For purposes of claiming the foreign earned income exclusion, one must have income earned in a foreign territory. Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad, lists earned income as salaries and wages, commissions and bonuses, tips and professional fees. It also includes related payments such as vacation, sick leave, severance, certain reimbursements and allowances. The list of unearned income include annuities, alimony, capital gains, dividends, interest, unemployment and social security benefits, and gambling winnings. But what if your means of livelihood is gambling? Will your winnings still be considered unearned?

It is hard to define what it means to be a professional gambler. Every situation is different and the U.S. Tax courts do not have a “one case fits all” template to follow as guidelines for determining whether one is a professional gambler or not.  In the IRS Letter Ruling 8235006, May 21, 1982, a taxpayer was engaged in full-time gambling activities such as playing cards and wagering in various sports games. The taxpayer had a daily routine he followed like studying the games, playing cards, and making bets. Yet according to the ruling, the taxpayer was not considered a professional gambler because his gambling activities were not considered a trade or business within the definition of Code Section 162(a). According to this code section, a deduction of all ordinary and necessary expenses paid or incurred is only allowed for carrying on a trade or business.

In another case, Pansy v. Panages, a taxpayer gambled regularly but only after she was done with her regular work. The tax court ruled that the taxpayer’s gambling activities were not a trade or business as gambling was not her primary means of livelihood. The taxpayer maintained a flower shop business in addition to another wholesale business that occupied most of her time. The courts argued that “for gambling to reach the level of a trade or business activity it must be ‘pursued full time, in good faith, and with regularity, to the production of income for a livelihood, and ***not a mere hobby’”. Commissioner v. Groetzinger , 480 U.S. 23, 35 (1987). As a result, the taxpayer could not deduct her gambling losses on Schedule C, although she may have been able to itemize them on Schedule A.

Just from the above case and ruling we have an idea of how difficult it is to determine what constitutes a professional gambler. In general, you are a professional gambler if you are regularly engaged in full-time gambling with the primary purpose of making a living. Weekend gambling trips to Las Vegas does not make one a professional gambler.

As a professional gambler, one will have earned income reportable on Schedule C. Consequently, as someone engaged in a trade or business of gambling, losses and business expenses are deductible up to the amount of his winnings. Examples of expenses related to gambling include travel, meals and entertainment, interest, telephone and internet, vehicles expenses, and other fees and expenses.

Professional gamblers living outside of the United States will be able to claim the foreign earned income exclusion if they meet the physical presence test or the bona fide residence test. However, they will be subject to self-employment taxes unless the foreign country in which they reside has a totalization agreement with the United Sates.

Much to the taxpayer’s dismay, even if a foreign corporation does not have a permanent establishment in the United States and does not have any U.S. sourced income, the U.S. has taxing authority over certain foreign corporations with involvement by U.S. persons.  If the foreign corporation has U.S. officers, directors, or shareholders who meet certain filing requirements, the U.S. officers, directors or shareholders are subject to U.S. income tax and must file Form 5471.  Form 5471 is an information return for U.S. Persons with respect to certain foreign corporation, and includes mechanisms through which the US Government can tax foreign profits even before they are distributed as dividends.

5471 has five categories of filers which are based upon stock ownership and control of the corporation.  Unfortunately, to complicate things even further for the taxpayer, ownership is not limited to direct ownership and can instead be based above constructive ownership (i.e. attribution of ownership of other entities that are controlled by the taxpayer or certain family members). Interestingly enough, there is no constructive ownership in the case of a non-resident alien spouse.  This may require someone who is an indirect owner to file Form 5471 as well.   The categories of persons potentially liable for filing Form 5471 is very broad and includes U.S. citizens, U.S. resident aliens, U.S. domestic corporations, U.S. domestic partnerships, and U.S. domestic trusts.  However, the definition of a “U.S. person” changes with each category of filer.  The schedules required to be filed also vary with each category of filer, so it is very important to carefully read the IRS General Instructions for Form 5471 for specific descriptions of each category of filer as well as the filing requirements.  We have copied the categories of filers below for your convenience:

Category 1 Filer

This filing requirement has been repealed by section 413(c)(26) of the American Jobs Creation Act of 2004, which repealed section 6035.

