Employer-Offered Benefits That Can Save You Money and Taxes

Article Highlights:

  • Health Insurance
  • Retirement Plans
  • Qualified Transportation Fringe Benefits
  • Flexible Spending Accounts (FSAs)
  • Group Term Life Insurance
  • Qualified Employee Discounts
  • Employer-Provided Education Assistance
  • Adoption Expenses
  • Child and Dependent Care Benefits
  • Health Savings Accounts

Tax law includes several tax- and financially favored benefits that employers can offer or provide to their employees. This article is intended to make you aware of these perks, with the caveat that all employers, especially small businesses, may not provide all, or perhaps any, of these covered perks. But whichever of these benefits your employer offers, you should seriously consider taking advantage of them, if you haven’t already.

Health Insurance – The Affordable Care Act (also known as Obamacare) requires businesses with over 50 employees to offer at least 95% of its full-time employees, and their dependents, with affordable minimum essential health care coverage. Companies that do not meet this requirement are subject to penalties. If you work for one of these larger employers and the company picks up the entire health insurance premium cost, consider yourself lucky, as the prices of health insurance coverage have risen dramatically over the last few years. More likely, you may have to pay part of the premium costs, and the plan may have a high deductible or co-pays. Even so, the tax-free benefit of what the employer covers is valuable. While not required to, businesses with fewer than 50 employees may offer health care coverage, often for competitive purposes in retaining employees. The health insurance premiums paid on your behalf by your employer are tax-free to you. If you aren’t aware of the value of this nontaxable employee benefit, you can look at your Form W-2, box 12a, code DD, which shows your share of the cost of employer-sponsored health coverage. You can claim the part of the coverage that you pay for with post-tax dollars as a medical expense if you itemize your deductions.

Retirement Plans – Although some larger employers may provide a company-funded retirement plan that will pay you a monthly benefit when you retire, most generally offer 401(k) plans with which an employee can save for retirement by making pre-tax contributions up to $19,000 for 2019. If the employee is age 50 or over, they can qualify to make a catch-up contribution of up to $6,000, bringing the total to $25,000. Some employers also match their employees’ contributions up to a certain amount, which means an employee should endeavor to contribute at least the amount that the employer will match.

Qualified Transportation Fringe Benefits – Certain transportation-related fringe benefits that an employer may provide to employees are tax-free to the employee. Before the passage of the tax reform in late 2017, employers were able to provide employees with tax-free reimbursement for parking, transit passes, commuter transportation, and bicycle commuting, subject to certain limits, and the employer could deduct the cost. The tax reform had a significant impact on these benefits. It eliminated the $20-per-month bicycle benefit and no longer allowed the employer to deduct reimbursements made to employees for other transportation benefits, making some employers less likely to offer any transportation fringe benefits. However, they remain tax-free to the employee; for 2019, the limit on tax-free employer reimbursements is $265 per month each for qualified parking, transit passes, and commuter transportation.

Flexible Spending Account (FSA) – This is a unique account established by an employer that allows employees to contribute to the account through salary-reduction contributions. The benefit is that the contributions are pre-tax, meaning the employee doesn’t pay taxes on the money contributed to the account. This allows employees to pay for individual out-of-pocket health care costs with pre-tax dollars. The health care expenses can be used for health plan deductibles, co-payments, and even some over-the-counter-medications. The annual limit on contributions is inflation-adjusted and is $2,700 for 2019. However, if you don’t use the money in your FSA, you will lose it.

Group Term Life Insurance – The cost for the first $50,000 of group term life insurance (GTLI) coverage provided by an employer is excluded from the employee’s taxable income. However, the employer-paid cost of group-term coverage in excess of $50,000 is taxable income to the employee, even if he or she never receives it (i.e., it is “phantom income”). So, while the tax-free coverage of the first $50,000 is a good perk, an employee shouldn’t automatically sign up for more than $50,000 of GTLI coverage without considering whether they genuinely need the coverage and what the extra cost will be. In some cases, an employee who wants more than $50,000 in coverage may be able to privately acquire a policy that will cost less than the tax on the imputed income for the extra coverage through the employer’s plan.

Qualified Employee Discounts – A certain amount of an employee discount on purchases from an employer or on services provided by an employer is excludable from the employee’s income. The exclusion is limited to the employer’s gross profit percentage for property or 20% of the price at which the employer sells services to non-employee customers for services.

Employer-Provided Education Assistance – An employee doesn’t have to include, in his or her income, amounts paid by the employer for educational assistance under a qualified education-assistance program. The maximum amount of educational support that an employee can exclude is $5,250 for any calendar year. Excludable assistance under a qualified plan includes, among others, tuition, fees, books, supplies, and equipment. The education is any training that improves an individual’s capabilities, whether or not it is job-related or part of a degree program.

Adoption Expenses – An employee may exclude amounts paid or expenses incurred by the employer for qualified adoption expenses connected to the employee’s adoption of a child, if the amounts are furnished under an adoption-assistance program in existence before the costs are incurred. If the adopted child is a special needs child, the exclusion applies regardless of whether the employee has adoption expenses. The maximum exclusion amount is inflation adjusted annually and is $14,080 for 2019 per child, for both non-special needs and special needs adoptions. The exclusion phases out when the employee’s modified adjusted gross income is between $211,160 and $251,160 for 2019. Taxpayers can claim a tax credit for qualified adoption expenses, subject to the same phaseout range as for the exclusion. Still, any employer-paid excludable expenditures can’t be used for the credit.

Child and Dependent Care Benefits – Qualified payments made or reimbursed by an employer on behalf of an employee for child and dependent care assistance are excluded from the employee’s gross income. The amount of the exclusion is limited to the lesser of $5,000 ($2,500 for married individuals filing separately), the employee’s earned income, or the income of the employee’s spouse. A child and dependent care tax credit is available to taxpayers. Still, no credit is allowed to an employee for any amount excluded from income under his or her employer’s dependent care assistance program.

Health Savings Accounts – Employees who have a high-deductible health plan through their employer can open a health savings account (HSA) and make annually inflation-adjusted pre-tax contributions, which, for 2019, can be up to $7,000 for families and $3,500 for a single individual. When you make distributions for medical expenses, the money comes out tax-free. However, distributions not used to pay qualified medical expenses are taxable, and if the plan’s owner is under the age of 65, nonqualified distributions are subject to a 20% penalty. Some individuals let the account grow and treat it as a supplemental retirement plan, waiting until after age 65 to begin taking taxable but penalty-free distributions.

