What Does It Take To Exclude Foreign Income?

At this point of the tax season I usually lament not having won the lottery since last year’s tax season. I would travel extensively, most likely overseas.

That would put me out of the country, and you may have heard that there is a tax “break” for people who work outside the country.  I sincerely doubt it would apply to me in my imaginary lottery-fueled world, but let’s talk about it.

If you work overseas, you get to exclude up to $100,800 of earned income – such as salary – from U.S. tax. This sounds like a great deal, and usually it is, but remember that you would have been allowed a credit for income taxes paid the other country. If the foreign taxes are the same or higher than the U.S. taxes, the effect of the income exclusion is likely a push. If the other country has lower taxes than the U.S., however, this could be a very sweet deal for you.

There are ropes to claiming this exclusion. You have to meet one of two tests. The first test is being outside the U.S. for at least 330 days during the year. Think about this for a second. You take a job in Japan for a couple of years, but your family stays in the U.S. This means that you can see them up to 35 days a year – or forfeit the exclusion. I suppose they could travel to Japan instead, but you get the idea.

There is a second way, and that is to be a “bona fide” resident of the foreign country. This is hard to do, as it means that your home is there and not here. “Home” in this context does not just mean a place where you hang clothes and keep food in the refrigerator. The tax Code wants more: it wants your “main” home to be overseas.

Does this happen much? You bet. Think an American expatriate – perhaps retired military or someone who married overseas. I have family for example who have lived in England for decades. They have gone to school, worked, married and raised children there. They would easily qualify for the foreign income exclusion under the bona fide test.

What if one works overseas but still maintains ties to the U.S.? Can one also be a bona fide citizen of another country?

You can expect the IRS to be skeptical, especially if you leave a house or family behind. This is the IRS equivalent of New York Department of Revenue not believing you when you tell them you moved to Florida.

Let’s look at one someone who recently tried to make the bona fide argument.

Joel Evans took a job on Sakhalin Island in Russia, which has to count as going to the end of the world. He was working the oil rigs, both on land and offshore. His normal schedule was 30 days on followed by 30 days off. A 30- day stretch gave him the flexibility to return frequently to the U.S.  

He had a house in Louisiana, and somewhere in there he got divorced. His daughter moved into his house for a while. He returned to Louisiana whenever he could. He eventually married a second time, and his wife moved into, and his daughter moved out of, his house in Louisiana.

He claimed the foreign income exclusion for years 2007 through 2010. The IRS said no and wanted over $31,000 in back taxes from him

He had absolutely no chance under test one, as he spent way more than 35 days annually in the U.S. He argued instead that he was a bona fide resident of Russia.

I give him credit, I really do. It was his only argument. He spent a lot of time in Russia. He learned a little Russian. He fixed up a place to stay. He made friends. He even dated some Russian women, which I presume he ceased doing when he got remarried.

But that isn’t the test, is it?

The test is where his main home was. He pretty much gave his hand away when he kept returning to Louisiana almost every thirty days.

The Tax Court agreed with the IRS and disallowed his foreign income exclusion. He was not a bona fide resident of Russia, and he could not exclude his foreign earned income. He had failed both tests.

Let’s state the obvious: he had no chance winning this one.

In my practice, almost everyone relies on the 35-day test, and it is common to monitor the 35 days like a hawk. I suppose if I were an expat (that is, living overseas) preparing taxes for other expats, I would see the bona fide test more frequently. There are not too many bona fides who would need my services in Cincinnati.

Which rule – the 35 day or the bona fide – would trip me up when I hit the lottery?

Neither. It takes earned income – think self-employment or a salary – to power the foreign earned income exclusion. I have no intention of working.

An Interim Report On Tax Season

I was speaking with a colleague earlier this week who wants to set up a tax storefront. That means a place that prepares taxes, probably only individual taxes and only for a few months a year. Think H&R Block, but without a franchise involved. I suspect he would be successful, but like any business start-up the cash drain is difficult to pull off.

