Defense Contractor Entitled to Foreign Earned Income Exclusion

(Parker Tax Publishing September 2021)

The Tax Court held that a defense contractor was entitled to exclude from gross income, as foreign earned income under Code Sec. 911(a)(1), the wages she earned while working on a U.S. military base in Afghanistan. The court also concluded that the taxpayer was not subject to a late filing penalty because she was serving in a combat zone and, under Code Sec. 7508, she was entitled to several extensions of time in which to file based on her period of service in the combat zone. Wood v. Comm'r, T.C. Memo. 2021-103.

Background

Deborah Wood grew up and attended high school in Boston, Massachusetts. Her parents, siblings, and other relatives still live in the Boston area. In 2001, she joined the Army Reserves, completed specialty military training, and was deployed to Iraq from 2003 to 2005. In Iraq she specialized in logistics, coordinating transportation for vehicle convoys, rail movements, and air transport. After her U.S. Army deployment ended in 2005, she returned to her family in Boston.

In late 2005, Wood moved to Texas and started working for Dell Technologies (Dell) in 2006 as an account manager. In June 2011, she bought a house in a new development under construction near Fort Hood because rents were increasing and she regarded real estate as a good long-term investment. In mid-2011 she became increasingly dissatisfied with corporate life and began looking for defense contracting jobs overseas. She had both personal and financial motivations for investigating these opportunities. She missed the close bonds that she had formed with her colleagues - mostly young service members about her age - while living and working on military bases in Iraq. By becoming a defense contractor, she believed that she could put to best use the logistics skills she had learned during her time in the military. Foreign defense contractor jobs paid a much higher salary than she was earning at Dell.

In October 2011, Wood received an offer from AC First, LLC (AC First), to work in Afghanistan. That offer came with a six-figure salary, and she accepted it at once. Wood's house was completed in late October 2011. She registered her 10-year-old car at that address and left it parked in the garage. She departed for Afghanistan one month later and began working at Kandahar Airfield.

Wood speaks only English and the Afghans with whom she interacted consisted almost exclusively of day laborers and cleaning staff on the base, which she described as reluctant to speak with Western women. Because she had little meaningful contact with local people, learning the local languages would have been of no practical use. Wood had U.S. bank accounts and credit cards during the years at issue. She was paid in U.S. dollars, and her paychecks were deposited by her employer directly into her bank account. Businesses on the base, such as the restaurants, uniformly accepted U.S. dollars and generally did not accept Afghan currency. Contractors and service members typically paid their bills with cash, credit cards, or EagleCash - a stored value card linked to the user's bank account - that is widely used on military bases. When needing items not available for purchase on the base, Wood submitted orders to Amazon.com.

Because Wood was generally forbidden to leave the base, it would have been difficult for her to open an account at an Afghan bank. In addition, opening a local bank account would have afforded her no benefits and complicated her security clearance, which she was required to maintain as a condition of her employment. For similar reasons, it would have been impractical and inadvisable for her to purchase real estate or make other investments in Afghanistan. As a condition of her employment, Wood was required to maintain a valid driver's license from the country that issued her passport and she maintained her Texas driver's license.

While she lived at Kandahar Airfield, Wood socialized with others on the base and formed close friendships. She embraced the diversity of the base, regularly attended barbecues and dances, went to the gym, watched sporting events, and took part in weightlifting competitions. She did not carry a weapon as part of her employment and, for security reasons, she was not permitted to leave the base except when departing for international travel. She did not, and could not, travel within Afghanistan because it was a war zone.

Wood used some of her vacation time to make trips to the United States, such as to Texas to visit her property and Boston to visit her family. She spent 22 days in the United States during 2012, 42 days during 2013, zero days during 2014, and 40 days during 2015. She did not rent out her house in Texas, which remained unoccupied except when she was visiting.

