Tax & Business Strategies Monthly Newsletter - June 2008

Tax Planning Strategies
IRS Policy on Waiving the IRA Rollover Deadline
The Mysterious Miscellaneous Deductions
Documenting Charitable Contributions

Business & Management Practices
Employee Medical Reimbursement Arrangements
Tax-Free and Tax-Favored Fringe Benefits For Passthrough Entity Owners

General Information
Charitable Giving Through Donor-Advised Funds
Working Abroad Can Yield Tax-Free Income

Briefs
Billions in Telephone Excise Tax Refunds Go Unclaimed
Military Families Receive Recovery Rebate Break

TAX PLANNING STRATEGIES

IRS Policy on Waiving the IRA Rollover Deadline

An individual can avoid taxation and the 10% early withdrawal penalty from an IRA or qualified plan distribution (other than required distributions) if they return the funds to an IRA or qualified plan within 60 days. This is commonly referred to as a rollover.

Prior to the passage hardship provisions included in the Economic Growth and Tax Relief Reconciliation Tax Act of 2001, the only time in which the IRS had the authority to waive the penalty for not completing an IRA rollover within the statutory 60-day period was if the transfer was not made in a timely manner due to military service in a combat zone or a presidentially-declared disaster. Under the hardship provisions, for distributions made after 2001, the IRS has the power to grant a waiver of the 60-day requirement if failure to do so would be against equity or good conscience. The Code specifically lists casualty, disaster, or other events beyond the reasonable control of the individual subject to the requirement.

Criteria for automatic waiver - The IRS provides guidelines for the waiver of the 60-day rollover rule. Generally, the 60-day rule is automatically waived if ALL of the following apply:

• The financial institution receives the funds on the taxpayer's behalf before the end of the 60-day rollover period.

• The taxpayer followed all the procedures set by the financial institution for depositing the funds into an eligible retirement plan within the 60-day period (including giving instructions to deposit the funds into an eligible retirement plan).

• The funds are not deposited into an eligible retirement plan within the 60-day rollover period solely because of an error on the part of the financial institution.

• The funds are deposited into an eligible retirement plan within one year from the beginning of the 60-day rollover period.

• It would have been a valid rollover if the financial institution had deposited the funds as instructed.

Criteria for waiver based on facts and circumstances - If the taxpayer does not meet the criteria for automatic waiver, but still believes that he or she meets the requirements due to the facts and circumstances of his or her situation, the taxpayer can apply for a hardship exception to the 60-day rollover requirement by requesting a letter ruling, accompanied by the required user fee.

The Service will issue a ruling waiving the 60-day rollover requirement for cases in which the failure to waive such requirement would be against equity or good conscience. This consists of casualty, disaster, or other events beyond the reasonable control of the taxpayer. All relevant facts and circumstances will be considered in determining whether to grant a waiver. The Revenue Procedure specifically includes:

• Whether the errors were caused by the financial institution.

• Whether the taxpayer was unable to complete the rollover due to death, disability, hospitalization, incarceration, or restrictions imposed by a foreign country or postal error.

• Whether the taxpayer used the amount that was distributed.

• How much time has passed since the date of distribution.

Most taxpayer requests for waivers under the revenue procedure have been granted. The IRS has been quite lenient in granting favorable private letter rulings concerning the 60-day requirement. Since the inception of, only a few dozen rulings have denied a waiver. Many of the waivers were denied because the taxpayer used the funds with the expectation of replacing them within the 60 days. In other rulings, taxpayers originally had no intent to roll over the proceeds until they became aware of the tax consequences. In addition, taxpayers using ignorance of the law as an excuse have not received favorable rulings.

When the IRS is determining whether to grant a waiver to the 60-day requirement, what the taxpayer originally intended to do with the proceeds holds a lot of weight in the determination. Taxpayer “intent” has been quoted in many of the rulings both for the benefit and to the detriment of the taxpayer. If the original intent was something other than rolling the money over into another IRA, the Service will most likely rule against the taxpayer. However, if the taxpayer has a documented medical or mental condition that precluded him or her from transferring funds in a timely manner and the original intent does not appear to be an issue, the IRS will most likely rule in favor of the taxpayer. Also, the use of the funds as a short-term loan is not viewed favorably unless the taxpayer has a debilitating illness and was physically or mentally unable to complete the transaction within the required time. Under those circumstances, use of the funds has been ignored.