And he asked me if tax seasons are getting “harder.” Yes, he is younger than me. I am getting to that age.

I hesitated on his question, as my long-standing position is that the accounting firm determines the difficulty of the season for its employees. Some firms do a good job, and other firms simply do not care. It is one of the reasons that the average career of an accountant in a CPA firm is little more than that of an NFL player.

Bet you did not know that.

Still, there are issues for tax practitioners that did not exist a few years ago – or even last year.

I was speaking this week with a good friend about whether it was safe for him to prepare his personal tax return on TurboTax. Depending upon the year and other factors, he prepares a draft return and I review it for him. Last year he changed jobs and states, so I expect I will review his return this year.

Why TurboTax? It turns out that a number of states experienced suspicious electronic filing activity this year and, upon investigation, in many cases the electronic return was filed using TurboTax.

Let’s be fair, though. That does not mean that the information came from TurboTax. There have enough recent breeches of data security that the information may have come from elsewhere.

Intuit, the parent of TurboTax, responded aggressively to this development, as you would imagine. A number of states, including Kentucky and Minnesota, temporarily halted the processing of electronically filed returns.  Meanwhile TurboTax encouraged its customers to log-in and review their accounts. They instructed their customers to review their direct-deposit information specifically.

Makes sense.

Why the states? In the past, fraudsters have targeted the IRS rather heavily. The IRS responded with stricter identity measures, including lockdowns on any tax refunds and the required use of security passwords. Florida was so hard-hit, for example, that one can request a federal security PIN number under a pilot program – even if one was not the victim of identity theft.

It may be that the fraudsters saw easier picking elsewhere.

Then we have the information documents to prepare a tax return.

I am reading that the federal health insurance marketplace has sent out approximately 800,000 erroneous Forms 1095-A. This is not insignificant and represents approximately one-in-five people using the marketplace. These forms are new and are issued by the exchanges to individuals who purchased insurance there. They include information on any government subsidy, so they are an important tax document.  For example, even if you are not otherwise required to file a tax return, you must file if you received a subsidy.

The error concerns the “benchmark plan” premium and doesn’t concern the amount of subsidy itself. The “benchmark plan”” is the second lowest cost silver plan for where one lives, and it is part of the arithmetic to settle-up whether one received too much or too little subsidy. As you know, if you received too much subsidy you have to pay it back.

Taxpayers who received Forms 1095-A are encouraged to wait until March before filing their individual tax returns. Not a problem. Surely these are people who do even meet with their tax advisors until March.

Meanwhile, it has finally dawned on some politicians that people may not realize the effect of ObamaCare on them until they file their 2014 taxes. There will be rude surprises for those who did not acquire insurance and now have to pay the penalty. Perhaps they acquired insurance but were over-subsidized, and now they have to repay the excess subsidy.

Wait until they learn that the penalty will go up every year.

Then there is a problem with the timing of obtaining health insurance. ObamaCare requires everyone to have insurance in place by February 15 – which of course is two months earlier than April 15, when taxes are due. That may be the first time people understand this Rube Goldberg contraption foisted 50-shades-of-grey style upon society. What happens then? Well, in addition to owing the penalty for 2014 it would appear that one would also owe a penalty for some part of 2015 – at least until one can acquire health insurance. The penalty goes month by month.

Many politicos – not the brightest class emerging from natural selection – are now up in arms, demanding that deadlines be changed, penalties ameliorated and so on. I suppose there is a nuance there, but it escapes me. 

Somewhat on cue, on February 20 the Center for Medicare and Medicaid Services declaimed that the enrollment period shall reopen from March 15 to April 30.

To which I have two questions:

1. What happened to the period from February 15 to March 15?
2. Why is the Center for Medicare and Medicaid Services changing the law?