Category 2 Filer

This includes a U.S. citizen or resident who is an officer or director of a foreign corporation in which a U.S. person (defined below) has acquired (in one or more transactions):

1. Stock which meets the 10% stock ownership requirement (described below) with respect to the foreign corporation or

2. An additional 10% or more (in value or voting power) of the outstanding stock of the foreign corporation.

A U.S. person has acquired stock in a foreign corporation when that person has an unqualified right to receive the stock, even though the stock is not actually issued. Stock ownership requirement – For purposes of Category 2 and Category 3, the stock ownership threshold is met if a U.S. person owns:

1. 10% or more of the total value of the foreign corporation’s stock or

2. 10% or more of the total combined voting power of all classes of stock with voting rights.

U.S. person – For purposes of Category 2 and Category 3, a U.S. person is:

1. A citizen or resident of the United States,

2. A domestic partnership,

3. A domestic corporation, and

4. An estate or trust that is not a foreign estate or trust defined in section 7701(a)(31).

Category 3 Filer

This category includes:

• A U.S. person (defined above) who acquires stock in a foreign corporation which, when added to any stock owned on the date of acquisition, meets the 10% stock ownership requirement (described above) with respect to the foreign corporation;
• A U.S. person who acquires stock which, without regard to stock already owned on the date of acquisition, meets the 10% stock ownership requirement with respect to the foreign corporation;
• A person who is treated as a U.S. shareholder under section 953(c) with respect to the foreign corporation;
• A person who becomes a U.S. person while meeting the 10% stock ownership requirement with respect to the foreign corporation; or
• A U.S. person who disposes of sufficient stock in the foreign corporation to reduce his or her interest to less than the stock ownership requirement.

Category 4 Filer

This includes a U.S. person who had control (defined below) of a foreign corporation for an uninterrupted period of at least 30 days during the annual accounting period of the foreign corporation.

U.S. person – For purposes of Category 4, a U.S. person is:

1. A citizen or resident of the United States;

2. A nonresident alien for whom an election is in effect under section 6013(g) to be treated as a resident of the United States;

3. An individual for whom an election is in effect under section 6013(h), relating to nonresident aliens who become residents of the United States during the tax year and are married at the close of the tax year to a citizen or resident of the United States;

4. A domestic partnership;

5. A domestic corporation; and

6. An estate or trust that is not a foreign estate or trust defined in section 7701(a)(31).

Control – A U.S. person has control of a foreign corporation if, at any time during that person’s tax year, it owns stock possessing:

1. More than 50% of the total combined voting power of all classes of stock of the foreign corporation entitled to vote or

2. More than 50% of the total value of shares of all classes of stock of the foreign corporation.

A person in control of a corporation that, in turn, owns more than 50% of the combined voting power, or the value, of all classes of stock of another corporation is also treated as being in control of such other corporation

Category 5 Filer

This includes a U.S. shareholder who owns stock in a foreign corporation that is a CFC for an uninterrupted period of 30 days or more during any tax year of the foreign corporation, and who owned that stock on the last day of that year.

U.S. shareholder – For purposes of Category 5, a U.S. shareholder is a U.S. person who:

1. Owns (directly, indirectly, or constructively, within the meaning of sections 958(a) and (b)) 10% or more of the total combined voting power of all classes of voting stock of a CFC or

2. Owns (either directly or indirectly, within the meaning of section 958(a)) any stock of a CFC (as defined in sections 953(c)(1)(B) and 957(b)) that is also a captive insurance company.

