Does A Flight Attendant In Hong Kong Have Foreign Income?

I am going to put you on the spot. I will give you some facts and present a tax issue for you.

Yen-Ling is a U.S. citizen. She is an expat living in Hong Kong. She works international flights for an airline, and her flights include

• Hong Kong to/from San Francisco
• Hong Kong to/from Chicago
• Hong Kong to/from Ho Chi Minh City
• San Francisco to/from Nagoya

 What tax issues do you see?

·        Hong Kong is a red herring. As a U.S. citizen, she has to pay income taxes on her worldwide income.

·       She however does get some tax relief from the double taxation this would otherwise entail. She gets to offset her Hong Kong taxes against her otherwise payable U.S. income taxes. This is the “foreign tax credit.”

 You are doing well. Anything else?

·        I recall a “foreign income” exclusion in the tax code. I am a bit fuzzy on it, though.

Good catch. A U.S. citizen who both lives and works overseas can exclude a certain amount of his/her salary from U.S. tax. This amount is not chump-change. For 2013, for example, the maximum foreign income exclusion is $97,600.

Is all of her income foreign? She does live in Hong Kong.

·       Wait, she comes into and out of the U.S. on a regular basis. Some of her income has to be U.S. source.

You are right. How to do you propose to allocate it?

·        Hopefully the airline sent her something – maybe a breakdown of her flight and service hours.

Let’s say they do and it looks something like this:

• Hours in U.S.
• Hours in Vietnam
• Hours in Japan
• Hours in Hong Kong
• Hours in international air space

 Her total hours are 1,960 hours. How do you propose to calculate this?

 ·        I propose to divide her hours in the U.S. into 1,960 total hours.

Seems reasonable. But ...

... you would be wrong. Not surprisingly, there has been litigation on this.

The Code defines "foreign earned income” as “the amount received by such individual from sources within a foreign country.”

·        So? She did not earn it within the U.S., so how can it be anything other than “foreign?”

Take a look at the wording in the following Regulation:

• The term ‘foreign country’ when used in a geographical sense includes any territory under the sovereignty of a government other than that of the United States.”

Did you pick up on the tax hook?

 ·        You mean the word “sovereignty?”

That’s it. Under whose sovereignty is international airspace?

·        No one’s. That is why it is international.

Is her time in international airspace considered time in a “foreign country?”

·        That is ridiculous. According to this reasoning, an American on the moon would have all his/her income considered U.S. source.

You are right that this is ridiculous, but an American living (and working) on the moon would have U.S. source income. He/she would not have a foreign income exclusion, as he/she would not have foreign income.

·        Who dreamed this up?

To some extent, it is an unfortunate by-product of the U.S. worldwide tax system. It borders on the intellectually incoherent, which is why virtually all other advanced nations eschew it in favor of a territorial tax system.

·        How did it turn out for the flight attendant?

She got hosed. You can read about it at Rogers v Commissioner.

·        I could but I won’t.

IRS Small Business Audit Areas

The IRS has announced selected business areas it is prioritizing for audit this upcoming fiscal year. The IRS is increasingly focused on small business underreporting, which it considers responsible for the majority of a $450 billion tax gap. Here are the areas:

1.      Fringe benefits, especially use of company cars

The IRS is finding that employers are not correctly reporting employees’ personal use of company vehicles on Forms W-2.

2.      Higher income taxpayers

The IRS will focus on self-employed taxpayers with gross receipts (that is, before expenses) of more than $1 million.

3.      Form 1099-K matching

Forms 1099-K report payments from credit cards and payment clearinghouses (such as PayPal). The IRS granted a reprieve for 2012, but it announced that it will start Form 1099-K matching in 2013.

4.      The small business employee health insurance tax credit

The IRS wants to make sure that small business employers and tax exempts are complying with credit eligibility requirements.

5.      International transactions

The IRS has announced its third voluntary foreign bank account initiative and intends to look for offshore transactions.

6.      Partnership returns reporting losses  

This is a new area of emphasis. Expect the IRS to look into partnerships reporting large losses.

7.      S corporations reporting losses and reasonable officer compensation

The IRS will be looking at S corporations claiming losses, looking for losses taken in excess of shareholder basis.

The IRS is also interested in profitable S corporations reporting little or no salary to officers.

8.      Proper worker classification

The IRS is interested in employer treatment of worker versus independent contractor status. The IRS thinks there is significant noncompliance in this area.

Taxpayers Keep Leaving The United States

The number of expatriates continues to increase. The number for 2011 was 1,781 and represents more than a 15% increase from 2010.

Not all expatriates are wealthy and seeking to sidestep what they perceive as harsh and confiscatory government policies. The IRS itself estimates that up to seven million U.S. residents reside abroad. I have family overseas, for example, and they have no intention of returning. They must nonetheless file a U.S. tax return annually, file a FBAR and, assuming that they have not spent every nickel they ever earned, have to deal with FATCA reporting. Did you know that there are tax restrictions on a U.S. citizen marrying a non-U.S. spouse? Does that make sense to you?

The most recent assault by Treasury on non-U.S. financial institutions, such as UBS, has had the perverse effect of these institutions dropping U.S. clients – and certainly not accepting new ones. I am not condoning the uber-wealthy hiding their income and assets from the U.S., but it is a far reach to argue back that a U.K. bank should report electronically on the bank activity and balances of my family.

Here is a chart on the number of expatriates over recent years. Kudos to Andrew Mitchel for the graph. Draw your own conclusion, if a conclusion is there to be drawn.

               

Be Careful With Foreign Tax Information Returns

Today we filed an extension for a client company with a foreign subsidiary. I was recently reading a Chief Counsel’s Advice concerning the same type of tax return that our client will be filing in a few months.

There is an additional form to file when one owns a foreign corporation. That is Form 5471 “Information Return of U.S Persons with Respect to Certain Foreign Corporations.” The common ownership threshold for filing is 10 percent. There is a twist in which an officer or director has a responsibility to file, even if the officer or director owns no shares directly, as long as a US citizen owns at least 10 percent.

Frankly, this is a confusing return. There are four types of “filers,” and each has to fill-out – or not fill-out- certain sections of the return. One may have to provide an income statement for the foreign company, for example, or track its earnings and profits.

The 2010 HIRE Act amended the tax Code (Section 6501(c )(8)) so that the statute of limitations for an income tax return to which an international “information return“ relates does not start until the information return is filed.

What does this mean? Well, Form 5471 is considered an “information return.” This means that it has numbers on it, but there is no line that says “tax due.” There is a similar form (Form 8865) for foreign partnerships and another (Form 3520) for foreign trusts.

So you own (enough of) a foreign corporation to file Form 5471. The accountant doesn’t think about it and files the corporate return without it.  The IRS in CCA 201104041 clarified that the statute of limitations on the corporate return does not begin to run until the Form 5471 is filed.

The client referred to above is new to the firm. One of the reasons that they switched firms? Their former CPA had not been filing Forms 5471.

If you remember, there are also penalties for not filing foreign information returns, including Form 5471. That however is for another blog post.