Allowances, Differentials, & Other Special Pay

Most payments received by U.S. Government civilian employees for working abroad, including pay differentials, are taxable. However, certain foreign areas allowances, cost of living allowances, and travel allowances are tax free. The following discussions explain the tax treatment of allowances, differentials, and other special pay you receive for employment abroad.

Pay differentials. Pay differentials you receive as financial incentives for employment abroad are taxable. Your employer should have included these differentials as wages on your Form W-2, Wage and Tax Statement.

Generally, pay differentials are given for employment under adverse conditions (such as severe climate) or because the location of the post of duty is outside the United States. They include:

• Post differentials,
• Special incentive differentials, and
• Danger pay.

Foreign areas allowances. Certain foreign areas allowances are tax free. Your employer should not have included these allowances as wages on your Form W-2.

Tax-free foreign areas allowances are allowances (other than post differentials) received under the following laws.

1. Title I, chapter 9, of the Foreign Service Act of 1980.
2. Section 4 of the Central Intelligence Act of 1949, as amended.
3. Title II of the Overseas Differentials and Allowances Act.
4. Subsection (e) or (f) of the first section of the Administrative Expenses Act of 1946, as amended, or section 22 of that Act.

These allowances cover such expenses as:

• Certain repairs to a leased home,
• Education of dependents in special situations,
• Motor vehicle shipment,
• Separate maintenance for dependents,
• Temporary quarters,
• Transportation for medical treatment, and
• Travel, moving, and storage.

Allowances received by foreign service employees for representation expenses are also tax free under the above provisions.

Republic of Panama. Employees of the Panama Canal Commission and civilian employees of the Department of Defense stationed in Panama can exclude from their income certain allowances that are comparable to the allowances (under the 4 laws listed earlier) that can be excluded by employees of the State Department stationed in Panama. However, the overseas tropical differential paid to civilian employees is taxable.

Cost-of-living allowances. If you are stationed outside the continental United States or in Alaska, your gross income does not include cost-of-living allowances (other than amounts received under Title II of the Overseas Differentials and Allowances Act) granted by regulations approved by the President of the United States. Cost-of-living allowances are not included on your Form W-2.

Federal court employees. If you are a federal court employee, the preceding paragraph applies to you with one change. The cost-of-living allowance must be granted by rules similar to regulations approved by the President.

American Institute in Taiwan. If you are an employee of the American Institute in Taiwan, allowances you receive are exempt from U.S. tax if they are equivalent to tax-exempt allowances received by civilian employees of the U.S. Government.

Reemployment after serving with an international organization. Reemployment payments received by a federal employee who is reemployed by a federal agency after serving with an international organization are taxable. These payments are equal to the difference between the pay, allowances, post differential, and other monetary benefits paid by the international organization and the pay and other benefits that would have been paid by the federal agency had the employee been detailed to the international agency.

Allowances or reimbursements for travel and transportation expenses. See How To Report Business Expenses, later, for a discussion on whether a reimbursement or allowance is included in your income.

Lodging furnished to a principal representative of the United States. Lodging (including utilities) furnished as an official residence to you as principal representative in a foreign country is tax free. However, amounts paid by your employer for your usual household expenses (which you must bear) are taxable. If amounts are withheld from your pay to cover these expenses, they are not deductible.

Peace Corps. If you are a Peace Corps volunteer or volunteer leader, some allowances you receive are taxable and others are not.

Taxable allowances. The following allowances must be included on your Form W-2 and reported on your return as wages. These include:

1. Cash allowances received during training.
2. If you are a volunteer leader, allowances paid to your spouse and minor children while you are training in the United States.
3. The part of living allowances designated by the Director of the Peace Corps as basic compensation. This is the part for personal items such as domestic help, laundry and clothing maintenance, entertainment and recreation, transportation, and other miscellaneous expenses.
4. Leave allowances.
5. Readjustment allowances or "termination payments."

Taxable allowances are considered received by you when credited to your account.

Example. Gary Carpenter, a Peace Corps volunteer, gets $175 a month during his period of service, to be paid to him in a lump sum at the end of his tour of duty. Although the allowance is not available to him until the end of his service, Gary must include it in his income on a monthly basis as it is credited to his account.

Nontaxable allowances. These generally include travel allowances and the part of living allowances for housing, utilities, food, clothing, and household supplies. These allowances should not be included on your Form W-2. These allowances are tax free whether paid by the U.S. Government or the foreign country in which you are stationed.

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