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How to not get caught off-guard by the IRS when claiming the Bona fide residence status

How to not get caught off-guard by the IRS when claiming the Bona fide residence status

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.

First let's start at the source. The IRS Publication 54 reads:

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.

Determined according to each individual case, ha! Not the most reassuring of definitions. Further reading reveals:

"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."

Well, what if you spent the entire year in Timbuktu and the following year you want to claim a Bona Fide Residency qualification? Here goes the next paragraph:

"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.

Hence, what are the criteria the IRS takes into account to make the determination on each individual case?

  • First and foremost, one of the most important considerations in establishing bona fide residency is actually your physical presence, though this is distinct from the 330-day requirement of the physical presence test. It's a slippery slope because there is no hard-and-fast rule about what number of days qualifies or disqualifies bona fide residency. However, each additional day spent in the US may be a minor mark against bona fide residency. Certainly, a bona fide residency claim with 300 days in the US is likely to be challenged by the IRS.
  • The second criterion is the correct answer to the question on line 13a of form 2555, "Have you submitted a statement to the authorities of the foreign country where you claim bona fide residence that you are not a resident of that country?" The answer should always be No. Question 13b , "Are you required to pay income tax to the country where you claim bona fide residence?" is ambiguous. Generally, it is better to answer "Yes". What if you live in a tax heaven country without income tax? Answering "Yes" would be a lie. Then, answer "No". If other conditions for the Bona Fide residency are met, you will not become disqualified by the negative answer to this question.
  • The third and very important criterion is the nature and length of your job. If your work is contract-based with the established length of the contract, you may not qualify. I say "May not" instead of "Do not" because there are other factors explained below that will be taken into consideration. Yet, generally speaking, a job with a finite employment length does not qualify an expat for the Bona Fide Residency status. Please note - this definitely applies to the government civilian contractors working in Conflict Zones. No matter how long you stay in Iraq, no matter how good employee you are that your contract will certainly be renewed, there is no way American citizen can claim himself Bona Fide Resident of Iraq (or Afghanistan, or Kuwait).
  • Next thing the IRS will take into consideration is your housing status. If you purchased a house - great, your chances to qualify as a Bona Fide resident are very high. If you rent an apartment - acceptable but you must give more proof for qualification. Hotel is the least acceptable yet possible if other conditions are met. If you have free housing in an employer-provided barracks, then you are not a Bona Fide resident in the foreign country (another reason why civilian contractors in Conflict Zones do not qualify).
  • Type of visa: If you have a student visa or a temporary work visa, the renewal of which is contingent upon your employment - you are not a Bona Fide resident. If you are a permanent resident or have a dual citizenship, then other factors have little bearing and you qualify as a Bona Fide Resident.
  • Family composition: Family is important in general. For the purpose of our discussion, it is particularly important as a demonstration of your serious intent with regard to the stay in the foreign country. There is a reason why form 2555 asks you about people residing with you and the length of their stay. If you took along your wife and have two kids attending the local school, then the odds of being approved as a Bona Fide resident are very high. You can become unemployed but your family is with you, and you do not lose the Bona fide residency qualification.
  • There is one factor conveniently disguised on form 2555, yet very important for the IRS determination of the Bona Fide Residency: if you get married to a citizen of the foreign country or have a common-law partner (domestic partner) citizen of that country, this alone increases your chances to become approved as a Bona Fide resident. You can add this detail on line 12a of form 2555 answering to the question who lives with you in the foreign country.
  • Questions 15d and 15e on form 2555, "Do you maintain a home in the United States while living abroad?" Not that there is anything wrong with maintaining a home in the Unites States - you can rent it out or let your second cousin live there free. However, if the answer to the question 15e "The name of the occupants and their relationship to you" reveals that your spouse and children live in that home of yours, then you are most probably not a Bona Fide resident and your intent is to complete the foreign job assignment and come back home to your beloved family.

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.