U.S. person – For purposes of Category 5, a U.S. person is:

1. A citizen or resident of the United States,

2. A domestic partnership,

3. A domestic corporation, and

4. An estate or trust that is not a foreign estate or trust defined in section 7701(a)(31).

The forms required to be filed by each category of filer are illustrated on the matrix below:

Among other items, Form 5471 requires the filer to report certain details related to the corporation including ownership information, stock transactions, foreign taxes, currency conversions, earnings, and foreign bank and financial accounts.  Unlike domestic corporations that report their taxes using Form 1065, 1120 or 1120s, Form 5471 is more extensive and requires foreign corporations to report and evaluate other important issues such as subpart F income, transfer pricing, and foreign tax credits.  Subpart F income will be addressed in detail in a future post.

When determining if Form 5471 is required to be filed, it is very also important to remember that a foreign limited liability company (LLC) will be treated as a foreign corporation if an election has not been made to classify the entity as a foreign disregarded entity or a foreign partnership (which in itself would have to file a form similar to 5471, form 8865).  Additionally, according to the IRS, a “foreign corporation” also includes an “International Business Company” (IBC) in which a U.S. person has partial ownership.

It is very important to be aware of the Form 5471 filing requirements and make sure you properly assess whether each particular entity needs to file the form.  The stakes are very high as failure to timely file Form 5471 can result in penalties imposed by the IRS of up to $10,000.  This penalty can increase if the form is not filed after a failure to file notification has been issued by the IRS.  Additionally, an incomplete 5471 is deemed unfiled and the same penalties apply.  Just one small mistake can cost you $10,000!  Hire a professional to avoid this costly mistake.

The deadline for most corporations is March 15^th and April 15^th for individuals if an extension has not been granted.  As with most tax forms, the common law “mailbox rule” applies.  That is, as long as the form is postmarked and “in the mailbox” by the deadline, the form is counted as received by the IRS despite the actual receipt date.

Please stay tuned for several more articles highlighting certain aspects and nuances of Form 5471!  These will include topics related to the pros and cons of having an offshore corporation, Subpart F income, what can/cannot be deferred, penalties, and ways to mitigate penalties.

Ever since I stepped foot on this country, I have started to embrace Australian culture.  While the culture shock here is minimal compared to other countries, it’s certainly important – as a foreigner – to respect the country you are in.  Whether it means learning the language (or in my case, jargon and slang), participating in the country’s festivals and celebrations, or honouring a country’s holiday, it’s important to open yourself up to new experiences in a foreign country.

As an American expat, I get very excited when an Australian holiday rolls around because it’s a chance to witness a foreign holiday celebration and a chance to appreciate the country’s culture and history.

I celebrated the Queen’s Birthday in June at a pub with some friends.  Father’s Day in Australia is celebrated in September (as opposed to June in the States), so it was interesting to see cafes and restaurants packed in celebration.

Every year, January 26th marks Australia Day – a day that commemorates the arrival of the First Fleet at Sydney Cove.  Australians celebrate this day with parades, beachside BBQ’s, an awards ceremony, and an amazing fireworks display to cap the night.

I’m looking forward to celebrating Australia Day with the Aussies to honour this great country, celebrate my own life in Australia, and compare celebrations between Australia and the U.S.

My time here over the last eight months has been incredible.  I have discovered a new sense of freedom and happiness in Australia than I ever thought I could find living in the U.S.  I will always be a proud U.S. citizen, I will always celebrate Independence Day regardless of where I am in the world, and I will always scowl at the Aussies who call me a “yank” or a “seppo,” but on January 26 this year, I will don my Australian t-shirt and honour Australia with the other Aussies by celebrating these last eight months (and the next seven) on Bondi Beach, throwing a BBQ with my flatmates and some Aussie friends, and enjoying life in Australia.

