Foreign earned income and housing exclusion denied

The Tax Court ruled against a taxpayer’s petition for the foreign earned income exclusion and foreign housing exclusion, holding that she had waived the right to each in a closing agreement with the IRS.

Facts: Nicole Henaire, a U.S. citizen, lived and worked in Australia during 2017 and 2018.  During this time, she was employed by defense contractor Northrop Grumman at the Joint Defense Facility Pine Gap ( JDFPG), a satellite surveillance base in rural Australia.  Henaire began working in this role on Jan. 6, 2017, two days after moving to Australia.  She was in Australia for almost all of 2017 and 2018 except for three trips back to the United States on April 17–30, 2017; March 12–28, 2018; and Oct. 18–28, 2018. While Henaire was in Australia, she lived in housing provided at no cost by the U.S. government approximately 10 miles from JDFPG in Alice Springs.  When she filed her petition with the court, she was a U. S. (Arizona) resident.

Before moving to Australia, Henaire completed a closing agreement in which she agreed to “irrevocably waive[] and [forgo]” rights to foreign earned income and foreign housing exclusions under Sec.  911(a) for the 2016, 2017, and 2018 tax years. The agreement also referred to the United States–Australia tax treaty as it relates to joint defense stations, which states that income derived as a contractor at sites like JDFPG “shall be deemed not to have been derived in Australia, provided it is not exempt and is brought to tax, under the taxation laws of the United States.”

Henaire signed the agreement, which was mailed by Northrop Grumman and signed by the IRS Director for Treaty Administration, Deborah Palacheck, on May 12, 2017. In late 2018, Henaire also consented to the disclosure of certain tax return information that pertained to this closing agreement.

With respect to her housing in Australia, Henaire had an International Assignment Agreement with Northrop Grumman that provided “Government furnished housing in accordance with Site policy.” If she chose to not accept that option, Northrop Grumman offered an $11,000 annual housing allowance. Henaire chose the governmentfurnished housing at no cost to her and lived in Alice Springs, where she did all of her training work at home.

Henaire timely filed her 2017 and 2018 Forms 1040, U.S. Individual Income Tax Return.  On her 2017 tax return, she reported wages of $121,865, which consisted of $107,981 in wages for services she performed for Northrop Grumman at JDFPG and $13,884 from the Secretary of the Air Force.  She received a Form 1099-MISC, Miscellaneous Income, from the Air Force for the latter amount.  The return resulted in a tax liability of $25,519.

Henaire amended her 2017 tax return in October 2018, in which she reported wages of $107,981 and other income of -$102,100, described as an adjustment for a foreign earned income exclusion on Form 2555, Foreign Earned Income.  The amended return also included a Schedule C, Profit or Loss From Business, that included the $13,884 housing allowance and a deduction in the same amount as “employee benefit programs.” These amendments resulted in a $25,170 refund.

Her 2018 tax return showed similar treatment of income as the 2017 return, excluding $103,900 of wages as foreign earned income and $9,666 of nonemployee compensation.  This return indicated a tax liability of $195.

The IRS adjusted the 2017 and 2018 returns, disallowing both the foreign earned income exclusion and the deduction for the housing allowance on Schedule C. Since the Schedule C adjustment resulted in self-employment income, the IRS added a deduction for one-half of self-employment tax to each return After these adjustments, the corrected tax liability for 2017 and 2018 was $26,407 and $22,943, respectively.

Henaire challenged the IRS’s determinations for 2017 and 2018 in Tax Court.

Issues: The main issue was whether Henaire was entitled to a foreign earned income exclusion and foreign housing exclusion despite waiving these exclusions in a closing agreement.  Under Sec.  911(a), a “qualified individual” as defined in Sec.  911(d)(1) may elect to exclude their foreign earned income (up to the annual exclusion amount allowed in Sec.  911(b)(2)(D)).  To do so, Henaire needed to prove that the closing agreement in which she waived her right to make a Sec.  911(a) election was invalid and that she was a qualified individual. First, the court considered the validity of Henaire’s closing agreement. Although under Sec.  7121(b)(1), a closing agreement approved by the IRS is “final and conclusive … except upon a showing of fraud or malfeasance, or misrepresentation of a material fact,” Henaire made three arguments to support her position that her closing agreement was invalid.

Henaire first contended that Palacheck lacked the authority to have signed the agreement on the IRS’s behalf.  Regarding Palacheck’s authority, the court had previously held that she was authorized to sign another closing agreement in Smith, 159 T.C. 33 (2022).  The Smith case pertained to an agreement Palacheck signed on the same day as Henaire’s, and the taxpayer in that case, Cory Smith, was also employed at the JDFPG site (see “Engineer Cannot Escape Closing Agreement,” The Tax Adviser, November 2022).  The court held that Smith was the controlling authority on Palacheck’s authority to sign and that its holding in that case applied to Henaire.  In Smith, the court found that Internal Revenue Manual Sections 1.2.43.12(14) and (15) (Sept. 7, 2016), gave Palachek the authority to have signed the closing agreement.

Henaire also argued that the IRS committed malfeasance when it procured the closing agreement through a third party, her employer, and thereby disclosed confidential information. She alleged the Service thus violated the Sec.  6103 requirement that tax returns remain confidential.

