One of the more interesting tax returns Bill and I worked on last year was for an employee of a private security firm in Afghanistan. While I’m the expert on foreign income, Bill’s our “go to” guy for all things military. While our client wasn’t working for the US military, he was clearly working with the US military and was definitely working in a combat zone.
Our goal of course was to make sure he didn’t pay more income tax than he was required to pay. I realize we’re not supposed to give preferential treatment to clients, but I gotta confess, we do tend to go the extra mile for our service members and for people who are working to keep our service members alive. (Plus he was just a really nice guy.)
My tactic was to claim a foreign income exclusion (Form 2555). While it reduced the guy’s taxable income, it still left him owing the IRS and we were trying to eliminate that balance due. Bill, coming from the military side, was trying to exclude the income under something called Internal Revenue Code Section 112. This basically excludes income that was earned in a combat zone, so we were thinking we might have something there. But here’s the actual rule:
“Gross income does not include compensation received for active service as a member below the grade of commissioned officer in the Armed Forces of the United States for any month during any part of which such member served in a combat zone.”
The key issue here, we decided, was that the person had to be a member of the Armed Forces to qualify for the income exclusion. And so we advised our client to pay the tax.
What we didn’t know at the time was that a similar case was being heard in Tax Court while we were working on the return. In the court case, Nathaniel J. Holmes v. Commissioner (TC Memo 2011-6), the Tax Court ruled that a civilian working for a private company doesn’t qualify for the combat zone income exclusion. So it turns out, we had been right. Had the case gone the other way, of course, we’d be amending our client’s tax return for FREE!
The bottom line though is – if you’re a private contractor in a foreign country, you won’t be able to exclude your income under the Section 112 rules for income earned in a combat zone. You still may be able to exclude your income (or a portion of your income) under the Foreign Income Exclusion on a Form 2555. Or, if you’re paying tax in the foreign country, there’s also the credit for foreign tax paid on Form 1116. There are options out there, you just have to make sure you’re using the right one.