July 2011 Archives

July 25, 2011
Posted by Sanger & Manes, LLP

Canadian Snowbird Issues III- Canadian Citizens Who Are Not US Residents Must Still Pay Certain Taxes in the US, What Taxes are These?

Canadian citizens who have not inadvertently become US residents must still pay certain taxes in the US. What sort of taxes are these? First, remember we are assuming the Canadian citizen merely visits the US frequently, but at no point becomes a US resident. There are 2 basic types of categories of income to consider: (A) income effectively connected to a US trade or business; and (B) income not effectively connected to a US trade or business, but stemming from a US source.

Effectively Connected to a US Trade or Business

What does it mean to have income "effectively connected to a US trade or business". If a non-US resident conducts a US trade or business, the effectively connected US income is taxed in the same manner as business income of a US citizen-resident (i.e., standard ordinary US income rates (currently 35% maximum federal rate for an individual, but with normal deductions available as well)). There exists very little guidance as to what it means to be engaged in a trade or business (see IRC Section 864 generally). For example, a non-US resident individual merely collecting interest or dividends from a US payer is likely not engaged in a US trade or business. However, if a foreign taxpayer conducts US business activities through an office located in the United States, that may rise to a US trade or business. When sales of products are consummated in the US, they are generally effectively connected to a US trade or business. Although there is no bright-line test, the threshold for conducting business in the US is low, so typically some business conducted in the US will qualify as effectively connected income.

Noneffectively Connected Income But From a US Source

Non-US resident citizens are also taxed on their noneffectively connected income, provided the income is US source income. There is a big difference in the tax treatment of effectively-connected income (to a US trade or business) versus noneffectively connected income from a US source. Canadians with income effectively connected to a US trade or business are generally treated like US citizens (income at ordinary US rates plus deductions). But for non-effectively connected income, the general rule provided in under IRC Section 871(a) is that the nonresident is subject to a flat 30% tax on US source income (no deductions available here). However, the US-Canada Treaty (as do many US tax treaties) generally reduces the rate on many types of US source income. The various types categories of income addressed in the treaties (subject to the flat tax lowered by the treaties include the following):

1) Interest income

2) Dividend income

3) Rents (watch the distinction here between rents connected to the active management of property (ie, effectively connected to a US trade or business taxed at ordinary US rates) versus the passive receipt of rent, subject to the flat tax and the lower rate provided by the treaty.

4) Pensions and other Retirement Plan Distributions

5) Capital Gains

6) Income from services performed in the US (almost always deemed effectively connected to a US trade or business and taxed at ordinary US rates).

We discuss each of these categories individually, and the US-Canada Tax Treaty treatment of them, in the next post......

July 18, 2011
Posted by Sanger & Manes, LLP

When am I Deemed a California Resident for California State Income Tax Purposes?

California residents are subject to California state income tax on all income regardless where earned. Frequent visitors to California who are not deemed California residents are only subject to California state income tax on their California source income. So the stakes are big when determining whether one is a California resident.

Under California law, a person who stays in the state for other than a temporary or transitory purpose is a legal resident, subject to California taxation. Basically, brief vacations or transactions, such as signing a contract or giving a speech, constitute temporary or transitory purposes that do not confer residency. Every other kind of visit can confer such a status, including coming to California for health reasons, extended stays, retirement or employment that requires a long or indefinite period to accomplish.

How does the Franchise Tax Board determine whether a visit has a temporary or permanent purpose? It applies the "Closest Connection Test." This refers to the state with which a person has the closest connection during the taxable year. For the FTB, this literally means counting all the California contacts a person has and comparing that number with the non-California contacts. Of course, some contacts simply weigh more than others. A job or real estate ownership indicates a closer tie than merely enjoying a round of golf at a country club or a concert at the McCallum. The weightiest factors for residency are:

• Amount of time you spend in California versus amount of time you spend outside California.
• Location of your spouse/RDP and children.
• Location of your principal residence.
• State that issued your driver's license.
• State where your vehicles are registered.
• State in which you maintain your professional licenses.
• State in which you are registered to vote.
• Location of the banks where you maintain accounts.
• The origination point of your financial transactions.
• Location of your medical professionals and other healthcare providers (doctors, dentists etc.), accountants, and attorneys.
Location of your social ties, such as your place of worship, professional associations, or social and country clubs of which you are a member.
• Location of your real property and investments.
• Permanence of your work assignments in California.

