November 1993 Pages 8-11
the CEN-TA PEDE
US TAX INFORMATION - NEWSLETTER
There is more BAD NEWS and GOOD NEWS for US citizens living in Canada and Canadians with investments and rental property in the United States.
The IRS has stepped up its search for non-filing legal or illegal residents and in particular, is looking for US citizens living in Canada. This also applies to Canadians with Green Cards, L1, H1, H2 and other US visas and most SNOWBIRDS of 120 OR MORE DAYS A YEAR IN THE US "including" shopping and gas buying days.
The GOOD NEWS is that the IRS has extended its time for filing the "up to $70,000" earned income exemption. Before June 30, 1993, you had to have filed your $70,000 exemption within one year of its due date (similar to the rule for Canada's $100,000 Capital Gain Exemption). If you were late, the effective exemption dropped to $20,000 or $30,000.
Quoting directly from the Internal Revenue Service:
Under final 911 Regulations (effective June 30, 1993), you may claim the exclusion on all returns, regardless if timely filed, if either of the following provisions apply:
If the taxpayer OWES NO INCOME TAX after taking into account the exclusion, and files Form 1040 with Form 2555 or comparable form attached either before or after the Service discovers the failure to elect, the taxpayer may file and make the election under this paragraph.
or, under 1.911-7(a)(2)(i)(D)(2)
If the taxpayer OWES INCOME TAX after taking into account the exclusion and files Form 1040 with Form 2555 or comparable form before the failure to elect is discovered by the Service (IRS), then the taxpayer can file and make election under this paragraph.
TAX DUE ON REFUND DEFINED
Tax due on the return is defined as Income Tax. It is not meant to mean Self Employment Tax (FICA) or any other add on taxes defined under the Other Taxes section of Form 1040.
THEREFORE, if you owe income tax on delinquent return(s), and are discovered by the IRS, the exclusion cannot be claimed as above for more than one year without applying for a special ruling. The IRS fee for this special ruling (which is usually not granted) is $500 if your income is under $150,000 (US) and $3,000 if income is over $150,000.
The REALLY GOOD news is that if you have already filed and paid taxes because your income fell into the Alternative Minimum Tax category, the IRS will consider and likely allow a 1040X and late filing of the $70,000 exemption back to 1987, PROVIDED that the US citizen originally came forward voluntarily. You are encouraged to backfile the exemption claim provided the expected refund is more than the "fee for service" will be.
In checking my own files, this works out to about $1,500 less tax per client for many clients who have already filed. Why would the IRS allow this? Well, it makes it easier for the errant taxpayer to file, and it "gets them on the books". So, what should you do now?
1. Check over old late filed returns to see if the 2555 $70,000 exemption will be of benefit. If there was $400 US AMT paid in 1987, the refund now is about $800 CDN.
2. File a 1040X and 2555 for each year if beneficial.
3. Remember to ask your regular Canadian Tax clients if they are a US citizen OR the holder of a US "Resident Alien (green) Card". I have been continuously surprised this past year with at least one old Canadian Client a week, 'fessing up to being an American citizen or green card holder and asking to have the old US returns prepared.
4. Remember to ask your Canadian Clients if they have a rental in the States. Many Canadians have been renting out a property in the US and losing money and not bothering to report the rental anywhere. If the IRS finds the situation, they will tax 30% of the GROSS rent and fine the non-filing Canadian up to $10,000 a year for "failing to comply".
Questions and comments to david ingram at (604) 657-8451.
The following are some very real US / Canadian tax cases handled by our office in the last two months. Each one of them has the possibility of $200,000 tax liabilities and in each case, the US citizen "thought" they were doing everything okay. All individuals were and are high income earners.
AND everyone had consulted at least once with a professional accountant who gave either incomplete advice, or wrong advice, or because of the 1986 Tax Reform Act, the advice given in 1984 or 1985 (or even 1977) was no longer valid. In a couple of cases, bank managers had given an incorrect opinion because "anything else did not make sense".
CASE 1: (Please note that ALL cases have facts changed for obvious reasons.)
The taxpayer and his wife are both US citizens. He earns $100,000 US in Canada from four different sources. Source one is his American Employer who has been paying him a salary (through a Canadian subsidiary) which has gone from $40,000 a year to $80,000 a year over the last six years. Source two is a Canadian Employer at about $14,000. Source three is a Canadian Educational institution at $5,000 to $6,000 and there is about $1,000 from an American University for work performed in Canada.
His wife earns $20,000 US from a Canadian Employer. This was not on the US return.
I prepared his US and Canadian Returns in 79, 80 and 81 when he only had the US source of income and when he was working half in Canada and half in the US. At that time, he had enough earned income in the US and was there enough that doing the calculations to exempt the money earned in Canada was "too hard" when a foreign tax credit calculation wiped out all the tax and was relatively simple to do. The client then prepared his own returns for 1983 to 1992. Unfortunately, he only reported his American Employer's money and the US College on his American return and omitted his wife's Canadian salary and his other two employers. He also left off Canadian Dividends, Canadian Interest and Canadian Capital Gains.
