Form 2555, Foreign Earned Income Exclusion, is no doubt one of the more difficult forms taxpayers, and their tax preparers, may encounter. While the Court's opinion here is subject to section 7463(b) - meaning it may not be treated as precedent for any other case - it is still a good explanation of section 911, the foreign earned income exclusion.
An exclusion is different from a deduction, but in most instances it functions just the same.
The taxpayer, Mr. Musshafen, works for Parker Drilling Management Services, Inc., an oil drilling company located in Houston, Texas. Oklahoma is his home, but he works on a rig in Kuwait. He works 35-days-on and 35-days-off. While on duty, he works 12-hour days and is on call 24 hours per day. During his off-duty days, he returns home to his family in Oklahoma. After consulting with his CPA, Mr. Musshafen excluded a portion of his PDMS wages from his 2004 and 2005 tax return under the foreign earned income exclusion. The IRS disallowed the exclusion and assessed section 6662(a) accuracy penalties.
The Foreign Earned Income Exclusion
Section 911(a) excludes from gross income the foreign earned income and the housing cost of a qualified individual. Section 911(d) defines a qualified individual as, an individual whose tax home is in a foreign country and, who is either (1) a U.S. citizen who establishes he/she is a bona fide resident of a foreign country for an entire year (the bona fide residence test), or (2) a U.S. citizen who is present in a foreign country for at least 330 days during a 12 consecutive month period (the physical presence test). Under section 911(d):
The term “tax home” means, with respect to any individual, such individual’s home for purposes of section 162 (a)(2) (relating to traveling expenses while away from home). An individual shall not be treated as having a tax home in a foreign country for any period for which his abode is within the United States.Confused yet? In simpler terms, tax home can have two different meanings under 911(d). Its first definition is the same as that for deducting travel expenses - principal place of business. BUT, if a person has an abode in the U.S., her abode is the tax home, not the foreign country. The Tax Court defines abode as, "the location where [a person] has a strong economic, family, and personal ties." This means "residence, domicile or place of dwelling."
Tax Court Holds Mr. Musshafen's Tax Home is Oklahoma
The Tax Court cites several cases that analyzed the same issue (taxpayer works on an oil rig) and finds that Mr. Musshafen's tax home is Oklahoma. Because Mr. Musshafen returned to Oklahoma during his 35-day off schedule, he spent about 182.5 days per year in Oklahoma. Moreover, his family lived in Oklahoma, he had an Oklahoma driver's license, and he never really left the jobsite to mingle with Kuwaiti citizens.
On balance, his "economic, family, and personal ties" were with Oklahoma. Therefore, he did not meet the tax home test and was not entitled to the foreign earned income exclusion.
Here is an excerpt from Form 2555's instructions for 2008:
Your tax home is our regular or principal place of business, employment, or post of duty, regardless of where you maintain your family residence. If you do not have a regular or principal place of business because of the nature of your trade or business, our tax home is your regular place of abode (the place where you regularly live).
You are not considered to have a tax home in a foreign country for any period during which your abode is in the United States. However, if you are temporarily present in the United States, or you maintain a dwelling in the United States (whether or not that dwelling is used by your spouse and dependents), it does not necessarily mean that your abode is in the United States during that time.What should become instantly apparent - if you are still reading - is that the Form's instructions are so vague they are misleading. That is probably why the instructions contain an example that mirrors Mr. Musshafen's facts, and conclude a taxpayer with his circumstances does not pass the tax home test.
Fortunately for Mr. Musshafen, the Tax Court realized how confusing the law is, and abated the section 6662(a) penalties. The IRS should do us all a favor and re-write the instructions for Form 2555.