Discussion:Dumb Question about Foreign Earned Income Exlusion

Many US states treat ALL domiciliaries as tax residents, no matter how long or for what reason they are absent from the state. A person who moves to another US state for employment purposes may change domicile at the same time, depending on the facts. But a US citizen working in a foreign country generally does not establish a new domicile there. Until a new domicile is established, the old one continues (with some exceptions -- some generous case law in Maryland, for example). Some states (NY, NJ, for example) have special rules under which a domiciliary who is absent in a foreign country for a specified period of time is treated as a nonresident; but many states do not have such provisions. You're a resident for tax purposes until you establish a new domicile somewhere else, i.e., move there with the intention of remaining permanently.

Under California law, a domiciliary who is absent from the state for a purpose that is not temporary or transitory is a nonresident. Indefinite employment in a foreign country, coupled with a severing of ties to California at the time of departure, has frequently been held to create nonresidence even though the domicile remained in California. There are a lot of State Board of Equalization decisions on this. Of course, if the taxpayer maintained his or her place of abode in California so as to be able to walk right back into it, and left other ties in California suggesting that the purpose of the absence was temporary, the taxpayer would lose. These cases were extremely fact-driven and when you read the decisions, which necessarily summarize the facts, sometimes it is hard to tell the difference between a taxpayer who wins and one who loses.

In 1993 this problem was fixed by legislation in California. Cal. Rev. & Tax Code Sec. 17014(d) provides a "safe harbor" for domiciliaries who are absent under an employment-related contract for a period of at least 18 months. As long as such a person does not spend more than 45 days of any taxable year in California, he or she is treated as a nonresident for California tax purposes.

So don't say California wants to tax your foreign earned income. No they don't; not if you meet the safe harbor to be treated as a nonresident, even though your domicile remains in California. Of course, if you do not meet the terms of the safe harbor, and you cannot show by facts and circumstances that your absence was not for a temporary or transitory purpose, all of your income will be subject to California tax.

But many other states are MUCH more aggressive than California in taxing foreign income of domiciliaries. Some of those states, however, do conform to the IRC Sec. 911 exclusion.

In the situation you describe, I think I would explain the situation and go by the client's wishes. In other words, how aggressive does the client want to be? If the client clearly intended and expected to be absent for at least 546 days, regardless of the original term of the contract, I'd file as a nonresident (or part-year resident) for the first year, but I'd also advise the client to behave otherwise as if he or she intended to be absent for a long time -- e.g., giving up the place of abode, closing bank accounts, etc., etc., so as to enhance the likelihood of passing the facts-and-circumstances test if for some reason the 546-day requirement is not met. I'd also warn the client that if it turns out the safe harbor is not met, there is a risk of additional tax liability, especially if ties to California are not severed. On the other hand, if the client is uncertain, or wants to take the conservative position and file a claim for refund when the contract is extended, I'd go along with that. Just be sure the client understands the ramifications either way.

He is a German citizen and lives there permanently, with annual visits to the US to see relatives. He also does free-lance work, over the internet, and has no workplace in California.

No clue why he is having US withholding - doubtless this is contrary to German law so he needs urgent advice in Germany.