Please call our office if you need more information or have a specific question about the IRS’s policy.


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The Mysterious Miscellaneous Deductions

When filing your tax return, you can generally choose between itemizing your deductions and taking the standard deduction. It all depends on which method provides you with the greater tax benefit. Taxpayers that choose to itemize will find that itemized deductions are broken down into several categories, which include medical, taxes, interest, charity and miscellaneous deductions.

Of all the categories, miscellaneous deductions may be the most mysterious because it is broken down into two sub-categories, one of which has limitations based upon income. In addition, since it is a catch-all category, many of the deductions themselves have special rules and limitations. On top of all this, one of the sub-categories is further limited by the alternative minimum tax (AMT).

This may all seem too complex, but we will attempt to shed enough light on the mysteries to give you a better understanding of this deduction and how it can or cannot benefit you.

First of all, the deductions are broken down into two sub-categories, often referred to as tier I and tier II deductions in tax lingo. The tier I deductions are not limited by income or the AMT and include the following infrequent deductions:

o Gambling losses – A deduction for gambling losses (not to exceed gambling winnings).

o Impairment-related work expenses – A deduction for impairment-related work expenses for taxpayers having a physical or mental disability that limits their activities.

o Claim of right deduction – A deduction is allowed when a taxpayer has repaid income that was taxable in a prior year.

o Federal estate deduction – A deduction is available when inherited income is subject to inheritance tax and is also taxed to the beneficiary (double taxed).

o Amortizable bond premium – Not applicable to most taxpayers.

All other deductions fall under the tier II sub-category. The tier II category is deductible for regular tax purposes only to the extent the deduction exceeds 2% of your adjusted gross income (AGI) for the year. In addition, to the extent you might be subject to the AMT, this sub-category is not deductible at all. Let’s say your AGI (generally your income for the year) is $75,000. 2% of $75,000 is $1,500. Thus, your first $1,500 of tier II itemized deductions would not be deductible. If it exceeds $1,500, then you are only allowed to deduct the amount that exceeds the $1,500. So, if your tier II miscellaneous deductions are clearly less than 2% of your AGI for the year, there is no need to spend time on this deduction. If you are subject to the AMT, there is a chance that even the amount that exceeds the 2% might not be deductible, since tier II deductions are not allowed in the AMT computation. So what deductions are included in the tier II sub-category? Tier II deductions generally include:

o Employee business expenses – Tools, uniforms, supplies, travel, occupational licenses, etc., not reimbursable by the employer and required as part of employment. It does not include commuting expenses.

o Investment expenses – Includes certain investment fees, custodial fees, trust administration fees, and other expenses paid for managing investments that produce taxable income.

o Home office deduction - If the taxpayer uses part of his home regularly and exclusively for business purposes and meets the stringent IRS requirements for this deduction, he or she may be able to deduct part of the operating expenses and depreciation of the home.

o Employee education expenses - To be deductible, educational expenses must be closely related to the taxpayer’s present job and must either maintain or improve skills required in the taxpayer’s present job, or be required by the employer to retain the taxpayer’s position.

o Legal expenses - For the protection or production of taxable income (generally excludes divorce issues).

o Tax preparation fees – Includes costs for planning, consultations and representation, as well as the actual return preparation.

How much these deductions will save you in taxes depends upon your tax bracket. If you are in the 25% tax bracket, you will save 25 cents for every dollar of deductible deduction. Another way to look at it is that you recoup 25 cents for every deductible dollar spent as a reduction in your tax. However, because of the various limitations and AMT you may not benefit as you might think for your tax bracket. Therefore, where possible, attempt to have employee business expenses reimbursed by your employer under an accountable plan, even if it means reducing your salary slightly to pay for the tax-free reimbursement. Your employer may also be able to reimburse you for all or a portion of your education expenses.