In 1987, the US government changed their rules to only allow 90% of a foreign tax credit when the family income was over $40,000 US. He missed it and the US government accepted the 87, 88, 90 and 91 returns as filed. Then in March this year, after filing the 92 return, they caught up to him, and sent a bill for $700 of alternative minimum tax for 91. He was indignant and wanted to know what this was all about. After all, as he told them, he had done his return the same way every year. And, of course, by the time he had finished talking to them, they knew he had not reported all his income and he was "in the glue".
People do not know what to say to the "revenuer". If a person who exceeded the speed limit in the same place every day for twos years was finally stopped for speeding, he would not be indignant and tell the policeman that "you can't give me a ticket, I've been speeding here every day for two years and my brother, boss, and next door neighbour speed here too."
But the first time a "revenuer" implies that they cannot deduct something, they immediately say, "of course I can, I've been deducting it for five years and my brother, boss, and next door neighbour do as well." This kind of statement gives the tax auditor another three names to deal with and allows him or encourages him to open up four or five more years of your own file in the US. (Incidentally, in case you have forgotten, while Canada will usually only ask for the last three years of unfiled returns, the IRS wants theirs back to 1987 for everyone and can ask for back to 1967 if they wish to.)
In the case above, the situation is not too bad. Because we can now file the $70,000 exemption forms back to 1987, there will be no tax on the earned income. The $70,000 exemption for him and another for his wife mean that his earned income will either be exempt or under the $40,000 threshold for the 100% of foreign tax. He will have to pay tax to the US on about $50,000 of Capital gains which were tax free in Canada but which are taxable in the US. Because of his other income, he will hit the 28% tax rate and owe about $21,000 US in tax and interest.
CASE 2 involves a Canadian Accountant and his wife who is an American Citizen as well as a Canadian Citizen.
For Canadian income splitting reasons, they have been paying her hefty salaries in Canada even though she has done little or no real work for the company. In addition, they have realized a $600,000 US profit on the sale of their family home and in buying another home, downsized from a $1,000,000 US home to a $400,000 US home in Canada and another $400,000 US place in the US.
The US IRS now wants tax on her half of the $600,000 profit plus they want alternative minimum tax of about $20,000 on the last 6 years of income. Altogether, with interest, about $125,000.
How did the IRS find out about this situation? The couple applied for a "resident alien" card for the husband so that they could spend more time in Hawaii without worrying about being a visitor and so that he could maybe start a company in Hawaii without INS hassles.
CASE 3 - Both husband and wife are DUAL citizens
A Canadian couple who are also US citizens sell out their Canadian Computer company for $2,200,000 US in 1989. They have not filed US returns since they came to Canada. They claim their $500,000 each tax free in Canada and only pay about $400,000 tax to Canada.
The Canadian/US couple start a new operation and end up with an article in a computer newspaper. The IRS spots it and checks the facts. Article has all the information. Started with nothing in a basement. Built it up to $10,000,000 a year sales (mostly to the US) and sold it to an American Company. Also casually mentions that they are Americans.
The IRS now wants tax returns back to 1979 for each individual "PLUS" tax returns for the Canadian Company which has been ruled an American Company for tax purposes. I haven't finished, but I think the taxes will be over $400,000 US plus penalties, plus interest.
And that points out an interesting fact. There are rarely any penalties when we file these late returns to catch up. The IRS recognizes that most people who came to Canada prior to 1986 and went to work in Canada were told that they would not owe tax to the US (because the Canadian taxes were usually HIGHER until 1987).
However, where an American has spent a lot of time in the States (as this couple did) or came to Canada after 1986 Tax reform when the Alternative Minimum Tax rules were in place, or got "caught", late penalties are normal. The later the return, the larger the penalty. There is a real advantage catching up sooner than later. Remember that the $70,000 exclusion now applies retroactively to 87 if the US taxpayer comes forward VOLUNTARILY.
PLEASE NOTE when filing these late returns! To make sure that there is no penalty, it is necessary to attach a letter explaining that the taxpayer had been told he would not owe tax and took this to mean that he or she would not have to file a return. This letter or a copy must be attached to EACH return. If you are filing 87, 88, 89, 90, 91 and 92, attach one letter to each year. Otherwise, when the returns are separated for processing, one return will come back with no penalties, and the other 5 will have penalties. In addition, depending on which of the two situations applies, one should write "Filed Pursuant to 1.911-7(a)(2)(i)(D)(1) or 1.911-7(a)(2)(i)(D)(2)" at the top of the Form 2555 for each year.
If this NEWSLETTER is of no use to you, your clients, or your business, please let us know and we will happily remove your name from the list.
On the other hand, if YOU have a situation you would like included, I welcome all submissions and will give editorial credit.
The next issue will deal with the problem of having a green card and living in Ferndale or Point Roberts, or Bellingham and working in Canada. The biggest question? Can I still belong to my provincial Medical plan?
I don't know yet. BC Medical is making a supreme effort to cancel "RETROACTIVELY" coverage for these people, even though they pay full taxes to British Columbia. We have letters out to Cabinet Ministers and a lot of other individuals who should be able to give us an answer soon. The B C Medical Plan will certainly have to change its official policy.
the CEN-TA GROUP