Foreign Earned Income Exclusion: Exception for Injuries?

This week's tax question comes from J.B. in Virignia. He asks:

"Mr. Perez, I saw an article online that you wrote in December 2005 on the website EscapeArtist.com. The article was very informative. I have a quick question reference working overseas in Afghanistan. If I do not complete a full 12 months overseas is the amount made still tax free? The reason I would not complete my year is due to an injury. I hurt my shoulder while I was over there on the job. Is workman’s comp tax exempt as well? "

Under the Foreign Earned Income Exclusion, the first $80,000 of foreign wages is tax-exempt as long as you meet one of two residency requirements.

Normally, you must reside in a foreign country for a full calendar year (the bona fide residence test) or for 330 "full days" in a consecutive 12-month period (the physical presence test). You will want to count up how many "full days" you spent in Afghanistan to figure out if you meet the residence test.

There is an exception to the residency tests if you are forced to leave the foreign country because of "war, civil unrest, or similar adverse conditions." It would be up to you to document that you would have met the residency tests otherwise. In an audit situation, I imagine that the IRS would want to know if your injury prevented you from doing your job in Afghanistan, or if your employer forced you to leave the country for medical or health reasons. You would want to keep any documentation, letters, medical reports, or reassignment papers that support this position. Also, you would need to prorate your maximum exclusion based on the number of days you were physically present.

Generally, workers' compensation is tax-exempt income. For more information, see IRS Publication 525, Taxable and Nontaxable Income.

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