By Will Grant

After spending eight and half years in the Marine Corps, like a lot of veterans, the Kansas-born officer took a job contracting. He signed on with one of the big, generic-sounding U.S. contractors as a weapons instructor training Afghans in 2011. Like many contracts, the work is hard, hours are long, and conditions are Spartan, but every sunset means good money in the bank. Our contractor spends almost all of his time overseas to make that $220,000 a year. Occasionally he gets a quick furlough stateside to visit friends and family to take care of those numerous nagging chores.

One of those chores is filing federal and state taxes.  Making $200,000 a year is good money, but when he looked at his tax returns he was shocked at how much he had to give right back to the same government that was hiring him. He was aware of the chunky $90,000-plus tax exclusion for expats because he worked overseas. But he was surprised how much he had to cough up in State and Federal taxes.  More than he made back in civilian life—and all in taxes. His fellow contractors had a number of theories and plans to reduce their taxes that involved living offshore, forming corporations and even moving their home address, but this Marine simply paid what his accountant told him to pay and sucked it up.

His girlfriend looked over his tax returns from 2010 and 2011 and suspected he’d overpaid. She invested in a little internet time and phone calls to see exactly what contractors who effectively work and live overseas should pay.  What ensued was a fascinating trip down the tax rabbit hole and fair warning to every contractor that they should seek competent advice as soon as they get their first letter of engagement.

Initially there was much confusion over the use of contractors in the security industry. While the media was arguing “mercenary or contractor” the industry was trying to clarify if security contractors were in fact independent contractors or employees. Bob Wood a lawyer for Wood LLP in San Francisco points out an isolated case in which the IRS actually determined that one security contractor was in fact an employee: “In early 2007, a Blackwater security guard who worked in Afghanistan in 2005 sought back-pay and requested clarification of his status from an IRS office in Vermont. “

On March 30, 2007, the IRS ruled he was an employee. The IRS called Blackwater’s independent contractor classification “without merit.”  While this ruling applied only to one man, the IRS warned that the ruling might “be applicable to any other individuals engaged by the firm under similar circumstances.”

The IRS in this case ruled as it had in many domestic cases of contractor-versus employer-cases, that the working relationship determined the classification, not the employer’s designation.

The IRS found several factors in determining employee versus independent contractor status:

– Blackwater had its personnel sign a written agreement to provide services, and the agreement explained the “type of work and work rotation, and that the worker’s services were an essential part of the services that the firm offers its clients”;

– To protect its financial investment, Blackwater retained the rights to “change the worker’s methods” and to direct the worker;

– Blackwater required the worker to personally perform the services for its client, paid the worker’s travel expenses, performed an evaluation and had the right to suspend the worker” for any violations. In addition Blackwater “contractors” followed instructions regarding his assignment from the client, had no opportunity to realize a profit or incur a loss because the worker did not invest capital or assume any risk.

Blackwater also had contractors sign confidentiality documents to protect this information.  Luckily this single case was not considered policy and security contractors are considered (and taxed) as independent contractors. This puts extra responsibility on the contractor to make sure he gets full benefit from their hard work in the field. Transitioning from a career in the military to essentially a private businessman takes some rethinking.

This lone case turned into a political football and the threat of massive back taxes owed by Blackwater were finally resolved in Blackwater’s favor.  But the lesson is that the world of taxes and security contractors is a murky and ever changing one.

Eventually the IRS realized that trying every case for every contractor was a losing proposition. By lumping hired guns into traditional expat tax classifications, the IRS focused on the “330/365” test.  This shifts the confusion to that of where you hang your hat stateside. The IRS calls it your  “abode”.

Your Section 911 physical presence benefits might be denied if you continued to maintain a residence in the U.S., if you retained your state drivers license, voted in U.S. elections or even returned to the U.S. after your assignment ended.

Last year the IRS waived certain Section 911 rules if an American had left a certain country, after a certain date.  Americans who had left Egypt, Syria, Libya or Yemen due to unrest were allowed to return to the U.S. without tax penalty. But former military that worked in harsher conditions in Iraq and Afghanistan were not allowed to claim those same benefits regardless of the safety conditions. Unfair, confusing, complicated? Yep.  So despite even this advice seek out a tax pro that keeps up with the latest IRS rulings and actions.

One thing the search for a lower tax rate uncovered is that contractors should “reside” in a State with no local taxes. Our Marine discovered that California, his state of residency, is hard on all its residents. The contractor simply thought he was getting taken to the cleaners like everyone else. There are seven states in the U.S. that don’t levy a tax: Alaska, Florida, Nevada, South Dakota, Texas and Washington. Some of these states have high use taxes and opinions on the quality of life in each state may vary, but you are not going to be physically living there most of the year.

