Taxable Talk

I was talking with a friend who is an attorney in the Midwest. She told me about an individual who decided to use ten layers of shell companies to hide his income. It worked so well that the Bozo had trouble accessing his income.

He was using the usual foreign shelter countries: the Cayman Islands (in the Caribbean), the Channel Islands (in the English Channel), the Isle of Man (in the Irish Sea), and Vanuatu (in the South Pacific). There was a land-based country in there, too: Panama. In any case, somehow the ownership got so messed up that one of the shells refused to deal with another.

My friend didn’t get involved to get the money situation resolved. No, she got involved because her client ended up going through a messy divorce, and her client’s now ex-wife happen to find one of the papers dealing with one of the shells companies. My friend’s a divorce attorney, and a good one, and she was able, with some help, find a lot of the hidden money. The judge was not as amused as I was hearing about the difficulties the man was having getting his money out. And neither was the IRS because he had “forgotten” to pay tax on a lot of income.

There are lots of good strategies for businesses to use to lower their taxes. Income balancing to C corporations can be a good strategy. Maximizing Section 179 depreciation is another. So is my least favorite deduction, the Domestic Production Activities Deduction (Section 199). There are many, many others. But hiding income in foreign jurisdictions is a very bad one, and if you get caught you are likely looking at a lengthy term at ClubFed.

Another repeat from 2008, mainly because people still try to peddle this snake oil. This conversation took place just yesterday.

Two prospective clients came into my office (husband and wife). I showed them my Engagement Letter first, and they wanted to ask me some questions. The first were routine about the wife’s income. But then the husband told me he didn’t have a W-2 from his job.

“Well,” I asked, “Were you paid under the table?”

“Oh, it was nothing like that. I was working in South Korea last year.”

It turns out he was working as an independent contractor in Korea. “And isn’t it great,” he continued, “that I don’t have to pay US tax on that income.”

I corrected him. “You do have to pay US tax on that income. Americans pay tax on their worldwide income. Now, had you had income tax taken out of your Korean income you would be eligible for a tax credit. Were you overseas for 330 days in 2008?”

“No,” he said. “I came back for the summer. I didn’t like the humidity.”

“That’s a shame, because had you been overseas for 330 days out of a 365-day period, you’d be eligible for the foreign earned income exclusion.”

I told the potential client that he would pay both income and self-employment tax on his Korean income. He didn’t like my answers, and said he’d find another accountant who would see things his way. He’s likely still searching.

As noted above, if you do earn income abroad, there are some real tax tips you can take advantage of. If you have a genuine residence overseas or meet the physical presence test (generally, being abroad 330 days out of 365), you may be eligible for the Earned Income Exclusion. If eligible, you can exclude up to $87,600 in 2008. And the time period does not have to be a calendar year; if you’re overseas from May 1, 2008 through April 15, 2009, you would likely be eligible for a prorated credit.

If you earn income abroad and it’s taxed abroad, you are likely eligible for the Foreign Tax Credit. The general principle is that income should only be taxed once, so if (say) Japan taxes your income, you should get a credit of that tax on your US tax return.

Finally, anyone who is not in the United States on April 15th gets an extra two months (until June 15th) to file his tax return. (You need to attach an explanation to your tax return.) If you’re abroad, you won’t be subject to penalties but you will be subject to interest on what you owe (interest is statutory).

There are numerous caveats and gotchas, and numerous ways to lessen your tax if you either have foreign source income or live abroad. Talk to a professional who can help you if you’re contemplating living abroad or will soon have significant income from abroad. But whatever you do, remember that foreign income is just as taxable as income earned in the United States

It’s time for our annual rundown of Bozo Tax Tips, strategies that you really, really, really shouldn’t try. But somewhere, somehow, someone will try these. Don’t say I didn’t warn you.

Here’s a repeat for the third year:

Let’s thank Michael Graham of Queens, New York for coming up with this gem. Mr. Graham decided to file phony tax returns with the IRS. He used consecutive social security numbers on his tax returns.

He did get one tax refund through the system and collected $900. However, the other 1,799 returns were caught by the IRS and he didn’t get the $1.6 million he attempted to collect. He did find his way to court, though….

I strongly suggest that you do not try anything like this. The IRS and state tax agencies do have systems in place to catch bozos who attempt crimes like this. Instead of trying to bilk the system, ask your tax preparer about legitimate deductions that are available for you to take. The regular IRA allows you to deduct $5,000 ($6,000 if you’re 50 or older) from your income (if you’re eligible). You have until April 15th to make your contributions.

And if you’re self-employed, you may be able to contribute to a SEP IRA. You have until your return is timely filed, including extensions, to contribute to a SEP IRA. You can contribute 20% of your net self-employment income up to a maximum of $46,000 to a SEP (for the 2009 tax year this will rise to $47,000). This is one tax deduction that’s available until October 15th if you file an extension.

Phony tax returns will likely lead you to a stint at ClubFed (where Mr. Graham went). We recommend the IRA or SEP IRA over ClubFed….