If you have questions on how job-related benefits might apply to you or if you are an employer interested in providing any of these benefits to your employees, please contact us.

3 Common Personal Income Tax Problems and How to Respond

Common tax problems can go far beyond the numbers that you report, and they can require additional evidence that your bank statements and paychecks can’t provide. Additionally, the IRS isn’t the only source of those problems. State tax authorities are hungry for revenue, and if you divide your time among different states, you may find it challenging to establish nexus and may even have to file taxes in multiple states.

Below are some of the most common personal income tax issues people are likely to face.

1. You didn’t make (or underpaid) estimated tax payments.

Self-employment is the most common cause of this. When you’re used to having taxes withheld from your paychecks at work, it can be a shock to have to pay taxes yourself. You can end up owing not just a large amount of self-employment and income taxes, but also penalties for not making tax payments on time. Estimates must be deposited quarterly, or you will face an underpayment penalty.

If your total tax due when you go to file is under $1,000, you won’t have to worry about getting smacked with an underpayment penalty. However, it’s a good idea to set aside at least 25%-30% of your income for estimated tax payments and commit to paying this amount every month if quarterly taxes are too complicated to figure out.

Other situations like freelancing on the side or rental income while you’re still employed can also cause you to fall short at tax time, so make sure to have extra taxes withheld from your paycheck if you don’t want to make estimated payments. State tax payments also shouldn’t be neglected.

2. You didn’t correctly file state tax returns after moving.

Moving to a state with little or no income taxes like Nevada or Florida can be appealing if your bank account feels squeezed in high-tax states like New York or California. Many people divide their time between multiple states for work or personal reasons. If it’s not just a two- or three-week creative retreat or corporate assignment, it can make nexus challenging to determine in some cases.

With the prospect of a lower tax burden becoming even more appealing, it seems logical to move to the tax-haven state you’ve been eyeing. But even after you file for a change of address with the postal service, change your voter registration, and get recognized as a resident by your new state, the high-tax state that you left is likely to also still treat you like one.

Typically, you must spend at least 183 days of the year in the other state and maintain a primary residence there. Merely owning property in another state won’t do if your family doesn’t also live there while you work or travel. Where you spend time outside of work also matters because where you sleep every night is what ultimately matters.

If your move is indeed permanent and your residency is valid, you may have to file a part-year resident tax return for the final months you stayed in the old state. You won’t need to worry about it for following years, but keep track of how many days you spent in each state before and after moving day.

3. You neglected to file state income tax returns as a non-resident.

If you have a business or rental income in another state, you may be required to file state tax returns as a non-resident. If this income is significant, it can end up producing a large tax bill if you’re unprepared.

If you have an out-of-state job, your payroll provider may also be incorrectly withholding taxes for the appropriate state or city. In concentrated regions like the tri-state area, especially for New York City and Philadelphia residents, ensure that city taxes are being correctly withheld if you are a resident, and that withholding curtails if that is no the longer the case. There are usually reciprocity agreements among states and municipalities in areas where state lines cross. Still, you should carefully check to make sure you don’t owe non-resident taxes in addition to what you owe your home state.

Failure to make tax payments on time, and to the right agency, are income tax problems that are often overlooked and can quickly spiral out of control. To avoid these issues and many more, please contact us so we can consult you on your state and local taxation, as well as rules for establishing nexus.

Is It Better to Have a Tax Credit or a Deduction?

Article Highlights:

  • Itemized Deductions
  • Above-the-Line Deductions
  • Business Deductions
  • Asset-Sale Deductions
  • Refundable Credits
  • Nonrefundable Credits
  • Carryover Credits
  • Business Tax Credits

People often say that an expense is a tax write-off and interpret this to mean that the expense will have a tax benefit. Generally, such a benefit takes the form of either a deduction or a credit.  The effects of these benefits are quite different; however, and each type has various categories. As a result, the tax implications may not be as expected. This is especially true when the write-off claim comes from a salesperson who is touting the tax benefits of a product or service, as such individuals often leave out key details. In general, a deduction reduces taxable income, whereas a credit reduces the tax itself.

Tax Deductions – In one way or another, tax deductions reduce the taxable portion of an individual’s income, which thus reduces the tax on that income.

Itemized Deductions – When taxpayers think of deductions, they typically think of the itemized deductions that are claimed on Schedule A. This is the only way to deduct personal expenses such as medical costs, state and local tax payments, investment and home-mortgage interest, charitable contributions, disaster-casualty losses, and various rarely encountered expenses. In some cases, itemized deductions are limited. For instance, medical expenses are only deductible to the extent they exceed 10% of the taxpayer’s adjusted gross income (AGI). Similarly, state and local tax payments (including those for income, sales, and property taxes) are capped at $10,000. On top of that, itemization only reduces taxable income to the extent that the total of the itemized deductions exceeds the standard deduction. When the sum does not exceed the standard deduction, the itemized deductible expenses provide no tax benefits at all.

Above-the-Line Deductions – Certain deductions reduce income. These are commonly called above-the-line deductions because, when applied, they reduce the income figure that is used to calculate AGI. Thus, their benefits apply regardless of whether the taxpayer uses itemized deductions. Above-the-line deductions include educators’ expenses; contributions to health savings accounts, traditional IRAs, and certain qualified retirement plans; deductible alimony payments; and student-loan interest. Most of these deductions have annual maximums.

Business Deductions – Taxpayers who operate noncorporate businesses can deduct from their business income any expenses that they incur when operating their businesses. These deductions (which cover advertising fees, employee wages, office-supply costs, etc.) are used to reduce profits, which in turn reduces taxable income and, ultimately, income tax. In addition, most self-employed taxpayers pay Social Security and Medicare taxes on their net business income, so any reduction in their business profits also reduces their Medicare taxes and possibly their Social Security taxes.

Asset-Sale Deductions – An individual who sells an asset is allowed to deduct that asset’s cost from the sale price to determine the taxable profit. Good recordkeeping is helpful here because the original expense may have been incurred years prior, even though it is only deductible when the asset is sold. For example, any improvements that an individual makes to a home over years of ownership are not deductible until the home is sold. At that point, the individual can reduce the taxable gain from the sale by counting the improvements as part of the home’s cost.

