No foreign tax surprises

The United States tax authority – Internal Revenue Service – is the only institution that requires U.S. citizens and deemed U.S. residents to file an annual tax return on which is reported income from all sources worldwide. Other countries apply this requirement to residents rather than citizenry.

Occasionally Americans living abroad are surprised by this requirement in those circumstances where they are already filing a tax return and paying taxes to a foreign country of residence. So refusing to file a U.S. tax return, they may also believe that filing tax returns on the same income to both countries means double taxation.

As the Internal Revenue Service has in place the power and wherewithal to assess rather stiff penalties against anyone who neglects his/her duty, noncompliance can ultimately be expensive. Where one has not filed a return stateside for many years, IRS requires filings for three prior years in addition to the current year. In 2011 this means filing tax returns for 2007, 2008, 2009 and 2010. While owing taxes to the United States Treasury is unusual due to filers being able to apply foreign tax credits and/or foreign earned income exclusions against any IRS assessments, the Service will require that six years be filed in the event that taxes are owed.

Filing requirements are actually based on a predetermined income level per filing status. It works something like this:

Filing Status Age End of 2010 Gross Income Determines

Single Under 65 $9,350
65 or older 10,750
Married Filing Joint Under 65 (both spouses) 18,700
65 or older (one spouse) 19,800
65 or older (both spouses) 20,900
Married Filing Separate Any age 3,650
Head of Household Under 65 12,050
65 or older 13,450
Qualifying widow(er) Under 65 15,050
65 or older 16,150

So if your filing status is, say, Head of Household and you are under 65, you would have to file a U.S. tax return if your gross income in 2010 was at least $12,050.

Re-emergence of Estate Tax in 2011

Anyone whose estate is valued at more than $1m might wishfully contemplate dying this year. That is if they intend to leave property to their heirs. Because on 1 January 2011, the federal estate tax is scheduled to re-emerge with a vengeance and impose a 55% levy.

From 2001 – 2009, an increasingly valuable exclusion amount rose from $675,000 and a maximum tax rate of 55% to $3.5m and 45%. In 2010 the estate tax was repealed. Next year it may be adjusted to a $1m exemption amount and 55% top rate if Congress does nothing.

So beginning next year, families whose property values and retirement plans (and other assets too) have risen to over $1m will be vulnerable to the estate tax.

Meanwhile wealthy persons who died this year and so escaped the estate tax include George Steinbrenner, New York Yankees owner, whose estate has been estimated at $1.1 billion. The federal estate tax in 2009 was 45 percent, with the $3.5 million per-person exemption. If Steinbrenner had died last year, his estate could have been taxed almost $500 million. But not in 2010. Undoubtedly the beneficiaries of the estates of Lynn Redgrave, Art Linkletter, Dennis Hopper, J D Salinger, Lena Horne, Jean Simmons and other members of the rich and famous club are also comforted that Uncle Sam was not among the heirs of these decedents in 2010.

The Obama Administration would like to see the estate tax return to 2009 level. But Republicans blocked this proposal. More recently Senators Jon Kyl and Blanche Lincoln re-introduced legislation that exempts $5m from estate taxes with a 35% maximum tax rate. The problem with Congress passing a lenient bill is that the US Government needs the money. And though politicians may say little about raising taxes, privately they must surely be whispering in the quiet corridors of power: ‘show us the money!’

American Expats and Social Security

The eligibility of American expatriates and their families to receive US Social Security benefits depends on understanding the qualifications. Citizens of most European countries may receive benefits but not US citizens residing in Cambodia, Vietnam, Cuba, North Korea or certain areas of the former Soviet Union. Survivors or dependents who are citizens of Central and South American countries as well as Bosnia-Herzegovina, Croatia, Cyprus, Hungary, Iceland, Jordan, Latvia, Liechtenstein, Lithuania, Monaco, Montenegro, Serbia, Slovakia and Turkey must meet certain additional requirements. Anyone who is not a US citizen or a citizen of these countries will not receive Social Security benefits after being outside the United States for six calendar months unless he or she is a resident of a treaty country. Treaty countries – countries with which the US has a Social Security Totalization agreement – include most European countries.

The right of non-US citizen dependents and survivors to receive benefits depends on US residency. They must have lived in the United States for at least five years, during which the family relationship on which benefits are based must have existed. This residency requirement is not required of citizens of most European countries or countries with which the United States has a Social Security agreement.