If you have significant miscellaneous deductions that are being lost to the various limitations listed above, it may be appropriate to schedule a consultation to see if there are tax scenarios that can help your specific situation.

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Documenting Charitable Contributions

A frequently encountered question is what records are required for charitable contributions. In recent years, Congress has passed some very stringent recordkeeping rules for charitable contributions and some harsh penalties for understating taxable income. The following is a summary of those recordkeeping rules currently in effect for a variety of contribution types. This list is not all-inclusive, so if you don’t see anything that applies to your particular situation, please give our office a call.

Cash Contributions - Cash contributions include those paid by cash, check, electronic funds transfer or credit card (see special requirements for payroll cash contributions). Taxpayers cannot deduct a cash contribution, regardless of the amount, unless they can document the contribution in one of the following ways:

1. A bank record that shows the name of the qualified organization, the date of the contribution, and the amount of the contribution. Bank records may include:
a. A canceled check,
b. A bank or credit union statement, or
c. A credit card statement.

2. A receipt (or a letter or other written communication) from the qualified organization showing the name of the organization, the date of the contribution, and the amount of the contribution.

As a result of these rules, taxpayers may need to change the way they make contributions to certain charities. For example, a taxpayer who has been used to dropping a $5 or $10 bill into the collection plate each week at a worship service would no longer be able to deduct that donation on his tax return. Instead, he should write a check to the religious organization and put the check into the collection plate, or make other arrangements with the organization for making his contribution to ensure that a bank record or receipt/letter is provided.

Payroll Contributions – For contributions by payroll deduction, a taxpayer must keep:

A. A pay stub, Form W-2, or other document furnished by the employer that shows the date and amount of the contribution, and

B. A pledge card or other document prepared by or for the qualified organization that shows the name of the organization. If the employer withheld $250 or more from a single paycheck, the pledge card or other document must state that the organization does not provide goods or services in return for any contribution made to it by payroll deduction. A single pledge card may be kept for all contributions made by payroll deduction, regardless of the amount, as long as it contains all of the required information.

If the pay stub, Form W-2, pledge card, or other document does not show the date of the contribution, the taxpayer must also have another document that does show the date of the contribution. If the pay stub, Form W-2, pledge card, or other document does show the date of the contribution, the taxpayer need not have any other records except those described in (A) and (B).

Non-Cash Contributions

Deductions of Less Than $250 - A non-cash contribution includes the donation of property, such as used clothing or furniture, to a qualified charitable organization. If a taxpayer claims a non-cash contribution, it must get and keep a receipt from the charitable organization showing:

1. The name of the charitable organization,

2. The date and location of the charitable contribution, and

3. A reasonably detailed description of the property that was donated.

Deductions of At Least $250 But Not More Than $500 - If a taxpayer claims a deduction of at least $250 but not more than $500 for a non-cash charitable contribution, he or she must have and keep an acknowledgment of the contribution from the qualified organization. If the contributions were made by more than one contribution of $250 or more, the taxpayer must have either a separate acknowledgment for each or one acknowledgment that shows the total contribution. The acknowledgment(s) must be written and should include the following:

1. The name of the charitable organization,

2. The date and location of the charitable contribution,

3. A reasonably detailed description (but not necessarily the value) of any property contributed,

4. Whether or not the qualified organization gave the taxpayer any goods or services as a result of the contribution (other than certain token items and membership benefits), and

5. If goods and or services were provided to the taxpayer, the acknowledgement must include a description and good faith estimate of the value of those goods or services. If the only benefit received was an intangible religious benefit (such as admission to a religious ceremony) that generally is not sold in a commercial transaction outside the donative context, the acknowledgment must say so and does not need to describe or estimate the value of the benefit.

