Not many U.S. expatriates realize that the foreign earned income exclusion is an election and is not automatic. In a recent tax court Nancy McDonald learnt this in a painful way when her exclusion was denied. Nancy McDonald V. Commissioner TC Memo 2015-169.
IRC Section 911(a) provides that a qualified individual may elect to exclude from gross income the foreign earned income of such individual. To qualify for the foreign earned income exclusion (FEIE), the taxpayer must satisfy a three-part test:
- Taxpayer must be a U.S. citizen who is a bona fide resident of a foreign country for an entire taxable year or physically present in a foreign country during at least 330 days out of a 12-month period, sec. 911(d)(1);
- Taxpayer must have earned income from personal services rendered in a foreign country, sec. 911(d)(2); and
- Taxpayer’s tax home for the period must be outside of the United States, sec.911(d)(3).
Although a taxpayer may satisfy these three requirements, the opening words of section 911(a)—“At the election of a qualified individual”—make clear that the taxpayer must also affirmatively elect to exclude the foreign earned income from his or her gross income.
Nancy McDonald, a U.S. citizen, left the United States in October 2009 to work overseas. Her Form 1040, “U.S. Individual Income Tax Return”, for that year was due on April 15, 2010. Ms. McDonald did not request an extension of time to file her 2009 return and did not timely file it. The IRS evidently received, from Ms. McDonald’s employer, information about her wages; and in January 2012 the IRS prepared and filed for Ms. McDonald a substitute for return for 2009, pursuant to section 6020(b).
On April 9, 2012, the IRS issued to Ms. McDonald a notice of deficiency (NOD) for 2009 based on the substitute for return. It was determined that there was a deficiency of $19,449 in tax and additions to tax under sections 6651(a)(1) and (2) and 6654.
On May 18, 2012, Ms. McDonald filed her Form 1040 for 2009. The Form 1040 reported income of $101,244, but Ms. McDonald attached thereto a Form 2555, “Foreign Earned Income”, and claimed thereon an FEIE and excluded $23,032 from her total income. With her return Ms. McDonald sent the IRS a payment of $3,018, the balance due reported on her return. The IRS processed Ms. McDonald’s return and payment and closed the first NOD in July 2012.
Subsequently, the IRS selected Ms. McDonald’s 2009 return for audit. As a result of the audit, on June 20, 2013, the IRS issued Ms. McDonald a second NOD, upon which this case is based. The second NOD disallowed Ms. McDonald’s claimed Foreign Earned Income Exclusion because she:
- did not make a valid election and file Form 2555 with a timely filed return;
- did not elect to exclude the foreign income on a previous return; and
- did not otherwise comply with the procedural rules to make a valid election to exclude the foreign income under section 1.911-7(a)(2).
In recent times when number taxpayers are coming forward to catch up and comply with the filing requirements due to FATCA impacts, this case serves as an important reminder as lack of knowledge can be a trap for the unwary. There are ways to avoid such scenarios. CPA Global Tax professionals can help.