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Civilian Contractor Alert-Tax Avoidance versus Tax Evasion

I have frequently heard it said by non tax people, including those in the U.S. military, that it was their understanding that civilian contractors employed in a combat zone, say in Iraq or Afghanistan, do not pay U.S. income tax on their salary earned overseas. Although the U.S. tax law does provide for a tax exemption for military pay while serving in a combat zone, this law does NOT apply to workers who are not employed by the U.S. military. Although some may consider this to be discriminatory (in which case they need to take this up with their local congressional elected officials to convince them to submit a Congressional bill), there is nothing in the U.S. tax law that provides such an exemption.

First let me explain the difference between exempt income and excluded income. Exempt income is that which by law is not taxed  and not required to be included in a U.S. person's income tax return. A member of the U.S. military who receives a W-2 from the DoD does not have combat pay included as wages subject to tax and therefore it is not reported on line 7 of Form 1040. On the other hand, a person who's income may qualify for an exclusion, such as the foreign earned income exclusion (FEIE) under Section 911 of the U.S. Tax Code, is required to report the gross income on line 7 of the tax return and then subtracts the permitted exclusion on line 26 as a negative "other income" amount.

In order to qualify for the FEIE certain conditions must be met. However it has been brought to my attention that there are some civilian contractors who, although they have families here in the U.S., have not done anything to abandon their U.S. abode, and spend a significant amount of their leave time returning to the States and residing with their families, may be filing Form 2555 and claiming that they are bonafide residents of Iraq and by using their Iraq mailing address (often an APO), they hope to "sneak the return by the IRS" while claiming the maximum allowed FEIE using the bonafide resident test. This is tax evasion, not tax avoidance and illegal. They are filing a tax return with intentional disregard for U.S. tax law and the underlying rules and regulations.

Beside being illegal and putting themselves in jeopardy, they are causing the IRS to scrutinize tax returns of all U.S. expatriates who, although may be in total compliance wit the U.S. tax laws, may end up having to undergo the expense and significant inconvenience of a U.S. tax audit, while also being potentially subject to an erroneous assessment by an inexperienced or overzealous IRS agent. Also, this increases the possible perception that the FEIE is a tax loophole that must be closed, without regard for the underlying purpose of the FEIE provision which is to mitigate duplication of costs and foster a more equitable employment and business environment for U.S. multinationals.

Said a different way, their decision to cheat on their income tax return is making it bad for everyone. 

Either you qualify for the FEIE or you do not, it is that simple. Given today's economic situation, more and more Americans are seeking employment overseas rather than be unemployed here in the U.S. This does not give them the right to evade paying their fair share of income tax and abide by U.S. tax laws. Those who want to minimize their U.S. tax bill on foreign earnings should take necessary planning steps to do what is required to qualify for the exclusion.

Those who feel that it is unfair or discriminatory that members of the U.S. military are exempt from taxation on their combat zone earnings should take this up with the appropriate authorities and do what they can to change the law. Given that since terminating the draft in 1973 the U.S. military has become dependent upon civilian contractors and their employees to fill the boots as regards jobs once done by military draftees, maybe there should be some sort of equitable tax legislation as an incentive for U.S. persons to work in combat zones (rather than being unemployed here in the U.S.), but this requires an amendment to the U.S. tax laws which starts with a Congressional Bill.

For those who want to cheat on their taxes  preparing it in a way that they hope will "slip by", the IRS is looking for you, and will not view this favorably. Although many of these returns have been audited by the IRS and the exclusion disallowed and the agents have used their discretion to not impose the substantial underpayment penalty, this penalty abatement is discretionary and merely working in a combat zone does not automatically entitle you to penalty relief.

 

 

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