An Expat Tax Horror Story

I acquired a client last week. He was an expat living in Scotland for more than a decade. He recently returned to the US and is now working the in the oil industry.  Yep, based in Cincinnati and working the oil fields of west Texas. While in the UK he worked in the North Sea, went to college, met his wife and started and closed a restaurant, losing quite a bit of money along the way.  He is in the process of immigrating his wife into the US. He has not filed US tax returns since he left the US way back when.

What does a tax guy see here?

(1)    The first is obvious: he hasn’t filed individual tax returns.

There are two saving graces: he will receive foreign income exclusion while working in the UK. That should remove all or almost all his income from taxation. As the UK tax rates are higher, he may also receive a foreign tax credit for tax paid on income in excess of the exclusion.

(2)    He hasn’t filed FBARs.

This is the annual report one sends to Treasury if one has more than $10,000 in an overseas bank account. He made pretty good money while in the North Sea, so he would have exceeded the $10,000 threshold.

This is where it becomes unfair. After the UBS episode, the IRS has taken a very tough stance with overseas accounts.  Some of this is understandable, as the IRS is pursuing the “fat cats.”  This fellow is not a fat cat. He is an ordinary guy who lived in Scotland, and while there he made a couple of dollars. If you have previously read my blog, you may know that I have in-laws overseas. His situation is not disparate to my brother-in-law.

The IRS has an initiative (the Overseas Volunteer Disclosure Initiative) which was to close yesterday (August 31) but was extended to September 9^th because of Hurricane Irene. We considered the OVDI.

Here is the IRS:

A penalty for failing to file the Form TD F 90-22.1 (Report of Foreign Bank and Financial Accounts, commonly known as an “FBAR”).United States citizens, residents and certain other persons must annually report their direct or indirect financial interest in, or signature authority (or other authority that is comparable to signature authority) over, a financial account that is maintained with a financial institution located in a foreign country if, for any calendar year, the aggregate value of all foreign accounts exceeded $10,000 at any time during the year. Generally, the civil penalty for willfully failing to file an FBAR can be as high as the greater of $100,000 or 50 percent of the total balance of the foreign account. See 31 U.S.C. § 5321(a)(5).  Nonwillful violations are subject to a civil penalty of not more than $10,000.

I spoke with an attorney in the IRS unit yesterday afternoon, and he informed me that – because of the favorable facts – the IRS would not penalize my client more than 12.5% for not filing his FBARs timely. The penalty might even be reduced to 5%. So if my client had $50,000 in a Scotland bank, he could be facing a fine of $6,250.

(3)    He owned a business in Scotland.

This business was organized as a private limited company. Had he made a timely US election, we would have treated this entity as an LLC and folded the numbers into his personal return. As the returns are late, that avenue is not available. The entity is therefore treated as a foreign corporation. Since the corporation is controlled by a US citizen, it has to file Form 5471 with the IRS.

Take a look at these penalties from the IRS Voluntary Disclosure website:

A penalty for failing to file Form 5471, Information Return of U.S. Person with Respect to Certain Foreign Corporations. Certain United States persons who are officers, directors or shareholders in certain foreign corporations (including International Business Corporations) are required to report information under sections 6035, 6038 and 6046.The penalty for failing to file each one of these information returns is $10,000, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return.

(4)    He funded a business in Scotland.

There is additional reporting here. He is required to file Form 926 disclosing his outbound investment into the restaurant. Now, it wasn’t really “outbound” as he lived in Scotland at the time, but because he is a US citizen it is considered “outbound.”

Let’s look again at the IRS:

A penalty for failing to file Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation. Taxpayers are required to report transfers of property to foreign corporations and other information under section 6038B.The penalty for failing to file each one of these information returns is ten percent of the value of the property transferred, up to a maximum of $100,000 per return, with no limit if the failure to report the transfer was intentional.

Now, does this appear reasonable to you?

As a long-standing tax practitioner I have very firm opinions on desirable attributes of a fair and efficient tax system. One is that a citizen should be able (in most cases) to prepare his/her tax return without the need of someone like me.  Second is that the system should not be random and arbitrary, either in its laws or regulations or in its enforcement of the same. Third is that the system should not mete out draconian punishment for matters representing less-than- extreme abuse or disregard of the system. I cannot help but feel that the Treasury has violated the third precept. This fellow is a driller, not a hedge fund manager. To me his noncompliance is roughly equivalent to me not knowing the holidays in Peru.

