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The TaxBarron Report
January 2008
As the festive Christmas season recedes and thoughts of income tax filing emerge, we cannot help but be struck how the Internal Revenue Service is increasing its audit presence. A new Act has been passed that penalizes preparers who take unacceptable positions on tax returns. IRS is turning its attention to auditing Form 2555 - Foreign Earned Income Exclusion - and Form 1116 - Foreign Tax Credit. And the national debt, funded by income taxes, has exceeded $9t. So with the taxman increasing his presence in the lives of American taxpayers, both at home and abroad, tax compliance this year will have to be more carefully orchestrated to avoid problems with the IRS. For previous issues of the TaxBarron Report, click here.
In This Issue
IRS Targets Tax Preparers
In 2007 Congress passed the Small Business & Work Opportunity Act. Included in the provisions of this Act are small business tax incentives, Gulf Opportunity Zone Relief and certain individual breaks designed to stimulate spending. One provision that appears counterproductive and has the community of tax preparers in turmoil is whether a position(s) they may take on a tax return meets a level of confidence loosely described as "more likely than not."
What this rather ambiguous phrase means is that the tax position taken by a preparer on a return that results in an understatement of a client's tax liability and that IRS later rejects as unreasonable, whether on an income or estate tax return, will subject the preparer to penalty: the greater of 50% of the tax return fee or $1,000. Supposing the tax preparer charges the client $250. A $1,000 penalty would be an extraordinarily hefty fine to pay.
In the alternative, the preparer can file Form 8275 - Disclosure Statement - unless he believes the position taken on an item is more likely than not to be sustained on its merits in the event of its being challenged by IRS. The rub is that Form 8875 is an invitation to IRS to audit that tax return.
What constitutes an unrealistic position is unfortunately less clear. In the past, IRS accepted a reasonable basis level of assurance, meaning that a 20% - 25% possibility existed in a position being accepted in the event of an audit. The more likely than not standard ratchets this percentage up to 50% or greater.
As IRS is still developing guidelines on the application of tax return preparer penalties, the National Association of Tax Preparers (NATP) has protested that the probable correctness of a tax treatment may be limited by a lack of IRS guidance or else guidance that does not cover every circumstance.
Given that penalties are so severe, preparers could potentially urge their clients to include disclosures for virtually every item for which there is the slightest uncertainty. The resulting excessive disclosures could therefore overburden tax administration such that the disclosure system would be undermined.
How does dislosure work in practice? If a client provides false information that the tax preparer relies on to prepare the tax return, then the preparer is not liable for disclosure penalties. On the other hand, tax return preparers are expected to make reasonable inquiries if the information appears incorrect or incomplete. And they are expected to follow guidelines that often require further information from the taxpayer.
A consequence of IRS imposing higher penalties on tax return preparers will certainly be an increase in fees as preparers more rigidly scrutinize the information provided them by their clients. They may want to include in an engagement letter, the following or similar wording: If we conclude as a result of our research that you are required to disclose a transaction on your tax return, you consent to attach a completed Form 8275 to your tax return after we discuss the situation with you and you also agree to hold our firm harmless with respect to any and all actual and consequential damages that you incur as a result of including such disclosures with your filed tax returns. Another consequence will see fewer preparers staying in the profession.
NATP recommends that the more likely than not standard apply to tax shelter (tax avoidance) items only with the reasonable basis standard being applicable to non- tax shelter items.
Tax Filing Obligations
Residents of foreign countries generally have to report and pay taxes on their world-wide income to the tax authority of the country wherein they reside. But US citizens or deemed US residents are also obliged to report world-wide income to the Internal Revenue Service (IRS). And without due diligence in how to go about reporting that income, they could in certain circumstances end up paying taxes stateside in spite of double taxation treaties.
Understanding whether there is a filing requirement is therefore essential - since anyone receiving earnings below a threshold is not obliged to file. This threshold is merely the combination of two categories: exemption(s) and standard deduction (or itemized deductions). Anyone receiving income below the following combined category amounts need not file:
| Filing Status | Amount |
|---|---|
| Single | $8,750 |
| 65 or older | $10,050 |
| Head of Household | $11,250 |
| 65 or older | $12,550 |
| Qualifying widow(er) | $14,100 |
| 65 or older | $15,150 |
| Married Filing Jointly | $17,500 |
| Not Living with Spouse at Year End | $3,400 |
| One Spouse 65 or older | $18,550 |
| Both Spouses 65 or older | $19,600 |
| Married Filing Separately | $3,400 |
So any taxpayer whose earnings exceed an applicable threshold amount must file a tax return. Foreign earned income (wages, salaries, self- employment) must also be included in the calculation of total income even if excluded by the foreign earned income exclusion (FEIE).
To reduce the chances of double taxation, IRS allows that FEIE be applied against foreign earnings; $87,500 in 2007. Foreign earnings above this $87,500 excludable amount are taxable stateside, but the US tax may be offset by a foreign tax credit (FTC) applied against taxes paid to the foreign country of residence. In fact, the FTC is available on any income taxes paid abroad. A problem is that the FTC does not always fully offset US taxes.
Certain penalties apply for failing to comply with US tax laws. IRS assesses penalties at 5% a month against any unpaid taxes up to 25%. In cases where fraud is deemed to have been committed - for instance, in failing to report foreign earned income - IRS can assess 75% while denying the taxpayer the foreign earned income exclusion. It may also seek criminal penalties for not reporting foreign earnings, in which case the taxpayer could face jail time. Americans are also obliged to file information returns on investments in foreign corporations, foreign partnerships and foreign accounts, or risk very severe penalties.
