The Foreign Income Exclusion When You Leave Mid-Year

We have a client who worked as a contractor in Afghanistan last year.

Let’s talk foreign income exclusion.

There are ropes.

The first is simple: to get to that exclusion you (a) must be a bona fide resident of a foreign country or (b) you have to be outside the United States for a certain number of days.

The bona fide exception is few and far between, and I doubt Afghanistan-as-a-destination would ever enter the conversation. In my experience, bona fide means a military, military-contractor or foreign service person (or family) who went overseas and did not return. There are only so many of those folks.

Nope, you and I (likely) have to meet a second test: the “physical presence” test. You and I have to be outside the United States for at least 330 days in a 365-day stretch.

A few things about this:

(1) 365 days does not necessarily mean a calendar year. It just needs to be 365 successive days. It does not have to end on December 31 or start on January 1.

(2) Let’s say that you are overseas for years. You can reset that 365-day period every year, as long as you can get to 330 days each time you reset.

(3) It does not mean that you have to be in the same country for 330 days. It just means that you have to be outside the United States. You can travel like a fiend – as long as you do not come back to the U.S.

(4) This is an all-or-nothing test. Botch the 330 days and you get nothing. There is no participation trophy here.

The maximum 2016 foreign income exclusion is $100,800.

Wait! There is a second calculation.

You have to prorate $100,800 by the number of days you were outside the U.S.

Huh?

Leave the U.S. late in the year – say August – and most of the exclusion disappears. Why? An August departure means the most you can claim is 5/12 of the maximum exclusion.

This second calculation very much means a calendar year.

And there you have the reason for much confusion in this area: there are two 12-month tests. The first one does not care whether your 12 months line-up with the calendar. The second one definitely means a calendar year.

Let’s recap:

(1) Take a 365-day period. It does not have to start on January 1; you can start it whenever you want.

a.    You need 330 days.

b.    Implicit in that statement is that some of those 330 days may have occurred in the calendar year before or following. It doesn’t matter. The 365 does not need to be in the same calendar year.

c.     Fail this test and you are done.

d.    Pass this test and you have a shot at winning the $100,800 prize.

(2) Next calculate how many days you were outside the U.S. in 2016. Divide that number by 365, giving you a ratio. We will call the ratio Mortimer.

a.    Multiply Mortimer by $100,800.

b.    The result is your maximum 2016 foreign income exclusion.

The first year can be a tax surprise for an American working overseas. It was for our client.

Why?

He was counting on the full $100,800.

What went wrong?

He did not leave the United States until April.

He was not happy.

When Is A Car Not A Car?

I had a conversation today with someone who wanted to understand the “tax side” of a series of transactions. More specifically, transactions that – to a non-tax person – would appear to have no tax side at all.

It made me think of a tax case I read while grabbing a quick dinner one night during busy season.

          COMMENT: Glamorous life, eh?

Think of your car. In the eyes of the IRS, is it one asset or is it a collection of interdependent systems that – together – form a car but which can be separately depreciated, abandoned, sold or whatnot?

This is easy: it is one asset. You start depreciation on the whole thing and you eventually sell or abandon the whole thing. You are not picking and choosing manifolds from rotors.

Except if ….

It is a race car.

There is a racing team. After each race the team strips down the car, perhaps to the nuts and bolts. They decide as they go though:

(1) Damaged parts

(2) Obsolete parts

a.    There is enough technological change in racing that a part can become obsolete almost overnight.

(3) Stress and wear parts

a.    These are not damaged or obsolete, but the team knows they have very limited life left because of the high stress and wear of racing.

                                                             i.     Some parts can be reused in a race.

                                                           ii.     Some parts cannot be raced again, but would be fine for a show car or pit car.

The team had a question for the IRS: can they deduct some of this stuff when they disassemble the car after every race?

To a tax nerd, the question is whether there has been a “disposition.” That is the trigger that allows one to remove an asset from a depreciation schedule and claim a gain or loss on the tax return – hopefully a loss.

But what does “disposition” mean to a race car?

Turns out that disassembling it after every race is the disposition. The IRS took pains to point out that the same car is never raced twice. Dale Earnhardt Jr races number 88, but you never see the same number 88 twice.

          COMMENT: There is a Zen quality to this.

That makes it easy: if you get rid of a part, you can write-off its remaining cost.

But what if you keep the part?

To phrase it another way: what if you had a disposition but did not, you know, dispose of the part?

