The update below was provided by Fairfield Hughes, CPAs, a professional tax preparation and consulting services company with expertise assisting individuals living and working outside of the country – specifically OCONUS contractors.



Generally you will receive the first $97,600 (for 2013) of your income earned in a foreign country tax free provided that:

a. You were physically present in a country other than the U.S. for at least 330 days out of a 365 day period.  This does not have to have been completely in the 2013 calendar year as a prorated partial exclusion can be obtained by extending your tax return until the 330 day period is up.  You will still only file using the 2013 calendar year income but your test period for the physical presence test may run from June 2012 – June 2013 or any other dates spanning 365 days.  What this does NOT mean is that you can have less than 330 days overseas out of a 365 day period and still take a prorated exclusion.  This is a persistent myth and is absolutely not true.

b. You were a bona fide resident of a country other than the U.S. during 2013.  Many OCONUS contractors have received residency Visas from Iraq this year.  This is not enough proof to prove bona fide residency per the IRS.  Filing under this method requires that you are a foreign resident for the full year starting Jan 1.  No partial year exclusion is available.  Based on the current audit situation, using this method has become more risky than in the past.

Filing Form 673… all that filing this form will do is exempt you from tax withholding; contrary to rumor it is NOT required to claim NOR does it qualify you to claim the foreign income exclusion.  Additionally, some companies now add the cost of travel, incidentals, meals, reimbursements, etc. to the taxable income of employees filing Form 673.  This causes you to be taxed on income that you never received.  The best alternative to regulate tax withholdings is to file a Form W4 with your payroll department and claim a large number of allowances on line 5.  Generally between 9 and 15 allowances will have enough withheld to cover your tax bill but you can also write in “exempt” or claim up to 99 allowances to drop withholding to close to zero if you do not expect to owe any tax.

CAUTION: If you choose to file this form, be aware that you may be short on federal income tax withholding if you are injured and unable to remain overseas. This could result in a very large tax bill when your return is prepared.

Keep a list of job related expenses – these are deductions for you.  This can include travel, meals, weapons, supplies, body armor, computer, auto, telephone, postage, etc.  A simple spreadsheet with yearly totals is the best way to provide this to me.  Please do not send receipts; I can provide a very simple spreadsheet template for you to record your eligible expenses.

There is a vast difference in what can be deducted for an IC versus an IE.  As an IC (you receive a 1099), all expenses related to your work are deductible.  As an IE (you receive a W2), only expenses required by your employer but not reimbursed are allowed as deductions and under audit the IRS will require a letter from your company detailing this.  Needless to say, this is impossible to obtain from many of the companies.  You can continue to deduct work related expenses as an IE but be aware that deducting too much can quickly put you on the radar.

You are generally eligible for an additional extension of time to file and pay your taxes.  You have 180 days from the time you return to the states to file any missing tax returns without penalty. if you were in a combat zone.  That being said, file on time if you can.

In many cases starting an S-Corp or an LLC is a good move. If properly structured it allows you a savings on what you would otherwise pay in self-employment tax.

What does your accountant need from you? Every situation varies but in general, W-2s, 1099s, amount added to income due to the 673, list of work related expenses, foreign address and city you worked out of and any other tax documents you receive relating to home mortgages, property taxes, investments and other income.

For ICs working for companies paying you as an independent contractor (1099): Do not forget that the IRS will take 15% right off the top of your net income as self-employment tax.  You will also pay regular income tax on the earnings.  In addition, the foreign income exclusion of $97,600 does not apply to the self-employment tax calculation even though you will get the exclusion in the calculation of income tax.  This can result in a very large, very surprising tax bill.  Be aware of this and plan accordingly when saving for taxes.

Important Updates for 2013:

  • Please check our website at  It has some valuable info and answers to many frequent questions.
  • It is critically important that you retain copies of your Diplomatic passport and regular passport, overseas orders, LOAs, overseas expense receipts, VISAs and anything else that can prove you were overseas in a combat zone.  Keep these for at least 5 years.  Do not turn in your passports without making a scanned, color copy of them.
  • Should they choose to do so under audit, the IRS now has the ability to obtain an entry report from CBP and Homeland Security to verify your time in the US.
  • Audits on the foreign income exclusion have greatly increased. As a result, I would recommend being even more cautious in claiming the foreign income exclusion in 2013.
  • To qualify as a bona fide resident under IRS audit guidelines, you need to prove that you rent or own a dwelling overseas, do not have an abode in the US, pay foreign taxes, do not maintain a US driver’s license and in general do not have any social or economic ties to the US.  In my opinion this is nearly impossible to prove and the IRS is taking full advantage of this fact.
  • Typical penalty on additional tax due under audit is 20%.  It has been possible to have that waived in many cases if combat zone work location can be proved BUT that is not always the case.
  • If you are claiming the exclusion under the physical presence test (330 day rule), some IRS offices are now requiring that your “abode” be outside the US to qualify.  Unfortunately this term is not defined in the tax code and the IRS is using some very old court case ruling to say that it is where you maintain your social and economic ties.  For those of you with family in the US, this can raise an issue.
  • In a typical audit, you are asked to provide some or all of the following:

a. A letter from your employer stating your work location and job duties for the year.
b. Letter of Authorization from the DOD stating your qualification to work overseas.
c. Copy of your passport to include any visa stamps.
d. A schedule of days outside the US for the period in question.
e. A copy of receipts for expenses claimed as deductions.
f. A copy of your work contract.
g. If claiming bona fide residency, they want to know where you lived, for how long and if it was your intention to remain overseas for a certain period.

  • If you do not think you could provide the above information or prove your qualification think twice about claiming it as you will most likely incur a 10 – 20% penalty on the additional tax due.
  • Audit results have varied and can depend on who the auditor is which is also frustrating.  What one auditor allows is often not enough for another and different IRS offices frequently handle issues in different ways.
  • Afghanistan Tax:

a. Tax paid to a foreign country can be claimed as a credit on your US tax return (Form 1116).
b. The credit can be combined with the foreign income exclusion if you qualify but the foreign tax credit is partially reduced when both are used, making this a complex calculation.
c. In general, claiming the tax credit on foreign tax paid can be a better tax break than the foreign income exclusion alone meaning that if you are nervous about claiming the foreign income exclusion, you can skip it and may still get about 85% of the tax break you would have received by claiming both.

Luke M. Fairfield
Certified Public Accountant

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