Non-US citizens, as opposed to dependents and survivors, can qualify to receive Social Security benefits as long as they were assigned a Social Security number based on authorization to work in the United States at any time on or after 1 January 2004 or were admitted to the United States as a nonimmigrant visitor for business.
When a Social Security recipient dies, the Social Security Administration should be notified as soon as possible. A one-time payment of $255 will be paid to the surviving spouse. In addition, the following surviving members may be eligible for monthly benefits:

  The widow or widower aged 60 or older (50 if disabled)
  Surviving spouse at any age who is caring for the deceased’s child age 16 or under (or    disabled)
  An unmarried child of the deceased who is younger than age 18
  Age 18 or older with a disability that began before 22 years of age
  Parents aged 62 or older who were dependents of the deceased for at least half their support
  Surviving divorced spouse under certain circumstances

Social Security can be contacted via their website: www.ssa.gov

IRS TAX AMNESTY

Earlier this year, the Internal Revenue Service had in place a tax amnesty. In former times, a tax amnesty might have signified forgiveness of taxes. Tax debtors found their obligations to the governing authority wiped clean. The populace then felt good about their governors and, if anything, more readily paid up on imposed taxes.

The IRS wants to find Americans who have squirreled away their wealth in hidden accounts so as to tax the earnings they are convinced have long been undeclared. Indeed, the US government estimates that the treasury is losing $10b a year in tax revenues due to this sort of failure to report. And given that the government, despite an incomprehensible budget deficit, has obliged itself to continue financing wars in Afghanistan and Iraq, to pay Social Security retirement pensions to the aging baby-boomer generation, and to legislate a national health care system, the business of tax collection was never higher on the agendas of tax collectors.

Accordingly on 27 March 2009, the IRS announced a six month amnesty for Americans to voluntarily report their worldwide income, gains, bank accounts, trusts and other secreted entities. Given that only about one-third of American expatriates file annual tax returns and some 20% file the required foreign financial holdings report known as FBAR, the IRS has legislated this six month window of opportunity for anyone heretofore under the radar screen to emerge from obscurity.

Responding to this window, a representative of American Citizens Abroad had this to say: ‘The IRS this time apparently thinks it is offering us (Americans abroad) a tempting amnesty. But if you look more closely, it is rather more akin to urging us to commit financial suicide.’ Arguing that IRS can impose significant penalties for both unpaid income taxes up to six years and for failure to file FBAR, he warned that complying Americans can be economically destroyed.

The six month amnesty expired on 23 September. But IRS has just extended the deadline to 15 October. The amnesty protects Americans who come clean from possible criminal prosecution as well as substantial civil and fraud penalties.

The question noncompliant Americans abroad have to ask in an age of electronic technology and tax treaties, and in spite of portentous advice, is whether they are willing to continue rolling the dice.

US Tax Filing Requirement Imposed on Nonresidents

Recently the friend of a client posed the question whether a US non-resident alien has to file a US tax return based on interest earned on an account in the US? To understand this tax filing requirement, it is first necessary to distinguish between resident and non-resident alien status.

A resident alien is someone who meets the green card or substantial presence tests. A green card holder is anyone who took no steps to revoke the card even though he or she is treated as a resident of a foreign country under a tax treaty. So according to this example, a non-resident alien can be treated as a resident alien for US tax purposes. The substantial presence test applies to any foreign person who a) was physically present in the United States for at least 31 days during the calendar year, and b) 183 days during the previous three calendar years (2008, 2007 and 2006). This latter criterion may be waived if the foreign person establishes that during 2008 he or she had a tax home in a foreign country and therefore had a closer connection to the foreign country of residence. It is possible while qualifying for substantial presence test in a tax year to be considered both a resident and non-resident alien.

Having established residency status, a non-resident alien may be obliged to file a US tax return on US source income. If the income is effectively connected with a US trade or business, then it is taxed at ordinary income tax rates and reported on line 9a of Form 1040NR (see www.irs.gov, forms and publications). Otherwise it is reported on line 76b and taxed at 30% unless superseded by tax treaty rate. Generally such income is reported by payers on Form 1042-S. When the withholding rate is correctly applied and no other US source income has been received, a non-resident alien is not obliged to file Form 1040NR.

1040NR filing is required of non-resident aliens where they have a trade or business in the United States, income is exempt from US taxation under a tax treaty, a deceased person or estate/trust is represented, or withholding amounts are incorrect. Resident aliens may file Form 1040, and is taxed the same as a US citizen.

US source interest income includes interest on bonds, notes or other interest-bearing obligations, interest paid by an entity engaged in a US trade or business, original issue discount, or government-source interest. Excludable interest income includes income not effectively connected with a US trade or business if from deposits with persons in the banking business; accounts with mutual savings banks, cooperative banks, credit unions, domestic building and loan associations, and other savings institutions chartered as savings and loan; and amounts held by an insurance company.