Deductions Over $500 But Not Over $5,000 - If a taxpayer claims a deduction over $500 but not over $5,000 for a non-cash charitable contribution, they must have the same acknowledgement and written records as for contributions of at least $250 but not more than $500 (as described above). In addition, the records must also include:

o How the property was obtained (for example, by purchase, gift, bequest, inheritance or exchange).

o The approximate date the property was obtained or, if created, produced, or manufactured by the taxpayer, the approximate date the property was substantially completed.

o The cost or other basis, and any adjustments to the basis, of property held less than 12 months and, if available, the cost or other basis of property held 12 months or more. This requirement, however, does not apply to publicly-traded securities. If the taxpayer is not able to provide information on either the date the property was obtained or the cost basis of the property and there is reasonable cause for not being able to provide this information, attach a statement of explanation to the return.

Deductions Over $5,000 – Because of special rules related to contributions over $5,000, please call this office for documentation requirements of the particular contribution before making the contribution.

Out-of-Pocket Expenses - If a taxpayer renders services to a qualified organization and has unreimbursed out-of-pocket expenses related to those services, the following three rules apply:

1. The taxpayer must have adequate records to prove the amount of the expenses.

2. The taxpayer must get an acknowledgment from the qualified organization that contains:
a. A description of the services provided,
b. A statement of whether or not the organization provided the taxpayer with any goods or services to reimburse the taxpayer for the expenses incurred,
c. A description and a good faith estimate of the value of any goods or services (other than intangible religious benefits) provided as reimbursement, and
d. A statement that the only benefit received was an intangible religious benefit, if that was the case. The acknowledgment does not need to describe or estimate the value of an intangible religious benefit.

3. The acknowledgement must be obtained before the earlier of:
a. The date of filing the return for the year the contribution was made, or
b. The due date, including extensions, for filing the return.

Car Expenses - When a taxpayer claims expenses directly related to the use of their car in giving services to a qualified organization, they must keep reliable written records. Whether the records are considered reliable depends on all the facts and circumstances. Generally, they may be considered reliable if made regularly and at or near the time the expense was incurred. The records must show the name of the organization being served and the date each time the car was used for a charitable purpose. If the standard mileage rate of 14 cents a mile is used, the records must show the miles driven for the charitable purpose.

If the taxpayer deducts actual expenses, the records must show the costs of operating the car that are directly related to a charitable purpose. General repairs and maintenance expenses, depreciation, registration fees, or the costs of tires or insurance cannot be deducted.

Vehicle Donations - When the deduction claimed for a donated vehicle exceeds $500, IRS Form 1098-C (or other statement containing the same information as Form 1098-C) furnished by the charitable organization must be attached to the filed tax return. Without the 1098-C or other statement, no deduction is allowed. When the charity sells the vehicle, the Form 1098-C (or other statement) must be obtained within 30 days of the sale of the vehicle. Otherwise, the Form 1098-C (or other statement) must be obtained within 30 days of the donation.

If you have questions regarding charitable recordkeeping or what is deductible as a charitable contribution, please give our office a call.


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BUSINESS & MANAGEMENT PRACTICES

Employee Medical Reimbursement Arrangements

For those employers who would like to provide a medical plan for their employees, there are a number of options. Among those options are two infrequently discussed plans: Health Reimbursement Arrangements (HRA) and Flexible Spending Arrangements (FSA).

Each has its own distinct set of rules and requirements, which will be briefly discussed in this article. Before taking any action, an employer should obtain more in-depth information to determine how the plan will benefit his company and employees and be able to weigh the cost of the plan to the benefits it will provide.

Health Reimbursement Arrangements

A health reimbursement arrangement (HRA) is a type of employee benefit plan provided by an employer to reimburse eligible employees and their dependents for specified medical expenses not covered by other forms of insurance.

If all the requirements for this type of plan are met, then reimbursements of medical care expenses of a current or former (including retiree) employee and the employee's spouse and dependents generally are excludable from the employee's gross income. The medical expenses reimbursed by the plan may not be claimed as a medical deduction as part of itemized deductions on the employee’s Schedule A.