Tax Credits – Tax credits come in several varieties, and the amount of benefit can vary:

Refundable Credits – A refundable credit offsets current tax liability; it is so-called because any amount of unused credit is refunded to the taxpayer. Refundable credits include the Earned Income Tax Credit, the Additional Child Tax Credit, and the Premium Tax Credit (net of any advances received), as well as the American Opportunity Tax Credit (an education credit that is 40% refundable). As a matter of general interest, these credits are subject to significant filing fraud because of their refundability. The IRS also considers prepayments such as income-tax withholding and estimated tax payments to be refundable credits.

Nonrefundable Credits – A nonrefundable credit only offsets tax liability; any unused amount is lost (unless it can be carried over to another year; see below). Over time, Congress has become more generous with credits; most credits that are not refundable now carry over for a given period. Nonrefundable credits include the Saver’s Credit, the Lifetime Learning Credit, and the personal portion of the Electric Vehicle Credit.

Carryover Credits – For some nonrefundable credits, any unused current-year credit can be carried over to the next tax year (or for a longer period) until the carryover amount is used up. These credits include the Adoption Credit (which can carry over for up to five years) and the Home-Solar Credit (which carries over through at least 2021; tax law is unclear on whether it will expire then).

Business-Tax Credits – Numerous business-tax credits are available; however, they are grouped into the General Business-Tax Credit, which is nonrefundable but which carries forward for twenty years and back for one year. (This allows a business owner to amend the prior year’s return to claim the credit.) This category includes the business portion of the Electric Vehicle Credit.

If you have questions related to how you might benefit from tax credits or deductions, please contact us.

Child Daycare and Taxes

Article Highlights:

  • Daycare Providers
  • Simplified Food Deduction
  • Special Rules for Business Use of the Provider’s Home
  • Home Sale Consequences
  • Other Expenses
  • Other Daycare Provider Issues
  • Daycare User Credit
  • Employer Dependent Care Benefits
  • Other Credit Criteria

When discussing daycare for children so their parents can work, there are two primary areas of discussion: one from the viewpoint of the individual providing the daycare services and another from the parents using a daycare provider’s services. Tax law provides exclusive benefits for both.

DAYCARE PROVIDERS

Daycare providers are generally self-employed individuals who provide care in their home, and like other self-employed individuals conducting a business, they are allowed to deduct business expenses, including the following:

  • Business Use of a Vehicle – Examples of business-related use of a personal vehicle by a daycare provider include taking the kids to the park, on field trips, or the movies. Also eligible are miles used to purchase supplies and other business-related travel. What’s deductible is the standard mileage rate of 58 cents per business mile (2019) or the prorated business portion of the actual operating expenses for the vehicle. In either case, daycare providers should maintain a contemporaneously prepared log detailing all business-related trips.
  • Food – Daycare providers can deduct the cost of meals provided to the children, not including meals for their own children. The simplest method, which does not require documenting food purchases, is to use the simplified meal deduction. The simplified meal deduction does not preclude a care provider from using the actual expenses if the actual cost is higher, and the provider is willing to document the costs without including food purchased for his or her own family’s use. The simplified meal deduction amounts for 2019 are illustrated in the table below. 
Year States Breakfast Lunch Dinner Snack
2019 Contiguous States
Alaska
Hawaii
$1.31
$2.09
$1.53
$2.46
$3.99
$2.88
$2.46
$3.99
$2.88
$0.73
$1.19
$0.86

The rates do not include the cost of nonfood supplies (e.g., utensils), which may be deducted separately. The number of meals per day per child is limited to the amounts below. (The table uses the amounts based upon the rates for contiguous states and will be higher for Alaska and Hawaii.)

Meal Rate 2019 Allowance
One Breakfast $1.31 $1.31
One Lunch $2.46 $2.46
One Dinner $2.46 $2.46
Three Snacks $0.73 $2.19
2019 Daily Maximum Per Child $8.42

If the provider receives some form of reimbursement or subsidy, then the provider may deduct only the part of the simplified rate that exceeds the reimbursed amount.

Business Use of the Home – Self-employed individuals may take a business deduction for the business use of a portion of their home if that portion is used exclusively for business. Daycare facilities are not subject to the exclusive use requirement that applies to other home offices. However, that special rule only applies to providers who:

  1. Are licensed, certified, registered, or approved as a daycare provider under state law;
  2. Have a pending application for licensing, certification, registration, or approval under state law as a daycare provider that has not been denied; or
  3. Are exempt from licensing, certification, registration, or approval under state law.

Any daycare provider not meeting one of these three requirements is still subject to the exclusive use rules. These rules will generally preclude them from the deduction unless they use some portion of the home exclusively for daycare purposes, such as a bedroom or a storage area. The daycare facility exception does not apply if the services performed are primarily educational or instructional (e.g., musical instruction). However, the limitation does apply if the services are mostly custodial and if the educational, developmental, or enrichment activities are only incidental to the custodial services. The services must be provided for individuals age 65 or older, children, or individuals who are physically or mentally incapable of caring for themselves.

When calculating the percentage of the business use of the home, both the space used to operate the daycare business and the amount of time that space is used to provide daycare, including preparation and cleaning time, are factors.

Example: Edna uses her living room, kitchen, and bathroom ten hours a day, five days a week, to provide licensed daycare services. The home is 2,400 square feet, and the living room, kitchen, and bathroom are a combined 1,400 square feet. The exclusive use requirement doesn’t apply. Edna’s percentage use of her home for business is determined as follows:

Once the percentage is established, all of the home expenses, including interest, taxes, home insurance, maintenance, utilities, and depreciation, are summed up and multiplied by the percentage to determine the deduction for the business use of the home. If an individual rents the home, the rent expense replaces the interest, taxes, and depreciation. After determining the deduction, it is further limited to the gross income from the daycare. If limited by the total income, there is a specific order in which the home expenses can be used (not discussed in this article).

Claiming the business use of the home deduction will also impact any future sale of the home. For taxpayers who own and use their home for two years out of the five years before the sale, they can generally exclude up to $250,000 ($500,000 if married filing jointly) of any resulting gain. However, any depreciation claimed, or that could have been claimed after May 15, 1997, cannot be excluded and, as a result, will be taxable to the extent of any gain from the sale.

Example: A care provider is entitled to claim $1,000 per year of home depreciation, and she operates that business for ten years, claiming a total of $10,000 in depreciation. Whenever she ultimately sells her home, the $10,000 cannot be included in the excluded gain and will always be treated as a taxable capital gain to the extent of any home sale gain.