On February 13 - which seems a lifetime ago at this point - the IRS finally provided some guidance on how to comply with the new repair Regulations effective with the 2014 tax returns. Considering that their first pass at the Regulations required almost everyone with real estate or other depreciable property to file for a change in accounting method - a change which the IRS mandated, by the way - the IRS then had the temerity to say that we also had to formally ask them for permission to change. I had and have a stack of real estate partnership returns in my office waiting on their guidance. Forests have been felled by tax practitioners divining for weeks and months what the IRS wanted from us this year in order to comply with their new Regulations. 

Do you ever wonder if our government is suffocating under the weight of people who - having accomplished little more than going to a name school or playing at politics - think they now have the chops to bludgeon those of us who actually accomplish something every day? 

Back to our initial question though: are tax seasons getting “harder?”

I don’t think “harder” is the word I would use for for it.

Distinguishing Capital Gains From Ordinary Income

The holy grail of tax planning is to get to a zero tax rate. That is a rare species. I have seen only one repeatable fact pattern in the last few years leading to a zero tax rate, and that pattern involved not making much money. You can guess that there isn’t much demand for a tax strategy that begins with “you cannot make a lot of money….”

The next best plan is capital gains. There is a difference in tax rates between ordinary income (up to 39.6%) and capital gains (up to 20%). A tax geek could muddy the water by including phase-outs (such as itemized deductions or personal exemptions), the 15% capital gains rate (for incomes below $457,600 if you are married) or the net investment income tax (3.8%), but let’s limit our discussion just to the 20% versus 39.6% tax rates. You can bet that a lot of tax alchemy goes into creating capital gains at the expense of ordinary income.

The tax literature is littered with cases involving the sale of land and capital gains. If you or I sell a piece of raw land, it is almost incontrovertibly a capital gain. Let’s say that you are a developer, however, and make your living selling land. The answer changes, as land is inventory for you, the same as that flat screen TV is inventory for Best Buy.

Let’s say that I see you doing well, and you motivate me to devote less energy to tax practice and more to real estate. At what point do I become a developer like you: after my second sale, after my first million dollars, or is it something else?

The tax Code comes in with Section 1221(a), which defines a capital asset by exclusion: every asset is a capital asset unless the Code says otherwise.

For purposes of this subtitle, the term “capital asset” means property held by the taxpayer (whether or not connected with his trade or business), but does not include—

(1)  stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business;

Let’s take Section 1221(a)(1) out for a spin, shall we? Let’s talk about Long, and you tell me whether we have a capital asset or not.

Philip Long lives in Florida, which immediately strikes me as a good idea as we go into winter here. From 1994 to 2006 he operated a sole proprietorship by the name of Las Olas Tower Company (LOTC). Long had a drive and desire to build a high-rise condominium, which he was going to call Las Olas Tower.

He is going to build a condo, make millions and sit on a beach.

Problem: he doesn’t own the land on which to put the condo. Solution: He has to buy the land.

He finds someone with land, and that someone is Las Olas Riverside Hotel (LORH). LORC and LORH are not the same people, by the way, although “Las Olas” seems a popular name down there. Long enters into an agreement to buy land owned by LORH.

Long steps up his involvement: he is reviewing designs with an architect, obtaining government permits and approval, distributing promotional materials, meeting with potential customers. The ground hasn’t even been cleared or graded and he has twenty percent of the condo units under contract. Long is working it.

LORH gets cold feet and decides not to sell the land.

Yipes! Considering that Long needs to land on which to erect the condo, this presents an issue. He does the only thing he can do: he sues for specific performance. He needs that land.

He is also running out of cash. A friend of his lends money to another company owned by Long to keep this thing afloat. Long is juggling. Who knows how much longer Long can keep the balls in the air?

In November, 2005 Long wins his case. The Court gives LORH 326 days to comply with the sales agreement.

But this has taken its toll on Long. He wants out. Let someone finish the lawsuit, buy the land, erect the condo, make the sales. Long has had enough. He meets someone who takes this thing off his hands for $5,750,000. He sells what he has, mess and all. 

    QUESTION: Is this ordinary or capital gain income?

