Foreign Earned Income Exclusion Only Available to Ocean Going Crew Member for Portion of Trip in Foreign Territorial Waters

Wendell Wilson lived in Mexico and was an engineer on ocean going container ships during the years in question.  In the case of Wilson v. Commissioner, TC Summary Opinion 2016-19 the issue was whether and to what extent Mr. Wilson was eligible for the foreign earned income exclusion under IRC §911(a)(1)

That provision provides:

(a) Exclusion from gross income

At the election of a qualified individual (made separately with respect to paragraphs (1) and (2)), there shall be excluded from the gross income of such individual, and exempt from taxation under this subtitle, for any taxable year—

(1) the foreign earned income of such individual,.

Generally “[t]he term “foreign earned income” with respect to any individual means the amount received by such individual from sources within a foreign country or countries which constitute earned income attributable to services performed by such individual…”

Mr. Wilson undertook voyages that mainly placed him in international waters.  While he lived in Mexico, he would travel for his trips to California which is where his trips both began and ended.  On such trips he would spend time in various foreign ports, as well as in the territorial waters surrounding those areas, though most of his time was spent in international waters.

Mr. Wilson relied upon his long time accountant (Mr. Contract) to prepare his tax returns.  His accountant had prepared his returns for approximately 20 years before the years the IRS examined.  On those returns the accountant had shown Mr. Wilson’s entire income from these trips as eligible for the foreign earned income credit, which Mr. Wilson elected to make use of.

The Court noted:

Petitioner moved to Mexico during 2005, and Mr. Contract, on the basis of petitioner’s place of residence and the fact that he was on ships involved in foreign travel for his work, prepared petitioners’ returns for the taxable years 2005 through 2010 so as to report that petitioner’s income was exempt from U.S. taxation.

The IRS had examined Mr. Wilson’s returns for 2005-2008 and had not changed the return, accepting his designation of all of his income as eligible for the foreign earned income exclusion.

However apparently reasonable that might appear at first glance, there is a problem with this position that the Tax Court pointed out.  It doesn’t agree with the law on the issue as Mr. Wilson performed much of his service in international waters.  Merely income outside the United States does not make such income foreign earned income for these purposes.  Rather the work must be performed in a region under the control of a foreign country.

The Court noted:

This Court has held that income earned in international waters is not excludible under section 911(a). Clark v. Commissioner, T.C. Memo. 2008-71. Accordingly, during the days petitioner earned income in the territorial waters of a foreign country, essentially in a port of a foreign country, his earned income would be exempt under section 911(a).

Based on the number of days Mr. Wilson was in foreign territorial waters and/or foreign ports vs. total days worked, the Court found that only 23% of his income earned in 2009 and 15% of his income earned in 2010 was foreign earned income eligible for the exclusion.

The IRS asserted that Mr. Wilson, in addition to the tax due, should be subject to the accuracy related penalty under IRC §6662 due to the substantial understatement of tax.  While the penalty generally applies if the understatement in excess of the greater 10% of the tax that should have been shown on the return or $5,000, IRC §6664(c)(1) provides that the penalty does not apply if there was reasonable cause for the understatement and the taxpayer acted in good faith.

In this case the Court found Mr. Wilson met this requirement based on his reasonable reliance on a tax professional who just happened to have arrived at the wrong answer.  The Court noted:

Petitioner had employed his preparer for 20 years and relied upon his expertise to report that petitioner’s income was exempt under section 911(a). The preparer was informed about petitioner’s residence and the facts surrounding his income earned during international voyages on cargo ships. The reporting position had been approved for earlier years, and it was reasonable for petitioners to rely on the preparer under these circumstances. Accordingly, we hold that petitioners are not liable for accuracy-related penalties with respect to any underpayments that may result from our holding on the section 911(a) issue.