If you wonder how my client turned out, there was another way to file. He loses the certainty of the OVDI penalty structure, but when the penalty is that severe can you blame a taxpayer for preferring an unknown to the known?

Doing Business Across State Lines

Does your business lease property in another state? Do you have sales people who travel to other states?

You may have multistate tax issues.

There are many types of state and local taxes. Three of the most common are income tax, sales tax and use tax. These taxes may have different names in different states. For example, an income tax may be referred to as a franchise tax, or a sales tax may be called a transaction privilege tax.  The use tax is the twin to the sales tax: if the seller does not collect sales tax, then the purchaser may be required to separately pay use tax.

There is a new breed of state taxes that meld the above. Ohio has a commercial activities tax, which sprung into existence as a replacement to the Ohio franchise tax but bears closer resemblance to a sales tax.

Why should you worry about multistate issues?

A key reason is that states are facing severe budgetary pressures and are looking to aggressively assert their tax laws in order to increase their tax receipts. It used to be, for example, that you did not have to worry about collecting sales taxes for another state unless you owned or leased property in that state or kept employees there. This is now changing.   California, for example, wants Amazon to collect sales tax if it pays a fee to “affiliates” located in California. An affiliate (say a California band) has a hotlink on its website to Amazon. By clicking on that link, one is transferred to Amazon where one can buy the band’s CDs. California believes that is enough reason to pull Amazon into its sales tax regime.

California is not the only state moving to this "affiliate" sales tax theory. New York became the first to do so in 2008, and Connecticut, Illinois, Rhode Island and Arkansas have since passed similar laws.

Did you know that some states subject services to sales tax? If you are performing services in those states, you may have multistate tax issues.

If you do not know you have a liability, you cannot file. Did you know that there is no statute of limitations on how far back a state can go if you never file returns? You could wind up owing 10 years or more in back taxes, plus penalties and interest. Not a problem, you say, as I can file for refund in my state and get that money back. What if the statute of limitations for a refund has expired with your state, but there is no limitation in the new state demanding sales taxes. In that case, you are paying tax twice.

There is a long-standing tax theory called “nexus” that states have to meet in order to pull you into their tax regime. The states have been changing, and aggressively expanding, their definition of nexus. It may be that ten years ago you did not have nexus but that you do have nexus today.

Examples of nexus are:

• An office
• A phone line
• Inventory or supplies in the state
• Office equipment or other property
• Business license
• Employees acting on your behalf
• Employees attending a trade show in the state
• Independent contractors acting on your behalf
• Use of intangible property (like a trademark) in the state

Did you notice the one about the trade show? In 2007 the Texas Comptroller of Public Accounts determined that a seller of dental equipment who attended a one-day trade show was responsible for collecting sales taxes on any sales generated at the trade show. The decision is not totally unexpected, as the salesman did generate quite a few sales and attended the trade show annually. However, many if not most tax planners would have missed this sales tax exposure by reasoning that it is only one day.

States are changing how they are apportioning or allocating multistate income to their respective state. It used to be that states would weigh sales, property and payroll evenly. Many states are now moving to sales only, with no weighting for either property or sales. This is an effort to more out-of-state businesses into their tax system. Why, some states will require you to treat income sourced to a non-taxing state as attributable to them! This is the “throwback” rule, and it is a transparent effort to increase their own tax apportionment.

What if you form separate legal entities to avoid nexus? For example, a manufacturer could have plants in several states but have a separate company make all retail sales.  Some states will assert “affiliate” nexus if any of the affiliated entities have nexus. One equals all. Once an affiliate has nexus, all the affiliates have nexus. In an income-tax environment this is referred to as the “unitary” concept.

It is important that you work with an accountant or advisor proficient in these matters. If you find that you have an issue (especially if the issue has existed for several years) that advisor will be invaluable to you and your business. An experienced advisor may be able, for example, to limit the number of back years that have to be filed with a state, as well as any penalties.

The New InvestOhio State Tax Credit

The recent Ohio biennial budget bill included an income tax credit for investments in qualifying small businesses.  This was a late addition, and it was made in response to some rather depressing statistics about Ohio business over the last decade:

·         Ohio has lost more jobs than any state other than California and Michigan

·         Ohio has ranked in  the bottom 10 states for population growth

·         Ohio’s economy has ranked in the bottom 5 states

The new tax credit is referred to as “Invest Ohio.” The credit will run for two years (Ohio has biennial budgets), and the state estimates that the program will cost $100 million. The state hopes to stimulate at least 30,000 jobs, at which number the state anticipates to breakeven.