  • Other Expenses – Other expenses include just about any cost that has to do with operating the daycare facility, including, for example:
    • Advertising
    • Business banking account fees
    • Daycare licensing
    • Daycare organization membership expenses
    • Seminars and education related to managing a daycare center
    • Business insurance
    • Games and toys
    • Supplies, diapers, wipes, and cleaning supplies
    • Phone services
    • Prorated internet service
    • Field trip expenses
    • Payroll for employees
    • Additional important tax issues apply to daycare providers:

Self-Employment Tax – Like all self-employed taxpayers, daycare providers must pay self-employment tax, which is made up of the Social Security tax of 12.4% on the first $132,900 (2019) of profit from the business and a 2.9% Medicare tax on all of the profits. In addition, there is an additional 0.9% Medicare tax on the extent to which the profits exceed $200,000 for single taxpayers, $250,000 for married taxpayers filing jointly, and $125,000 for married taxpayers filing separately. Also, daycare providers can deduct half of the self-employment tax from their gross income.

Retirement Plan Contributions – Profits from a daycare business qualify for IRA contributions and self-employed retirement plans, allowing daycare providers to put away substantial amounts for their future retirement.

Medical Insurance Above-the-Line Deduction 

While most taxpayers must itemize their deductions to deduct the cost of their medical insurance, self-employed taxpayers, including daycare providers, can deduct the premiums from their adjusted gross income and avoid the 10% medical expense haircut when itemizing deductions.

Employer Identification Number – Most daycare clients can claim a tax credit for the cost of daycare. However, to do so, they must include either the daycare provider’s Social Security number (SSN) or an employer identification number (EIN) on their tax returns. It is a best practice in this age of ID theft not to use the SSN and instead obtain an EIN.

DAYCARE USERS 

Individuals who use the services of daycare providers may qualify for a tax credit if the expense is an “employment-related” expense. For example, it must enable a taxpayer or spouse, if married, to work, and it must be for the care of a child, brother, sister, or stepsibling (or a descendant of any of these) who is under 13, lives in the taxpayer’s home for more than half the year, and does not provide more than half of his or her own support for the year. Married couples must file jointly, and both spouses must work (or one spouse must be a full-time student or disabled) to claim the credit.

The qualifying expenses are limited to the income from working and, in the case of a married couple, are limited to the lower of the spouse’s income from working. However, under certain conditions, when one spouse has no actual income from working and that spouse is a full-time student or disabled, that spouse is considered to have a monthly income of $250 (if the couple has one qualifying child) or $500 (for two or more qualifying children). This means the income limitation is mostly removed for a spouse who is a student or disabled all year.

The qualifying expenses can’t exceed $3,000 per year for those who have only one qualifying child, while the limit increases to $6,000 per year for those with two or more qualifying persons.

If there are two children, the care expenses are not divided equally. For example, if the taxpayer paid $2,500 in qualified expenses for the care of one child and $3,500 for the care of another child, the $6,000 can be used to determine the credit. The credit is computed as a percentage of qualifying expenses, in most cases, 20%. See the table below for the credit percentages based on the taxpayer’s adjusted gross income.

AGI Adjusted Applicable Percentage

AGI
Over
But Not
Over
Applicable
Percent
AGI
Over
But
Not Over
Applicable
Percent
0 15,000 35 29,000 31,000 27
15,000 17,000 34 31,000 33,000 26
17,000 19,000 33 33,000 35,000 25
19,000 21,000 32 35,000 37,000 24
21,000 23,000 31 37,000 39,000 23
23,000 25,000 30 39,000 41,000 22
25,000 27,000 29 41,000 43,000 21
27,000 29,000 28 43,000 No Limit 20

 

Example: Al and Janice both work with combined earned income in excess of $50,000 for the year. Janice has a part-time job, from which she earns $10,000 for the year. Her work hours coincide with the school hours of their 11-year-old daughter, Susan, so while school is in session, Al and Janice incur no childcare expenses for Susan. However, during the summer vacation period, they place Susan in a day camp program that costs $4,000. Since the expense limitation for one child is $3,000, their childcare credit would be $600 (20% of $3,000).

The credit reduces a taxpayer’s tax bill dollar for dollar. Thus, in the above example, Al and Janice would pay $600 less in taxes by the credit. However, the credit can only offset income tax and alternative minimum tax liability, and any excess is not refundable. The credit cannot be used to reduce self-employment tax if a taxpayer is self-employed, or the taxes imposed by the Affordable Care Act.

Employer Dependent Care Benefits – Some employers provide dependent care assistance programs to help their employees with the cost of daycare. Payments under these plans used by employees to pay dependent care expenses are excludable from employees’ income, up to the lower of:

  1. The employee’s earned income (for married employees, this is the earned income of the lower-paid spouse) or
  2. $5,000 ($2,500 for married filing separate).

Because reimbursement up to these limits is excludable from income, the benefits the employee receives are treated as reimbursement for daycare expenses that reduce the expense limits of $3,000 for one child and $6,000 for two or more children. Compensation above these limits is taxable to the employee and does not reduce qualified expenses for the credit.

Other Credit Criteria:

  • Age of the Child – If the qualifying child turned 13 during the year, count only the care expenses paid for the child for the part of the year when he or she was under age 13.
  • Day Camps – Many working parents must arrange for care for their children under 13 years of age (or any age if disabled) during school vacation periods. A popular solution, with a tax benefit, is a day camp program. The cost of day camp can count as an expense toward the child and dependent care credit. However, it’s essential to note that fees for overnight camps do not qualify. Also, not eligible are expenses paid for summer school or tutoring programs.
  • Both Parents Working in an Unincorporated Business – When both spouses of a married couple are jointly involved in an unincorporated business, it is relatively common, but incorrect, for all of that business’s income to be reported as just one spouse’s income. As a result, they lose the benefits of the childcare credit, which requires both spouses to have income from working.
  • School Expenses – Only school expenses for a child below the kindergarten level are considered qualifying expenses for this credit.
  • In-Home Care Providers – If a taxpayer provides daycare in their home, the daycare provider is considered a household employee.

This article provides an overview of the various tax issues related to daycare from the perspectives of both the provider and the recipient of daycare services. However, as in everything taxes, many more rules and issues exist than could be included in this article. For additional information about daycare and how it impacts your taxes, please contact us.