Wood's employment with AC First ended on April 19, 2016, because of a military drawdown in the region, but another defense contractor, DynCorp International, LLC (DynCorp), orally promised her a position at Kandahar Airfield contingent on the availability of funding. Wood returned to Texas and immediately began looking for other defense contracting work in Afghanistan in case the DynCorp offer did not come through. She looked for work only with other overseas contractors and repeatedly turned down opportunities to pursue jobs in the United States, even when offered by ex-military friends. She also filed for unemployment while waiting to see whether the DynCorp job came through. The DynCorp job came through and Wood returned to Afghanistan on December 24, 2016.

Wood filed her tax returns for 2012-2016 late because, she explained, she had been confused about the need to file U.S. tax returns while working on a U.S. military base overseas. She did not file her 2015 tax return until October 26, 2017. Wood considered herself a bona fide resident of Afghanistan for 2012-2016 and on each return included a foreign earned income exclusion under Code Sec. 911. The IRS rejected the foreign earned income exclusions included on Wood's returns and also assessed a late filing penalty with respect to her 2015 tax return.

Code Sec. 911(a)(1) provides that a "qualified individual" may elect to exclude foreign earned income from gross income, subject to limitations set forth in Code Sec. 911(b)(2). Under Code Sec. 911(b)(1)(A), foreign earned income is the amount received by such individual from sources within a foreign country or countries which constitute earned income attributable to services performed by such individual. Code Sec. 911(d) provides that, to be a qualified individual entitled to this exclusion, a taxpayer must satisfy two distinct requirements. First, the taxpayer must either be a bona fide resident of one or more foreign countries or be physically present abroad for a specified period. Code Sec. 911(d)(1)(B), for example, provides that a taxpayer can be a qualified individual by meeting a 330-day physical presence requirement. Second, the taxpayer must show that his or her tax home is in a foreign country.

Analysis

The Tax Court held that Wood had her tax home in Afghanistan and was a qualified resident of Afghanistan eligible for the foreign earned income exclusion for years 2012-2015, but not for 2016. In reaching its conclusion, the court considered Wood's ties to Afghanistan in the light of the nature of the region and the unique circumstances of her work. The court noted that Wood fully assimilated into the only community she had available to her, formed close friendships within this community, and participated in its activities to the fullest extent possible. Likewise, the court observed, although Wood lived in employer-provided housing and did not acquire her own space, she had no other housing option available to her. While Wood did not learn the local languages or participate in activities with the local Afghan community, the court noted that assimilation of this sort was a practical impossibility since Wood was forbidden to leave the base, and most Afghans with whom she interacted had little interest in conversing with her. The court noted that Wood could not stay in Afghanistan legally without employment, but her employment was structured as a series of one-year contracts which were regularly renewed.

The Tax Court found at least one factor adverse to Wood and that was the fact that she assumed few economic burdens by living in Afghanistan because she did not pay for lodging or most meals, and she paid no tax in Afghanistan. However, the court noted that the Fifth Circuit, in Jones v. Comm'r, 927 F.2d 849 (5th Cir. 1991), observed that a taxpayer's intent plays perhaps the most important part in determining the establishment and maintenance of a foreign residence. Wood testified that she intended to work as a contractor in Afghanistan for as long as such jobs remained available and the court found that testimony entirely credible. After weighing all the factors, and giving special consideration to her intent, the court concluded that Wood had supplied the strong proof necessary to carry her burden of proving that she was a bona fide resident of Afghanistan during 2012-2015.

As for 2016, the court found that Wood was not a qualified resident of Afghanistan because she was living in her home in Texas from April 21, 2016, thru December 24, 2016, and was collecting unemployment.

The court also held that Wood was not liable for the late filing penalty assessed with respect to her 2015 tax return because she had returned to Afghanistan, which remained a combat zone, on December 24, 2016, before her 2015 tax return was due. Under Code Sec. 7508(a)(1)(A), Wood was entitled to an extension of time for filing her 2015 tax return as a result of being in a combat zone and her filing deadline was 289 days after April 19, 2016 (i.e., February 2, 2017). Thus, the court said, Wood's 2015 return was timely filed and she was thus not liable for the addition to tax under Code Sec. 6651(a)(1) for that year.

For a discussion of individuals qualified for the foreign earned income exclusion, see Parker Tax ¶78,610

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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