This is only a partial list of the factors to consider.

So What is a Frequent California Visitor (aka, a "snow bird") of California to do?

First, know the rules for keeping your status as a part-time resident. Snow birds have a presumption of nonresidence if they follow certain guidelines. The total amount of time you spend in California during the year has to be less than 6 months. You can own a vacation home (but it should probably be smaller or of less value than your main out-of-state residence). You're allowed to have a small local bank account to handle your financial needs related to your stay. Your can have a membership in a local country club. Limit your California contacts to these, and you will probably avoid a lengthy audit, form or no form.

Second, lower your local profile. The State of California doesn't know you're here unless you or the financial institutions you deal with let them know. For instance, any interest generated on your local bank account gets reported to the State of California as a form 1099. You can fly under the State of California's radar by opening a non-interest bearing account. It may cost you a few bucks in interest, but it may avoid an expensive residency audit. Given the ease with which you can access funds across state lines nowadays, it may not even be necessary for you to open a local account.

Similarly, a lot of part-time residents like to have local brokerage accounts. It seems free time and sunshine go together with playing the market. The problem arises when stock in a local account issues dividends, which get reported to the State of California. You should consult your broker concerning ways to avoid this. Again, because of the ease of trading stock nowadays, the broker may be able to hold the stock for you in an out-of-state affiliate of his office, or you can forget about brokers and trade online (you didn't hear that from me). At the very least, have all brokerage statements sent to your out-of state address. The same is true for bills from all local professional services.

July 13, 2011
Posted by Sanger & Manes, LLP

Tax Court Says Downturn in the Economy is an Acceptable Reason For Penalty Abatement on Failure to Deposit Employment Taxes? No Kidding.

On July 5, 2011, in the case of Custom Stairs & Trim, LTD., v. Commissioner (TC Memo 2011-155), the US Tax Court addressed the issue of what circumstances constitute "reasonable cause" for the purpose of abating a penalty for an employer's failure to deposit employment taxes in a timely manner. Does a downturn in the economy constitute reasonable cause? Some may find the result surprising.

Federal law requires employers to withhold taxes from its employees' paychecks. Each time the employee pays wages, it must withhold - or take out of its employees' paychecks - certain amounts for federal income tax, social security tax, and Medicare tax (these taxes are termed "employment taxes"). Further, an employer must file a quarterly Form 941 reporting the wages it paid to its employees for the previous quarter. The IRS Form 941 includes totals for: (a) the number of employees and total pay for the period being reported; (b) amounts withheld from the pay of employees for the period; (c) taxable Social Security and Medicare wages for the period; and (d) calculation of total Social Security and Medicare wages. The form requires a calculation of the total taxes and the total deposits (from the employer to the government) made during the period. Beginning January 1, 2011, an employer deposits all depository taxes (such as the employment tax) electronically by electronic funds transfers.

IRC Section 6656 imposes penalties on late deposits of the employment tax (of 2 to 15% on the amount of tax, depending on the lateness of the deposit). Under IRC Section 6656(a) and Rev Proc. 2001-58, however, the IRS may abate the penalty if it determines there exists "reasonable cause" to do so.