Life-Changing Events Can Impact Your Taxes

Article Highlights:

  • Marriage
  • Buying a Home
  • Having or Adopting Children
  • Getting Divorced
  • Death of Spouse

Throughout your life, there will be significant occasions that will impact not only your day-to-day living but also your taxes. Here are a few of those events:

Getting Married – If you are getting married, it is essential to understand that once you are married, you no longer file returns using the single status. Instead, you will file as married taxpayers filing jointly (MFJ). When you file MFJ, both spouses combine their income on one return. When both spouses have substantial income, your combined incomes could put you in a higher tax bracket. However, when filing MFJ, you benefit by being able to claim a standard deduction equal to twice that of the standard deduction for a single taxpayer. It may be appropriate for newly married couples to estimate the differences of filing as unmarried and filing as married before tax-filing time. Depending on your situation, you may decide to adjust withholding to compensate for the MFJ status.

Keep in mind that filing status is determined on the last day of the tax year. Regardless of when you get married during the year, you will be considered married for the entire year for tax purposes. In addition, when a spouse is changing names, the Social Security Administration should be notified, and the IRS should be informed of any address change by either or both spouses.

Buying a Home – Buying a home, especially your first home, can be a trying experience. Without a landlord to take care of repairs and upkeep of the property, those tasks will become your responsibility as a homeowner. When you rent, you are responsible for making a rental payment, which is not tax deductible. On the other hand, when you own a home, in addition to being accountable for its maintenance, you have to make homeowner’s insurance, mortgage, and property tax payments. While the routine upkeep costs aren’t tax deductible, the interest on the mortgage and the property taxes you pay may be tax deductible, providing you with a significant saving in income tax. However, if the standard deduction amount for your filing status exceeds the total of all itemized deductions the law allows you to claim, you won’t get a tax benefit from the home mortgage interest and property tax payments. So, when determining if you can afford a home, it’s important to consider whether you’ll benefit from those home-related tax savings. Also, consider the long-term benefits of homeownership. Homes have generally appreciated in the past, so you can look forward to your home gaining value. When you sell it, the gain up to $250,000 ($500,000 for a married couple) can be excluded from income if the property has been owned and used as your primary residence for any two of the five years just before the sale.

Having or Adopting Children – Besides the loss of sleep, changing diapers, middle of the night feedings, and constant attention, a newborn also brings some tax benefits, including a maximum $2,000 child tax credit, which can go a long way in reducing your tax liability. If both spouses work, you will no doubt incur childcare expenses, which can result in a maximum (can be less) credit of between $600 and $1,050 for one child or twice those amounts for two or more children. The credit amounts are based on a maximum childcare expense of $3,000 for one child and $6,000 for two or more multiplied by 20 to 35 percent of the expense based upon a taxpayer’s income.

Of course, the medical expenses are deductible if you itemize your deductions, but only to the extent that the medical expenses exceed 10% of your adjusted gross income. Although rarely encountered, the expense of a surrogate mother is not deductible.

If you adopt a child under age 18 or a person physically or mentally incapable of taking care of himself or herself, you may be eligible for a tax credit for the qualified adoption expenses you paid. The credit, which is a maximum of $14,080 for 2019, is not refundable, but if the credit is more than your income tax, you can carry over the excess and have five years to use up the credit. If the child is a special needs child, the full credit limit will be allowed for the tax year in which the adoption becomes final, regardless of whether you had qualified adoption expenses. The credit phases out for higher-income taxpayers.

It is also time to begin planning for the child’s future education. The tax code offers two tax-favored education savings accounts. The Coverdell account allows a maximum contribution of $2,000 per year, and the Qualified State Tuition plan, more commonly known as a Sec 529 plan, allows large sums of money to be put aside for a child’s education. There is no tax deduction for contributing to either of these programs. However, the earnings from the plans are tax-free if used for qualified education expenses, so the sooner the funds are contributed, the more significant the benefit from tax-free earnings.

Getting Divorced – If you are recently divorced or are contemplating divorce, you will have to plan for significant tax issues such as asset division, alimony, and tax-return filing status. If you have children, additional issues include child support; claiming of the children as dependents; the child, childcare, and education tax credits; and perhaps even the earned-income tax credit. Here are some details:

  • Filing Status – As mentioned earlier, your filing status is based on your marital status at the end of the year. If on December 31, you are in the process of divorcing but are not yet divorced, your options are to file jointly or to each submit a return as married filing separately. There is an exception to this rule if a couple has been separated for all of the last six months of the year, and if one taxpayer has paid more than half the cost of maintaining a household for a qualified child. In that situation, the spouse can use the more favorable head-of-household filing status. If each spouse meets the criteria for that exception, they can both file as heads of household; otherwise, the spouse who doesn’t qualify must have the status of married filing separately. If your divorce has been finalized and if you haven’t remarried, your filing status will be single or, if you meet the requirements, head of household.
  • Child Support – This is support for the taxpayer’s children provided by the non-custodial parent to the custodial parent. It is not deductible by the parent making the payments and is not income to the recipient parent.
  • Children’s Dependency – When a court awards physical custody of a child to one parent, the tax law is particular in awarding that child’s dependency to the parent who has physical custody, regardless of the amount of child support that the other parent provides. However, the custodial parent may release this dependency to the non-custodial parent by completing the appropriate IRS form.
  • Child Tax Credit – A federal credit of $2,000 is allowed for each child under the age of 17. This credit goes to the parent who claims the child as a dependent. Up to $1,400 of the credit is refundable if the credit exceeds the tax liability. However, this credit phases out for high-income parents, beginning at $200,000 for single parents.
  • Alimony – The recent tax reform also impacts the tax treatment of alimony. For divorce agreements that were finalized before the end of 2018, the recipient (payee) of the alimony must include their income for tax purposes. The payer, in such cases, is allowed to deduct the payments above the line without itemizing deductions. This is technically referred to as an adjustment to gross income. The recipient, who includes this alimony income, can treat it as earned income to qualify for an IRA contribution, thus allowing the recipient to contribute to an IRA even if he or she has no income from working. For divorce agreements that are finalized after 2018, alimony is not deductible by the payer and is not taxable income for the recipient. Because the recipient isn’t reporting alimony income, he or she cannot treat it as earned income to make an IRA contribution.
  • Tuition Credit – If a child qualifies for either of two higher-education tax credits, (the American Opportunity Tax Credit [AOTC] or the Lifetime Learning Credit), the credit goes to whoever claims the child as a dependent even if the other spouse or someone else is paying the tuition and other qualifying expenses.

