a bona fide resident, not that he satisfied the test for physical presence. So that is the analysis the court undertook.
The court considered the following factors, based on a Seventh Circuit Court decision in 1962:
- The taxpayer’s intention
- Whether the taxpayer established his home abroad without a set end date
- Participation by the taxpayer in community activities, whether he identified with the lives of local residents on a daily basis, and the more general consideration of assimilation
- Whether the physical presence was consistent with the needs of his employment
- The reasons for any temporary absences
- The extent of tax payments to the country, and economic burdens assumed
- The taxpayer’s status compared to a transient
- How the taxpayer’s employer treated their income
- Family residence and marital status
- The type of employment and the duration, and whether the work abroad is able to be completed in a finite period of time
- Whether the trip abroad was made in good faith rather than for purposes of evading taxes
In a similar case in 1991, the Fifth Circuit Court said that the primary factor is the intent of the taxpayer. In this specific case, the Tax Court took this same opinion and cited the Fifth Circuit Court’s decision.
Hudson’s argument before the court was that his case was similar to the other cases where the courts found the taxpayers met the test for bona fide residency. The decision of the Tax Court, however, was that although the facts in the three cases were similar Hudson had not been able to prove that his intention was to become a resident. In fact, his visits to the United States showed his intent to eventually return there. Thus, he did not pass the test for bona fide residency.
The difference in the eyes of the court is that Hudson planned to spend nearly all his days off work in the US, and indeed spent up to 132 each year within the US. The court said that extended absences not justified by extenuating circumstances preclude one from being a bona fide resident.
There was another similar case decided by the courts in 2017. Clearly, this is an issue that affects many pilots flying for foreign airlines or other contractors who plan to use the majority of their vacation time in the US. These cases show that the taxpayer should take verifiable measures to show their intent to establish residency if they intend to claim the foreign earned income exclusion.