Now you have an accounting twist. You value the part at its invoice cost (which is normal) and then adjust down for the amount of useful life already expired. Let’s say you have a $7,500 part, and the team experts say that it has 40% useful life remaining. Well, that part stays on your books at $3,000 ($7,500 times 40%). The other $4,500 gets written-off as a loss.

Heck, you can deduct a loss even if you keep the part!

Rinse and repeat for however many parts make up a race car.

COMMENT: I feel sorry for the person who has to bookkeep for all this.

I wonder if racing aficionados would recognize which racing team the IRS addressed in PLR 201710006.

A PLR is a private letter ruling, meaning that someone presents a situation to the IRS and requests the government position on tax consequences. This is generally done in advance to obtain some certainty to a transaction, especially if there is a lot of money involved.

And PLRs are published. For many years the IRS did not publish them, but there was a famous lawsuit requiring the IRS to do so. There was an issue, however, as the IRS is not allowed to release confidential information. The answer was heavy redaction of any confidential information while drafting the PLR.

Such as the name of the racing team.

Data Security And Your Tax Preparer

I annually reflect on what was unique about every tax season, other than this is a difficult profession. I can understand why accounting graduates increasingly dismiss public accounting as a career choice.

I am concerned with the increasing concentration of confidential information in an accounting office.

We have always had your name, address, birthdate and social security number.

Right there is big bucks to an Eastern European identity thief.

Riding the best-intentions train, you now have states – Tennessee comes to mind – that will not allow you to pay their (Hall) tax with a check. No sir, you have to have that bad boy drafted against your bank account. I understand Tennessee’s position – it is cheaper than handling a check – but I do not care about their position. How dare they coerce you to make it convenient for them to Soprano your money. If it is so much trouble, then stop taking the money!

You have no choice with those states.

So we have your bank information.

We now have additional “identity theft” safeguards. For example, some states require driver’s license information before you can file your return. Wow, I now have a copy of your driver’s license. And your spouse’s, if you are married.

Seems the government has shifted data protection responsibility to your friendly neighborhood tax preparer.

I did not want your data. I still don’t want it, but there it is - on my server.

Which can be carried away in an instant.

How hard would it be for someone to take down my office door, walk to the server, pull out all the wires and walk out with the thing?

And their goes your name, address, birth date, social security number, bank account information, driver’s license, those of your spouse and children, and who knows what else.

Identity thieves are spending way too much time hacking into Target and other major corporations.

It would be easier to break into CPA offices across the fruited plain. One person. One server. Repeat. You could probably knock out a dozen or two in a day.

Thank heavens our government is standing guard over all CPA firm servers in all the offices in all the cities across the land. 

Otherwise we would have reason to be concerned.

IRA or 401(k): Which Is Better If You Get Fired?

Name me a major difference between an IRA and a 401(k).

I will give you the setup.

After 17 years in the construction industry, Mr C lost his job in 2010. He was unemployed for the next year and a half.

Mrs C was also going through a difficult stretch and lost her job. She was eventually reemployed, but at approximately half of her former salary.

Both Mr and Mrs C were age 56.

He depleted his savings. They then turned to the retirement accounts. You know why: they were trying to survive.

Mrs C took out approximately $4,000 from her retirement.

Mr C told his insurance agent to withhold taxes when he took distributions, as he did not want any surprises come tax time. He took monies out at different times, in different amounts and from different accounts. To add to the confusion, he was also sending money back to the insurance agent, presumably to settle-up on the income taxes withheld on the distributions.

All in all, he took out approximately $28,000.

Mr and Mrs C later received 1099s for approximately $17 thousand, which they reported on their tax return.

Question: what happened to the other $11,000 ($28 - $17)?

Who knows.

Unfortunately, the actual distributions taken from the retirement accounts were closer to $32,000.

Real … bad … accounting … happening … here.

But let’s be chivalrous: Mr and Mrs C did not receive all the 1099s. It happens.

The IRS – of course – did receive all the 1099s. They probably also have all the socks that go missing in clothes dryers, too.

And the IRS wanted tax on the $15,000 that Mr and Mrs C did not report.

No surprise.

And 10% penalties.

Must be that “early” distribution thing.

And more penalties on top of that, because that is the way the IRS rolls these days.

Not OK.

Mr and Mrs C represented themselves (“pro se”) at the Tax Court.

And I love their argument:

They had dutifully paid their taxes for more than 30 years without fault or complaint. Could the Court find it in its heart … you know, this one time?

The Court could not grant their argument, as you probably guessed. Thirty years of safe driving doesn’t mean you can go on a society-threatening tear one sodden Saturday night. It just doesn’t work that way.

The Court decided they owed the tax. They also owed the 10% penalty for early distribution.