The difference means approximately $1.4 million in tax, so give it some thought.

The closer Long gets to being a developer the closer he gets to a maximum tax rate. The Courts have looked at the Winthrop case, which provides factors for divining someone’s primary purpose for holding real property. The factors include:

1. The purpose for acquisition of property
2. The extent of developing the property            
3. The extent of the taxpayer’s efforts to sell

The Tax Court looked and saw that Long had a history of developing land, had hired an architect, obtained permits and government approvals and had even gotten sales contracts on approximately 20% of the to-be-built condo units. A developer has ordinary income. Long was a developer. Long had ordinary income.

Is this the answer you expected?

It wasn’t the answer Long expected. He appealed to the Eleventh Circuit.

What were the grounds for appeal?

Think about Long’s story. There is no denying that a developer subdivides, improves and sells real estate. Long was missing a crucial ingredient however: he did not have any real estate to sell. All he had was a contract to buy, which is not the same thing. In fact, when he cashed out he still did not have real estate. He had won a case ordering someone to sell real estate, but the sale had not yet occurred.

The IRS did not see it that way. As far as they were concerned, Long had found a pot of gold, and that gold was ordinary income under the assignment of income doctrine. That doctrine says that you cannot sell a right to money (think a lottery winning, for example) and convert ordinary income to capital gains. You cannot sell your winning lottery ticket and get capital gains, because if you had just collected the lottery winnings you would have had ordinary income. All you did was “assign” that ordinary income to someone else.

The problem with the IRS point of view is that someone still had to buy the land, finish the permit process, clear and grade, erect a building, form a condo association, market the condos, sell individual units and so on. Long wasn’t going to do it. There was the potential there to make money, but the money truck had not yet backed into Long’s loading dock. Long was not selling profit had had already earned, because nothing had yet been “earned.”

Long won his day in Appeals Court.

He had ordinary income in Tax Court and then he had capital gains in Appeals Court.

Even the pros can have a hard time telling the difference sometimes.

Why Audit Veterans Organizations?

I suppose that any examination of an exempt organization by the IRS nowadays is going to be viewed in harsh light.

What got me thinking about this is the controversy concerning IRS audits of veterans organizations. While it hasn’t garnered the attention of the 501(c)(4) imbroglio, there has nonetheless been harsh criticism. U.S. Senator Moran (Kansas) for example has stated:

On the heels of Americans' anger over revelations that the IRS intentionally targeted certain groups, it has been brought to my attention that the IRS is now turning their sights toward our nation's veterans. The IRS seems to be auditing veteran service organizations by requiring private member military service forms. If a post is unable or not willing to turn over this personal information, it is possible they could face a fine of $1,000 per day.

I am deeply concerned about this revelation and will insist on answers. This policy ... deserves, at a minimum, a thorough look to make certain the IRS is not overstepping bounds of privacy and respect for our nation's heroes."

For its part, the House Veterans Affairs committee has threated to investigate what the IRS is up to.

So why would the IRS – in a time of budget restraints – be auditing these groups?

A couple of reasons come to mind:

•  The IRS has to audit exempt groups occasionally, if only in the interest of enforcing tax compliance among all exempt groups.

• Veterans organizations have unique tax requirements that are relatively easy to run afoul of.

Reason (1) is easy to understand, even if we would rather have a root canal than undergo a tax audit. Reason (2) is a bit more involved.

Tax-exempt organizations come in multiple flavors, depending on what the organization does. For example, a veterans organization could qualify as a social welfare group – that is, a 501(c)(4) – given its purpose of promoting patriotism, championing the issues of veterans, assisting needy and disabled veterans and conducting social and recreational activities among its membership.   

Let’s go a step further, and you will understand how the sausage of tax law comes to be.

Let’s say the veterans organization buys a building. Let’s say it puts a kitchen and bar in said building. We may now have a social club under Sec 501(c)(7), the same as a college fraternity or private golf course. Had you and I gotten together and built our own golf course, our activity (of playing golf) would not be taxable. The tax Code acknowledges this and allows for larger groups to do what you and I could have done together if only we were multibillionaires. There could be tax consequences if we did other things, but let’s keep our discussion general.