The credit is nonrefundable. You need to have an Ohio income tax to make this worthwhile.

Let’s go through the steps:

(1)    This is an income tax credit. More specifically, only taxpayers with income taxes will be able to use it. You may recall that Ohio C corporations pay a Commercial Activity Tax (or “CAT”) in lieu of income taxes, so this credit is not for C corporations. Rather it is for individuals, passthroughs, trusts and estates.

(2)    You have to be an eligible small business.

a.       Your total assets are $50 million or less OR your total sales are $10 million or less

                                                               i.      Because of the “or,” you must meet one of the two tests to qualify.

b.      You must have enough presence in Ohio to qualify. There are two alternative tests:

                                                               i.       More than half your employees are in Ohio.

1.       It doesn’t matter how many employees you have. Just one (yourself) is enough.

                                                             ii.      You have more than 50 full-time equivalent employees in Ohio.

1.       This does not need to be more than half.

NOTE: Let’s go over this, as it may not be clear. If you have 2 employees and both are in Ohio, you qualify. If you have 274 employees, of which more than 50 are in Ohio, you qualify. Technically, this second test is done by full-time equivalents rather than employees, but you get the idea.

(3)    Fresh money is going into the business as equity.

a.       This fresh money is going to acquire, increase or maintain an equity interest.

                                                               i.      You are not playing banker here. This is not a “Loan from Owner.”

                                                             ii.      You are receiving shares, units – something- that indicate ownership.

                                                            iii.      An easy example is someone who becomes a new shareholder in an S corporation by investing $25,000. This is fresh money and he/she has acquired an ownership interest.

1.       What is you already own 100%? You cannot go over 100%.

a.       Answer:  this will count.

(4)    You have to spend the money in an approved way.

a.       You have to buy tangible personal property.

                                                               i.      Desks, a copier, computer monitors or a business van will qualify.

b.      You can buy real property, as long as it is in Ohio. Ohio will not subsidize that Florida condo.

c.       You can buy intangibles, such as patents, copyrights or trademarks.

                                                               i.      The one that occurred to me was enterprise software or a website.

d.      Compensation for new or retrained employees for whom the business is required to withhold Ohio income tax.

                                                               i.      I am not sure my firm has clients that would incur employee “retraining.”

                                                             ii.      A new employee will count.

1.       There is a big EXCEPT here: the employee cannot be an owner, manager or officer.

                                                            iii.      The Ohio tax withholding becomes an issue for the border residents. For example, I live in northern Kentucky but work in Cincinnati. I do not have Ohio withholding because of the reciprocal tax agreement.  As I read this, I would not qualify.

(5)    You have to spend this new money within six months.

(6)    The credit is 10 percent.

a.       There is a maximum however.

                                                               i.      The maximum credit is $1,000,000 per taxpayer.

1.       If you are married, this becomes $2 million.

b.      My understanding is that this $1 million limit is for the first credit period, which is two years. If the credit is renewed, my understanding is that you will get a brand new $1 million limit.

(7)    Tax credit period

a.       The first period of the program runs from 7/1/2011 to 6/30/2013 (remember: biennial budget).

b.      The timing of this credit is odd.

                                                               i.      You have to wait until the period is up (6/30/13) before you can claim the credit.

1.       So an investment in 2011 gets no payoff until 2013.

2.       At least you can use it in the same year the period expires.

c.       You then get 7 years to use up the credit. More specifically, an investment in 2011 would get to use its credit in tax years 2013 to 2019.

d.      IF THE PROGRAM IS CONTINUED IN 2013 …

                                                               i.      Then the waiting period becomes five years rather than two. That is a long time to it for a credit to kick-in. An investment in 2014 would have to wait until 2019 before using the credit.

(8)    You have to keep the money invested for the credit qualifying period.

a.       That is, you cannot put money in and take it right back out.

b.      But, then again, the first period is only two years. This is not a long time.

(9)    Paperwork

a.       There is paperwork for …

                                                               i.      The application and qualification,

                                                             ii.      The certification, and

                                                            iii.      A pledge not to dispose of the investment before the end of the holding period

b.      In short, the business and its owner will have paperwork. This makes sense, as Ohio wants (at a minimum) to keep track of how many people are using the program.

c.       The program is being administered by the Ohio Department of Development. They are your contact, not the Department of Taxation.