While many portions of the U.S. tax code possess confusing and sometimes harsh rulings, the tax regime for Passive Foreign Investment Companies (PFIC) is almost unmatched in its complexity and almost draconian features. Countless times, our international clients have come to us to prepare what they thought would be straightforward tax returns- only to later learn that the small investment they had made in a non-US mutual fund was now subjecting them to all the concomitant filing requirements and tax obligations. While it is beyond the scope of this article to cover all the numerous details related to PFIC reporting requirements, my hope is to provide guidance and insight into the world of PFICs.

History
The PFIC tax regime was created via the Tax Reform Act of 1986 with the intent to level the playing field for US based investment funds (ie mutual funds). Prior to the legislation of 1986, U.S.-based mutual funds were forced to pass-through all investment income earned by the fund to its investors (resulting in taxable income). In contrast, foreign mutual funds were able to shelter the aforementioned taxable income as long as it was not distributed to its U.S. investors. After the passage of the Tax Reform Act of 1986, the main advantage of foreign mutual funds was effectively nullified by a tax regime that made the practice of delaying the distribution of income prohibitively expensive for most investors. To employ this punitive regime, the IRS requires shareholders of PFICs to effectively report undistributed earnings via choosing to be taxed through one of three possible methods- Section 1291 fund, Qualified Election Fund, and Mark to Market election.

Basics
Defined in the Internal Revenue Code (section 1297), a Passive Foreign Investment Company is any foreign corporation that has either:
1. 75% or more of its gross income classified as passive income (i.e. interest, dividends, capital gains, etc…), or
2. 50% or more of its assets are held for the production of passive income.

While there are a few exceptions to above rules, most foreign mutual funds, pension funds, and money market accounts would be good examples of PFICs. Furthermore, many foreign REITS also get trapped in the PFIC web. Finally, a foreign holding company that possesses passive investments (like rental real estate or government bonds) would be subject to PFIC regulations if the company was set up as a corporation.

 

PFIC related information is reported on Form 8621 .

Taxation Methods
Section 1291 Fund
The Section 1291 Fund election (Excess Distribution) is the default taxation regime unless the taxpayer chooses either of the two alternatives. Under the Sect 1291 regime, all “excess distributions” for prior years will be taxed at the highest marginal rate for each particular year an excess occurred and will incur underpayment interest expenses on those unpaid taxes. In contrast, the current year “excess distributions” are added to the “Other income” line of one’s personal tax return. For the purposes of this election an “excess distributions” are either:
1. The part of the distribution received from a section 1291 fund in the current tax year that is
greater than 125% of the average distributions received in respect to such stock by the shareholder during the 3 preceding tax years (or, if shorter, the portion of the shareholder’s holding period before the current tax year; or
2. Any capital gains that result from the sale of PFIC shares
To add to the complexity- excess distributions that are taken (in either of the two aforementioned forms) must be allocated ratably over every year since the most recent excess distribution was taken (if any). Furthermore, all dividends are still required to be reported on Schedule B of the income tax return but any capital gains or losses do not get reported on Schedule D.

To provide an illustration:
1 share of XYZ Inc. (a foreign mutual fund) that was purchased for $100,000 on January 1, 2008. It distributed $8,000 of dividends on July 4 of each year. On December 31, 2010, the share was sold for $400,000. Since the dividends for each year never exceeded the prior year’s amount, there are no excess distributions relating to the dividends. However, since the sale resulted in a capital gain of 100,000, the gain is an excess distribution and will be allocated ratably of each day the share was held. In particular, the excess distributions would result in $100,000 being allocated to 2008 and 2009 and taxed at the highest marginal tax rate (35% in 2008 and 2009). Also, interest would be charged to both years for the amount owed as of the due date for the particular tax year’s tax return- i.e. interest would accrue from April 15, 2009 for the 2008 excess distribution tax). Finally, the allocation of excess distribution for 2010 would be added to ordinary income line of the income tax return (line 21 for those filing Form 1040). Assuming the taxpayer was in the 33% income tax bracket for 2010, the additional tax caused by the PFIC regime would exceed $120,000. Please note that the transaction will not be recorded on the taxpayer’s Schedule D and that the dividends, though not taxed as part of the excess distribution regime, would still need to be reported on the taxpayer’s schedule B as non-qualified dividends.