Generally speaking, if the income was derived from the conduct of a US business activity, then it is effectively connected.

Congress Legislates Accuracy Penalty

RJ has been employed as a consular agent since 2003. As a foreign resident, he should qualify for the Foreign Earned Income Exclusion (FEIE) even though he does not report or pay taxes to the foreign country wherein he resides. To be sure, he consulted with IRS agents in Paris who told him that he qualified for FEIE because his employment was non-permanent and intermittent. As a result, RJ has taken the Foreign Earned Income Exclusion each year in filing his annual income tax return.

In 2008 he was audited by Internal Revenue Service for tax years 2006 and 2007. The auditor in a letter notified RJ that he was being denied FEIE and assessed Accuracy Penalties. On Form 886-A – EXPLANATION OF ITEMS – the auditor stated: ‘Per IRC 911(b)(1)(B)(ii), amounts paid by the United States or any of its agencies to its employees are not considered foreign earned income for the purposes of the foreign earned income exclusion.’

RJ, however, was bewildered. He had relied on the advice of IRS agents only to find their advice contradicted by another agent. In denying RJ his FEIE, the auditor was assessed additional taxes of $11,000 in 2006 and $9,000 in 2007, as well as Accuracy Penalties $2,200 ($11,000 x 20%) and $1,800 ($9,000 x 20%).

Accuracy penalties include 1) negligence or disregard of rules or regulations, 2) substantial understatement of income tax, 3) substantial valuation misstatement, 4) substantial overstatement of pension liabilities, and 5) substantial valuation misstatement in connection with gift or estate tax. In the auditor’s notice, the Accuracy Penalty was for substantial tax understatement per IRC Section 6662(d). The notice further stated: ‘If we increase your tax and the increase exceeds 10% of the corrected tax and is also equal to or greater than $5,000, the law requires an accuracy-related penalty due to substantial understatement of tax. The penalty is 20% of your tax increase.’

Human performance can be affected by a variety of factors such as age, attitude, physical health, state of mind, emotional state, and stressful events. To err is simply to be human. In addition to these contributing factors, accuracy errors in preparing a tax return occur due to missing tax documents, inexact records, mathematical mistakes, misinterpreting tax code or instructions, rush to meet filing deadlines, erroneous use of tax tables, etc.

IRS states that an Accuracy Penalty may only be decreased or waived if the taxpayer can 1) provide substantial authority (Internal Revenue Code, Regulations, Revenue Rulings, Revenue Procedures, etc.) used to treat disputed income or deduction; 2) show the facts supporting the treatment of disputed income or deduction; 3) submit a signed statement that outlines the facts supporting the treatment of understated income.

While it would appear heavy-handed that Congress should have armed the Internal Revenue Service with the power to assess Accuracy-related penalties and then allow limited defenses, taxpayers must exercise diligence in preparing their tax returns if they are to avoid the nightmare of IRS tax and penalty assessments.

Graduated Tax or Gradually Taxed

Twenty years ago when the writer had a public tax practice in Santa Fe, New Mexico, he received a call from a shopkeeper on Canyon Road. ‘I’ve received a notice from IRS. Can you help me with my taxes?’ Santa Fe is the capital of New Mexico and famous for its art community and its Mexican food.

Once at Tomasita’s near the old train depot, my brother and I had finished one of their great meals. As we were exiting through a very crowded lobby of people waiting to be seated, I hollered at my brother: ‘Sure was worth the 2 hour wait!’

Canyon Road climbs toward the Sangre de Cristo Mountains back of the old town plaza. The houses that were built there are adobe. Many have been converted into art galleries that attract tourists bent on acquiring art or adding to their art collections.

As a public accountant in that city of 60,000 inhabitants, I could count many clients from the small business and art community. Referrals were not unusual. So when this shopkeeper called, I soon learned that he had not filed any tax returns for a number of years. And so IRS was on the prowl, insisting he file the last three years. After a few moments of conversation in which he disclosed using one checking account for all his business activity, I advised: ‘Put together for me three years of bank statements. We will first have to create year-end financial statements from those statements for each of the three years, and then from those statements prepare the tax returns.’

We met the following week. He had dutifully put together the statements. I discovered that he made and sold attractive decorator pillows. He rented a small space in a larger gallery to display his works.

In the coming week, the financial statements and tax returns were prepared. For each year, the shopkeeper had had a net profit of approximately $10,000. His tax liability for each year, though, was over $2,500. In 1988, the Social Security Administration published that the poverty level of a single person in America was someone who earned no more than $6,000 in a year. Santa Fe being one of the most expensive small cities in America would have put this person at the poverty level.