Does a Downturn in the Economy Constitute "Reasonable Cause"?
In Custom Stairs & Trim, LTD., v. Commissioner, the employer failed to make certain employment tax deposits. As a consequence, the IRS imposed a penalty under IRC Section 6656- Failure to Make Deposit of Taxes. The issue before the US Tax Court was whether the company's failure to make the deposit of taxes was attributable to reasonable cause, so that the penalties should be abated. As a reason for failing to make the deposit for the 2nd quarter of 2008, the company cited the effects of the economic recession. It noted it had been forced during this time to lay off employees, eliminate vacations and reduce employee benefits. The company stated it simply did not have enough money to deposit the taxes for that quarter and meet its other crucial operating expenses. The company did deposit taxes during that time it owed for a previous quarter for which it was in arrears. The IRS responded, in turn, that it never constitutes reasonable cause (for the purposes of abating penalties) to pay other creditors before the IRS.

In its decision, the Tax Court noted that in the 2nd, 3rd, 7th and 9th circuits (the 9th circuit is California's circuit) the courts have opined that financial hardship, under certain circumstances, can constitute reasonable cause. The Tax Court stated reasonable cause will be found if the taxpayer "exercised ordinary business care and prudence in providing for payment of his tax liability and was nevertheless either unable to pay the tax or would suffer an undue hardship." In determining whether the taxpayer exercised ordinary business care and prudence, "consideration will be given to all the facts and circumstances of the taxpayer's financial situation, including the amount and nature of the taxpayer's expenditures in light of the income. Primary factors in determining whether a taxpayer exercised ordinary business care are: (1) the taxpayer's favoring other creditors over the Government, (2) a history of failing to make deposits, (3) the taxpayer's financial decisions, and (4) the taxpayer's willingness to decrease expenses and personnel."

Because the company did actually make deposits during the 2008 quarter (albeit, for amounts due from prior periods, and not the actual amounts due for the 2nd quarter of 2008) the Tax Court reasoned the company was not paying other obligations instead of its obligation to the IRS. That fact coupled with the economic downturn (including proof that the company cut benefits and payroll and was attempting to sell some of its real property) satisfied the Tax Court, which ruled that the company exercised ordinary business care, and that the IRS must abate the company's penalties for failure to deposit the employment taxes for the second quarter of 2008.

Include your author as one of the surprised.

July 7, 2011
Posted by Sanger & Manes, LLP

Tax Court Decision Offers a Refresher on Definition of Chronically Ill Individual for Deducting Long-Term Care Expenses

On July 7, 2011, the US Tax Court, in Estate of Lillian Baral (137 T.C. No. 1), the Tax Court offered a good refresher on the fundamentals of deducting long-term medical costs for those who qualify as "chronically ill".

The opinion walks through a series of particular and critical definitions for this process.

The general rule of deductibility, provided under IRC Section 213, is that certain expenses paid during the taxable year for the medical care of the taxpayer or a dependent that are not compensated for by insurance or otherwise may be deducted to the extent that the expenses exceed 7.5 percent of the taxpayer's adjusted gross income.

"Medical Care", under IRC Section 213, includes amounts paid for the diagnosis, cure, mitigation, treatment, or prevention of disease, and amounts paid for qualified long-term care services.

"Qualified long-term care services", under IRC 7702B, means necessary diagnostic, preventative, therapeutic, curing, treating, mitigating, and rehabilitative services and maintenance or personal care services required by a chronically ill individual and provided pursuant to a plan of care prescribed by a licensed health care practitioner.

A "chronically ill individual" means any individual who has been certified by a licensed health care practitioner as meeting one of three tests: (1) being unable to perform at least two of six specified activities of daily living (eating, toileting, transferring, bathing, dressing, and continence) for a period of at least 90 days due to a loss of functional capacity ("the ADL level of disability"); (2) having a level of disability similar to the ADL level of disability as determined under regulations prescribed by the Secretary in consultation with the Secretary of Health and Human Services ("the similar level of disability"); or (iii) requiring substantial supervision to protect the individual from threats to health and safety due to severe cognitive impairment ("cognitive impairment").