Death of Spouse – Losing a spouse is painful emotionally. Unfortunately, it can be accompanied by several tax issues that may or not apply to the surviving spouse. Here is an overview of some of the most frequent problems:

  • Filing Status – If a spouse passes away during the year, the surviving spouse can still file a joint return for that year if the surviving spouse has not remarried. However, after the year of death, the surviving spouse will no longer be able to file with the deceased spouse jointly and will have to use a less favorable filing status.
  • Notification – If the deceased spouse is receiving Social Security benefits the Social Security Administration must be immediately notified. This would also be true of pensions and retirement plans of the deceased spouse.
  • Estate Tax – Where the deceased spouse’s assets and prior reportable gifts exceed the current lifetime inheritance exclusion ($11.4 million for 2019), an estate tax return may be required. However, the lifetime inheritance exclusion can be changed at the whim of Congress. Even when an estate tax return isn’t needed because the value of the deceased spouse’s estate is less than the exclusion amount, it may be appropriate to file the estate tax return. There could be an impact on the estate tax of the surviving spouse when he or she passes.
  • Inherited Basis – Under normal circumstances, the beneficiary of a decedent’s assets will have a tax basis in those assets equal to the fair market value of the assets on the date of death. Thus, generally, a qualified appraisal of the assets is required. However, for a surviving spouse, this can be more complicated depending upon whether the state of residence is a community property state and how title to the property was held.
  • Changing Titles – The title to all jointly held assets needs be changed into the survivor’s name alone to avoid complications in the future.
  • Trust Income Tax Returns – Many couples have created living trusts that, while they are both alive, don’t require a separate tax return to be filed for the trust and can be revoked. But upon the death of one of the spouses, this trust may split into two trusts, one of which remains revocable and the other becomes irrevocable. A separate income tax return for the latter trust will usually have to be prepared and filed annually.

These are just a few of the issues that must be addressed upon the death of a spouse, and it may be appropriate to seek professional help from your Tarlow tax advisor.

If you have questions about the tax impacts of life-changing events or situations, please contact us.

In a Divorce, Who Claims the Children: You Or Your Ex-Spouse?

Article Highlights:

  • Custodial Parent
  • Dependency Release
  • Joint Custody
  • Tiebreaker Rules
  • Child’s Exemption
  • Head of Household Filing Status
  • Tuition Credit
  • Child Care Credit
  • Child Tax Credit
  • Earned Income Tax Credit

If you are a divorced or separated parent with children, a commonly encountered, but often misunderstood issue is, who claims the child or children for tax purposes. Parents often dispute this issue; however, tax law includes some particular but complicated rules about who profits from the child-related tax benefits. Under consideration are many benefits, including the children’s dependency, child tax credit, child care credit, higher-education tuition credit, earned income tax credit, and, in some cases, even filing status.

This is one of the most complicated areas of tax law, and inexperienced tax preparers or taxpayers preparing their returns can make serious mistakes, especially if the parents are not communicating well. If parents cooperate, they often can work out the best tax result overall. Even though it may not be the best for them individually, it’s possible to compensate for it in other ways.

Physical Custody (Custodial Parent) – If a family court awards physical custody of a child to one parent, tax law is particular in awarding that child’s dependency to the parent with physical custody, regardless of the amount of child support provided by the other parent. However, the custodial parent may release that dependency to the non-custodial parent for tax purposes by completing the appropriate IRS form. The release can be granted every year or for multiple years at one time. But once made, it is binding for the specified period.

CAUTION – The decision to relinquish dependency should not be taken lightly, as it impacts several tax benefits.

Joint Custody – On the other hand, if the family court awards joint physical custody, only one of the parents may claim the child as a dependent for tax purposes. If the parents cannot agree between themselves as to who will claim the child and the child is actually claimed by both, the IRS tiebreaker rules will apply. Per the tiebreaker rules, the child is treated as a dependent of the parent with whom the child resided for the greater number of nights during the tax year. Or, if the child lives with both parents for the same amount of time during the tax year, the parent with the higher adjusted gross income will claim the child as a dependent. Parents in the process of divorcing should be aware that for tax purposes, the IRS’s rules as to who can claim a child’s dependency takes precedence over what a divorce decree says or what a judge may have ruled. So, for example, if the family court awards full custody of a child to Parent A but says that Parent B can claim the child as a tax dependent, the IRS’s position is that the child is a tax dependent of Parent A unless Parent A releases the dependency to Parent B, as explained above.

Child’s Exemption Allowance –While there is no longer (through 2025) a monetary tax deduction, or an “exemption allowance” for a dependent child, it still matters who claims the child as a dependent because certain tax credits are only available to the taxpayer claiming the child as a dependent.

Head of Household Filing Status – An unmarried parent can claim the more favorable ‘head of household’ filing status if he or she is the custodial parent, and pays more than half of the costs of maintaining a household that is the child’s principal place of abode for more than half the year. This is true even when the child’s dependency is released to the non-custodial parent.

Tuition Credit – If the child qualifies for either the American Opportunity or the Lifetime Learning higher-education tax credit, the credit goes to whoever claims the child as a dependent. Credits are significant tax benefits because they reduce the tax amount dollar-for-dollar, while deductions reduce income to arrive at taxable income, which is then taxed according to the individual’s tax bracket. For instance, the American Opportunity Tax Credit (AOTC) provides a tax credit of up to $2,500, of which 40% is refundable. However, both education credits phase out for higher-income taxpayers. For instance, the AOTC phases out between $80,000 and $90,000 for unmarried taxpayers and $160,000 and $180,000 for married taxpayers.

Child Care Credit – A nonrefundable tax credit is available to the custodial parent for childcare while the parent is gainfully employed or seeking employment. To qualify for this credit, the child must be under the age of 13 and be a dependent of the parent. However, a special rule for divorced or separated parents provides that if the custodial parent releases the child’s exemption to the non-custodial parent, the custodial parent can still qualify to claim the childcare credit, and the noncustodial parent can not claim it.

Child Tax Credit – A $2,000 credit is allowed for a child under the age of 17. That credit goes to the parent claiming the child as a dependent. However, this credit phases out for higher-income parents, beginning at $200,000 for unmarried parents and $400,000 for married parents filing jointly.

Earned Income Tax Credit (EITC) – Lower-income parents with earned income (wages or self-employment income) may qualify for the EITC. This credit is based on the number of children (under age 19 or a full-time student under age 24) the custodial parent has, up to a maximum of three children. Releasing the dependency of a child or children to the noncustodial parent will not disqualify the custodial parent from using the children to qualify for the EITC. The noncustodial parent is prohibited from claiming the EITC based on the child or children whose dependency has been released by the custodial parent.