The idea behind a graduated tax system is that everyone should contribute his or her fair share to the tax treasury regardless of living circumstances. But should contributions be enforced when the income is at or near the poverty level? It would perhaps be fairer if a tax structure were something like the following. Suppose a person’s average income is $5,000 and his necessary expenses amount to the same sum, then no taxes should be collected from him. If another person’s income is $10,000 and his necessary expenses are $5,000, then he could be assessed 10% since there will be no decline in his standard of living. If a third person has an income of $20,000 and his costs of living are determined to be $10,000, he should be assessed twice the amount or 20% of the person earning $10,000. And if still another person earns $50,000 and his expenses are $20,000, then he should pay 30% of his income in taxes. But if an indigent person has an income of $4,000 where the poverty level is determined to be $5,000 and he sacrifices to make his living but the fruit of his labor is inadequate, he should be helped from the treasury so as not to live in want.

So a fair graduated tax system would not impose taxes on the lower income earners. It would help those whose incomes are below the poverty level. And it would not impose excessive tax rates on middle income levels so as to encourage their productivity and contributing to economic growth.

As to high income earners, America between 1944 and 1963 imposed in most of these years 85% + on taxable income levels over $400,000 ($4,000,000 today). So the idea that the wealthy should also pay their fair share was once acceptable. But given the anemic condition of the economy and the treasury today, it could again become acceptable. In America, the top bracket is 39.6%.

Capitalizing Gains and Losses

The history of capital gains treatment stateside is interesting. As well, it is reflective of how the American tax authority periodically tampers with the tax law. From 1913 to 1921, capital gains were taxed at 7%. In 1921, a rate of 12.5% was applied to assets held for two years or more. From 1942, investors could exclude 50% of gains on assets held for at least six months. In 1978, the exclusion was increased to 60% against which 28% tax was applied. Three years later, this tax rate was lowered to 20%. The Tax Reform Act of 1986 repealed the capital gains exclusion and raised the maximum tax rate to 28%. In 2003 the rate was reduced to 15% for the higher tax brackets and 5% for the two lower ones (rates that apply to 2007 tax returns). In 2008, 2009 and 2010, the tax rate on long term capital gains has been lowered to 0% for anyone in the 10% and 15% income tax brackets. After 2010, this situation will change. A Single taxpayer whose taxable income is less than $32,550 will pay 5% on long term capital gains in 2007; 0% from 2008 – 2010. A married joint filer’s taxable income can be $65,100 for the 5% rate in 2007.

To take maximum advantage of capital gains tax rates, investors need to understand what happens when there is an interplay between short-term and long-term gains, the distinction being for assets held for more than one year before sold versus assets held for less than a year. Long term gains are taxed at the favorable capital gain tax rates. Short term gains are taxed at ordinary income tax rates.So a sale can be long term. Or it can be short term. When both sales occur in a tax year, four possible outcomes can occur:

  1. Long term gain with short term gain. The former is taxed at 5% or 15% depending on tax bracket. The latter is taxed with your other income up to 35%. 
  2. Long term loss with short term gain. If the gain is bigger than the loss, you will be taxed up to 35%. If the loss is bigger, the resulting netlong term loss up to $3,000 for married joint filers can be taken to offset other income.
  3. Long term gain with short term loss. If the gain is bigger, you would have a net long term gain taxed at favorable capital gains tax rates. If the loss is larger, the resulting net short term loss up to $3,000 applies as in 2) above.
  4. Long term loss with short term loss. Long term losses offset long term gains while short term losses offset short term gains. But whenshort term losses exceed $3,000, you must use these up first to offset that ordinary income with the balance being carry-forwarded with the long term losses to a subsequent tax year(s).

2007 Tax Preparation

One of the expat advantages of a later tax filing due date – 16 June 2008 – for the 2007 US federal income tax return is the extra time to put together those papers related to foreign taxes.  This 16 June due date can even be extended to 15 October by filing Form 4868.  Because IRS wants to tax US citizens wherever they reside on world-wide income, expats should gather certain tax-related documents.  The IRS website – www.irs.gov – in its booklet of instructions for Form 1040, discusses the reportable income items.

While some expats have some US source income, they should pay particular attention to items of foreign income and corresponding taxes paid or accrued.  As income items rise, the possibility of being taxed twice – by both the foreign country and IRS – increases dramatically.

