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IRS Update: Combat-zone contract workers qualify for Foreign Earned Income Exclusion (FEIE)

Less ambiguity and reliance upon IRS discretion 

US military contractors and employees finally received official approval for claiming the Foreign Earned Income Exclusion (FEIE). Up until the enactment of Bipartisan Budget Act of 2018, claiming the Foreign Earned Income Exclusion (FEIE) for civilian contractors working in support of the US Army in designated combat zones was a challenge due to having an abode in the US. Prior to the Act, approval or disapproval of the exclusion was at the discretion of the IRS agent reviewing the return.

The Foreign earned income exclusion (FEIE) allows US taxpayers to exclude their foreign earnings from US income tax (up to certain limits and adjusted each year). The ability to exclude up to $105,900 (2019) from taxable federal income and some states from the state taxable income, too, provides huge tax savings. 

The housing exclusion is not applicable for this category of taxpayers because they usually do not incur housing expenses while serving in those areas. 

Income tax withholding and Form 673 – burden shifts to taxpayers

US employers are required to withhold income taxes on the earnings unless there is Form 673 on file signed by the employee. The form is also known as the Statement for Claiming Exemption From Withholding on Foreign Earned Income Eligible for the Exclusion(s) Provided by Section 911)

Once the Form 673 is completed, signed and presented to the employer, further responsibility for tax underpayment is entirely on the employee. If he or she spent one day over the limit and failed to meet the Physical Presence Test  the employer will not be responsible for non-withholding. The taxpayer will pay tax on the entire income with penalties for tax underpayment.

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