Many complex rules are surrounding the tax benefits provided by the children of divorced parents. If you are a divorced parent with children, it is highly recommended that you consult with your Tarlow tax advisor to prepare your return. If you are the custodial parent, you should contact us before deciding whether to release a child as a tax dependent.

Disaster-Related Tax Losses May Be Less Than Expected

Article Highlights:

  • Limitation to Losses within Disaster Areas
  • Cost versus Market Value
  • Home Tax Losses
  • Home Tax Gains
  • Replacement Properties
  • Home Gain Exclusion

The late-2017 tax-reform package changed the rules for personal casualty losses, which now are only deductible if they occur in a federally declared disaster area. As a result, if a home is destroyed in a forest fire or other disaster within a declared disaster zone, the homeowner can claim a casualty loss on that year’s tax return. However, if a home is destroyed as a result of a normal accident, or is destroyed in a natural disaster but lies outside of a disaster zone, the homeowner cannot claim a casualty loss. Currently, the rules are only in effect for the years 2018 through 2025. Because of these rules, you should also make sure that your home insurance coverage is adequate.

Even those who have deductible losses may quickly find out that they cannot claim as much in tax losses as they expected. This is because the losses are not based on the cost of replacing the home; instead, they are based on the original cost of the home (plus any improvements prior to the date of the casualty). For those who have owned their homes for a long time before a casualty, the tax benefits of the resulting loss are greatly diminished.

This all stems from the fact that a casualty loss on a home is valued at the lesser of the home’s cost or its current market value (minus any insurance reimbursements). Because real estate generally appreciates in value, most casualty losses are based on the original cost of the home rather than on its current value or its replacement cost.

Example #1: Joe and Susan purchased their home many years ago for $125,000, but its current market value is $400,000. Their home is then destroyed as a result of a federally declared disaster. They did not have insurance. Thus, their casualty loss is only $125,000 (the original cost), as that is less than the current market value. Thus, even though they suffered a $400,000 financial loss, the tax loss is only $125,000. (Even worse, the actual deductible loss is even less, as reductions of $100 per casualty and 10% of adjusted gross income must first be applied.)

If a home is insured, then an actual financial loss due to a disaster can actually result in a tax gain.

Example #2: The circumstances are the same as in Example #1, except Joe and Susan’s homeowners’ insurance paid them 100% of the home’s current value. For tax purposes, the $125,000 original cost must be used; the insurance reimbursement is then subtracted from that cost to determine the casualty loss. As a result, after the $400,000 reimbursement, Joe and Susan actually have a $275,000 tax gain ($400,000 minus $125,000) instead of a loss.

Luckily, the new tax law includes a provision in which the homeowner can treat the involuntary conversion of a principal residence due to destruction (among other situations) as a sale. Such sales are eligible for the home-sale gain exclusion, provided that the taxpayers meet certain requirements for length of ownership and occupancy. Married taxpayers who file jointly can exclude up to $500,000 of home-sale gain after such a disaster, provided that they have owned and lived in the destroyed home for at least 2 of the prior 5 years. (For a single taxpayer, that exclusion is $250,000.) Thus, in Example 2, if Joe and Susan meet these requirements, they can exclude all of their $275,000 gain (because it is less than $500,000). If the gain is greater than this limit, the remaining amount can be deferred, provided that the taxpayer purchases a replacement residence.

The insurance proceeds that homeowners receive for a destroyed residence (or its contents) are treated as a common pool of funds. If those funds are used to purchase a property that is similar to lost property, then the taxpayer must recognize the gain only to the extent that the funding pool exceeds the cost of the replacement property. The period for replacing damaged or lost property is four years, starting with the end of the first taxable year when any part of a gain due to involuntary conversion is realized.

Under all circumstances, homeowner’s insurance is appropriate; in fact, mortgage lenders generally require it. Be sure that your home is insured for an appropriate amount that includes any appreciation.

As you see, disaster-related casualty losses can be tricky, and the results can be unexpected. Please contact us if you have experienced a disaster-related loss or if you have any questions.

What Is the Statute of Limitations on Unpaid Taxes?

If you have unpaid taxes that you haven’t yet been making payments toward, it might make you fearful that the IRS will come a-knocking one day to collect on what you owe. Tax debt can quickly snowball from interest, penalties, late fees, and the amount of the taxes due.

However, a lot of the scaremongering surrounding the IRS is largely sensationalized in media and daily conversation. Agents won’t come bursting through your door just because you have tax debt. Instead, they must follow due process in accordance with the Internal Revenue Service Restructuring and Reform Act of 1998 (RRA). This means that you will always receive written notice concerning your balance due as well as collection actions and any requests for payment plans or settling your account.

However, if you haven’t received further notification concerning what you owe, you may be able to ride out the little-known statute of limitations on tax debt collections, which is 10 years.

What the 10-Year Statute of Limitations Entails

Your tax debt can actually be canceled in 10 years if the IRS makes no efforts to collect on your account – and if you also don’t contact the IRS. However, it’s not as simple as just waiting a decade without ever paying the taxes you owe. There are conditions that must be satisfied. The first is that this 10-year time frame doesn’t begin when you filed that tax return with a balance due or when you realized you owed taxes you couldn’t pay.

The official statute of limitations date begins once you receive written notice from the IRS concerning what you owe. You may receive a notice of deficiency with an actual tax bill or a substitute tax return if you didn’t file by the due date. So, if you filed your tax return on June 15, 2019, and got a notice in the mail dated September 1, your statutory period would begin September 1, not June 15. This date is called the CSED (Collection Statute Expiration Date), and if you make it to September 1, 2029, without further collection actions, then you can actually get your entire tax bill from this period canceled. (Note: Future tax bills, such as next year’s taxes you also can’t afford to pay on the due date, do not count toward this.)

However, the IRS will not notify you of this. While the date of assessment is also generally when that notice is received, the IRS has argued over when the assessment date actually was. Some situations can also delay the CSED by halting the clock on the 10-year time frame, such as:

  • Filing for bankruptcy
  • Being outside the U.S. for at least six months
  • Military deferment
  • Submitting an offer in compromise to settle back taxes
  • Filing a lawsuit against the IRS
  • Having your assets held in court custody due to divorce, judgments against you, etc.