To have perspective on the degree of additional taxation that can occur with the Excess Distribution method- if the $300,000 gain listed in the aforementioned scenario would have come from the sale of a non-PFIC, the tax would have been $45,000 (almost a third of the total PFIC tax liability). As you can clearly see- the IRS wants to discourage investing in foreign mutual funds.

QEF Election (Qualifying Electing Fund)
A second, simpler option for shareholders of PFICs is the QEF election. A first glance, it would appear to be a much better option for most investors since effectively results in the PFIC being treated like a US based mutual fund- the ordinary and capital gains income of the PFIC separately flow through to the shareholder according to percentage of ownership. For example, a taxpayer with a 1% stake in a PFIC that earns $100,000 in ordinary income and another $50,000 in capital gains income will report $1,000 as “other income” on the tax return while $500 will be reported on Schedule D.
However, there is one huge obstacle to making this election- most PFICs are unable to be classified as a QEF since the IRS demands that a QEF comply with IRS reporting requirements (a large request for a non-US based company). Consequently, the QEF election is not frequently available.

Mark-to-Market Election
The third option available to PFIC shareholders is to make a mark-to-market election. This method allows the shareholder to report the annual gain in market value (i.e. unrealized gain) of the PFIC shares as ordinary income on the “other income” line of their tax returns. Unrealized losses are only reportable to the extent that gains have been previously reported. The adjusted basis for PFIC stock must include the gains and losses previously reported as ordinary income. Upon the sale of the PFIC shares, all gains are reported as ordinary income whereas losses are reported on Schedule D.
To choose this method, the PFIC generally must be traded on a major international stock exchange and can only apply to the current and future tax years.

Also, this election is independent of prior PFIC elections (i.e. QEF or Sect 1291 election). for example: If stock X was purchased in 2007 for $100, has a FMV on 12/31/11 of $120, and no PFIC forms were filed until 2011 (when Sect 1296- Mark-to-market- election was made), no PFIC filings would be needed for the prior years as long distributions were less than 125% and no capital gains occurred. For the current year, 8621 would be filed using Mark to market and the ordinary income would be $20. see Section 1.1296-1 3 b.iii

EARNED VS. UNEARNED INCOME

For purposes of claiming the foreign earned income exclusion, one must have income earned in a foreign territory. Income is considered earned in a foreign country if services were performed there regardless of whether the payment is deposited to a bank account in the United States. It is often a challenge distinguishing between earned and unearned income. For this reason, we will carefully examine each category in order to determine the types of income allowed for exclusion.

Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad, defines earned income as pay for personal services performed. It includes salaries and wages, commissions and bonuses, tips and professional fees. However, it also includes related payments such as vacation, sick leave, severance, certain reimbursements and allowances. Furthermore, if noncash income were received through meals, lodging, or the use of a company car, the fair market value of such benefits will be considered earned income.

Just as much as there is a list of earned income, Section 911(b)(1)(B) of the federal tax code outlines the types of income that are unearned: annuities, alimony, gambling winnings, capital gains, dividends, interest, unemployment and social security benefits.

Read the rest of this entry »

2011 has been a very good year for me.  I lived in Prague, Czech Republic to become a certified TEFL teacher.  I traveled back to my motherland, South Korea, a place I have not visited since I was adopted.  I moved to Australia and traveled up the East Coast to Brisbane and Surfer’s Paradise.  And last week, I spent one week in the Philippines.

It was my first trip to South East Asia, a region that I have been dying to visit since I started this epic journey around the world, and it was also my first time visiting a third world country.