The general requirements for a health reimbursement arrangement (HRA) are that the employee benefit plan:

• Is funded solely by the employer and not through a salary reduction election or otherwise under a cafeteria plan;

• Reimburses the employee for medical care expenses incurred by the employee and the employee's spouse and dependents;

• Provides reimbursements up to a maximum stated dollar amount for a coverage period; and

• Carries forward any unused portion of the maximum dollar amount at the end of a coverage period to increase the maximum reimbursement amount in subsequent coverage periods.

These plans are allowed to reimburse employees for insurance premiums that cover medical care expenses including amounts paid for accident or health coverage premiums for current employees, retirees, and COBRA qualified beneficiaries. Reimbursable medical care expenses generally do not include expenses for qualified long-term care services.

Although owners who are sole proprietors, partners, or more-than-2% shareholders of an S corporation are themselves not eligible to participate in an HRA, an owner's spouse and children may participate if they are bona fide employees of the business.

An HRA may continue to make reimbursements to former employees or retired employees for medical care expenses after their employment has terminated or if they have retired (even if the employee does not elect COBRA continuation coverage). Thus, an HRA could, for example, provide that it will reimburse a former employee for medical care expenses (but only) up to an amount equal to the unused reimbursement amount remaining at retirement or other termination of employment. The HRA also could specify that the maximum reimbursement amount available after retirement or other termination of employment is reduced for any administrative costs of continuing such coverage. An HRA could, but is not required to, provide for an increase in the amount available for reimbursement of medical care expenses after the employee retires or otherwise terminates employment (regardless of whether the employee does not elect COBRA continuation coverage).

An HRA is a group health plan that generally is subject to the COBRA continuation coverage. However, an HRA would not be subject to the COBRA rules if the employer does not have at least 20 employees during an applicable measurement period.

Flexible Spending Arrangements

Flexible spending arrangements are employer-sponsored plans that permit employees to contribute pre-tax dollars to the plan, which, in turn, reimburses employees for qualified expenses. However, no contribution or benefit from an FSA may be carried over to any later plan year or period of coverage, other than in the case of certain orthodontia expenses reimbursed through a health FSA. Use it or lose it: unused benefits or contributions remaining at the end of the plan year (or at the end of a grace period, if applicable) are forfeited. Employees who itemize their deductions when filing their income tax returns may not claim a medical expense deduction for the medical expenses that were reimbursed from the health FSA.

There is no dollar limit on the amount that an employer may allow its employees to set aside under their individual health FSAs. However, an employer is free to set a limit, for each employee participating in the health FSA arrangement. Typically, employees will base their contribution on a conservative estimate of their medical needs for the year.

A health flexible spending arrangement may reimburse only “medical expenses” and therefore may not reimburse for other expenses such as dependent care expenses. A health plan that is a flexible spending arrangement must satisfy the following requirements to qualify for the exclusion from income:

(1) Meet the medical coverage and reimbursement exclusion requirements.
(2) The maximum amount of coverage must be available at all times throughout the year.
(3) The coverage period must not be less than 12 months except in the case of a short year. In addition, there is a 2½ month grace period for qualified expenses that occurred within the coverage period to be paid.
(4) Prohibit the reimbursement of expenses other than medical expenses.
(5) Provide that the payment schedule for required employee premiums not be based on the rate or amount of covered claims.
(6) Require that adequate written substantiation be given before reimbursement is made.
(7) Restrict reimbursements to medical expenses incurred during the period of coverage.
(8) Not allocate forfeitures among premium payers based on their individual claims experiences.

In addition, FSA plans can be set up to cover dependent care and adoption expenses. Neither is discussed in this article, but you can call our office for more information.

The following are the major differences between Flexible Health Spending Accounts (FSA) and Health Reimbursement Accounts (HRA):

(1) Employers may opt (are not required) to also make nondiscriminatory contributions to the plan on behalf the employees.

(2) Owners who are sole proprietors, partners, or more-than-2% shareholders of an S corporation are themselves not eligible to participate in an HRA.

These plans are normally administered by commercial firms who act as plan administrators, have pre-approved plans, monitor your plan for compliance and perform other required functions. Please call for additional information.