In 1969 Congress expanded the reach of the unrelated business income tax (UBT). UBT by definition relates to tax-exempt organizations, and it means that the organization has to pay tax on profitable business activities that are not in furtherance of its tax-exempt purpose.

What does that mean? Let’s go back to that golf course you and I built. Let’s say that we rent out our course to the PGA annually for a major tournament. We of course charge the PGA big bucks for using our course. We apply as a (c)(7), albeit a small one, considering it is only you and me. The IRS is not going to let us pocket all that money and not pay tax. Why? Because it is not our exempt purpose to rent our course to the PGA.

The veterans organizations became upset with the UBT. It was not even the kitchen and bar, truthfully, as much as it was the insurances – life, health and so on – that they were offering to their members. That was a big deal, and their insurance activity was now being pulled into the orbit of the UBT because of that (c)(4) or (c)(7) status.

Congress, thinking that the answer to everything problem is yet another law, passed Code section 501(c)(19): 

(19)  A post or organization of past or present members of the Armed Forces of the United States, or an auxiliary unit or society of, or a trust or foundation for, any such post or organization—

(A)  organized in the United States or any of its possessions,

(B)  at least 75 percent of the members of which are past or present members of the Armed Forces of the United States and substantially all of the other members of which are individuals who are cadets or are spouses, widows, widowers, ancestors, or lineal descendants of past or present members of the Armed Forces of the United States or of cadets, and

(C)  no part of the net earnings of which inures to the benefit of any private shareholder or individual.

And veterans organizations now had an escape clause from the UBT – as long as they could fit into (c)(19).

It worked well enough for long enough. And now it is starting to work less well.

Why?

It’s the math. Code section (c)(19) states that at least 75% of the members must be veterans  and substantially all other members  (generally defined as 90% or more) must be spouses, widows and descendants. Let’s go through the math. To start, at least 75% of the members must be veterans. Of the remaining, 90% or more must be related to a veteran. Doing the math, only 2.5% of the total membership (25% times 10%) may consist of non-veterans or persons unelated to a veteran.

That is a tight window.

Statistics show over 19 million veterans in the United States. More than 9 million are age 65 or over. Veterans are aging, and every year there are fewer of them. Those demographics are pushing on the percentage tests of (c)(19).

Let’s point out another problem.

How do you prove the 75%? I suppose you could (and probably should) obtain documentation from the veterans. The same could be said for proving the other 90%.  It would be business- standard procedure to keep files and maintain a policy and post signs that only members and families are admitted. I suppose we could boost documentation even more by requiring sign-in books, but you get the idea.

Is it intrusive? You bet. We are talking about IDs and proof of military service, for example. The IRS aggravated the matter recently by asking for DD 214 forms, which is the paperwork accompanying military discharge. The IRS had not routinely asked for this before, so many organizations were caught flat-footed. To exacerbate the matter, the IRS then threatened $1,000 per day penalties.

Cue the resentment and anger of organizations like the American Legion. These generally are not organizations that can easily accommodate drastic changes in tax rules. Many are small, reliant on volunteers and operating on a tight budget.  One cannot approach them as though one were dealing with the tax department of an Apple or Pfizer.

What is the answer? I don’t know. The 501(c) area is a motley of tax grab-bag accreted over the years. Some (c)’s can receive tax-exempt contributions; others cannot. Some organizations are (c)’s just by existing; others have to formally apply and get approval. Some do not pay income tax unless they get carried away and flat-out run a for-profit business. Others pay tax on income “not sufficiently related” to their exempt purpose, a standard sometimes bordering on the mystical. Some are huge, own buildings and have tens of thousands of employees. Others are tiny, have space donated and do everything through volunteers.

It is maddening, but they all have to be (at least in theory) auditable by the IRS.

And there is the rub.