But our Marine turned contractor never thought of this when he took his first contract two years ago.

“My tax guy missed it,” says the contractor, “even after I specifically asked him about it.  Admittedly, he didn’t have much or any experience with overseas contractor tax preparation, which made me nervous.”

He should be nervous.

The security contracting industry has drawn the attention of Congress in the past few years not just for the usual claims of violence, legality and conduct but the IRS has launched it’s own jihad in that prosecutorial environment. When Congress applies pressure, typically the IRS was lock stepped. At least part of this attention can be traced to a single tax preparer:  A company called Blackwater that came from nowhere and was soon providing most of the security personnel to embassies, the CIA and other government agencies in hostile areas.

“If you worked for Blackwater in 2009 chances are you were audited,” says Luke Fairfield, a leading provider of tax service for the industry, in a release posted on former contractor “Feral Jundi”. “Count yourself lucky if you were not, as you are in the minority. If you have not heard of a teammate or fellow employee who has been through an audit I would be surprised. These audits have spread from ex-Blackwater employees to nearly anyone filing for the foreign income exclusion.”

The official story is that a batch of fraudulent returns filed by a preparer for a number of Blackwater employees effectively moved the industry higher up on the IRS’s priority list. The truth is that a new segment of high income earners were simply not filing correctly allowing plenty of financial return for the IRS, usually contracted, auditors. Chris Hughes, a partner at Fairfield Hughes, points to Triple Canopy, who replaced Blackwater on a number of contracts as being the current subject of a rumored “IRS project,” though on a larger scale, it’s the industry that concerns the IRS.

“They find an area when they think they can collect revenue, and they concentrate their resources on it,” Hughes says. “In other words, it’s not always random.”

If you work overseas as a security contractor, you’re in the IRS’s sights and you had better file a clean and correct tax return. Below are three tips to keep the IRS off your back.

1. Contract a Professional

Trained professionals need a trained professional to do their taxes. “Whether or not you understand it, you are responsible for your own return,” says Hughes. “You need to go somewhere [to get your taxes done] where you know you can get good, sound advice and not have to worry about problems with the IRS.”

Hughes and his partner, Luke Fairfield, review past returns of all new clients, and the two “find many, many mistakes.” While finding errors, like incorrect locations of work, may be possible to the amateur, there is no substitute for good hired help. The best way to a qualified certified public accountant is through referral—find someone in the industry who is satisfied with their CPA and contact the accountant.

“It’s not a good idea to use a preparer simply because a friend says, ‘Hey my guy gets $20,000 or $30,000 refunds for everyone,’” Hughes says. Saving money on your taxes should not be the focus of your tax preparation, say the accountants. Rather, the focus should be on filing as clean and correct a return as is possible while maximizing the use of tax benefits and deductions to achieve the lowest tax liability legally possible. The framework of the IRS allows for exemptions that should be viewed as opportunities, but first and foremost you need to avoid the pitfalls. Some sites that advertise tax advice are also fishing for disgruntled contractors who suddenly realize they owe back taxes and choose a legal dodge. Buyer beware. If a web site is screaming at you, perhaps the more low key professionals are where you should turn.

Kaitlin Krozel, a San Diego-based CPA specializing in preparing taxes for expats, says that a tax preparer who is unfamiliar with foreign income regulations can cost their clients thousands of dollars. The good CPAs make the most of their client’s situation and don’t blame

“If you currently have a tax preparer, make sure to ask his or her familiarity with the foreign earned income exclusion, physical presence test, et cetera,” Krozel says. “Also ask if they know how your state of residence taxes overseas income… Most contractors fall under the rules of the physical presence test, which limits the amount of days one can be in the US to claim the full-year income exclusion.”

2. Watch the Straddle

You can qualify for an exclusion but within a tax year. Your start date might straddle two years.  For 2013 is $97,600. That’s the maximum amount of foreign generated income that the IRS will allow you to declare tax-free. It’s called the Foreign Earned Income Exclusion, and it can save you a lot of money. It’s also blood in the water for the IRS and, some think, increases your chances of being audited. If you’re audited and you Falsely filed for the exclusion—that is, you filed for it when you don’t qualify for it—you can expect a hefty year-end bill.

