We do nothing but international tax stuff. On the outbound side (U.S. humans and companies doing business outside the USA) we have a steady flow of questions about the foreign earned income exclusion. The Federal government has just done a review of tax returns claiming the foreign earned income exclusion and has found (shocking, I know) that there are a lot of errors made by taxpayers. Maybe even a bit of lying and cheating going on.
We’re playing on the Form 2555 playground today, kids.
The foreign earned income exclusion rules help U.S. taxpayers living abroad to eliminate double taxation of income. The rules are unneccesarily complex. If you are a taxpayer, you have extra work and expense built into your tax return preparation every year. If you are a bureaucracy, the point to remember is that bad systems create bad results.
U.S. citizens pay U.S. tax while living abroad
Start with the basic idea that a U.S. citizen (or green card holder) living abroad is required to file a U.S. tax return and pay U.S. income tax on his/her worldwide income.
Fred is a U.S. citizen living in Germany. He works there and has not visited the United States for ten years.
Fred must file U.S. income tax returns and pay U.S. income tax.
The United States, by the way, is almost entirely alone in this perspective. Other countries claim the right to tax your worldwide income only if you are actually, y’know, a really-truly resident of the country. Leave the country, they don’t tax you.
You can listen to a recent NPR story on this topic here: http://marketplace.publicradio.org/display/web/2010/09/13/pm-salam-no-taxes-for-americans-abroad/ (Thanks L for the heads-up about this).
Making it fairer
In order to make it a bit fairer to U.S. citizens (and permanent residents) living and paying income taxes abroad, there are two ways the U.S. government attempts to make sure that a dollar of income doesn’t get taxed twice:
- The foreign tax credit (tax you paid in Germany acts as a dollar-for-dollar reduction of your U.S. income tax bill); and
- The foreign earned income exclusion (the first $91,400 of earned income is not taxed in the USA at all).
These two methods are logical in concept. But they’re horrifically complex in application.
The mind boggles, Bucko!
The Internal Revenue Code and the Treasury Regulations written by the IRS make medieval theologians and scholars of the Talmud look like children building sandcastles. You know how the word “byzantine” has crept its way into the English language as an adjective? In one way or another our friends in Washington DC are going to become an adjective, too.
This is not the time to bore you with examples. There’s plenty of time for that later. The foreign tax credit is vastly more complex than the foreign earned income tax credit. In the foreign earned income arena
It is not surprising, therefore, that:
- It costs a metric tonne more in professional fees to prepare these tax returns; and
- People make mistakes; and
- Taxpayers lie.
TIGTA audit and results
The Treasury Inspector General for Tax Administration is an internal government auditing arm which checks on the IRS to see how well things are going. They just issued a report (43 glorious pages of PDF, warning!) saying that tax returns claiming the foreign earned income exclusion are riddled with lies and errors.
From the summary of the report:
IMPACT ON TAXPAYERS
Taxpayers excluded $19.2 billion in foreign earned income on Tax Year 2008 tax returns. Our review identified 23,334 Tax Year 2008 tax returns with erroneous foreign earned income tax exclusions totaling $675 million with an estimated revenue loss totaling $90 million. Over 5 years, TIGTA estimates erroneous claims could result in total revenue losses of $450 million.
WHY TIGTA DID THE AUDIT
This audit was initiated to assess the IRS’ process to ensure the accuracy of foreign earned income tax exclusions. If an individual is a United States (U.S.) citizen or resident alien, his or her worldwide income generally is subject to U.S. income tax, regardless of where the individual lives. The individual is subject to the same income tax filing requirements that apply to U.S. citizens or resident aliens living in the U.S. However, if an individual meets certain requirements while living abroad, the individual may exclude up to $91,500 of foreign earned income (Tax Year 2010).
WHAT TIGTA FOUND
Using information on the completed Foreign Earned Income (Form 2555), TIGTA reviewed 231,277 Tax Year 2008 tax returns with claims for foreign earned income tax exclusions and identified that some individuals incorrectly calculated the exclusion or did not qualify for the exclusion.
- 17,787 (8 percent) individuals overstated their foreign earned income exclusion by $410 million.
- 5,547 (2 percent) tax returns with $265 million in exclusions had incomplete information or inaccuracies on the Forms 2555.
WHAT TIGTA RECOMMENDED
TIGTA recommended that the Commissioner, Large and Mid-Size Business Division, review the tax returns of those individuals TIGTA identified as incorrectly claiming the foreign earned income exclusion; establish a unit to address taxpayers identified as erroneously claiming the foreign earned income exclusion; and assess whether compliance project criteria can be used to identify erroneous claims during tax return processing.
In addition, TIGTA recommended that the Commissioner, Wage and Investment Division, include programming to forward tax returns (both electronically filed and paper) to the Error Resolution System for correction for individuals who incorrectly compute their foreign earned income exclusion.
IRS management agreed with four of the seven recommendations. Management stated that substantial barriers prevent the implementation of the remaining three recommendations at this time. TIGTA is concerned that the lack of corrective action will allow continued revenue loss as noted in our report.
Maybe gilding the lily isn’t the right strategy. Maybe simplifying compliance requirements is the right strategy. Simpler = easier for taxpayers. Simpler = less opportunity to hide a lie in a deep and dark crevasse of the Regulations.
Suggestion for the government
I have two words for the IRS. John Seddon. He runs a consultancy called Vanguard Consulting Ltd.
John Seddon has an idea.[1. Actually John Seddon has many ideas, not just one. :-)] It is “D’Oh!” obvious but I had never thought about it before.
Demands from customers (read taxpayers) on a business (read bureacracy) will fall into one of two categories:
- Benefits demands – the customers want something of value from the business; or
- Failure demands – the customers are wanting something fixed that the business failed to provide or screwed up.
Failure demand is created by bad systems. Not bad customers, not bad bureaucrats. Bad systems.
I subscribe to John Seddon’s monthly newsletter. I see him rail against the boneheadedness of the U.K. government so he is doing the Lord’s work in Britain. I just wish some of that thinking would trickle over to Washington, DC.
Suggestion for taxpayers
You have two solutions available to you.
- Good systems create good results. The transition years (the year you move out of the U.S. or the year you return to the U.S.) are the hardest to work with. Get help with those years, and the first full year you are living abroad. Once you are permanently living abroad you can go on auto-pilot and perhaps do the returns yourself if you want to save some money. You’ll have a template to follow in preparing your tax returns. Then all you have to worry about is Congress changing the tax laws.
- Expatriate. Renounce your U.S. citizenship or your permanent resident status and eliminate the IRS from your life.
Shameless plug: we have first-hand and extensive experience with both alternatives.