It takes six months after bankruptcy cases settle to get the clock restarted on the CSED, so this means the IRS has more time to take collection actions against you, and the IRS will tend to ramp up these efforts before the statute of limitations expires.

State Tax Debt

Unlike the IRS, state tax departments do not have reciprocity with the RRA or the Taxpayer Bill of Rights. Taxpayers who are subject to state income tax need to find out what options, if any, are offered by their state tax department. State tax departments may actually take harsher collection actions since they don’t have to have oversight committees and the option for taxpayers to settle back taxes or make payment plans, and they do not have a statute of limitations on collections. The IRS tends to get a bad rap in movies and on TV, but it’s actually the state tax departments that are more likely to show up unannounced or issue liens a lot sooner.

It’s very rare than anyone rides out the statute of limitations, and it’s usually due to extenuating circumstances like disability or a debilitating business closure. If enough time has passed that you think you might be able to go the whole 10 years without payments or responses to collection actions, you must keep fastidious records of all correspondence with the IRS. If the IRS sent you little or no mail in the time period after the time you think the CSED kicked off, you may qualify for the statute of limitations but should not intentionally try to ride it out without the guidance of a tax professional specializing in tax relief and resolution issues.

If you have any questions about the statute of limitations on unpaid taxes, please contact us.

See the U.S. Tax System Illustrated in One Complex Map

Not sure whether you should hire a tax professional to file your taxes? Thinking that maybe this year you’ll do it yourself? You may want to think again after taking a look at a new graphic released by the Taxpayer Advocate Service (TAS). The organization, which is dedicated to helping taxpayers resolve tax problems, releases a map every year that’s designed to help us all understand the workings of the tax system.

To truly understand just how complicated America’s tax system is, take a look at the newest TAS chart:

If you were to Google, “Why are taxes so complicated in the U.S.?” You would receive endless options for pages and websites looking to give you an explanation. Reviewing the top results will make it clear that even though we were promised taxes so simple that we could send them in on a postcard, the Tax Cuts and Jobs Act of 2017 made the situation even more complicated. Even tax professionals are still scratching their heads and trying to figure the whole thing out.

Though the leader of TAS, National Taxpayer Advocate (NTA) Nina Olson’s goal is to “recommend changes that will prevent problems,” her hopes for doing that are as dashed as the average taxpayer’s when she looks at this year’s chart. “Anyone looking at this map will understand that we have an incredibly complex tax system that is almost impossible for the average taxpayer to navigate,” she said.

In the face of increasing complexity, what’s a taxpayer to do to make sure that their taxes are prepared properly and in a way that minimizes their tax liability? The only good answer seems to be to seek professional help.

Hire a Tax Professional.

It’s tempting to try to make your way through your tax forms yourself, especially with the advent of so many off-the-shelf, do-it-yourself tax programs. But in light of the complexities that the process involves, you are subject to a wide margin of error. We strongly recommend that you retain an accounting firm that is on top of every rule change and regulation, as it is issued. If you’re on the fence, just consider what you’d have to do to get even a basic understanding of the impact of the latest tax reform law: for instance, reading this 14-page document from the IRS. Unfortunately, reading this document is not likely to make things particularly clear or easy to understand.

When you consider the amount of studying you would have to do just to understand the basics, and not even scratch the surface of the extra deductions and credits that you may be entitled to, there’s no doubt that it’s worth your investment to hire a tax professional. It’s the decision that 72% of small business owners have made, acknowledging that the money they spend on these services is well worth it.

If you have any questions or would like to discuss your particular tax situation and planning options, please contact us.

Earn Tax-Free Income from Working Abroad

Article Highlights:

  • Tax-Free Income from Working Abroad
  • Foreign Earned Income and Housing Exclusions
  • Foreign Self-Employment Income
  • Claiming or Revoking the Exclusion

U.S. citizens and resident aliens are taxed on their worldwide income, whether they live 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.

This exclusion applies to both employees and self-employed individuals. In addition to the excludable income, this can also be an attractive option to individuals who wish to travel the world while still earning income from their employer or self-employment clients.

You can have payroll disbursements and client payments deposited in your U.S. bank account, charge expenses on your credit card, and use online banking to make credit card payments, thus avoiding any foreign bank account reporting.

You will still have to file a U.S. 1040 tax return and report your income the same way as if you were living and working in the U.S. However, if you meet certain requirements, you will be able to exclude some or all of your foreign earnings from income tax.

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

  • Have foreign earned income (income received for working in a foreign country, including payroll disbursements from a U.S. employer and self-employment income);
  • Have a tax home in a foreign country; and
  • Meet either the bona fide residence test or the physical presence test.

The foreign earned income exclusion amount is adjusted annually for inflation. For 2019, the maximum is up to $105,900 per qualifying person. If the taxpayers are married and both spouses work abroad and 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 $211,800 for the 2019 tax year, but if one spouse uses less than 100% of his or her exclusion, the unused amount cannot be transferred to the other spouse.

In addition to the foreign earned income exclusion, qualifying individuals may also choose to exclude or deduct a foreign housing amount from their foreign earned income. The amount of qualified housing expenses eligible for the housing exclusion and housing deduction is generally limited to 30% of the maximum foreign earned income exclusion. The housing amount limitation is $31,770 for the 2019 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.

It’s important to note that foreign earned income does not include the following amounts:

  • Pay received as a military or civilian employee of the U.S. Government or any of its agencies.
  • Pay for services conducted in international waters (not a foreign country).
  • Pay in specific combat zones, as designated by a Presidential Executive Order, that is excludable from income.
  • Payments received after the end of the tax year when the services were performed to earn the income.
  • The value of meals and lodging that are excluded from income because they were furnished for the employer’s convenience.
  • 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 the individual’s regular income tax but will not reduce his or her 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 a deduction for foreign income 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 to consider are as follows:

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 must initially choose the foreign earned income exclusion with one of the following income tax returns:

  • A return filed by the due date (including any extensions);
  • A return amending a timely filed return;
  • An amended return, which 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
  • 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 if the qualifying individual again wishes to choose the same exclusion within 5 years, he or she must apply for approval by requesting a ruling from the IRS.

State Tax – If your U.S. state of residence when departing the U.S. is one with state income tax, you may be required to report all of the foreign income on the state tax return, unless there is an exception.

If you are considering working abroad, please contact us before you make your decision. We can provide information on foreign earned income and housing allowance exclusions, or about how to meet the bona fide residence or physical presence tests.