What they didn’t owe was another IRS penalty on top of that. The Court found that they did the best they could and genuinely believed that the broker was using the monies Mr C forwarded to cover withholding taxes. They were as surprised as anyone when that wasn’t the case. It created a tax hole they could not climb out of, at least not easily.

Here is my question to you:

Did they take monies from their 401(k)s or from their IRAs?

Whatchu think?

I am thinking their IRAs.

Why?

An early distribution from an IRA is defined as age 59 ½. Unless there is an exception (you know, like, you died), you are going to get tagged with that 10% penalty.

On the other hand, the age test for a 401(k) is 55.

The Cs got tagged, thus I am thinking IRA.

To be fair, there is more to this exception. Here are some technicals:

•    It applies only to company sponsored plans, like 401(k)s.
•    It applies only to a plan sponsored by the company that let you go. That 401(k) at a former employer doesn’t qualify.

And here is the biggie:

·       You have to withdraw the money in the same year you are let go. You cannot stagger this over a period of years.

Why that last one?

Seems harsh to me. Isn’t it bad enough to be fired? Why not make it the year of discharge and the year following? Is Congress concerned that getting fired will become the next great tax shelter? How about lifetime pensions for 30+year tax CPAs?

Thought I would slip-in that last one.

Mr and Mrs C were age 56. Old enough for 401(k) relief, but too young for IRA relief.

BTW, if you need money over several years, there may be a way around the “you have to withdraw the money in the year you were let go” requirement.

How?

Roll your 401(k) money into an IRA.

Then start “substantially equal periodic payments” from the IRA. This has its own shortcomings, but it is an option.

And you can withdraw over more than one year without triggering a penalty.

Problem is: you have to withdraw over a minimum number of years and the annual payouts can vary only so much. It is of little help if you need money, lots of it and right now.

I do not believe we have spoken of “substantially equal” payments on this blog before. There is a reason: that is dry country and likely to send both of us into a coma. Let me see if I can find a case that is even remotely interesting. 

Tax Preparers And Making Things Up

The following question came up this year. It was from an experienced CPA, so I was surprised that he even asked:

Are there rules on overstating income on a tax return?

You can anticipate the thought process. It is intuitive why one is not allowed to overstate deductions, as that has the effect of reducing taxes otherwise going to the government. But to overstate income? Why would the government care if you wanted to pay more tax?

Because folks, 999 times out of 1000 that is not the reason someone overstates income.

People do this to tap into the tax-credit-money-goodies in the tax Code. Most credits will reduce your tax, but when you get down to zero tax the credit ends. There are some exceptions. The main one, of course, is the earned income credit, although in recent years the government has added the American Opportunity (usually called the college) and the child tax credits.

The government will send you a check.

The earned income credit has the peculiar feature that the credit increases (as does your refund) as your income increases – up to a point, of course, and then the credit goes away.

I have reached a point in practice where I simply do not accept a client with an earned income credit. Chances are they could not afford my fee, granted, but I have a bigger issue: as a professional preparer, I take on additional penalty exposure by signing a return with this credit. I am “supposed” to perform extra due diligence, such a verifying that there is a child in your house. I have options other than parking across the street from your place overnight to verify your comings and goings, though: I can look at your kid’s report card (if it shows an address) or a doctor’s bill (again, if it shows an address).

Sure, pal. You know what I am not going to do? Prepare your return, that is what I am not going to do.

Unless I have known you for years, and I know that you have had a financial reversal. That is different. My due diligence has already been done and over several years.

There are unscrupulous preparers who do not observe such niceties. One could set up a temporary storefront, crank out a thousand make-believe, earned income/American Opportunity/child credit tax returns, charge a usurious fee (refund anticipation loans are sweet profit), skip town and enjoy the summer at a nice beach.

I knew one of these guys, although his schtick was made-up deductions more than false tax credits. You automatically had business mileage if you were his client. It did not matter if you owned a car.

Oh, did you know that is one way for you to get audited? If the IRS looks at your preparer, your odds of also being audited go up astronomically.

I am looking at a case from my hometown – Tampa, also known as the tax-fraud capital of the nation.

Our protagonist (the “Tax Doctor”) prepared a 2007 return for Shakeena Bryant. She brought a W-2 for less than $200 from Busch Gardens and information regarding her kids.

You are not going to get much of a credit with $200 worth of income.

But the Tax Doctor had a solution: report additional income from a business.

So she went out, got a business license for auto detailing and returned with it to his office the same day.

He then put a bit over $18,000 auto-detailing income on her return.

