The Internal Revenue Service lost an estimated $90 million in revenue for tax year 2008 because of erroneously claimed foreign earned income tax exclusions, according to a new government report.

J. Russell George

If an individual is a U.S. citizen or resident alien, their worldwide income generally is subject to U.S. income taxes, regardless of where they live, and is subject to the same income tax filing requirements that apply to U.S. citizens or resident aliens living in the U.S. However, the foreign earned income tax exclusion allows a taxpayer to exclude up to $91,500 of foreign earned income. A taxpayer qualifies for this exclusion if he or she has foreign income and a home in a foreign country. An eligible taxpayer designates this status by filing Form 2555 (Foreign Earned Income) with the IRS. Taxpayers excluded $19.2 billion in foreign earned income on their tax year 2008 tax returns.

The report, by the Treasury Inspector General for Tax Administration, examined 231,277 tax returns from tax year 2008 and found that 23,334 (10 percent) taxpayers claiming the exclusion either failed to qualify for the exclusion or inaccurately computed the exclusion.

The income erroneously excluded totaled $675 million, while the estimated tax avoided totaled $90 million. Over five years, TIGTA estimates that the erroneous claims could result in total revenue losses of $450 million.

Using information on the completed Form 2555, TIGTA that 17,787 (8 percent) individuals overstated their foreign earned income exclusion by $410 million. In addition, 5,547 (2 percent) tax returns with $265 million in exclusions had incomplete information or inaccuracies on the Forms 2555.

“This is very troubling,” said TIGTA Inspector General J. Russell George in a statement. “Over five years, the estimated revenue loss to the IRS could total more than $450 million. Improvements must be made to reduce erroneously claimed foreign earned income tax exclusions.”

TIGTA made seven recommendations to the IRS in the report, and the IRS agreed with four of them. TIGTA recommended that the commissioner of the IRS’s Large and Mid-Size Business Division review the tax returns of those individuals that TIGTA identified as incorrectly claiming the foreign earned income exclusion; establish a unit to address taxpayers identified as erroneously claiming the foreign earned income exclusion; and assess whether compliance project criteria can be used to identify erroneous claims during tax return processing.

In addition, TIGTA recommended that the Commissioner of the IRS’s Wage and Investment Division include programming to forward tax returns (both electronically filed and paper) to the IRS’s Error Resolution System for correction for individuals who incorrectly compute their foreign earned income exclusion.

IRS management agreed with four of the seven recommendations, but stated that substantial barriers prevent the implementation of the remaining three recommendations at this time. TIGTA said it is concerned that the lack of corrective action will allow continued revenue loss as noted in its report.