American expats warned of further scrutinization by the IRS of their tax returns

US expats working and living abroad claiming the Foreign Earned Income Exclusion (FEIE) are being warned to expect further oversight by the Internal Revenue Service (IRS) in a recent report released by the Treasury Inspector General for Tax Administration (TIGTA).

To prevent double taxation of taxpayers who are earning foreign income whilst living overseas the IRS code section 911(a) provides for the Foreign Earned Income Exclusion (FEIE) and the Foreign Housing Exclusion/Deduction. In 2012 this amount the FEIE allowed taxpayers to exclude foreign earned income of up to $95,100 (in 2014 the amount is $99,200). Taxpayers qualifying for this relief and who are working in a foreign country may also claim a limited exclusion or deduction for the amount of their housing expenses. These benefits can significantly reduce or eliminate taxpayers’ US income tax liabilities regardless of whether they paid any foreign income taxes.

Around 0.25% of individual income tax returns filed for the 2009 tax year included a Form 2555/2555-EZ, Foreign Earned Income/Foreign Earned Income Inclusion. In this form the following exclusions, credits and deductions were claimed:

  • $23.3 billion in the FEIE.
  • $5 billion in Foreign Tax Credits.
  • $2.7 billion in Foreign Housing Exclusions.
  • $102.6 million in Foreign Housing Deductions.

By analysing a sample of these tax returns TIGTA estimated that U.S. taxpayers living and working in foreign countries who claimed the FEIE reduced their Federal income taxes by $562 million. Taxpayers claiming the Foreign Housing Exclusion/Deduction reduced their Federal income taxes by an additional foreign income while residing overseas, Internal $174 million for Tax Year 2009.

During the 2009 – 2011 fiscal years 99% of tax returns examined where a Form 2555/2555-EZ was present were not referred to an international examiner as required by IRS procedures. TIGTA estimated that by improving the auditing referral process $13.5 million in additional tax assessments could be collected over the next 5 years. Additionally, tax returns that were not required to be referred but which could have warranted referral to international examiners could potentially results in $7.5 million in additional tax assessments over the next 5 years.

TIGTA recommended that the IRS ensure that domestic examiners and their managers are aware of international referral criteria and that the international referral criteria process be evaluated to determine whether it should be expanded to include the Wage and Investment Division. IRS officials agreed with the recommendations of the TIGTA report and intend to take corrective actions.