Each year thousands of the US citizens and tax residents living overseas take advantage of the several tax breaks provided to them in the Internal Revenue Code. This article will focus on one of the more popular tax breaks, the foreign earned income exclusion ("FEIE") and how its requirements include more than just living overseas. We will use as an example the facts from the recently released Tax Court summary opinion Hirsch v. Commissioner, T.C. Summ. Op. 2016-37.
In Hirsch, the taxpayer represented himself in front of the Tax Court and unsuccessfully argued that he should be eligible for the FEIE. The FEIE allows United States citizens and resident aliens who work outside the United States to exclude all or part of their foreign income when filing their U.S. federal income tax return. In Hirsch, the taxpayer argued that because he resided in Israel, the FEIE should apply. However, as described in further detail below, the determinative factor for the FEIE is not the taxpayer's place of residence. Rather, section 911(d)(1) provides that a U.S. taxpayer may successfully claim the FEIE only if the taxpayer (i) is a bona fide resident of a foreign country or countries and (ii) has a tax home in a foreign country. In particular, a taxpayer's "tax home" may be completely different from the taxpayer's actual country of residence. This article will discuss the FEIE requirements in greater detail particularly with respect to a taxpayer's tax home and the application of the requirements to the taxpayer in Hirsch.
a. Bona Fide Resident - First Prong
The first prong of the FEIE test is whether a U.S. taxpayer is a bona fide resident of a foreign country or countries. A taxpayer can satisfy this requirement in one of two ways depending on the taxpayer's citizenship status. If the taxpayer is a US citizen or US tax resident, then the taxpayer must be a "bona fide resident of a foreign country or countries for an uninterrupted period which includes an entire taxable year". If the taxpayer is a U.S. citizen or resident, then foreign residency may be established by showing the taxpayer was present in a foreign country or countries during at least 330 days in a 12-month period.
b. Tax Home - Second Prong
The second prong of the FEIE test is whether the taxpayer has a "tax home" in a foreign country. The concept of "tax home" is subjective in nature and requires an analysis of all the facts and circumstances. Generally speaking, a taxpayer's tax home is considered to be his or her regular or principal place of business, and not necessarily where his or her personal residence is located. To identify the principal place of business, the court can look at the employer's practices and where the employer has identified the taxpayer's principal place of business on its records.
a. Bona Fide Resident
In Hirsch, the taxpayer was a citizen of both Israel and the United States. However, the court conceded the taxpayer was a bona fide resident of Israel without discussion. Therefore, the taxpayer satisfied the first prong of the test.
b. Tax Home
As noted above, the concept of "tax home" can be different from a taxpayer's country of residence. The court can consider all the facts and circumstances when making its decision. In Hirsch, the Tax Court focused particularly on the employer's records when determine the taxpayer's tax home. The court identified many factors which pointed towards the taxpayer having a tax home in the United States.
First, the taxpayer was employed full time by Merrill Lynch, Pierce, Fenner & Smith Inc. ("Merrill Lynch") as an investment associate and part of the Lynnvest Group ("Lynnvest"). During the tax years at issue, Lynnvest's offices were in New Jersey with approximately 80% of its clients based in the United States. The taxpayer travelled to the United States normally once a month to meet with clients and ended up spending about one-third of his year in the United States. Merrill Lynch did not reimburse him for this travel. The taxpayer even had an address in New York where he received his W-2 from Merrill Lynch.
Second, Merrill Lynch's internal policies, as well as his licensing, limited the taxpayer's ability to conduct business in Israel. Merrill Lynch authorized the taxpayer to work only out of the branch offices of Lynnvest and Merrill Lynch's locations in New Jersey and New York. The taxpayer's home in Israel was not listed as an alternate office location on the Merrill Lynch employee records. Furthermore, Merrill Lynch had not registered the taxpayer to conduct business in Israel with FINRA which effectively prevented the taxpayer from legally providing advice to clients in Israel.
In addition, Merrill Lynch issued a memorandum to the taxpayer limiting his ability to solicit, contact or meet existing or potential clients in Israel. The taxpayer could not add any new client accounts or open new accounts for existing clients from Israel. The only business activity the taxpayer could do while in Israel was review and monitor client portfolios. The taxpayer was even prevented from returning missed phone calls from clients while he was in Israel.
In light of these factors, the court in Hirsch determined that the taxpayer had a tax home in the United States, specifically the New York metropolitan area. In effect, there was nothing about the nature of his work or Merrill Lynch's internal protocols that required the taxpayer to live in Israel or conduct his market research in Israel. The court pointing out that it was a personal choice for him to live in Israel and not associated with his employment.
While the tax breaks provided by the Internal Revenue Code to US citizens and tax residents living overseas are generous, an individual must meet each of the requirements to qualify for the benefit. For the FEIE, the qualifications include both being a bone fide resident of the foreign country and having your tax home outside the United States. Qualifying for one does not necessarily mean that you will qualify for both. Furthermore, when required, a taxpayer must consider all the facts and circumstance when determining whether he or she qualifies. As Hirsch demonstrated, the records of the taxpayer's employer can play a large role in determining the outcome of this analysis. U.S. taxpayers who live in a foreign jurisdiction but conduct business in the United States should take heed of this decision and ensure they are correctly applying the FEIE.