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Iraq and Afghanistan Contractors Tax Alert

The IRS has recently issued Memorandum Number: AM2009-0003 dealing with the application to the Foreign Earned Income Exclusion and the Combat Zone Exclusion to Civilian Contractors Working in Combat Zones. It outlines who may or may not be entitled to claim the FEIE

 Contractors working in Iraq and Afghanistan need to keep several things in mind when doing their tax returns.

 While I will not address the issue of employee versus independent contractor which depends on several factors that need to be addressed directly with your tax advisor, here are some other things to keep in mind:

  •  Is you stay for a limited duration or indefinite.

  • Do you have a family in the U.S.

  • How many days do you spend in the U.S. and “on post”.

  • Who pays for your lodging and living expenses

First of all, as a civilian you are not entitled to exclude your compensation as “combat pay”. This is only reserved for U.S. service men and women.

Clearly if you work for an employer and receive a W-2, and are on assignment for a limited period of time, say 6 months, you may be able to deduct some away from home expenses as your tax home is in the U.S. But as these are often provided by your employer this may be a moot point.

FEIE Tax Home

American who have a tax home outside the U.S. can often exclude a significant portion of their foreign sourced income if they qualify under either the bona fide residence test (which includes being a foreign resident for at least an entire tax year, or 330 out of 365 days physically present outside the U.S.  during a consecutive 12 month period.


So you say, what if I was outside the U.S. for an entire calendar year (but returned home to visit my family frequently) after which I returned to my house in the U.S. So shouldn’t I get the FEIE? Not to fast. Even though you were in say Iraq for a year which under Section 162 defined your tax home as Iraq (thus denying you travel, meals and lodging), the IRS probably won’t allow you to deduct the FEIE as a bona fide resident of Iraq. That is because your abode was and still is in the U.S. and Section 911(d)(3) says that even if your tax home is not in the U.S. under 162, because your abode was in the U.S. during that time and therefore could not be in Iraq. Sorry, no Section 911exclusion as a bonafide resident. As you probably did not pay income tax in Iraq you are subject to tax on the full boat here in the U.S.

The Section 911 Physical Presence Test

 But, you say, what if I never came home during that time and met the 330/365 day rule. Well now it gets complicated. The statutory provision in IRC Section 911(d) merely states that if you have an abode in the U.S. you don’t have a tax home abroad and therefore don’t qualify for the exclusion. But how do you define “abode”? Recently the IRS updated its website to remind U.S. taxpayers of the U.S. abode requirement, although they mention that merely having a house in the U.S. where your family lives does not in itself disqualify you. This is because there is a provision that states that if you maintained a house in the U.S. while your were a bonafide resident of a country where your family would be in a hardship position that you would not be denied status as a bonafide resident.

The statute does not define “abode” and case law defines it as a domestic concept. Further, cited case law has dealt with situations where Taxpayers have been denied treatment as a bonafide resident where they clearly spent much more than 30 days in a 12 month period in the U.S. so the physical presence test was never at issue. In cases such as Lemay vs. the Commissioner the issue was whether the person qualified as a bonafide resident and never addressed the physical presence rule.

So what was the legislative (Congressional) intent of Section 911(d)(3) which stated that you could not have a foreign tax home if you had an abode in the U.S., and where is the IRS likely to be headed with this in the future? The law is vague as are the instructions to Form 2555. Worst yet, there is a technical error in the writing of Regulation 1.911-2 dealing with the issue of “abode”. After dealing with this issue for more than 30 years, it has always been felt by international tax professionals of major CPA and law firms that when Reg 1.911-2 stated that “for the purpose of paragraph (a)(i) of this section, the term tax home……”  referring to the definition of a tax home for purposes of Section 162 travel meals and lodging, that a tax home shall not be in a foreign country if there was a place of abode in the U.S. for purposes of the bonafide residence test. Well there is no paragraph (a)(i), there is only a paragraph (a)(1)(i) and a paragraph (a)(2)(i), both which deal with the issue of a bonafide resident, and (a)(2)(i) and (a)(2)(ii) both deal with physical presence. So is it safe to assume that if the Congressional issue of concern was to ensure that someone with a U.S. abode (absent maintaining a U.S. home for family because of hardship reasons) did not claim the bonafide residence rule, which made sense, and as paragraphs (a)(1) and (a)(2) (ii) dealt with physical presence that the Congressional legislative intent was not to impose this restriction on that sub-section of the Code (dealing with physical presence)?