She further contended that the IRS was not permitted to request the closing agreement from her employer, obtain the closing agreement from her employer, or use her employer to return the closing agreement to her.  Henaire claimed that the three “consent to disclosure” forms she signed after she executed the closing agreements were proof of the IRS’s malfeasance because the IRS thereby attempted “to remedy their [sic] illegal acts.”

The court, however, found that the IRS had not requested a closing agreement from Henaire, and, as it had held in Smith, using an employer as an intermediary between the taxpayer and the IRS does not constitute IRS malfeasance.  Furthermore, the court found that even if it accepted that the IRS’s requests for her to sign the consent for disclosure forms were admissions of its malfeasance, as Henaire suggested, they would not be grounds for setting aside the closing agreements because the only possible violation of Sec. 6103 through the requests for the forms occurred after the closing agreements were finalized.

Finally, Henaire argued that a provision of the Pine Gap agreements contained a material misrepresentation, but the Tax Court concluded that she had not advanced a valid argument for setting aside her closing agreement on these grounds.

The court interpreted her argument as asserting that “the waiver of her right to elect either or both of the section 911(a) exclusions was unnecessary for her Pine Gap wages to be treated as ‘not exempt’ and ‘brought to tax’ in the United States.” This, the court stated, was a question of law, not of fact.  As the court had held in Smith, under Sec.  7121(b), while a misrepresentation of fact provides grounds for invalidating a closing agreement, misrepresentations of law do not. Moreover, the court found that even if Henaire had prevailed with any of her three arguments regarding the agreement, to exclude her wages under Sec.  911(a)(1), she would also need to prove that she was a qualified individual under Sec.  911(d)(1), i.e.:

an individual whose tax home is in a foreign country and who is:

(A) a citizen of the United States and establishes to the satisfaction of the [IRS] that he has been a bona fide resident of a foreign country or countries for an uninterrupted period which includes an entire taxable year, or

(B) a citizen or resident of the United States and who, during any period of 12 consecutive months, is present in a foreign country or countries during at least 330 full days in such period.

While the IRS conceded that Henaire met the Sec.  911(d)(1)(B) physical-presence test, the court agreed with the IRS that she had not established her tax home in Australia. Sec.  911(d)(3) defines a “tax home” as a taxpayer’s “home for purposes of section 162(a)(2).” Sec.  162(a) indicates that the tax home is often near a taxpayer’s place of employment rather than personal residence (Wentworth, T. C. Memo.  2018-194; Mitchell, 74 T.C. 578 (1980)).  However, Sec. 911(d)(3) goes on to say that 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.”

The concept of “abode” versus “home” means that a taxpayer’s “familial, economic, and personal ties” should be considered (Wentworth; Bujol, T.C. Memo.  1987-230).  The fact that Henaire visited the United States several times and the lack of evidence in the record regarding such signs of an abode in Australia as her address there on a driver’s license or bank accounts or involvement with Australian civic or religious organizations led the court to conclude she had not met her burden of proof establishing that her domestic home and abode were not in the United States.

Regarding the value of the housing she was provided, Henaire argued in Tax Court that she was entitled to the Sec.  911(a)(2) foreign housing exclusion for that amount. The court rejected this argument for three reasons.  The court first found that the exclusion was available only to qualified individuals who elect the exclusion and, as it had already determined with respect to the foreign earned income exclusion, she was not a qualified individual.  Also, as the court had previously determined, she had signed a valid closing agreement in which she agreed not to elect the foreign housing exclusion, which precluded her from electing the exclusion.  In addition, even if she otherwise could elect the exclusion, under the formula for calculating the exclusion amount, her excludible housing cost amount for 2017 and 2018 was zero.

Henaire argued in the alternative that she could exclude it from her gross income under Sec.  119(a) as the value of lodging furnished to her for her employer’s convenience.  However, she did not establish that the housing was for the convenience of her employer, that she was required to accept it as a condition of employment, or that the housing qualified as part of her employer’s business premises, as required by Sec.  119(a), so the Tax Court concluded she was not eligible for any Sec.  119(a) housing exclusion as well.

Holding: The Tax Court held that Henaire was not entitled to the Sec. 911(a)(1) foreign earned income exclusion for her income from her work in Australia with Northrop Grumman at JDFPG in 2017 and 2018 and she was also not entitled to either the Sec. 911(a)(2) foreign housing exclusion or the Sec.  119(a)(2) exclusion for the value of housing that she was provided while working at JDFPG during those years.  The court determined that her closing agreement waiving the Sec. 911 exclusions for those years was valid and could not be set aside and that, even if it could be, Henaire was not a qualified individual under Sec. 911(d) eligible to take the exclusion.

Also, because the housing was not provided during those years for the convenience of her employer, as a condition of employment, or that the housing was on her employer’s premises, she was not entitled to an exclusion from income under Sec. 119(a)(2).

■ Henaire, T.C. Memo.  2023-131 .

— Thomas Godwin, CPA, CGMA, Ph.D., and John McKinley, CPA, CGMA, J.D., LL.M., are both professors of the practice in accounting and taxation in the SC Johnson College of Business at Cornell University. To comment on this column, contact Paul Bonner, the JofA‘s tax editor.