Was Worker Eligible for Foreign Earned Income Exclusion?

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By Howard Perlman

“I'm an independent contractor who was working abroad for a sufficient period of time, so I can claim the foreign earned income exclusion from taxation,” said Betty, a worker who had performed services for the federal government.

“Actually, you're an employee,” said Reed, a payroll manger. “In fact, because you're an employee of the federal government, you can't use the foreign earned income exclusion to reduce your U.S. tax liability.”

FACTS: A mechanical engineer performed services in five countries abroad during the six years he was under service contracts with the U.S. government. The engineer, who did not perform services for other organizations during the six years, considered himself to be an independent contractor of the federal government instead of an employee.

The service contracts specified the engineer's duties, indicated that the government could discharge him under certain conditions and enabled a government employee to supervise him. Among the engineer's services performed were building inspections and compliance assessments.

A salary, overtime pay and shift premiums were payable by the government to the engineer.

For the years he worked abroad, the engineer claimed the foreign earned income exclusion under Section 911 of the Internal Revenue Code to reduce his federal tax liability.

During the third year of the engineer's work for the federal government, an auditor working for the Internal Revenue Service examined the engineer's tax returns filed for the previous two years and determined that the engineer was entitled to claim the foreign earned income exclusion. However, in the year after the engineer's six-year period of performing services abroad for the federal government, the IRS sent him a notice of tax-payment deficiency.

The IRS said that the engineer was ineligible for the foreign earned income exclusion because he performed services abroad for the federal government as an employee. Section 911 specifies that the foreign earned income exclusion cannot be claimed on amounts paid by the federal government or one of its agencies to an employee of the federal government or one of its agencies.

The engineer timely filed a petition with the U.S. Tax Court for redetermination of his tax liability.

A mechanical engineer performed services in five countries while under service contracts with the U.S. government.

ISSUE: Was the engineer a government employee ineligible for the foreign earned income exclusion?

DECISION: The engineer was ineligible for the foreign earned income exclusion because he performed services abroad for the federal government as an employee and not an independent contractor, the U.S. Tax Court said.

Analyzing whether the engineer was an employee required a common-law approach because the IRC does not define the term employee, the court said.

The court's common-law approach involved assessing the degree of control that the federal government could exert over the way the engineer performed his work, his degree of opportunity for personal profit or loss, whether the government could discharge him and the permanency of the work relationship. While these factors “are important, the ‘right to control' is the ‘master test' in determining the nature of a working relationship,” the court said.

The engineer was “subject to substantial control” by the federal government, which was highly indicative of his status as an employee, the court said. The government's power to supervise the engineer and its ability to define many aspects of how he would perform his work, such as the work schedule and when he was able to take leave from work, indicated the government's substantial control over the engineer's work processes.

The engineer did not have an opportunity for personal profit or loss because he was paid a salary regardless of the quality of his work, indicating he was an employee, the court said. The federal government's ability to discharge the engineer also indicated he was an employee, it said.

The engineer's lack of work with entities other than the federal government during his years abroad indicated the permanency of his work relationship with the government and therefore showed that he was an employee, the court said (Co v. Commissioner, T.C., No. 25949-13, T.C. Memo. 2016-9, 2/8/16).

POINTERS: When the IRS determines if workers were properly classified as independent contractors, its auditors examine the degree of behavioral control and financial control that businesses had over the workers and the work relationships between the businesses and workers.

Employers may submit Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, to the IRS for clarification of the agency's perspective regarding a worker's classification.

When an expatriate is eligible for the foreign earned income exclusion, the exclusion can prevent a portion of the expatriate's income from being subject to federal income tax. The exclusion amount is annually adjusted.

For more information, see Payroll Administration Guide's “Employee vs. Independent Contractor” and “Employee/Employment Coverage Rules” chapters.

For More Information

This analysis illustrates how courts resolve pay-related disputes. The names and dialogue are fictitious.

To contact the editor responsible for this story: Michael Trimarchi at mtrimarchi@bna.com.