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The TaxBarron Report
March/April 2007

Anyone earning income abroad who relies on the Foreign Earned Income Exclusion to eliminate that income from U.S. taxation and attempts to file his or her own tax return is likely to misfigure the tax liability if the filer has other income to report.  As mentioned in previous issues of our Report, the Tax Prevention and Reconciliation Act (TIPRA) provides that the tax applicable to income not covered by FEIE will now be calculated as though the exclusion had not been elected.  What does this calculation imply? For previous issues of the TaxBarron Report, click here.

In This Issue

TIPRA's Impact on Foreign Earned Income Filers

Estate Tax Issues

Claiming Foreign Earned Income Exclusion

Recommended

 

TIPRA'S Impact on Foreign Earned Income Filers

Jay Gordon recently filed his 2006 tax return incorrectly.  Married and a resident in France since 1995, he owns an incorporated business from which he paid himself €52,845 ($66,300).  Were his salary his only source of income, he would owe no tax thanks to the Foreign Earned Income Exclusion that was raised last year to $82,400.  However Jay had other income totaling $67,300 that included interest, ordinary and qualified dividends, capital gain distribution, social security, and gain from sale of property.  After reductions for Exemptions ($6,600) and Standard Deduction ($12,300), his taxable income was $48,400.

Jay figured his tax from the graduated tax table for married joint and duly reported a liability of $6,500 on line 44, Form 1040.  Had he figured his tax from the Qualified Dividends and Capital Gain Worksheet, he would have more correctly written in $6,350.  But this $150 difference is paltry compared to his failure to properly calculate his tax liability on the new Foreign Earned Income Tax Worksheet.

This worksheet used in conjunction with the other worksheet previously mentioned requires that he calculate his tax liability on $114,700 ($67,300 + $66,300 - (12,300 + 6,600)) and NOT on $48,400 ($67,300 - (12,300 + 6,600)).  The resulting calculation is a tentative tax of $21,650 which is then offset by $9,700 tax on his Foreign Earned Income.  The result is that Jay actually owes $11,950 ($21,650 - 9,700).

So what is the outcome of TIPRA?  Jay owes $5,600 ($11,950 - $6,350) in additional taxes that he would not have otherwise owed.  In the event IRS assesses penalties for Jay's underpayment by the due date, he can anticipate .5% a month (up to 25%) and 8% interest.

So thanks to the subtleties of the taxman, many American expatriates earning foreign income with other sources of income will have less disposable income in 2007.

 

Estate Tax Issues

Sixty percent of Americans die without a Will and only 23% have a living trust.  Apparently those who do not take the time to consider these important documents believe that property will pass to their heirs automatically.  Some never review the legal arrangements necessary to protect their survivors.  Others are not convinced that their assets are enough to incur a transfer tax liability.

Americans offshore may not realize that as citizens of the United States the value of their world-wide assets becomes a part of their estate at death for tax purposes.  And while the Applicable Exclusion Amount (AEA) in 2007 and 2008 is $2,000,000, they should consider that such assets as real estate, stocks, jewelry, art and other like property may have appreciates significantly since their purchases; exceeding the AEA and inviting the taxman to take up to 45% of the remainder estate.  The potential problems of poor estate planning are complex, as the follow situations suggest:

• Mary's Will left her estate to her son, Carlos.  Six weeks prior to her death, she gave him her shares of Exxon stock worth $450,000.  Mary's $15,000 basis in the stock is now Carlos' basis.  If he sells the stock, he will have to pay capital gains tax on $435,000.  Had Mary kept the stock until her death, Carlos' basis in the stock would have been $450,000.
• Doug saved money by writing his own Will. He is married to Janice and they have three middle-aged children.  Having heard that each person can leave $2,000,000 without paying estate taxes, he left that much outright to their children, even if Janice survices him.  Doug's estate plan succeeds in utilizing his tax free amount, called the Applicable Exclusion Amount, and the property bypasses Janice's estate.  But in so doing, Doug has unnecessarily denied her the use of the property.  There are plans that use the first spouse to die's AEA by placing property in a trust without claiming a marital deduction on it, allow the surviving spouse to use the income from the property, and not have the property included in the survivor's estate.
• Jerry suffered a severe stroke several months ago.  Unable to communicate, he is hooked up to machines that keep him alive.  His prognosis is very poor.  His family realizes that they should have encouraged Jerry to consult an estate planner while he was still able to express his wishes.  Documents could have been drafted that would have nominated someone to manage his wealth during his incapacity and would have directed the eventual distribution of his wealth after his death.
• Yolanda was quite elderly and suffering the ravages of old age when she and her family lawyer drafted a simple Will, leaving her sizeable estate to her husband, Ian.  After hear death, Ian, who is ill, realizes that, as owner of the family wealth, estate taxes are due after his death.  Alas much of this tax could have been avoided if Yolanda's estate plan had incorporated a planning device known as a bypass trust.These situations represent a few of the many problems that can occur without adequate estate planning.  For American expatriates, such planning may be further complicated by the laws applicable in the countries wherein they reside.  For instance, Portugal has no inheritance tax.  Spain may allow a family business to continue after the death of the founder, respects American Wills but otherwise assesses up to 34% in inheritance taxes on residents' world-wide assets.  France wants up to 40% on world-wide assets of residents but allows 50% of business assets to pass free of inheritance tax.

 

Claiming Foreign Earned Income Exclusion

To claim the Foreign Earned Income Exclusion, the Foreign Housing Exclusion or the Foreign Housing Deduction, a taxpayer must have foreign earned income with a tax home in a foreign country.  One of t he following conditions must apply:  1) A U.S. citizen who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire year, 2) A U.S. resident alien who is a citizen or national of a country with which the United States has an income tax treaty in effect and who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year, 3) A U.S. citizen or a U.S. resident alien who is physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months.

IRS defines a foreign country as any territory under the sovereignty of a government other than the United States.  This includes air space and territorial waters but does not include Puerto Rico, Guam, the Commonwealth of the Northern Mariana Islands, the U.S. Virgin Islands, or American Samoa.  Nor does it include ships and aircraft traveling in or above international waters, or offshore installations located outside the territorial waters of any individual nation.

When applying for either the exclusion or deduction, complete Form 2555 - Foreign Earned Income.  The completed form must accompany Form 1040 with wages being reported on line 7 and the offset on the appropriate line per the Form 2555 instructions.

 

Recommended

Ten Estate Planning Mistakes

Democrats and AMT

Possible Tax Increases

Tax Compliance at Risk