I suppose business licenses in Tampa also allow one to travel back in time.

Wouldn’t you know she got audited?

The IRS asked her about the auto detailing business.

She told the IRS she did not have an auto detailing business.

The IRS then wanted to talk to the Tax Doctor.

He explained that he “reasonably” relied upon her statements and exercised “due diligence.” He had that license, for example, and two pages of notes. He may also have had a soiled napkin from Dunkin Donuts, but I am not sure.

Out comes the preparer penalty - $2,500 of it.

Then the Tax Doctor – not knowing when to walk away – filed suit to get his $2,500 back.

This was a really bad idea, as it allowed the IRS to depose Ms. Bryant and the friend who accompanied her to the Tax Doctor’s office that day. 

Both testified that the business income idea was his.

The Tax Doctor fired back: he observed the due diligence rules, meaning that he should not be penalized. Why, he had a business license and two pages of notes in his files!

He had a point.

The Court also made a point: Ms. Bryant never talked about an auto-detailing business until he brought up the need for more income to drive the tax credit. Perhaps a reasonable preparer would have asked for documentation …. bank statements, receipts, FaceBook postings, State Department leaks. Folks, it is acceptable for a preparer to use his/her skepticism-radar.

He was reckless.

The Court found intentional disregard of his preparer responsibilities and sustained the penalty.

My thoughts? 

Very little patience. The Tax Doctor got off easy.

A Sad Grandma Story

 You know a tax case is going to irritate when you read this sentence early on:

The Commissioner does not defend the justice of this result, but says the law requires it.”

The story involves a grandmother, a son and daughter-in-law and two grandkids. Grandma appears to be the only one working and that as a nursing assistant in Texas. She also collected social security, which was just enough to keep the household afloat.

          []’s job is hard, and it does not pay much.”

It was 2012. He son did not work. Her daughter-n-law…

          … stayed home and took care of the babies.”

She filed her 2012 tax return and claimed the two grandchildren as dependents. That made sense, as she was the only person there with a job.

This allowed her to claim head of household and the dependent exemptions. Much more important than that, however, it allowed her to claim the child and earned income credits. She got a refund of almost $5,300, almost half of which was those credits.

Good for grandma.

The IRS sent her a notice. They wanted the money from the credits back.

Being the warm, fuzzy IRS we have come to know, she was also assessed a $1,000 penalty.

She figured ID theft. Somebody else must have claimed the kids.

She was right, partially. Somebody else did claim the kids.

Their parents.

That would be her son, the one who …

… did not work, and he was into dealing with drugs.”

Sigh.

We all know what a child is, but in the tax Code must rise to the level of a “qualifying child” before the tax goodies flow. There are requirements, of course – such as age and where they live – and grandma easily met those.

But only one person can claim each qualifying child, which is why one is required to include dependent social security numbers on the return. The IRS tracks those numbers. If you are the second person to use a dependent’s number, the IRS will bounce (or at least hold up) your return.

Grandma was the second to file, so she got bounced.

Now, there are families where more than one person can say that a child was his/her qualifying child. Congress anticipated this and included tie-breaker rules. For example, if two people contest and have equal claim, then the tie-breaker goes to the person with more income.

Or if the parents and someone else claim, then the parents win the tie-breaker.

However, this can be sidestepped if the parents DO NOT claim the child.

In grandma’s case, her son and daughter-in-law filed and claimed.

Can this situation be saved?

You bet.

How?

Amend the return. Have the parents “unclaim” the kids.

To their credit, the son and daughter did amend. They handed the amended return to the IRS attorney.

And here we have the technicality that makes you cringe.

Filing a return means sending it on to a service center or handing it to “any person assigned the responsibility to receive hand-carried returns in the local Internal Revenue Service office.”

Problem: the IRS attorney is not “assigned the responsibility” to receive or handle returns. Handing him/her a return is the equivalent of giving your return to a convenience store clerk or a Starbucks barista.

I suppose the attorney could bail you out by filing the return on your behalf upon returning to the office, but that did not happen here.

The return was never filed. Without an amended return, the son and daughter never revoked their dependency claim.

As the parents, they took priority over grandma, who only supported everyone that year.

And grandma could not claim the kids a second time.

Which cost her the child and earned income credits.

She had to repay the IRS.

The Court did not like this, not even a little bit.

We are sympathetic to []’s position. She provided all the financial support for …, had been told by her son that she should claim the children as her dependents, and is now stuck with a hefty tax bill. It is difficult for us to explain to a hardworking taxpayer like [] why this should be so, except to say that we are bound by the law.”

Sad.

At least the Court reversed those blasted penalties.