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Tax-Free and Tax-Favored Fringe Benefits For Passthrough Entity Owners

Certain tax-preferred benefits that are available to employees are also available to owner-entrepreneurs of partnerships, LLCs treated as partnerships, and S corporations. This article examines how these tax-favored benefits apply to partners and more-than-2% S corporation shareholder-employees.

Note that the statutory rules allowing or denying fringe benefits to passthrough owners are stated explicitly only in the context of partners and partnerships. However, a domestic (i.e., U.S.) eligible entity with two or more members automatically is treated as a partnership unless it elects to be taxed as an association (i.e., as a corporation). And, for fringe-benefit purposes, more-than-2% S corporation shareholder-employees are subject to the rules that apply to partners, and S corporations are treated as partnerships. As a result, unless otherwise noted, the tax consequences of fringes for members of LLCs taxed as partnerships and for more-than-2% S corporation shareholder-employees are the same as they are for partners.

Working condition fringe benefits - Property or services supplied by an employer to an employee are tax-free working condition fringe benefits (WCFBs) if the employee were entitled to a business expense deduction for the item had he paid for it himself. For WCFB purposes, the term “employee” includes partners who perform services for the partnership. Thus, partners may receive the following WCFBs tax-free:

o Business-related use of a company auto, if properly substantiated. The personal-use value of the auto must, however, be treated as compensation income.

o The business-use portion of company paid country club dues, even though the dues are completely nondeductible by the business.

o Job-related education expenses paid by the firm

o Job placement assistance

De minimis fringe benefits - For purposes of the tax-free de minimis fringe benefit rules, “employees” include any recipient of a fringe benefit. Thus, partners are entitled to receive the following:

o Tax-free supper or supper money or local transportation fare if provided on an occasional basis in connection with overtime work.

o Traditional birthday or holiday gifts of property (not cash) with a low fair market value (an undefined term in the tax regulations), occasional theater or sporting event tickets, and fruit, books, or similar property provided under special circumstances (e.g., on account of illness, outstanding performance, or family crisis); and

o Traditional awards (such as a gold watch) upon retirement after lengthy service.

Dependent care assistance - Partners are eligible for the dependent care assistance exclusion. The exclusion is for amounts provided under a written plan of the employer and is limited annually to $5,000 ($2,500 for a married person filing separately). However, for a plan to qualify as a dependent care assistance program, no more than 25% of the amounts paid or incurred by the employer for dependent care assistance during the year may be provided for the class of individuals who are shareholders or owners (or their spouses or dependents), each of whom (on any day of the year) owns more than 5% of the stock or of the capital or profit interest in the employer.

Educational assistance programs - Employers can set up educational assistance programs under which employees can receive up to $5,250 per year of graduate- or undergraduate-level educational assistance tax-free, whether or not job-related. Employees for this purpose include partners who have earned income from their partnerships, which, in turn, are treated as employers of these partners. However, no more than 5% of the cost of annual benefits may be provided for the class of individuals (and their spouses and dependents) each of whom (on any day of the year) own more than 5% of the stock or of the capital or profits interest in the employer.

Athletic facilities - The exclusion for the use of on-premises athletic facilities (e.g., swimming pool, gym, tennis court) is available to partners (and their spouses and/or children).

No-additional-cost services and qualified employee discounts - For purposes of these tax-free fringes, partners who perform services for a partnership are treated as employed by the partnership. Generally, a no-additional-cost service is one that is offered for sale by the employer to its customers in the line of business in which the employee performs substantial services, and where the employer incurs no substantial additional cost in providing the service to the employee.

Transportation fringes – Generally, transportation fringe benefits are not available to partners; thus, a partner cannot exclude qualified transportation fringes that currently include the value of qualified parking up to $220 a month, and up to $115 a month of the combined value of transit passes and transportation in a commuter highway vehicle.