According to the IRS you can exclude a certain amount of income if you meet the following descriptions:

• A U.S. citizen who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year,

• A U.S. resident alien who is a citizen or national of a country with which the United States has an income tax treaty in effect and who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year, or

• A U.S. citizen or a U.S. resident alien who is physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months.

That’s a lonely window of 34 days to be Stateside for the typical contractor. Not much when you consider there is usually a week of travel just to get home and back. That’s right you have to be IN the foreign country for that gold month and three days. So your time stateside is even more limited.  That’s why you see a lot of long-term contractors moving to Bangkok, the UAE or other regions. For the newbies who don’t get it right, it can be a costly audit…with legal, accounting on top of fines and late fees.

“We get individuals who have very little withholding because they initially believe their foreign earned income is not taxable so they stop their withholdings but ultimately don’t qualify to exclude all or a portion of their foreign earned income from their taxable income,” Hughes says. “As a result, their tax bill can be upwards of $20,000 or $25,000 at the end of the year simply because they are under-withheld. Many are caught unprepared because they may have already spent that money on a new vehicle or included it with a down payment on a new house. Believe me, I’ve seen it happen many times.”

A big part of the withholding pitfall is that contractors falsely assume that filing an IRS Form 673 qualifies them for exclusion. That form, which is submitted to the contractor’s employer, tells the employer to stop all federal withholdings until the $97,600 amount is reached, according to Hughes. Whether the contractor actually qualifies for the exemption in the eyes of the IRS has nothing to do with the Form 673. IRS Form 2555 is the form that is submitted with the taxes to claim the foreign income exclusion.

“The real “gotcha” point is when you start work for a company,” says Jake Allen, former security contractor and founder of the job site Security Contracting Network. “The guys get burned in that first fragmented year. There’s an element of complexity there, but you don’t have to pay all that tax. It’s wise to get a pro to help.”

3. Homeless and Loving It.

“The biggest mistake I see guys make is that they don’t establish residency somewhere or they come home too often,” Allen says. “The guys that are smart just have their wife or girlfriend meet them in some other country and don’t come home more than once a year. Because once you break the seal on that 330-day limit, it costs you.”

Establishing a foreign residency means having a foreign “tax home,” which is basically your place of abode in a “real and substantial sense,” according to the IRS application. Pending a foreign tax home, there are two ways to qualify for the Foreign Earned Income Exclusion: Spend at least 330 days of the year outside the US, or demonstrate to the Secretary’s satisfaction that you’re a “bona fide resident” of another country.

To avoid social and economic ties to the US, which can be troublesome when disproving residency here, many young contractors, especially those without wives or families, set up residencies in other countries. But contractors may not claim residency in Iraq or Afghanistan, according the IRS.

Here is the rub, the IRS won’t accept that a contractor resides in what they consider a “combat zones”. Even though danger zones are exactly where contractors live and work.  And the same is true with a residence card from someplace like Kurdistan—it won’t fly with the IRS. In countries approved for contractors to live in, the agency uses common standards to qualify for residency: an electric bill, apartment lease, including involvement in the local economy. Yes the IRS knows the game because they have audited enough security contractors to repeat every story back to you.

“The IRS will look at what the substance of the claim is and compare that to what makes a foreigner a resident in the US,” Hughes says. “We look at it as a claim that’s going to be extremely difficult to sustain.”

You can minimize your taxes by qualifying for foreign residency. But if you live in the US, you can also minimize your taxes by living in states that don’t tax your income: Texas, Florida, Alaska, Nevada, Washington, South Dakota, Wyoming and Tennessee. Conversely, among the worst states that don’t allow for the foreign income exclusion are California, Alabama, Pennsylvania and Hawaii, though state programs within these states may allow for tax breaks in other ways.

If you choose a knowledgeable, reputable preparer, perform due diligence on your Foreign Earned Income Exclusion claim, and are smart about your residency, you can have a hassle-free relationship with the IRS—and save yourself money. You don’t want to garner undue attention from the agency, but you don’t want to distance yourself to where you’re completely off the radar, either. Like a lot of things, avoiding the common pitfalls and complying with regulations will serve you well.

“The best thing for contractors to focus on, what the goal should be,” says Hughes, “is to ask themselves where they can go to get sound tax advice and pay the least amount of tax legally possible without putting themselves in a risky tax position which may jeopardize their ability to continue working in the industry.”

Happy Ending

And what happened to our Marine turned contractor? At the end of the day, his girlfriend sent his tax return to a preparer who knew the IRS nut roll and saved him $50,000. So this tax season, put some money and effort into shopping for someone to do your taxes.