The due date for filing tax and certain information returns is 16 June 2008 (15 October by filing Form 4868). However any taxes due for 2007 must be paid by 15 April along with first quarter 2008 estimated taxes.
Any US citizen or deemed resident living abroad who has not filed a tax return for some years should promptly do so as an offensive position is always better than a defensive one. IRS is actively increasing its powers of audit in order to catch non-compliers. Generally the revenue service will only require the last three years tax returns be filed.
Tax Quiz
ANSWER TO LAST MONTH'S QUIZ: Yes. If the surviving spouse files a joint return in the year of death, the personal representative may file a separate return for the decedent spouse. The personal representative may disaffirm the joint return already filed by filing a separate return within one year of the due date (including extensions) for filing the joint return of the surviving spouse.
THIS MONTH'S QUIZ: If an individual has several IRAs and is under age 59 1/2, can he receive substantially equal periodic payments free from penalty from only one of the IRAs without considering the value of the other accounts? - NATP
International Tax Audits
Approximately 6.6m Americans live outside the United States excluding military. Beginning in 2008, the Internal Revenue Service in its Form 1040 National Research Program will increase audits of American expatriate tax returns claiming the Foreign Earned Income Exclusion and the Foreign Tax Credit. The Service will also be improving its use of Forms 1042-S information documents as well as information provided by US treaty partners via the Exchange of Information provisions.
Audits will be conducted for the purpose of assessing penalties for understated tax liabilities, particularly where the Foreign Tax Credit applies when the taxpayer's tax rate is below 30%.
Information Returns
Americans invested in foreign corporations or foreign partnerships are required to file Form 5471 or Form 8865. The requirements for filing Form 5471 depend on categories.
Category 1 is a US resident or citizen invested in a foreign personal holding company (repealed). Category 2 is a US resident or citizen who is an officer or director of a foreign corporation in which a US person has acquired stock which meets a 10% ownership requirement or an additional 10% or more of the outstanding stock of a foreign corporation. Category 3 is a US person who acquires stock in a foreign corporation that meets the 10% stock ownership requirement. Category 4 is a US person who had control of a foreign corporation for an uninterrupted period of at least 30 days during the annual accounting period of the foreign corporation. Category 5 is a US shareholder who owns stock in a controlled foreign corporation for an uninterrupted period of 30 days or more during the foreign corporation's tax year or who owned the stock on the last day of the year.
A US person can be a citizen or resident of the United States, a partnership or a corporation that is domestic, or an estate or trust that is not foreign. Control means that the US person owns 50% or more of the foreign entity's stock individually or constructively.
Form 8865 has four reporting categories. Category 1 is a US person who controlled the foreign partnership at any time during the partnership's tax year. Category 2 is a US person who at any time during the tax year of the foreign partnership owned a 10% or greater interest in the partnership while it was controlled. Category 3 is a US person who contributed property during that person's tax year to the foreign partnership. Category 4 is a US person that had a reportable event during the tax year.
Forms 5471 and 8865 must accompany the taxpayer's tax return. Penalties ranging from $10,000 to $100,000 can apply for failure to file these information returns.
Other information return filings that carry potentially substantial penalties for failure to file: Form 3520 - Annual Return to Report Transactions with Foreign Trusts & Receipt of Certain Foreign Gifts; Form TD F 90-22.1 - Report of Foreign Bank and Financial Accounts; Form 926 - Return by a U.S. Transferor of Property to a Foreign Corporation; Form 8858 - Information Return of U.S. Persons with Respect to Foreign Disgarded Entities.
2007 Tax Changes
Standard Deduction
MFJ $10,700
Head of Household $7,850
Single $5,350
MFS $5,350.
The additional deduction for the aged is $1,050 if married or $1,300 if Single or Head of Household.
Tax Rates
Single: $0 - $7,825, 10%; $7,826 - $31,850, 15%; $31,851 - $77,100, 25%; $77,101 - $160,850, 28%; $160,851 - $349,700, 33%; >$349,700, 35%.
MFJ: $0 - $15,650, 10%; $15,651 - $63,700, 15%; $63,701 - $128,500, 25%; $128,501 - $195,850, 28%; $195,851 - $349,700, 33%; >$349,700, 35%.
MFS: $0 - $7,825, 10%; $7,826 - $31,850, 15%; $31,851 - $64,250, 25%; $64,251 - $97,925, 28%; $97,926 - $174,850, 33%; >$174,850, 35%.
HH: $0 - $11,200, 10%; $11,201 - $42,650, 15%; $42,651 - $110,100, 25%; $110,101 - $178,350, 28%; $178,351 - $349,700, 33%; >$349,700, 35%.
The Capital Gains Tax Rates are 5% for taxpayers in the 10% and 15% tax brackets and 15% if they are in the upper 25% - 35% brackets.
Ponderable: The supreme quality for leadership is unquestionably integrity. - Dwight David Eisenhower
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BREAKING NEWS
On 17 December, Representative Gregory Meeks introduced the Working American Competitiveness Act. The proposed legislation stipulates: At the election of a qualified individual, there shall be excluded from the gross income of such individual, and exempt from taxation under this subtitle, for any taxable year, the foreign earned income of such individual. The bill has been referred to the House Ways and Means Committee.
If this legislation passes both houses of Congress, the foreign earned income exclusion will be unlimited.
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