Ines Zemelman, EAAug-20-2016
We love nothing more than to get every client a refund or get their tax bill down to zero. However in certain cases it is simply not possible (think high income, low host country tax rate). In such cases clients sometimes ask “But can’t you push the envelope, my cousin uses a guy in Venice Beach who uses some “creative accounting” to reduce his tax bill”?
US tax law spans thousands of pages and contains a zillion of potential deductions. The job of your accountant is not only to know of possible deductions but also if they are appropriate for your situation. Knowledgeable and honest accountants will only apply situation-appropriate strategies and never suggest ones that work only in cases when the IRS does not look into the case details. Because they will. Not in each tax return - but you may be the one whom they pick to investigate.
Direct penalties on tax resulting from the rejected deduction are just the tip of the iceberg of pain (because then everybody could just take a punt and pay tax due in case it doesn’t work out). The biggest pain is the audit process itself. Because of the (hypothetical) rejected $3K deduction the IRS will make you provide supporting documents for your entire tax return unrelated to that deduction, which will entail additional expenses. You may be required to provide certified translations of foreign documents and engage in lengthy communication by snail mail with the agency.
Being placed in the “rejected” bucket is very bad. The IRS strategy is to make every encounter with them exceedingly unpleasant, so that even if they catch 30% of false claims, the pain they inflict on those 30% is large enough that the cost/benefit analysis makes it a bad idea to try.
We wrote the following article to describe some of the most common ‘high-risk’ strategies and when they should (and should not) be used.
1. Inflated mortgage interest
Mortgage interest deduction must meet a number conditions in order to qualify:
- Person who takes deduction should have financial responsibility for mortgage repayment (his name must be on the loan, not just listed on the deed), If mortgage is taken in name of your NRA spouse, and you file separately in the US - you cannot deduct mortgage interest even if your husband is unemployed and you repay mortgage from your own salary.
- Only the interest part and PMI may be deducted, not the premium balance or escrow payments
- The maximum mortgage amount you can claim interest on is $1M. Therefore mortgage deduction of $50K on your foreign house will be disallowed right away because this amount indicates inflated deduction or interest on the loan of over $1M.
2. Claiming unreimbursed employee expenses
Employers will normally reimburse your work-related expenses. Only certain occupations with multiple work locations (i.e. a visiting nurse) have inherent unreimbursed expenses that qualify for a deduction.
Many expenses that appear work-related are not allowed to be deducted.
- Commute to work - isn’t this work related? Employers may reimburse you up to $255 per month for public transit. Everything you pay extra to commute to work is not allowed for the deduction. If your employer does not have a transit reimbursement plan - it’s too bad, but you cannot deduct commuting expenses regardless.
- You attended professional trade show during vacation time because this conference can greatly improve your job skills. Your tax preparer suggested to deduct the airfare, hotel, and registration fees. In the end, your employer will benefit from your improved skills - you just have to hold on to the receipts. Did he mention deduction of meals?
- This would be a legitimate expense - if you were self-employed. Then you could travel to Hawaii and deduct cost of travel in full as long as you registered for the conference related to your trade. Travel for the benefit of the employer must be approved by the employer and taken during work time. Then, if employer failed to reimburse your expenses, you could deduct it - although this is a very unlikely scenario.
- Employer allowed you to work from home each Friday because your daughter babysitter is off on Fridays. Your tax preparer suggested to deduct prorated cost of internet connection, utilities and other home office expenses because you have a separate area in your home dedicated to performing work duties. This all could be deducted - if your employer had asked you to stay home and work remotely because the company wanted to cut office expenses. Then your work from home would be for the convenience of your employer and qualify for the deduction. If it’s for your own convenience - the deduction is not allowed.
3. Rental loss without active participation
You were lucky to find a great management company that handles your rental condo in Florida. They advertise your apartment, verify potential tenants, sign contracts and collect rent. During the year you received from them only one email wishing you Merry Christmas. Every month they deposit agreed amount to your bank account.
Your income is above the threshold of $100K for taking unlimited rental loss. Your tax preparer checked a box on tax return that says “Active participation”. Checking this box allows you to take the rental loss. You are happy that this simple solution had slashed $10K from your annual taxable income. However, you do not meet the active participation test. To qualify, you should participate in management decisions and participate in the real estate rental activity. Activities include new tenant approval, rental terms, repairs, capital expenditures, etc.
