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Most American expatriates are familiar with the term - Bona Fide Residency. Many even know that the Bona Fide Residency test is preferred over the Physical Presence Test. Why? Bona Fide Residency gives the expat the luxury of spending a month-long vacation in California, Thanksgiving week at the parents' house in Jersey, and the winter holiday season in Vermont without having to worry about the dreadful 330 days count. (Provided one has resources and desire to fly in and out of the United States).
Very few, however, understand who can qualify as a Bona Fide Resident in the foreign country and who can not. In our practice we often encounter expats who made the mistake of using BFR status which was later disallowed by the IRS. The purpose of this article is to explain in simple terms when one can claim this status and how to not get caught off-guard by the IRS by doing it improperly. Lastly we will explain the consequences of claiming the status and having it later rejected by the IRS and how we can help you.
Questions of bona fide residence are determined according to each individual case, taking into account such factors as your intention or the purpose of your trip and the nature and length of your stay abroad.
"To qualify for bona fide residence, you must reside in a foreign country for an uninterrupted period that includes an entire tax year. An entire tax year is from January 1 through December 31 for taxpayers who file their income tax returns on a calendar year basis."
"You do not automatically acquire bona fide resident status merely by living in a foreign country or countries for 1 year."
Some expats, confused by these instructions, decide to double-proof their qualification for the foreign earned income exclusion and fill out both sections on form 2555EZ; Bona Fide Residency Test and Physical Presence Test. Usually it happens to those who think their taxes are so simple, the 2555EZ form will intuitively guide them through. The results are devastating.
Irrespective of the fact that the taxpayer could have qualified for the foreign earned income exclusion through one of the tests, the IRS automatically rejects foreign income exclusion when both sections are filled. The term "rejects" does not mean that the IRS sends you a note notifying you of your mistake and to kindly resend the amended form. Instead, the IRS accepts your tax return as is, yet treats the excluded income as taxable. Since examination usually occurs 18 to 24 months after filing, the IRS adds the interest accumulated over time and to "sweeten the deal", "Accuracy-related" penalties.
Now - here comes the scary part. What exactly will happen when the IRS examines your return (this normally happens occurs 18 to 24 months after filing) and decides to disallow your Bona Fide status? Bear in mind - IRS has full discretion whether to allow or disallow it. So unless you can safely prove the criteria outlined above, it will likely be disallowed, with little recourse available to you.
In that case the IRS will simply take away the Foreign Earned Income Exclusion and slap penalties & interest on top. In dollar terms - assuming your income was $100,000 and you used up the entire FEIE (assume $90,000). If 2 years later the IRS comes knocking, the amount they would seek would be $50,000 (comprised of $25,000 in tax and $25,000 in interest and penalties). At this point you may want to ask yourself the Dirty Harry question - do you feel lucky enough to risk this?
Now, we don't want to end this on a sad note, so here is the good news. At Taxes for Expats we know exactly how to prepare expatriate tax returns and what other venues (ie ones that aren't as risky) are available to minimize your US tax liability. We have over 20 years of experience doing this. So talk to us first - we are here to help.