Foreign earned income exclusion denied for State Department employee

The Tax Court's application of common law factors overrules a taxpayer's belief he was an independent contractor.
By Beth Howard, CPA, Ph.D.

The Tax Court disallowed a former government employee's foreign earned income exclusion related to income earned in various countries under personal service contracts with the U.S. Department of State, Bureau of Overseas Buildings Operations (OBO), determining that the taxpayer was an employee of the OBO rather than an independent contractor and was thus not entitled to the exclusion. The Tax Court did, however, find that it was reasonable for the taxpayer to believe he was not an employee of OBO, and it waived accuracy-related penalties.

Alfred S. Co, a mechanical engineer, provided engineering services from 2007 until 2012 exclusively to OBO for several projects in various foreign countries. Co provided these services under two personal service contracts, which defined his duties, scope of work, and the evaluation process. During the years in question, 2009 through 2011, Co worked under the direct supervision of an OBO project manager. He was not permitted to work for others and did not offer his services to the public. OBO determined in which countries Co would work and when he would be sent there. In addition, Co received an annual salary for his services and was obligated to work a 40-hour workweek, submitting time sheets to OBO, which were approved by his supervisor. Although Co provided his own air conditioning temperature gauge and a welding gauge, OBO provided all other equipment.

Co elected the foreign earned income exclusion for each of the years in question, which the IRS disallowed and assessed accuracy-related penalties on the underpayment amounts.

The United States taxes its citizens on their income irrespective of where it is earned. Under Sec. 911(a), a "qualified individual" may exclude foreign earned income from gross income. However, under Sec. 911(b)(1)(B)(ii), foreign earned income does not include amounts "paid by the United States or an agency thereof to an employee of the United States or an agency thereof." Thus, Co's ability to use the foreign earned income exclusion depended on whether he was an employee of OBO during the years in question or was, instead, an independent contractor.

Whether an individual is an employee is based on common law rules, and the Tax Court has used seven factors in determining whether an employee-employer relationship exists under these rules. Analyzing Co's situation using these seven factors, the Tax Court concluded that Co was OBO's employee.

Degree of control. Control is considered the most important of the seven factors, and the Tax Court has called it the "master test" for determining the nature of a working relationship. During the years at issue, OBO determined the taxpayer's responsibilities and supervised his performance, requiring daily and monthly reports. Further, OBO determined Co's hours, set his work schedule, and determined his salary as well as his annual leave, sick leave, and home leave. These facts indicated to the Tax Court that OBO exercised substantial control over the taxpayer and that Co was an employee.

Investment in facilities. Although the taxpayer provided his own temperature and welding gauges, this investment did not involve a risk of financial loss, since he could keep these purchased tools at the end of his employment with OBO. OBO provided the taxpayer with a government-furnished residence, training services, and other supplies. The Tax Court found that this factor was neutral.

Opportunity for profit or risk of loss. Co was paid biweekly based on his annual salary rate, which was determined in advance based on a Foreign Service Scale. OBO did not pay him based on performance or project completion, and he made no investment in the buildings he inspected. The Tax Court found that this factor indicated Co was an employee.

Right to discharge. OBO had the right to end the personal service contract with the taxpayer at any time for cause or with 30 days' advance notice. The Tax Court found that this factor weighed in favor of finding that the taxpayer was an employee.

Integral part of regular business. Co served as a mechanical engineer on OBO's construction projects. The Tax Court found that this work was in the scope of OBO's regular business, and, thus, this factor indicated that the taxpayer was an employee.

Permanency of relationship. An employment relationship is generally a continuing relationship, while a temporary relationship may indicate that one is an independent contractor. The relationship between OBO and the taxpayer appeared to be intended as permanent rather than temporary. Co worked exclusively for OBO for five years, was required to perform his services personally, and did not offer his services to the public or perform services for anyone other than OBO during the time in question. The Tax Court determined that this factor indicated that the taxpayer was an employee.

Relationship contemplated by the parties. OBO provided Co with Forms W-2 and withheld federal income taxes and FICA taxes from his pay. OBO also paid FICA taxes on his behalf. However, Co personally believed that he was not an employee of OBO. Overall, the Tax Court concluded this factor was neutral.

Based on the evidence presented, the Tax Court determined that the taxpayer was an employee of OBO during the years under review and was not entitled to the foreign earned income exclusion. However, the Tax Court also determined that it was reasonable for the taxpayer to believe that he was not an employee of OBO, given the difficulty in applying the common law employee test and his lack of background in accounting, finance, or tax. Further, the taxpayer testified that an IRS auditor had informed him in a previous audit that he was entitled to claim the foreign earned income exclusion in previous years (2007 and 2008). Thus, the court determined that the taxpayer was not liable for accuracy-related penalties.

  • Co, T.C. Memo. 2016-19

—By Beth Howard, CPA, Ph.D., associate professor of accounting, Tennessee Technological University, Cookeville, Tenn.

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