With no paper trail of any participation in the rental activity, you fail the active participation test and cannot take the rental loss.
4. Self-Employment Business Loss
You are passionate about landscaping. Your tax preparer suggests to turn your passion into a business. It is OK if the business is not profitable. It does not matter that you majored in French literature and don’t have any landscaping experience, you will build your skills up gradually, meanwhile writing off expenses for attending landscaping courses, buying tools and supplies.
This plan can work for one year, maybe two. When business shows loss for 3 years out of five, it is recharacterized into a hobby and all previously taken loss must be paid back.
But before that even happens the IRS may inquire - what made you believe that this business could be profitable? Do you have related education or work experience? With your background, you have no arguments to prove that this entity could possibly generate a profit. In the eyes of the IRS its only purpose was generating business losses - which is not allowed.
5. Education expenses deduction / credit for a non-qualified institution
If you, your spouse or dependent attend a higher education institution, cost of attendance may be deducted and in some cases create a refundable credit. However, the institution or university must participate in the U.S. Federal Student Loan Programs (FAFSA). List of foreign higher education institutions is regularly updated. Only schools included in that list are eligible for the education deduction.
Unless your local tax preparer knows where to find that list and can demonstrate that your school is on it - don’t get excited about the $2K credit shown on the return - you may be required to pay it back.
6. Claiming Extra Dependents
Your elderly mother was retired and had no income all year. She is not a U.S. citizen or green card holder. She lives on her own, but you provided more than half of her support for the year. Your tax preparer suggests to claim her as a dependent. Did he ask which country she lives in?
If your mother lives in Mexico you can claim her as a dependent. If she lives across the border, in Guatemala - you can not. To be claimed as a dependent, a qualifying relative must be a U.S. citizen or resident of US, Canada or Mexico.
7. Income Exemption under Treaty Benefits for Foreign Pension Income
Your local tax preparer might have shown you a paragraph in the Tax Treaty that reads :
- Pensions and other similar remuneration in consideration of past employment and beneficially owned by a resident of a Contracting State shall be taxable only in that Contracting State.
He explained that in laymеn terms this means that your foreign pension is taxable only in the country where you earned this pension. Thus it is not taxable in the U.S.
With little or no experience in international tax, he did not know about another paragraph present in each tax treaty and referred to as “Saving Clause”:
- Notwithstanding any provision of the Convention, the United States may tax its residents (as determined under Article 4 (Residence)), and by reason of citizenship may tax its citizens, as if the Convention had not come into effect.
That means that your foreign pension is taxable in the U.S. It would be non-taxable only if you were not a U.S. citizen or green card holder.
8. Misinterpretation of Social Security Totalization Agreement
Social Security Totalization Agreement provides exemption from duplicate contributing to two systems. This works for most countries that have Social Security totalization agreements with the U.S.
However - not all agreements are made equal. For example, Social Security totalization with Italy gives different level of protection to the Italian citizens vs other legal residents of the country. If your local tax preparer announced “You are exempt!” referring to exemption from the U.S. Social Security taxes - make sure he is aware of all subtleties of the particular country agreement.
9. Unqualified Earned Income Credit
This is the sweetest of all tax credits. Working family with two children can receive Earned Income Credit up to $5,572 for 2015 tax year in addition to the $2K child credit .
However - to qualify for the credit, both parent and child must have lived in the United States for at least 6 months within a calendar year for which return is filed. Tax preparer who mentions Earned Income Credit for the year when you lived abroad does not know that you are not qualified for this credit, no matter how many children you have and how little you earn. His tax program will not reject the credit, but the IRS will and you will have to pay the credit back with interest.
10. Miscalculation of Physical Presence qualifying period
You are borderline in calculation of days of presence in the U.S. for meeting the Physical Presence test. Your tax preparer suggest to count days “liberally” ignoring the travel time. However, the time when you fly over the international waters must be treated as US presence. The term “foreign country” includes the country's airspace and territorial waters, but not international waters and the airspace above them. Stretching the dates carries the risk of losing the entire $100K exclusion of foreign earned income.
Instead of taking risks, it is better to submit form 2350 requesting extension of time to file through the following year, when you meet the Bona Fide residence test. Then it will not matter whether you spent 34 or 36 days in your first year abroad. Whereas rejected exclusion due to miscalculation of Physical Presence dates would be hard to challenge.