Prompted by the COVID-19 global health emergency (the “COVID-19 Emergency”), Treasury and the IRS recently issued Rev. Proc. 2020-27 to provide relief for U.S. citizens and residents planning to take advantage of the foreign earned income exclusion under section 911 of the Internal Revenue Code whose expatriate assignments were interrupted due to the pandemic. The Revenue Procedure waives the time requirements of section 911(d)(1) for those individuals who reasonably expected to meet such requirements during 2019 and 2020, but for the COVID-19 Emergency interrupting normal business activities and forcing their return to the United States within certain time periods identified in the Revenue Procedure.
The Foreign Earned Income Exclusion
The foreign earned income exclusion under section 911 provides a significant U.S. tax benefit for a U.S. citizen or resident who maintains their tax home outside of the United States and satisfies either the bona fide residence test (i.e., a bona fide resident of a foreign country or countries for an uninterrupted period that includes the entire tax year) or the physical presence test (i.e., spends 330 days or more of the year outside of the United States). For purposes of this post, assume that a U.S. resident established tax residency based upon their immigration status as a lawful permanent resident of the United States and not under the substantial presence test. (For a recent post that discusses the substantial presence test, click here.)
For purposes of section 911, an individual’s tax home is generally considered to be the location of the individual’s principal place of business. Although the term suggests a mere place of residence, an individual’s tax home is the area in which an individual generally reports to work, not necessarily the area where the person lives. For example, if an individual lives in Tampa and commutes each day to work in Orlando, the individual’s tax home is Orlando where the individual works, not Tampa where the individual lives.
To claim the foreign earned income exclusion, an individual must file Form 2555 (Foreign Earned Income) with their Form 1040 (U.S. Individual Income Tax Return). Although U.S. citizens and residents must pay U.S. income tax on their worldwide income, the foreign earned income exclusion provides for a significant income exclusion for income earned abroad. The foreign earned income exclusion is adjusted annually for inflation. For 2019, the maximum foreign earned income exclusion is $105,900, and for 2020, the maximum exclusion is $107,600. Under certain circumstances, the value of lodging and employer-provided meals may also be excluded. Importantly, the tax benefit for purposes of the foreign earned income exclusion is limited in that it applies to the income earned at the lowest applicable marginal rates. In other words, income earned in excess of the exclusion is taxed at marginal income tax rates as if the exclusion had not been taken.
Waiver of the Time Requirements for the Bona Fide Residence Test and Physical Presence Test
Section 911(d)(4) provides for an exception to the time requirements under the physical presence test and the bona fide resident test if the Secretary of the Treasury, after consulting with the Secretary of State, determines that individuals were required to leave a foreign country due to war, civil unrest, or similar adverse conditions that preclude the normal conduct of business. The IRS issued Rev. Proc. 2020-27 recently to establish that such adverse conditions exist with respect to the COVID-19 Emergency, and that a “qualified individual” may still exclude foreign earned income for the period in which the individual was actually present in the foreign country even if the individual fails to meet certain time requirements. To qualify for relief, an individual must establish the following.
1. The individual must have established residency, or have been physically present in either:
- the People’s Republic of China on or before December 1, 2019; or
- any other foreign country on or before February 1, 2020;
2. The individual must have departed either:
- the People’s Republic of China (excluding the Special Administrative Regions of Hong Kong and Macau) between December 1, 2019, and July 15, 2020; or
- any other foreign country between February 1, 2020, and July 15, 2020; and
3. The individual would have met the requirements of either the bona fide residence test or the physical presence test, but for the COVID-19 Emergency.
Examples Applying the Exception
Two examples are provided in the Revenue Procedure that highlight key aspects of this relief. The first example describes an individual who reasonably expected to work in China from September 2019 through September 2020, but had to depart China on January 10, 2020, due to the COVID-19 Emergency. The example explains that the individual may exclude the foreign earned income earned from September 1, 2019, through January 9, 2020. This example highlights that the relief is only available for the period in which the individual actually worked in the foreign country. If, after returning to the United States, the individual resumes work, the income earned from the services performed in the United States cannot be excluded under section 911.
The second example describes an individual who reasonably expected to work in the United Kingdom for the entirety of 2020. The individual departed the United Kingdom on March 2, 2020, due to the COVID-19 Emergency and then returns to the United Kingdom and resumes work from August 25, 2020, through the end of the calendar year. The example notes that the individual may take advantage of the relief provided under Rev. Proc. 2020-27 and exclude the foreign earned income earned from January 1, 2020, through March 1, 2020, and from August 25, 2020, through December 31, 2020. This example highlights that (1) the individual is not required to return to the foreign country by July 15, 2020, even though it is the end of the period covered by Rev. Proc. 2020-27, and (2) foreign earned income earned after the period covered by Rev. Proc. 2020-27 is eligible for the relief and may be excluded from income if the conditions are satisfied.
To request an exemption from employer withholding on income subject to the foreign earned income exclusion, an employee may provide their employer with Form 673 (Statement for Claiming Exemption From Withholding on Foreign Earned Income Eligible for the Exclusion(s) Provided by Section 911). Based upon the Form 673 instructions, an employer may reduce or eliminate federal income tax withholding on applicable wages. However, the form instructions state that an employer should disregard the Form 673 if the employer believes the employee will not qualify for the exclusions.
As a technical matter, an employer is not required to withhold federal income taxes from an employee under section 3401(a)(8)(A) if it is reasonable to believe that the employee will exclude the wages from income under section 911 regardless of the employer’s receipt of a Form 673. As a practical matter though, it makes tremendous sense for employers to obtain Forms 673 from employees on foreign assignment and retain such forms in the event of an employment tax audit. IRS employment tax audits often occur years later, and employers should document and retain support for not withholding from employees working abroad to refute withholding challenges by examiners. It is not unusual for IRS employment tax examiners to scrutinize an employer’s treatment of fringe benefit issues and withholding taxes as they related to U.S. expatriate employees, and the premature disposal of key documents supporting such treatment can result in significant exposure.
Rev. Proc. 2020-27 does not address how employers should handle Forms 673 received from employees who were forced to return to the United States due to the COVID-19 Emergency. Employers should be cognizant that despite receiving a Form 673 from an employee on foreign assignment, the employer may need to terminate its reliance on the form if the employee returns to work in the United States in 2020. If the employee later returns to their foreign assignment in 2020, the employer should address the need for a revised Form 673 with the employee that correctly reflects the new dates to be spent outside of the United States, and the relief provided under Rev. Proc. 2020-27 for federal income tax withholding.