Getting in the Christmas spirit and year-end tax planning mixes like oil and water. Who wants to think about taxes, you ask, when it’s time for Santa Claus and candy canes.
It may surprise you to know that because of his investment in a fir tree farm in Montana some years back, Santa is a non-resident alien (for U. S. tax purposes) and does some tax planning in December himself. Seriously, for a lot of people, a little time spent at the end of the year concerning taxes can save a load of money in taxes not owed.

1. Start an IRA (from earned income); the maximum this year is $5,000 (and another $5,000 for your spouse). If you are age 50 or older the max is $6,000 (and $6,000 for your spouse). Even if you can’t afford to tie up the money for a long period of time, you can “cash out” the IRA after you file (which creates a taxable event for 2009, of course) and with possible tax planning in 2009, cover the cash-out with deductions or the possibility of lower income in 2009. In the meantime, you have created a $5,000 deduction in 2008 ($10,000 with a spouse). This strategy is particularly effective if it puts you in a lower tax bracket this year, but not in 2009. There is an old rule in tax planning: Always delay paying taxes as long as legally possible.

2. Turn that new hobby you started this year into a business, especially if there is a first-year loss, as there is in most new businesses. Be aware that the IRS states that if a business isn’t profitable in three years out of five that it can deem it a hobby. Also be aware that the IRS lost its case in federal court when it tried to enforce that rule. The court did not agree with that concept, stating that we all have the right to attempt to succeed at business as long as we like; that notwithstanding, I once worked with a couple who each had a separate business. It just happened to turn out, purely by circumstance, that while he had over $20,000 in losses each of the first two years, she made a slight profit both of those years ($10 the first year and $28 the second year). Then her business took a bad turn and lost over $55,000 over the next two years while his turned around a bit and showed a $19 and $36 profit. The fifth year, he made a profit of $16 while she made a profit of $119. The end result was the IRS rule was satisfied (even though legally, it did not have to be) and the couple racked up net deductions in excess of $95,000 over the five years. Most of the losses were items they might have purchased anyway (but would not have been deductible without a business) or involved travel costs that they deemed were business related and therefore deductible. Everything was covered with the proper receipts and bookkeeping (which I highly recommend). All was accomplished with proper tax planning.

3. For those couples where one is a U.S. citizen and the other is a non-resident alien (for U.S. tax purposes), there is the decision to be made as to whether to choose to treat the non-resident spouse as a U.S. resident. If you make this choice, you and your spouse are treated for income tax purposes as residents of the U.S. for your entire tax year. Whether to make this choice or not would depend on your individual circumstances (refer to IRS Publication 519, U.S. Tax Guide for Aliens). As one example, if the non-resident spouse were subject to the 30% tax on fixed or determinable income, it might be wise to make the election described above.

4. Converting an IRA (or a part of an IRA) to a Roth IRA (this subject was discussed in the September issue of Revue). This decision must be made by December 31. However, if later on you feel you made the wrong decision (more income than you expected showed up in the forms you receive in January and February), you can change it back to an IRA with no tax consequences. That is called a recharacterization and can be done on or before April 15 of the year following the year of conversion (October 15 if you file for an extension).

Once again, I will end my writing with a quote, this time from the late Louis D. Brandeis, U.S. Supreme Court Justice: “Where I live in Alexandria, Virginia, near the Supreme Court building, there is a toll bridge across the Potomac River. When in a rush I pay the toll and get home early. However, I usually drive outside the downtown section of the city and cross the Potomac on a free bridge. If I went over the toll bridge and through the toll without paying, I would be guilty of tax evasion. However, if I go the extra mile and drive outside the city of Washington to the free bridge, I am using a legitimate, logical and suitable method of tax avoidance. And, I am providing a useful social service as well.” (The italics are mine.)

Just because you are a U.S. citizens living and working abroad does not mean that you don’t have to report your yearly earnings to the IRS. However, if you pass two tests and qualify for the “foreign earned income exclusion,” you don’t owe any tax unless you made more than $87,500. That’s if your income was earned by working for someone else or within a corporate structure.

