The Treasury Inspector General for Tax Administration (TIGTA) issued an audit report on December 12, 2013, recommending that the Internal Revenue Service increase its scrutiny of tax returns claiming the Foreign Earned Income Exclusion. The report, which is entitled “The Referral Process for Examinations of Tax Returns Claiming the Foreign Earned Income Exclusion Needs to Be Improved,” is available here.
By way of background, to alleviate double taxation of taxpayers earning foreign income while residing overseas, IRC Section 911(a) provides for the Foreign Earned Income Exclusion (FEIE) and the Foreign Housing Exclusion/Deduction. For Tax Year 2012, the FEIE allowed taxpayers to exclude foreign earned income of up to $95,100. Qualifying taxpayers living and 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’ U.S. income tax liabilities regardless of whether they paid any foreign income taxes.
TIGTA found that of approximately 140 million individual income tax returns filed for tax year 2009, 372,119 (or 0.27 percent) tax returns included a Form 2555/2555-EZ, Foreign Earned Income/Foreign Earned Income Exclusion. The exclusions, credits, and deductions claimed were as follows:
- $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.
From a statistical sample of 2009 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 $174 million for 2009.
In addition, during FY2009 through FY2011, 2,851 (or 99 percent) of the 2,876 individual income 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 improving the audit referral process could result in approximately $2.7 million in additional tax assessments, or $13.5 million over five years. Moreover, 1,583 examinations that were not required by the IRS to be referred might warrant referral to international examiners. Referral of these tax returns could potentially result in approximately $1.5 million in additional tax assessments, or $7.5 million over five years.
As a result of its audit findings, TIGTA recommended that the IRS ensure that (1) domestic examiners and their managers are aware of the international referral criteria and (2) the international referral criteria process is evaluated to determine if it should be expanded to include the Wage and Investment Division. In their response to the report, IRS officials agreed with the recommendations and plan to take corrective actions.