When I started in the 1970s, most U.S. expatriates were executives or international management trainees (and sometimes technicians working on special projects) of major corporations who were taking 2-3 year (sometimes more) assignments overseas working at U.S. branches or foreign subsidiaries of their U.S. employers. As they would first qualify under the (at that time) 17/18 month rule for physical presence, they would then become bonafide residents of the foreign country for the remaining time during the assignment and paid income tax to their foreign  host country. If they were married they usually brought their families with them and lived in U.S. communities and the children went to U.S. schools. To avoid complications with the bonafide residence test we would advise them to either sell or rent out their U.S. homes, give up their U.S. drivers licenses and in essence give up ties to the U.S. and establish ties to their foreign communities. Of course there was and still is a requirement that if a resident of a foreign country one must always pay local taxes legally assessed by their foreign host country. In situations where the U.S. expatriate did not sever ties with their U.S. “abode” it was rare for a major CPA firm to claim a Section 911 FEIE based on bonafide residence and always used the physical presence test, again taking the position that any U.S. ties would prevent claiming bonafide residence status but did qualify for FEIE under the physical presence test.

I suspect that the IRS is positioning to confront contractors in Iraq and Afghanistan with a denial of Section 911 physical presence benefits for those who would otherwise have qualified for the 330/365 day test on the grounds that they continued to maintain an abode in the U.S. (especially if they were married and rented or owned a home), kept their state drivers license, voted in U.S. elections and eventually returned to the U.S. after their assignment was completed. Until Congress favorably intervenes by clarifying the statute, or the Administration requires that the Secretary of the Treasury instruct the IRS to clarify and correct the regulations, or sufficient case law that is not disqualified as precedent pursuant to IRC Section 7463(b) clearly addresses the issue of “abode” as it pertains to persons otherwise qualifying under the physical presence test defense and other civilian contractors returning from Iraq and Afghanistan will face the same tax problem of uncertainty.

The IRS Memo mentioned above extensively discussed the concept of “abode” concluding that if a person has an abode in the U.S. they do not have a tax home in a foreign country and therefore are not entitled to claim the FEIE if they have an abode in the U.S. leading one to conclude that if they had a place in the U.S., a U.S. driver’s license, etc. this would deny them the benefits of the FEIE under the physical presence test as well as the bonafide residence test. I predict that AM2009-003 will be the first step toward a campaign to deny FEIE benefits for U.S. persons who would otherwise have a tax home in a foreign country and qualify under the physical presence test.

Based on my decades of experience dealing with U.S. taxation of American expatriates and reading through historical documents pertaining to the Congressional intent of the Section 911 FEIE, I am convinced that the provision of 911(d)(3) is intended to prevent abuses as regards those claiming to be a bonafide resident while spending half of their time in the U.S. and avoid paying U.S. tax (and that the writers of the Regulation intended to write paragraph (a)(1)(i) which dealt with a foreign bonafide residence), my prediction is that we will see numerous taxpayers claiming the physical presence tax benefits of IRC 911(d)(1)(b) being arbitrarily and possibly capriciously denied the FEIE tax benefit and be faced with defending their position. My advice is to consult with a qualified tax professional in advance and be certain that you have a “tax return filing position” before you file in order to avoid substantial penalties; however always remember that the law states that a U.S. citizen is responsible for paying only that amount of tax that is legally due pursuant to the law.