Finally "licensed health care practitioner" is a physician, registered professional nurse, licensed social worker, or other individual who meets requirements that may be prescribed by IRS

In this particular case, while the doctor specified in his evaluation that the patient required assistance for daily living, he did not specify which activities (amongst the categories of eating, toileting, transferring, bathing, dressing, and continence) the patient could not accomplish on her own. The Tax Court did, however, refer to a doctor's report which stated that the patient suffered from dementia, and therefore would not take her medication regularly without supervision. Therefore, the patient qualified under the 3rd test of chronically ill individual, as she required substantial supervision to protect herself from threats to her health and safety due to severe cognitive impairment. As such, the amounts paid to the caregivers were deductible by the patient as amounts paid for qualified long-term care services under IRC Section 213.

One important final note, under IRC Section 7702B, an individual who otherwise qualifies as chronically ill will not qualify unless during the preceding 12 month period the licensed health care practitioner certifies the individual meets the requirements. In Estate of Lillian Baral, although the court refers to the doctor's notes from 3 years ago regarding the patient's not properly taking her medication, the court does note that in the last 12 months the doctor's evaluation states that the patient required supervision because of her memory deficit and therefore needed supervision for her health and safety. Hence, the 12 month certification requirement was satisfied.

July 1, 2011
Posted by Sanger & Manes, LLP

Taxpayer Advocate Service Issues Mid-Year Report With a Focus on IRS Fairness to the Taxpayer

On June 29, 2011, National Taxpayer Advocate Nina E. Olson released a report to Congress that identifies several issues the Taxpayer Advocate Service plans to address during the coming fiscal year. The Taxpayer Advocate Service is an independent office within the Internal Revenue Service. It is under the supervision and direction of the Taxpayer Advocate who is appointed by and reports directly to the Commissioner of Internal Revenue. The Taxpayer Advocate Service identifies systemic problems that exist within the Internal Revenue Service and, to the extent possible, propose changes in the administrative practices which may be appropriate to mitigate such problems.

The 2011 mid-year report expresses particular concern about the impact of IRS budget cuts on taxpayer service and tax compliance. The National Taxpayer Advocate has previously suggested that the IRS generally be exempt from budget caps or reductions.

With respect to IRS collection practices, the report praises several recent changes the IRS has announced, including making lien withdrawals available to taxpayers in a wider range of cases. However, the report expresses continuing concern about the IRS's practice of automatically filing tax liens based on a dollar threshold instead of basing lien-filing decisions on an analysis of the taxpayer's financial situation. The National Taxpayer Advocate believes that such an analysis "should balance the need to protect the government's interests in the taxpayer's assets with a corresponding concern for the financial harm the lien will create for that taxpayer." In situations where the IRS has determined a taxpayer is suffering an economic hardship or possesses no significant assets, the filing of a lien is unlikely to further tax collection but will further damage a taxpayer's credit rating.

In addition, The Taxpayer Advocate Service announced it planned to focus on the following areas in the upcoming year:

Tax Reform and Tax Complexity. The Taxpayer Advocate Service will continue to engage the public in a discussion about fundamental tax simplification. The Taxpayer Advocate Service has established an electronic suggestion box to solicit comments from taxpayers on tax simplification.

Earned Income Tax Credit Improvements. Taxpayers frequently face difficulty in substantiating their Earned Income Credit claims to the satisfaction of the IRS, notably by proving that a qualified child lived with the taxpayer for more than half the year and bears the requisite familial relationship. The Taxpayer Advocate Service wishes to aid taxpayers in making their substantiation problems easier to prove.

Tax-Related Identity Theft. The IRS continues to experience difficulties in expeditiously resolving tax identity theft-related cases, which continue to increase. The Taxpayer Advocate Service will continue to work with the IRS to mitigate identity theft problems, improve identity theft case processing, and follow up on previous recommendations in this area.

Innocent Spouse Relief. The IRC currently contains "innocent spouse" rules designed to shield individuals from responsibility for joint tax liabilities generally attributable to their spouse (or former spouse) in appropriate cases. However, equitable relief for otherwise eligible taxpayers is barred if an "innocent spouse" request is not filed within two years from the date of the first IRS collection action. The two-year rule can lead to poor and unfair results for true innocent spouses. The Taxpayer Advocate Service looks forward to working with the IRS to improve this rule.