US taxes can be offset by applying the Foreign Earned Income Exclusion, the Foreign Tax Credit and the Treaty Based Return Position (Form 8833).  Pay particular attention to putting together the following documents:

Foreign Country of Residence -
Earnings statement from foreign employer
Foreign taxes paid and/or accrued
Foreign tax return
Income and expenses from self-employment (sole proprietorships and partnerships)
Income from investments in foreign corporations
Interest earnings from investment accounts
Sales of stocks
Rental income and expenses
Income from installaments
Bonuses and reimbursements
NOTE:  All foreign income and expense items must be reported in US dollars

US source income -
W-2 wage statement
Employee-related reimbursed and non-reimbursed expenses
1099 Dividend and/or Interest Statements
Refunds of state income taxes
Alimony received
Earnings from self-employment
Sales of investments
Sales prices, dates of sales, cost bases, dates of purchases
Income from Rental activities
Income from K-1s (trusts, partnerships, corporations)
Gains from other sales
Note: Sale of residence carries a life-time exclusion: $500,000 married filing joint; $250,000 single
1099 Pension income
IRA distributions
Traditional or Roth?
Farm income and expenses
Unemployment compensation
Social Security
Other income – prizes, gambling winnings, jury pay (see 1040 instructions, p. 24)

Reductions to World-wide Income
Foreign earned income exclusion (See How to Qualify)
Foreign tax credit
Form 8833
Expenses
Education, health savings, IRA, alimony paid, student loan interest
Other
Medical costs, charitable contributions, casualties, state income taxes, property taxes, mortgage interest, job search (if
employed)
Dependent exemptions (Social Security numbers required)

Tax preparation can be complex and challenging.  Most Americans untrained in tax preparation who attempt to prepare their own tax returns commit one or more errors on their returns.  But if the income items involve a pension, social security and some investment income, then one is not so apt to make a mistake.

State of Your Personal Estate

Several weeks ago this writer was in Spain consulting with a dual citizen of both the United States and France.  Happily Mme Palu announced that in 2004 she had inherited oil stock valued at $600,000 from her mother, a citizen of the United States.  Having sold the same stock last year, Mme Palu was now investing the proceeds in Spanish property which she intends to eventually pass on to her daughter.  ‘Now I don’t want to pay any taxes on this inheritance,’ she firmly said.

According to U.S. tax law, the value of a decedent’s bequest is its fair market value at the time of death.  So the price at which Mme Palu sold the stock in 2004 would have approximated its value on the open market.  Therefore, she would have experienced very little gain or loss on sale.  And since the value of mom’s estate in the United States was less than the Unified Credit of $1,500,000, her estate would also have incurred no estate taxes.

However, because Internal Revenue Service defines Gross Estate as ‘the value of all property in which you had an interest at the time of death,’ Mme Palu’s estate upon her death will have to include all of her world-wide property.  If she dies in 2005 with a world-wide estate valued at $3,000,000 after allowable deductions, IRS will assess $695,000 in estate taxes, which is just over 46 cents for every dollar after the Unified Credit is applied (3,000,000 – 1,500,000 x .4633 = 694,950).

Mme Palu will have to prepare an American Will designating her daughter as heir to her estate.  When the daughter inherits, she will be obliged to pay Spanish inheritance taxes on any property located in Spain.  The top marginal tax rate is 34% on estates valued above €797,555 plus €199,291 in taxes from the lower marginal rates.  In France, the inheritance tax is paid by inheritors of the estate of a French resident or the French assets of a non-French resident.  Therefore, as long as Mme Palu does not reside in France or owns no property in her native country, her daughter will owe no inheritance taxes there (the top rate of which is 40% of estates exceeding €1,700,000 in value).

Like Spain, Portugal applies inheritance taxes only on property located within its borders.  But expatriated Brits who have not acted to establish a new domicile outside their home country can be liable to 40% tax against the value of their world-wide estate above £263,000.  Internal Revenue Service will allow as credit any inheritance taxes paid to a foreign country.

Mme Palu, who was a bit astonished at the complexities of inheritance tax laws, will probably maintain property only in the U.S. and Spain in order to avoid too much confusion.  If she does some estate planning, she can protect her estate from being eroded by inheritance taxes.

‘One more thing,’ Mme Palu added.  ‘My mother gifted me the stock just before she died.  She acquired the stock from her husband’s estate when he passed away in 1965.’  OH DEAR!!  IRS has this to say about that:  To figure the basis of property you (mme Palu) receives as a gift, you must know its cost basis to the donor (Mme Palu’s mother) before it was given to you.

After some discussion, we estimated that original basis to be $50,000.  Therefore, Mme Palu will pay capital gains taxes on $550,000 ($600,000 – $50,000).  Why, oh why, didn’t her mom speak with a U.S. tax specialist?  She died within two months of gifting her stock.