However, under the de minimis benefit rules, tokens or fare cards provided by a partnership to a partner that enable the recipient to commute on a public transit system (not including privately-operated van pools) are excludable from income if the value of the tokens or fare cards in any month doesn't exceed $21. If the full value of a pass provided in a month exceeds $21, the full value of the benefit is includible. In addition, if a partner could deduct the cost of parking as a business expense (e.g., parking cost incurred in connection with traveling from the regular office to another business office), the value of the free or reduced-cost parking is excludable as a working condition fringe benefit.

If you are looking for ways to maximize your tax-free compensation through tax-favored fringe benefits, please give us a call.


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GENERAL INFORMATION

Charitable Giving Through Donor-Advised Funds

Contribution to a donor advised fund is a way to warehouse funds in a year in which the donor has an unusually high income (and can benefit from a large charitable deduction) to satisfy the donor's social obligations to make charitable contributions in future years, without incurring the expense of setting up a private foundation and satisfying annual filing and other private foundation requirements.

Donor-advised funds, though they may bear the donor's name, are not separate entities, but are mere bookkeeping entries. They are components of a qualified charitable organization. A contribution to a charity's donor-advised fund may be deductible in the year it is made if it isn't considered earmarked for a particular distributee. The charity must fully own the funds and have ultimate control over their distribution. To document the contribution, the taxpayer must get a written acknowledgement from the fund's sponsoring organization that it has exclusive legal control over the assets contributed.

Though the donor can advise the charity, which generally will follow the donor’s recommendations, the donor cannot have power to select distributees or decide the timing or amounts of distributions. The charity must also ensure that all distributions from the fund are arm’s-length and do not directly or indirectly benefit the donor.

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Working Abroad Can Yield Tax-Free Income

U.S. citizens and resident aliens are taxed on their worldwide income, whether the person lives inside or outside of the U.S. However, qualifying U.S. citizens and resident aliens who live and work abroad may be able to exclude from their income all or part of their foreign salary or wages, or amounts received as compensation for their personal services. In addition, they may also qualify to exclude or deduct certain foreign housing costs.

To qualify for the foreign earned income exclusion, a U.S. citizen or resident alien must:

o Have foreign earned income (income received for working in a foreign country);

o Have a tax home in a foreign country; and

o Meet either the bona fide residence test or the physical presence test.

The foreign earned income exclusion amount is adjusted annually for inflation. For 2008, the maximum foreign earned income exclusion is up to $87,600 per qualifying person. If taxpayers are married and both spouses (1) work abroad and (2) meet either the bona fide residence test or the physical presence test, each one can choose the foreign earned income exclusion. Together, they can exclude as much as $175,200 for the 2008 tax year.

In addition to the foreign earned income exclusion, qualifying individuals may also choose to exclude or deduct from their foreign earned income a foreign housing amount. The amount of qualified housing expenses eligible for the housing exclusion and housing deduction is limited, generally, to 30% of the maximum foreign earned income exclusion. For 2008, the housing amount limitation is $26,280 for the tax year. However, the limit will vary depending on where the qualifying individual's foreign tax home is located and the number of qualifying days in the tax year. The foreign earned income exclusion is limited to the actual foreign earned income minus the foreign housing exclusion. Therefore, to exclude a foreign housing amount, the qualifying individual must first figure the foreign housing exclusion before determining the amount for the foreign earned income exclusion.

Before you become overly excited, foreign earned income does not include the following amounts:

o Pay received as a military or civilian employee of the U.S. Government or any of its agencies.
o Pay for services conducted in international waters (not a foreign country).

o Pay in specific combat zones, as designated by a Presidential Executive Order, that is excludable from income.

o Payments received after the end of the tax year following the year in which the services that earned the income were performed.

o The value of meals and lodging that are excluded from income because it was furnished for the convenience of the employer.

o Pension or annuity payments, including social security benefits.

A qualifying individual may also claim the foreign earned income exclusion on foreign earned self-employment income. The excluded amount will reduce his regular income tax, but will not reduce his self-employment tax. Also, the foreign housing deduction—instead of a foreign housing exclusion—may be claimed.

