IRS Update: Combat-zone contract workers qualify for Foreign Earned Income Exclusion (FEIE)
Less ambiguity and reliance upon IRS discretion
US military contractors and employees finally received official approval for claiming the Foreign Earned Income Exclusion (FEIE). Up until the enactment of Bipartisan Budget Act of 2018, claiming the Foreign Earned Income Exclusion (FEIE) for civilian contractors working in support of the US Army in designated combat zones was a challenge due to having an abode in the US. Prior to the Act, approval or disapproval of the exclusion was at the discretion of the IRS agent reviewing the return.
The Foreign earned income exclusion (FEIE) allows US taxpayers to exclude their foreign earnings from US income tax (up to certain limits and adjusted each year). The ability to exclude up to $105,900 (2019) from taxable federal income and some states from the state taxable income, too, provides huge tax savings.
The housing exclusion is not applicable for this category of taxpayers because they usually do not incur housing expenses while serving in those areas.
Income tax withholding and Form 673 - burden shifts to taxpayers
US employers are required to withhold income taxes on the earnings unless there is Form 673 on file signed by the employee. The form is also known as the Statement for Claiming Exemption From Withholding on Foreign Earned Income Eligible for the Exclusion(s) Provided by Section 911)
Once the Form 673 is completed, signed and presented to the employer, further responsibility for tax underpayment is entirely on the employee. If he or she spent one day over the limit and failed to meet the Physical Presence Test the employer will not be responsible for non-withholding. The taxpayer will pay tax on the entire income with penalties for tax underpayment.
Filing Form 673 with your employer is recommended to increase your cash flow through the year and avoid waiting for a refund. However, if your situation has changed and you spent too many days in the US to remain eligible for the exclusion - notify your employer and submit a new form W-4 to resume tax withholding.
Filing of Form 673 does not make you eligible for the foreign earned income exclusion automatically. It only relieves your employer from the liability for non-withholding and adds convenience in cash management to you.
Form 673 & withholding overview
- Form 673 only provides exemption from withholding of federal taxes.
- Withholding of state income tax for your home of record and FICA taxes will continue.
- Form 673 is valid for the time period indicated on the form and has to be resubmitted annually.
Form 673 has no impact on FEIE eligibility
Filing of Form 673 does not make you eligible for the foreign earned income exclusion. It only relieves your employer from the liability for non-withholding and adds convenience in cash management to you.
In order to exclude the income earned while you were deployed as an employee or military contractor serving in a designated combat zone, you need to file a US tax return and claim the exemption (correctly). We recommend enlisting the help of an expert tax preparer to assist with filing of the return.