For those of us who own businesses (or provide a service) the IRS has a different set of rules for “self-employment income.” If you are self employed, then every dollar over $400 is taxable (and, of course, you must file). The good news is that if you qualify for the foreign earned income exclusion, you still don’t owe any INCOME tax, unless you make more than $87,500.

But now the bad news: Unlike wages earned outside the U.S., self-employment income outside the U.S. IS subject to Social Security and Medicare tax (total of 15.3 percent) on every dollar above $400. And, worse yet, the foreign earned income exclusion does NOT apply to Social Security and Medicare tax.
So, you have a little widget business and you netted $20,000. You do qualify for the foreign earned income exclusion, so you don’t owe any income tax. However, you do have to file AND send a check to the IRS for Social Security and Medicare taxes in the amount of $2,999. ($19,600.00 x 15.3 percent).
There are several ways to avoid this problem; one of the simpler methods is to form a corporation, have all checks made to the corporation, and have the corporation pay you as an employee. Now you are governed by the “wage” rule, not the “self-employed” rule.

I have had a person tell me that they didn’t feel that was “playing fair” – that everyone should pay their “fair share” (of taxes). My first inclination was to tell them that under the present tax structure, there isn’t any amount that I consider to be “fair.” I believe in a flat tax system or, better yet, a national sales tax. Instead, I referred them to a quote from Judge Learned Hand: “Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the Treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible.”

I also agree with Arthur Godfrey, who said: “I’m proud to pay taxes in the United States; the only thing is, I would be just as proud for half the money.”

A few tips on U.S. taxpaying and IRA accounts

“I haven’t filed taxes for six years— ever since I’ve been down here.” That was the comment from my co-expat from the States, who had just bought me a drink at my favorite bar in La Antigua Guatemala. “I have had income every one of those years, so I guess I should file, right?” he continued.

He was confiding this to me because I am a retired tax specialist from the States currently residing in Guatemala. My specialty is showing retirees and/or small business owners how to legally reduce and avoid U.S. taxes. I stress the words “legally” and “avoid.” The difference between tax avoidance and tax evasion is five years (in federal prison).

U.S. citizens are required to file a tax return, no matter where they live in the world, if there has been any taxable income during that year. That does not necessarily mean that there will be any taxes to pay.

I believe that the worst, and most common, tax problem for retired individuals are “Qualified Plan Accounts.” These include IRAs, 401(k)s, 403(b)s and SEPs. Every dollar removed from any of these plans is taxable and in many cases, causes tax on Social Security. The amount withdrawn can also place an individual in a higher tax bracket.

In 1998 a “qualified plan” called the Roth IRA (sponsored by Sen. William V. Roth Jr.) became available. If you contribute to a Roth IRA, you receive no tax deduction, but the account grows tax free, and you can take the money out TAX-FREE. Allow me to emphasize this point: You don’t pay taxes on withdrawals from a Roth account, and it does not create tax on other income (i.e., Social Security). A Roth account also goes tax free to your children or anyone you designate as an heir.
The second thing the government said was, in addition to being able to contribute to a Roth (from earned income), we could also “convert” any of our IRA money (or any “qualified plan” money that had first been transferred to an IRA account) in any amount to a Roth account. We would have to pay taxes, of course, on the amount we converted. They also told us that the taxes owed on any amount converted in the year 1998 could be paid over the next four years in four equal installments.
There were many people who converted their entire IRA to a Roth account in 1998. That was a big mistake on their part (but it created a huge windfall of tax revenue for the government).

The mistake was not in converting IRA to Roth, it was how it was converted from IRA to Roth. By mistakenly converting the entire amount in one year, they not only paid (or owed over the next four years) the highest tax bracket amount (assuming a typical IRA account is over $150,000), but they also put themselves in the highest tax bracket possible on their other taxable income that year.
Most people don’t know that the IRS code allows us to split up an IRA account into as many separate IRA accounts. For example, a $200,000 IRA in 1998 could have been split into four $50,000 IRAs, and one could have been converted each year for the next four years. The total tax paid would be much less than the tax created with the single $200,000 “conversion”—because of a much lower tax bracket.