A qualifying individual claiming the foreign earned income exclusion, the housing exclusion, or both, must figure the tax on the remaining non-excluded income using the tax rates that would have applied had the individual not claimed the exclusions. In other words, the exclusion is off-the-bottom, not off-the-top.

Once the foreign earned income exclusion is chosen, a foreign tax credit, or deduction for taxes, cannot be claimed on the income that can be excluded. If a foreign tax credit or tax deduction is claimed for any of the foreign taxes on the excluded income, the foreign earned income exclusion may be considered revoked.

Other issues:

Earned income credit - Once the foreign earned income exclusion is claimed, the earned income credit cannot be claimed for that year.

Timing of election - Generally, a qualifying individual's initial choice of the foreign earned income exclusion must be made with one of the following income tax returns:

o A return filed by the due date (including any extensions);

o A return amending a timely-filed return;

o Amended returns generally must be filed by the later of 3 years after the filing date of the original return or 2 years after the tax is paid; or

o A return filed within 1 year from the original due date of the return (determined without regard to any extensions).

A qualifying individual can revoke an election to claim the foreign earned income exclusion for any year. This is done by attaching a statement to the tax return revoking one or more previously made choices. The statement must specify which choice(s) are being revoked, as the election to exclude foreign earned income and the election to exclude foreign housing amounts must be revoked separately. If an election is revoked, and within 5 years the qualifying individual wishes to again choose the same exclusion, he must apply for approval by requesting a ruling from the IRS.

Are you looking for foreign employment or has an opportunity already presented itself to you? Before you make your final decision, please call our office to learn more about the foreign earned income and housing allowance exclusions, or how to meet the bona fide residence or physical presence tests.

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BRIEFS

Billions in Telephone Excise Tax Refunds Go Unclaimed

A recent audit by the Treasury Inspector General for Tax Administration (TIGTA) indicates that only approximately 721,410 (5.6 percent) of the 12.8 million business taxpayers who had filed their returns had made telephone excise tax refund claims. The refunds associated with these claims totaled only $876.6 million, or 17.5 percent of the $5 billion collected.

The audit report was unable to pinpoint the reason that so many failed to claim the refunds. The report did, however, outline several conditions that may have contributed to businesses not making claims – the belief that the work involved and the associated fees outweighed the amount of the credit businesses would receive; the concern that the businesses would not have the required records to support the amount of their claims; and businesses remained unaware of the credit.

To request the Telephone Excise Tax Refund, businesses were required to complete the Credit for Federal Telephone Excise Tax Paid (Form 8913) and file it with their 2006 tax return. The form was completed by using the actual amount of refundable long-distance telephone excise taxes that were paid between March 2003 and July 2006 (41 months), or the business had an option to use an estimation method developed by the IRS.

If your business failed to claim this credit, it is not too late. You can still file an amended 2006 return with the Form 8913 to claim the credit. If we can be of assistance, please give us a call.

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Military Families Receive Recovery Rebate Break

The 2008 Heroes Act includes several benefits for military personnel. The Act was signed into law the last week of May, so we will include a summary of the provisions affecting individuals and small businesses in the next bulletin.

However, there is one new benefit that affects tax rebates currently being distributed by the IRS. Prior to the passage of the new law, a U.S. Armed Forces member who is married to a foreign spouse who was ineligible for a Social Security number would not receive a rebate credit if the couple filed a joint return.

The new 2008 Heroes Act provides that the identification number requirement doesn't apply to a joint return where at least one spouse was a member of the U.S. Armed Forces at any time during the tax year.

For couples who have already filed a 2007 return and who qualify for a rebate as a result of the new provision, IRS will either send the rebate automatically or provide a procedure by which taxpayers can notify IRS that they qualify.

Presumably, for those who have yet to file for 2007, IRS will explain what special notations (if any) need to be made on the return to alert the IRS that one spouse is a U.S. Armed Forces member.
Even if a couple doesn't receive an advance rebate during 2008, they can still claim the credit (if they qualify) on the 2008 return that they file in 2009.

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