TAX NEWS - DECEMber 2009

Foreign Income Exclusion for Individuals Providing Personal Services to a Federal Agency

BY KEVIN MACKESEY, FSLG SPECIALIST (FEDERAL GROUP)

It is important for agencies of the United States to properly establish whether a U.S. citizen or a resident alien of the United States who is providing personal services overseas is a common-law employee. Incorrect classification can result in improper claims by the individual for the foreign earned income exclusion, the foreign housing exclusion, and the foreign housing deduction.

Under IRC section 911(a)(1), a qualified individual may elect to exclude from gross income a certain amount of foreign earned income, subject to certain limitations. Under section 911(b)(1)(B), foreign earned income does not include amounts paid by the United States or its agencies to its employees or agencies.

Under section 911(a)(2), a qualified individual may elect to exclude from gross income the housing cost amount, subject to certain limitations. Under section 911(c)(4), a qualified individual may deduct the housing cost amount to the extent the housing cost amount is not attributable to employer provided amounts, subject to certain limitations.

Federal Acquisition Regulation (FAR) section 2.101 states that a "personal services contract" means a contract that, by its express terms or as administered , makes the contractor personnel appear to be, in effect, Government employees.

In determining whether a services contract is personal or nonpersonal, FAR section 37.104(c)(2) provides that, "each contract arrangement must be judged in the light of its own facts and circumstances, the key question always being: Will the Government exercise relatively continuous supervision and control over the contractor personnel performing the contract."

A person is an employee if the relationship between that person and the person for whom he or she performs services is the common-law relationship between employer and employee. This relationship exists when the person for whom services are performed has the right to control and direct the individual who performs the services, not only as to the result to be accomplished but also as to how the result is accomplished. An employee is subject to the will and the control of the employer concerning not only what is to be done but how it is to be done (Treas. Reg 31.3401(c)-1(a) and (b); 31.3121(d)-1(c); 31.3306(i)-1(a) and (b)). All the facts and circumstances of each case are considered, and no single factor is dispositive. For more information on determining whether a worker is an employee, see Publication 15-A.

While there are substantial similarities between the criteria used to determine whether a worker is providing personal services rather than non-personal services under federal government contract law, and the common-law factors used by the IRS to determine whether a worker is an employee or an independent contractor, the factors are not identical. The FAR is silent as to whether or not workers under personal services contracts with an agency are employees for federal tax purposes. A federal agency must consider the IRS common-law tests in determining whether a personal services contractor is an employee or an independent contractor.

After considering the common law tests, if the federal agency determines the worker is an employee, it must treat the worker for federal tax purposes as an employee and the individual's pay from the U.S. government does not qualify for exclusion or deduction.

If you have questions about whether the person providing personal services is an employee or an independent contractor, see Publication 15-A, Employer's Supplemental Tax Guide.