Almond Not-Joy

How much do you know about almond trees?

I know they are water-intensive and they come from California. I am uncertain whether they can be used for furniture. I presume they make good firewood.

So what would be a tax angle to this topic?

Growing almond trees.

Which gets us to farm taxation.

Farmers want (usually) to be cash-basis. This means that they report revenue when they receive cash and deduct expenses when they pay cash. It makes for relatively easy accounting, as one can almost get to a tax return from adding together 12 bank statements.

Then there are those issues.

I will give you one:

You buy a tractor-trailer load of seed and fertilizer late in December. Can you deduct it?

The issue here is whether you have incidental or nonincidental supplies. Incidental supplies (think printer paper to an accountant’s office) is deductible when purchased. Nonincidental supplies (think refilling an underground fuel tank of a trucking company) might be deductible only when used and not before.

Spend some big bucks on that fuel and the trucking company is keenly concerned about the answer.

Likewise, spend big bucks on seed and feed and the farmer is also keen on the answer.

Farmers have some nice tax bennies in the Code, and a large one is being able (in many cases) to use the cash basis of accounting. The Code furthermore allows farmers to deduct that year-end seed-and-feed (with some limitations) when purchased.

Nice.

That covers a lot of tax territory for row crops (that is: one growing season).

Let’s go next to orchards. Apples. Pears.

Almonds.

What new issue do we have here?

For one, orchards take years to become productive. There is no crop in the early years.

Is there any difference in the tax treatment?

Yep. It’s a sneaky one, too.

Let us talk about “uniform capitalization.” We have touched on this topic before, but never concerning almond trees. I am pretty sure about that.

The idea here is that the tax Code wants one to capitalize (that is, not immediately deduct) certain costs associated with inventory, self-produced assets any certain other specialized categories.

Almond trees are sort-of, kind-of “self-produced.”

Here is the fearsome tax beast in its canopied jungle home:

26 U.S. Code § 263A - Capitalization and inclusion in inventory costs of certain expenses

            (a) Nondeductibility of certain direct and indirect costs

(1) In general In the case of any property to which this section applies, any costs described in paragraph (2)—

(A) in the case of property which is inventory in the hands of the taxpayer, shall be included in inventory costs, and

(B) in the case of any other property, shall be capitalized.

I would argue that almond trees are “other property” per (a)(1)(B) above.

(2) Allocable costs The costs described in this paragraph with respect to any property are—

(A) the direct costs of such property, and

(B) such property’s proper share of those indirect costs (including taxes) part or all of which are allocable to such property.

Any cost which (but for this subsection) could not be taken into account in computing taxable income for any taxable year shall not be treated as a cost described in this paragraph.

The (B) above worries me. If this applies, then we have to “capitalize” real estate taxes on those trees.

Let’s look further at the definition of “property”:

(b)Property to which section applies Except as otherwise provided in this section, this section shall apply to—

(1) Property produced by taxpayer

Real or tangible personal property produced by the taxpayer.

(2) Property acquired for resale

(A) In general

Real or personal property described in section 1221(a)(1) which is acquired by the taxpayer for resale.

OK, I am getting worried. That (b)(1) sounds a lot like the almond trees. They are being “produced” (I guess) while they are growing and nonproductive.

Is there an out?

Here is something:

            (d)Exception for farming businesses

(1) Section not to apply to certain property

(A)In general This section shall not apply to any of the following which is produced by the taxpayer in a farming business:

(i) Any animal.

(ii) Any plant which has a preproductive period of 2 years or less.

I am zeroing-in on (d)(1)(A)(ii).

What is the growing (“preproductive”) period for almond trees?

Google says more than 2 years.

We are hosed.

We have to capitalize real estate taxes. 

COMMENT: Folks, that means “not deduct.” It gets expensive fast.

You know what else gets pulled-in via the gravitational pull of Sec 263A(a)(2)(B) above?

Interest.

We better not have any bank debt.

Arrggghhh! We have bank debt, meaning we have interest. We are going to have to capitalize that too.

The way this is going the only thing we are going to be able to deduct is the postage for the envelope in which we are sending a big check to the IRS.

We began the discussion by talking about how the cash basis of accounting lets farmers deduct stuff when they pay for them. Then we marched through the Code to find another section that tells us that we cannot deduct what we could deduct only a moment before.

COMMENT: I have heard a common lament over my years in practice: when to stop researching? There is no hard answer, but this case is an example of why tax practitioners fear and ask the question.

Our case this time was Wasco Real Properties I, LLC et al v Commissioner, for the home gamers.