United States

Ninth Circuit denies Foreign Earned Income Exclusion

TAX ALERT  | 

In a recent unpublished opinion, see Thompson v. Comm., the Ninth Circuit Court of Appeals affirmed the Tax Court’s decision to uphold IRS deficiency determinations for a couple that failed to prove they were entitled to a foreign earned income exclusion for the years at issue. Most notably the Ninth Circuit, in affirming the Tax Court’s decision, agreed that a prior allowance of the exclusion by the IRS or a failure by the IRS to provide a clear explanation as to the change in position regarding the exclusion did not provide the taxpayers with a basis for relief.

In this case, the taxpayers, a husband and wife, filed a joint tax return for the tax years at issue. During that time the husband worked overseas as a government contractor in support of the United States efforts in Iraq and Afghanistan for varying amounts of time. During that same time the wife continued to live in and maintain their residence in California. The issue in this case was whether the taxpayers were entitled to exclude their foreign earned income for the tax years at issue.

Generally, the U.S. taxes its citizens on all income – including income earned outside of the U.S. – unless a specific exclusion applies. One such exclusion to this general rule of worldwide taxation relates to foreign earned income. Specifically, qualified individuals may elect to exclude “foreign earned income” – income attributable to services earned by a U.S. individual in a foreign country – from their U.S. source gross income. In order for an individual to qualify to elect to exclude their foreign earned income, that person must maintain a home in the foreign country and, either have a bona fide residency in the foreign country for the entire taxable year or be present in the country for 330 full days in a 12 month period.

In this case the taxpayers failed to prove they met any of the statutory requirements entitling them to a foreign earned income exclusion. Specifically, the taxpayers did not maintain a home in either of the foreign countries (Iraq or Afghanistan) nor were they bona fide residents of the foreign countries, and failed to meet the 330 day physical presence test for any of the years in question.

However, the taxpayers went on to argue that, had the IRS disallowed the exclusion for the first year they claimed it, they would not have gone on to claim an exclusion for the remaining years at issue. While the Tax Court believed the taxpayers would not have claimed an exclusion had it been originally disallowed, the court ruled – and the Ninth Circuit agreed – that the acceptance or acquiescence by the IRS of returns filed in previous years provides the taxpayers with no basis for relief. Accordingly, the Court denied the taxpayers their claim to an earned income exclusion and upheld the IRS deficiency determinations.

While the outcome of this case does not surprise, the case provides a stark reminder to taxpayers that a tax position must be based on the merits of the position, and not on factors such as prior allowance by the IRS.

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