Read the rest of this entry »

Travel cost in the Philippines is generally quite low. This holds true even for air travel. Hotel rooms can range from low cost or rather high in cost. If you are use to traveling in style and without a lot of thought to cost, you can get a room costing over $1000 a night. You can also get a room with air conditioning and a private rest room with for under $30 a night.

International travel to nearby Asian countries can sometimes be obtained for around $50 round trip. Usually it will cost a couple of hundred dollars for international travel but special pricing is frequently available.

Flying within the Philippines can be achieved at an even lower cost. Last week, I took a trip via ferry to a nearby city and it took about 12 hours to make the trip. I’m going back to the same location but this time I’ll be flying. I purchased my ticket last night for about $80 for my round trip ticket from Bogo City in Cebu Province to Tacloban City in Leyte Province. This was normal pricing for this trip.

In some of the remote areas of the Philippines, you will find it difficult to find a three star hotel or above. The cost will be under $30 but the rooms could be below your standards. You can’t expect a great Western style bed and other furnishing for this kind of money. You’ll get a room that will get you through. It will usually be very clean but it will not be plush. It will usually include cable TV but no room Internet connection. For Internet you’ll usually have to go to the lobby.

Read the rest of this entry »

Many U.S. expats living in foreign countries are already overwhelmed by the complexity of the federal government’s international tax laws and regulations. And yet these complexities are nothing compared to the challenges same-sex couples or registered domestic partners endure under the federal government’s discriminatory tax laws. Factoring in the fact that these same-sex couples live abroad makes matters worse

Currently, the federal government does not recognize the union between gay and lesbian couples. According to P.L. 104-199, Section 3 of the Defense of Marriage Act (DOMA), the term “marriage” is referred to as the legal union between a man and a woman. In other words, same-sex married couples, civil unions, and registered domestic partners do not exist in the eyes of Uncle Sam. Consequently, many gay and lesbian couples get married in other states that recognize their union. Others even go as far as move to another country to tie the knot and to start a new life.

However, same-sex couples living abroad that are U.S. citizens or residents face a more rigorous process when it comes to complying with their filing obligations. For example, depending on their foreign country of residence, a same-sex couple usually files their foreign taxes jointly. But since the United States does not recognize their marriage to be legal, they must claim the “single” status when filing their U.S. tax returns; married filing jointly or married filing separately is not allowed.

Read the rest of this entry »

Did you know that American expats need to file U.S. taxes? I didn’t.

Which is why I’m glad that I discovered Tax Planner CPA.  Not only because they were kind enough to hire me as a blogger, but also because they specialize in filing expatriate taxes and maybe I can convince them to file my taxes at a discounted rate.

As the New Year quickly approaches, so does the dreaded U.S. tax season.  So if you’re living abroad and need to file your U.S. taxes, how do you do it?  Where do you go?

Well, you could hire a family friend’s accountant to do your taxes, though you may risk a chance of them being inaccurate.  Or you could just not file your taxes this year (obviously not recommended), but then you risk jail-time.  Or you could find a company, like CPA Tax Planner, who specializes in Expatriate Tax returns.

Read the rest of this entry »

The Philippines is a developing nation and is actively encouraging foreign investment in the country. For most businesses the number one benefit is that there is a large number of qualified English speaking individuals that are willing to work at cost much below those in the USA.

I have been living in the Philippines for nearly four years. The first thing that struck me was the amount of poverty in the Philippines. Starting or expanding your business to the Philippines would not only save you money but the business would also help to alleviate poverty in the Philippines.

Another benefit to doing business in the Philippines is that the government often offers huge tax incentivizes to new firms. These include an exemption to income taxes for an extended number of years. Furthermore, the Philippines provide several avenues for individuals to live in the Philippines. If you decide to do that, you can greatly reduce your living expenses including the possibility of having your personal income taxed in the Philippines rather than the USA. Personally, I love living in the Philippines!

Read the rest of this entry »