(10) Owners of passthrough entities will claim the credit based on their distributive or proportionate share of the entity.

Rick Kruse and I agree that the key point to this credit is the fresh cash. Perhaps the cash is funded by savings, by borrowings, or perhaps by a circular transaction, but somehow new money has to enter the picture. The problem may be getting the fresh cash in the owner’s name.

Think about the following examples:

(1)               The S corporation buys a truck. There is a down payment and a term note for the balance. Even if the shareholders sign on the note, there has been no fresh cash into the business, so there would be no tax credit.

(2)               The LLC wants to buy shop equipment. There are three members. Only one of the members is willing (or able) to start the required “fresh cash” sequence.  Perhaps he/she is the only one with enough savings, enough credit or enough collateral to borrow.  Therefore, only one of the members can initiate the “fresh cash” cycle. This situation may be more about member dynamics than tax planning.

(3)               The partnership constructs a building. The construction loan is signed by the partners. Under this loan, the draws are disbursed directly by the bank to the contractors and suppliers.  Whereas one can argue “fresh cash,” there has been no increase in equity. There has been only an increase in debt.  

Here is one that intrigues me:

(4)               A key employee is awarded 50 shares under a stock bonus program. The stock vests, so the employee recognizes taxable income on his/her personal return. The business in turn purchases equipment within the requisite six month period. Do we have a "fresh cash” cycle?

BTW, the instructions and directions for this credit are virtually nonexistent as I write this. For the time being there are questions with no answers. For example, can one set up a new company in order to qualify as an “eligible small business” or will the new company being aggregated with an existing company?  This is a basic technique – and therefore a basic question - for any tax practitioner.

If your business qualifies as an Ohio eligible small business, you simply must consider this credit in your tax planning. If you will be buying equipment, or trucks, or software, or hiring ANYWAY, why not plan for the credit? If you can’t make it work then you can’t, but at least consider it.

A Quick Lesson In Statistics

Did you hear about the guy that drowned in a river which is, on average, 8 inches deep?

I’ve been taking a look at some taxable income statistics from the IRS.

I studied statistics at both an undergraduate and graduate level. In fact, the single hardest course I took at the University of Missouri was Nonparametric Statistics. As I was also doing my graduate tax studies at the law school, that is saying something.

Let’s go through a little exercise.

Say that you and 199 of your friends live in a splendid closed-gate community which we will call Hamiltonville. Your community is especially prosperous, and every adult makes exactly $200,000 a year. You each have a net worth of $2 million. You are - by all reckoning - successful, and you feel and act that way. Congratulations.

Now, something happens…

Steve Jobs moves into your neighborhood. You know Steve Jobs: chairman of Apple, ridiculously successful businessman, widely considered as a technology visionary and the driving force behind Apple.

And also worth approximately $6 billion.

There are now 201 people in your neighborhood. Prior to Jobs moving in, the average net worth was $2 million. Everybody was affluent.

After Jobs moved in, the numbers are different. The average net worth is now approximately $32 million. Your paltry $2 million is WAY below average.  In fact, you are approximately 93% below average. Why, you have been virtually impoverished overnight!

One could see severe wealth inequality in this picture.

Question: are you any poorer?

A Tax CPA Not Filing Taxes

My daughter goes to the University of Tennessee. Perhaps it is because she is in Knoxville that the following story about Edgar H. Gee Jr. caught my eye.

Mr. Gee is a CPA and has (had?) a small accounting firm on the west side of Knoxville off Kingston Pike. He has been at this for a while, as he is going on 40 years of professional experience.  His resume is nothing to snicker at:

·    He has published articles in the Tax Adviser (a professional publication)

·    He has testified before the U.S. House of Representatives Subcommittee on   the Oversight of IRS Activities

·    He is co-author of PPC’s Guide to Worker Classification

·    He is the winner of the Max Block Award by NYSSCPAs for Distinguished Article of the Year 2000

·    He is a past president of the Knoxville Chapter of the Tennessee Society of Certified Public Accountants

·    He was the recipient of the Discussion Leader of the Year award from the Tennessee Society of CPAs in 2001

What did he do?

Well, the IRS Office of Professional Responsibility disbarred him because he did not pay taxes for tax years 1997 through 2005. The OPR said he had engaged in disreputable conduct by willfully evading his taxes for nine years. The amount of taxes, including interest and penalties, was approximately $340,000.

I guess he can continue lecturing, but he is not practicing before the IRS again.

