Congress has determined it would like to encourage the export of American products and services while increasing the competitiveness of Americans in the international economy by allowing "qualified individuals" to completely exclude "foreign earned income" from their gross income. I.R.C. § 911. A taxpayer becomes a qualifying individual by remaining in a foreign country for the entire tax year (12 months) or can prove he or she was actually outside the country for 330 full days during a period of 12 consecutive months. § 911(d)(1).
While the concept of living abroad to be a "qualified individual" is relatively straightforward, the case of Tobey v. IRS, 60 T.C. 227 (1927) is helpful for explaining the concept of "earned income" in an international setting. There, Mr. Tobey was an American artist living and doing most of his painting in Basel, Switzerland beginning in 1960. Id. at p. 228. He was domiciled in the state of Washington, where he had offices, bank accounts, and an attorney. In 1965 and 66, he sold many of his paintings in art galleries in Europe and the U.S. The taxpayer argued that roughly $25,000 earned from the sales of his paintings in Europe met the definition of "earned income," entitling him to an exemption under IRC § 911 for that amount. Conversely, the IRS argued that he was merely selling a capital product abroad, he did not "earn" the income there. After a lengthy review of precedent, the Tax Court clarified: "Income which accrued to the individual from application of his personal skills, whether received in the form of wages, salaries, professional fees or otherwise, was intended to be 'earned' income. Income which accrued to the individual as return on capital was not considered 'earned.'" Id. at p. 231. Accordingly, the taxpayers personal efforts creating colorful pieces of art to be sold in Europe, where he painted them, so his personal efforts constituted the basis for his income. Id. at p. 235. "We conclude that since the paintings were the result of petitioner's personal efforts, the income derived from their sales was "earned income" within the ambit of section 911(b) and is excludable from gross income to the extent of $25,000 per year under section 911(a)." Id.
In summary, the Earned Income Exclusion is a unique opportunity available to Eligible Family Members (E.F.M.s) within the Foreign Service who start their own businesses abroad or go to work for a company in a foreign country. The location criterion is relatively straightforward, at most involving disputes over counting days. Nonetheless, the more aggressive a taxpayer's position when filing time approaches, the more research that is necessary to securely position oneself prior to filing with the IRS or disputing a deficiency before the Tax Court.
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