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Airline Pilot Did Not Qualify for Foreign Earned Income Exclusion; Not Liable for Self-Employment Tax

(Parker Tax Publishing November 2017)

The Tax Court held that an airline pilot who worked for a Korean airline was not entitled to the foreign earned income exclusion because he was not a bona fide resident of Korea. However, although his employment agreement stated that he was an independent contractor, the taxpayer was not liable for self-employment tax because he was properly classified as an employee given the degree of control the airline exercised over his work. Hudson v. Comm'r, T.C. Memo. 2017-221.

Robert Hudson is a retired airline pilot who worked for 26 years as a commercial pilot and 8 years as a pilot for the Air Force Reserves. After retiring, Hudson sought employment with foreign airlines because of their policies of maintaining pilot seniority. He decided to apply for a position with Korean Airlines (KAL). He applied through a recruiting agency, Global Airline Pilots (GAP). During the interview process, Hudson was required to pass a simulator ride, complete a physical examination, and interview with KAL management. He did not interview with any representatives of GAP.

Hudson was offered and accepted a position with KAL. He signed an agreement with GAP stating that he would be an independent contractor and not an employee of the airline or GAP. The agreement had a five year term and stated that Hudson's flight base was in Korea. Hudson was required to undergo training at the KAL facility, complete a simulator program, and pass a Korean air law exam. While flying with KAL, Hudson was bound by the airline's policies and procedures as listed in the employee manual he received.

Hudson was based in Inchon, South Korea, and lived in a hotel owned and paid for by the airline. He stored large suitcases of his belongings at the hotel while he was away and would have these belongings brought to his room when he checked in. There was a designated area for Hudson to cook his meals, although he mostly ate out with friends. His activities included riding a bicycle provided by the hotel, using the hotel's golf course, and exercising. On long breaks, Hudson would travel to a nearby town. He learned basic phrases in Korean, such as greetings and terms necessary to order food in restaurants. He had a Korean bank account and a Korean cell phone for a limited time.

Under KAL's layover policy, Hudson had layovers outside Korea that could last for days at a time. He received 9 days off per month, which the airline typically gave in blocks, and 24 vacation days per year. Hudson would request to use his vacation days in the same period as his days off. He had the option of traveling at no cost to any city where KAL flew direct. He seldom spent his vacation time in Korea. Instead, Hudson sought to spend all of his time off, as many as 132 days per year, in the U.S. with his wife, who lived in Chicago and Arizona.

KAL did not pay Hudson directly. Rather, it transferred his salary to GAP, which in turn withheld Korean taxes and GAP's fees and then deposited the remainder into Hudson's U.S. bank account. Hudson also received per diem allowances which were deposited into his Korean bank account. He received an annual Korean tax statement listing him as a nonresident. Hudson did not view himself as a permanent resident of Korea, but as a registered alien paying Korean taxes.

Hudson sought professional advice from an accountant and a lawyer regarding his U.S. tax liabilities. His accountant was recommended by GAP as experienced in preparing returns for American pilots working for KAL. Hudson excluded his foreign earned income under Code Sec. 911 based in information provided by the accountant. He also filled out a questionnaire provided by his lawyer, who advised that he was eligible for the exclusion.

The IRS sent a notice of deficiency disallowing Hudson's foreign earned income exclusion for 2011 and 2012 on the basis that he failed to establish either bona fide residence or physical presence in a foreign country for the relevant period. The IRS also determined a self-employment (SE) tax deficiency. A 20 percent accuracy-related penalty was applied for the years at issue.

The Tax Court held that Hudson was not entitled to the foreign earned income exclusion, was not liable for SE taxes, and that the accuracy-related penalty did not apply. The Tax Court determined that Hudson was not a bona fide resident of Korea for the years at issue as required under Code Sec. 911 because he did not intend to be anything more than a transient, and always intended to return the U.S. The Tax Court found that Hudson intended to spend all of his time off in the U.S. and sought to travel to his home in the United States as often as work would allow. Although the record did not specify the number of days Hudson spent on duty in Korea versus off duty in the U.S., the Tax Court noted that Hudson had as many as 132 days off per year and intended to spend that time in the United States. Further, Hudson's limited contacts with Korean culture, combined with his extended absences, precluded a finding that he was a bona fide resident of Korea, according to the Tax Court.

Next, the Tax Court held that Hudson was not liable for SE tax on the income he earned while working for KAL. The Tax Court found that Hudson was an employee of KAL, not an independent contractor, because KAL exercised considerable control over his work. The Tax Court explained that Hudson was required to abide by the policies and procedures listed in the employee manual. Moreover, his schedule, including his vacation and the length of his layovers, was determined by KAL. The Tax Court also found that the GAP agreement was not determinative of Hudson's work status, reasoning that if the relationship of employer and employee exists, a different designation or description of the relationship by the parties is immaterial.

Finally, the Tax Court concluded that Hudson was not liable for an accuracy-related penalty because his reasonable reliance on professional advice constituted reasonable cause and good faith. Hudson gave his accountant the information necessary to accurately prepare his returns, and he filled out a questionnaire provided by his lawyer to determine his eligibility for the foreign earned income exclusion. His reliance on these qualified professionals constituted reasonable cause and good faith, in the Tax Court's view.

For a discussion of the foreign earned income exclusion, see Parker Tax ¶78,600. For a discussion of self-employment taxes. See Parker Tax ¶13,100. For a discussion of the accuracy-related penalty, see Parker Tax ¶262,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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