What argument does a tax CPA present when he hasn’t filed taxes for almost a decade? I didn’t know? That kite is just not going to fly.

It’s just sad.

BTW I do not know Mr. Gee, but maybe I’ll run into him sometime. I do hope that he is not teaching tax at UTK.

The Use Of A Dynasty Trust

President Obama’s 2012 budget included a provision to limit dynasty trusts to approximately 90 years.

What is a dynasty trust? This creature exists because of estate taxes and generation-skipping taxes. Say that you and your spouse are worth $25 million. You have a daughter, and you come to me because you want to plan your estate. You think you can live on $10 million. To make this easy, say that all your wealth is in publicly-traded stocks. We call the broker and transfer $15 million in stocks to her. At the end of the year you will have a gift tax return. The gift tax exemption this year is $5 million per person, which means that you and your spouse combine for a total exemption of $10 million. You will have a gift tax, as the net gift subject to gift tax is $5,000,000 ($15,000,000 - $10,000,000).

When your daughter passes away, that $15 million will be included in her estate again and she will pay estate tax.

Ah, you say. You now understand what the estate tax is doing. What if you gift to your grandson, that way the $15 million will escape estate tax at your daughter’s death. You “skipped” a generation. Enter the generation-skipping tax, whose purpose is – you guessed it – to tax that transfer to your grandson. No skipping allowed.

Let’s tweak this a bit. Say that you gift $10 million to your daughter and $5 million to your grandson. Now you have an interesting case study. You see, the generation-skipping tax has an exemption. That exemption amount is currently $5 million per person, or $10 million for you and your spouse. You can transfer up to $10 million to your grandson, have it escape the estate tax (at the daughter’s death) and also escape the generation-skipping tax.

Let’s tweak this again. Say that your grandson receives the gift amount (at some point in the future – it doesn’t matter when). When he passes away, the $5 million is in his estate and there will be estate tax. Is there some way to skip his estate tax?

Enter the dynasty trust. You put the $5 million in a dynasty trust. Your grandson is a beneficiary and receives distributions. He does not have enough retained power to dragnet the trust into his estate upon death. The trust escapes his estate and passes on to the next tier of beneficiaries, which are presumably your great-grandchildren.

This trust is designed to never be snared by the estate or generation-skipping tax ever again. Wow!

Enter the rule against perpetuities. There is a common law principle that allows a trust to carry-on for only so long without vesting, which is about 90 years. I studied trust law at the University of Missouri Law School and, frankly, its application in practice confused me both then and now. However, there are 23 states (including Kentucky and Ohio) that have “waived” the rule against perpetuities and allow dynasty trusts. So we can employ a dynasty in Ohio, for example, and sidestep the rule against perpetuities.

Enter Obama’s proposal to limit these trusts to 90 years or so. It would do so, not by limiting the trust, but by limiting the generation-skipping exclusion. As the trust is a creature of tax policy, the effect would be the same. Do not overly worry about this happening soon, however, as Obama’s budget was voted down without dissent in the Senate. However, the proposal does provide insight into future sources of revenue that Congress may revisit.

Because of the long-lived nature of these trusts, you are (almost by default) looking at a corporate trustee. If you haven’t reviewed trustee rates recently, you may be surprised at how expensive this can be. This in turn means that you want a certain minimum amount of money to seed the trust in order to justify the fees. This tax planning is not for the middle class. You also have to be careful in how much power is reserved to the beneficiaries, as too much may result in the trust being included in a beneficiary’s estate. You have to reserve a certain minimum, of course, such as the ability to dismiss and replace a trustee that has become unproductive or overly expensive.

I see these trusts primarily as a means of asset protection against creditor claims and divorces. It may also be a means to keep family businesses under family control, such as by placing the business(es) in a family limited partnership and then placing the partnership units into the dynasty. This would also allow one to utilize gift tax discounts, further magnifying the leverage of the dynasty trust. However, I can also see that society has an interest in not bankrolling a class of nonproductive trust-fund-uberwealthies. Perhaps the President has it right on this one: maybe 90 years is enough time for this tax vehicle.

Forget About The Airline Ticket Tax Refund

Well, that was short-lived.

I had an earlier post about obtaining refund of certain airline travel taxes.

That ended last Friday. Congress extended the FAA budget through September. Yep, next month, that September. Long-term planning specialists, this Congress. Anyway, the IRS has backtracked and said that there will be no refunds for tickets purchased before or after July 23^rd.