Just a few months back, in Hudson v. Commissioner, T.C. Memo. 2017-221, the US Tax Court held that a pilot working for Korean Air and living in a hotel in South Korea while there for his work could not claim the Section 911 foreign earned income exclusion (“FEIE”) because he was not a “bona fide resident” (BFR) of South Korea for purposes of the exclusion.
Americans working abroad are usually aware that under the FEIE rules they may be eligible to exclude certain foreign earned income (wages, compensation for services) from US taxable income. The FEIE amount, adjusted annually for inflation, is worth $104,100 in 2018. If a couple is married, each spouse can claim the full FEIE amount (e.g., for 2018, each spouse can exclude up to $104,100 of his or her earned income).
You don’t have to be a pilot to benefit from the lessons taught in the Hudson case. Let’s learn what the Tax Court looked at and how you can structure your work abroad to avoid losing valuable benefits of the FEIE. It pays to be proactive. Looking at the case law and the factors examined by the courts, you can help ensure that the FEIE will apply to your compensation income. With intent being the linchpin, your tax advisor can assist you in doing the “do’s” and not doing the “don’t’s”.
What Happened in the Hudson Case?
Mr. Hudson was a seasoned commercial airline pilot who had retired but found employment with Korean Air through a recruiting agency called Global Airline Pilots (GAP). He signed a 5-year agreement with GAP, that provided among other things, that his flight base was in South Korea. During his work with Korean Air, Mr. Hudson was based in Incheon, South Korea where he lived in a Hyatt Hotel owned by the airline, which paid for his lodging there. He became a registered alien of South Korea and received an annual Korean tax statement listing him as a “nonresident”. While Mr. Hudson spent considerable amounts of time in South Korea, whenever he had time off, he spent as much time as possible in the US with his wife who lived in the US. Mr. Hudson received nine days off a month, typically in blocks, and 24 vacation days a year.
In preparing his US tax returns for the years he worked for Korean Air, Mr. Hudson received advice from both a US CPA and attorney that he qualified for the FEIE as a BFR of South Korea. The IRS, however, disagreed and issued a notice of deficiency, because of his failure to establish either bona fide residence or physical presence in a foreign country for the relevant period. Mr. Hudson brought the case to the US Tax Court.
Factors Examined in Bona Fide Residency
The Tax Court noted that an individual qualified under the US tax laws for the FEIE benefits is defined in IRC Code Section 911((d) as an individual (i) whose tax home is in a foreign country and (ii) who is either a bona fide resident of a foreign country or physically present in a foreign country (or countries) for a certain number of days. The issue for the court to decide was whether Mr. Hudson qualified for the exclusion under the bona fide resident test.
In its analysis, the Tax Court examined the factors set out by the Seventh Circuit in Sochurek v. Commissioner, 300 F.2d 34 (7th Cir. 1962). These factors include:
(1) intention of the taxpayer;
(2) establishment of his home temporarily in the foreign country for an indefinite period;
(3) participation in the activities of his chosen community on social and cultural levels, identification with the daily lives of the people and, in general, assimilation into the foreign environment;
(4) physical presence in the foreign country consistent with his employment;
(5) nature, extent and reasons for temporary absences from his temporary foreign home;
(6) assumption of economic burdens and payment of taxes to the foreign country;
(7) status of resident contrasted to that of transient or sojourner;
(8) treatment accorded his income status by his employer;
(9) marital status and residence of his family;
(10) nature and duration of his employment; whether his assignment abroad could be promptly accomplished within a definite or specified time;
(11) good faith in making his trip abroad.
The Fifth Circuit had used these factors in Jones v. Commissioner, 927 F.2d 849 (5th Cir. 1991), and in that case, had opined that the most significant factor is the taxpayer’s intent. The Tax Court, citing the Jones case, agreed with this position in Cobb, T.C. Memo. 1991-376. In Jones and Cobb, the courts had applied the Sochurek factors and in each case, found that the taxpayers, who were pilots for Japan Airlines, met the BFR test. Mr. Hudson argued that his situation was analogous to the Jones and Cobb pilots. In those cases, the taxpayers lived in hotels in Japan, their families resided in the United States, they had not made any significant efforts to integrate into Japanese society and culture, and they paid Japanese income tax.
The court pointed out that the pilot in the Jones case was away from Japan only when work required or when he was on vacation, and the taxpayer in Cobb was only in the United States for flight layovers, during which time he frequently visited his family. In both cases the taxpayers credibly testified that they intended to be residents of Japan during their employment with the airline. Significantly, the pilot- taxpayer in Jones had declined to accept a dividend check from the state of Alaska, his former State of residence, because he said he was no longer an Alaskan resident. The pilot-taxpayer in Cobb had documentary evidence of his intent to be a Japanese resident and the court noted that his US visits were limited by convenience and his flight schedule.
While Mr. Hudson’s facts were similar to those of the taxpayers in Jones and Cobb, and Hudson credibly testified that he intended to work for Korean Air until his retirement, he had not proved that he intended to be anything more than a transient. The facts showed that Mr. Hudson intended to spend all of his free time in the United States when not working for Korean Air; in fact, he had spent as many as 132 days a year in the US. These factors indicated that he always intended to return to the United States, precluding a finding of bona fide residency in South Korea. The court noted that extensive absences from a country one claims as his residence, unless justified by good-faith reasons (such as travel requirements of the taxpayer’s profession), would negate a finding of bona fide residency. In summary, BFR status was denied because of Mr. Hudson’s extended absences from South Korea, along with his limited contacts with Korean culture.
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