Foreign Earned Income Exclusion – Audits are Coming!

By: Tom Andrews

Section 911 otherwise known as the Foreign Income Exclusion is probably the most commonly misunderstood and misapplied section of the Internal Revenue Code that is asserted by the yachting community in general. Basically the Foreign Income Exclusion or FEIE for the purposes of this article allows a qualified United States tax payer to exclude a portion of there earned income from taxation. To qualify for the FEIE, a U.S. citizen working abroad must have a “tax home” in a foreign country. If your tax home – where you have your regular or principal place of business or employment – is in a foreign country, and you meet either the bona fide residence test or the physical presence test, then you qualify for the foreign earned income exclusion. What this means is that you may exclude up to $80,000 for the year (computed on a daily basis). The exclusion is indexed for inflation and is $82,400 in 2006 and $85,700 in 2007.

To qualify under the bona fide residence test, you must be a bona fide resident of a foreign country or countries for an uninterrupted period that includes a full tax year. Since you’re a calendar year taxpayer, this would include a January to December period. During a period of bona fide residence, you may leave the foreign country for brief or temporary trips elsewhere for vacations or business. What qualifies

Even if you do not qualify under the bona fide residence test, you may still be eligible for the exclusion if you qualify under the physical presence test. Under this test, you would qualify if 330 full days out of any 12-consecutive month period are spent in a foreign country or countries. Physical presence that starts in the previous tax year but ends in the present year can be counted in determining whether you meet the 330 day physical presence test during a consecutive 12-month period for purposes of the exclusion for the present tax year.

Qualifying for the FEIE under the physical presence test is rather straight forward as explained above, qualifying under the bona fide residency test is a bit more dicey. Many crewmembers are under the impression that simply living on their yacht while it is docked in a foreign marina will qualify them as a “bona fide” resident of the country the yacht is docked in. In the event of an audit the IRS may not consider you a bona fide resident, some of the factors the IRS uses in determining whether or not you are a bona fide resident include but are not limited to the following: did you pay tax to this country, is your stay indefinite, do you speak the language, do you own property or a home. It is important you clarify with your accountant which section of the FEIE you intend on qualifying for so in the event you are audited you are fully able to defend your position of being considered a bona-fide resident of the foreign country you reside. The reason I bring this up is that I am hearing rumors in the taxing community that the IRS is beginning to ramp up tax audits of expatriates who claim the foreign earned income exclusion, I’ve even heard that the IRS has increased their staff on the international affairs side by 25% and this is sure to affect expatriates claiming the FEIE on their individual tax returns.

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