Salesmen Want More Sales, Businessmen Want More Profit!

When it comes to pricing a product there are two factors, an accounting side that sets an absolute minimum price and a sales/marketing side that exists to push the product out the door.

Priced Out of Lingerie Milan by flatworldsedge

Do Not Let the Salesmen Set the Price!

The concern of the salesman is more sales, not more profitable sales, and so don’t let the sales dog wag the profit tale.  In fact, many business owners will have their salespeople screaming at them, “we need to lower prices!  Jennny Blow over at XYZ Competitors is undercutting us by 10%!   We’re dying in the water here!”  There are a number of fascinating studies about the incentives of salespeople and how they frequently are not aligned with the best interests of their employers.  Perhaps the best known of these relates to real estate agents and was brought to fame by the hit book, Freakanomics.  To put it in a nutshell, the salesperson wants that product out the door NOW!  They don’t have the investment  in the product that you do and don’t have the incentive to get the maximum price, they’d rather sell more volume at the minimum price.

The problem is, most business owners are sympathetic to the sales staff.  After all, many come from a sales background and are heavily involved in the sales process.  To compound the problem, they know little about accounting, don’t really understand it’s benefit and so have some young kid fresh out of school doing it or some old guy name Bernie who always stinks like stale smoke and mumbles when he talks and so you generally avoid talking to him except when you sign the checks.

The Found Money Take on Owners Who Complain About Having to Lower Prices

Wow!  Harsh words indeed.  You see, the sales person mentality is an overriding obsession with the quantity of sales.  Now, as a business owner and officer, you need to become more focused on the quality of sales.  Not all customers are created equally and, inevitably, some of them suck.  In fact, I have helped many business owners put together an analysis of their customers by profitability and ease of doing business with and they are often shocked to find that some of their customers actually lose them money!  What’s worse, these are often the very same customers that are time-sucking pains in the asses that they really hate dealing with.  And yet the business owners are essentially paying these customers to do business with them!

Why the Lower Price Often Doesn’t Sell

A low price attracts a certain customer, and this is a very different customer from the customer who pays premium.  The customer who pays rock bottom price all the time views your product as a commodity and will drop you the minute they can find a better price, whereas the customer who pays a premium does so because she believes that she is getting something special for the price she is paying.  Which of those customers is more likely to be loyal?  Which of those customers is more likely to be a pleasure to do business with?
Now think about setting a rock-bottom, low ball price in front of the premium customer.  Can you just imagine the look on their face.  To them, your price says “Hey, we don’t do as good of work and so, to make it up to you, we are charging less.”  Instead, when dealing with the customers you need to lose the focus on price altogether.  These people focus on value, not price, and you will earn their business by showing that you can deliver this value

How to Set a Minimum Price

In order to set a minimum price you need to know your gross margin for every major product that you offer.  The math is simple, the gross margin is the price that you get for each unit sold minus your cost of producing that unit (cost of goods sold, in nerdy accountants speak).  Sound simple, right?  Well, the Devil is in the details and the details here are calculating what actually is included in the cost.  Certainly any materials used to produce it, that is relatively easy to calculate.  Add to that the cost of paying employees for for working on production.  To do this, you have to know how your employees use their time.  Finally, you need to allocate overhead in some way.  Overhead are all those other costs that you need to run a business but that you really can’t attribute to the production of any particular item.
The minimum price that you can charge now involves taking that cost of goods sold and adding your desired gross margin, or how much profit you want.  Hey, you’re not doing this for free, right?  That is were your desired gross margin comes in.  You should never sell for less than this minimum price unless perhaps you have discontinued a product and are liquidating inventory.

Finding Your Ideal Price

Think about every time a big, exciting new product is introduced, from an I-Pod to a recently released DVD, what happens to the price over time?  Inevitably, it falls.  This is why you really have to get the price right out of the gate.
We have already established a floor, a minimum price that you will accept for your product, now let’s target an optimal price.  “Of course I know the ideal price, as much as I can get people to pay!” you say.   And of course you are right.  The key is to remember that it is much easier to start at a certain price and then lower it in certain situations then it is to start low and then try to raise prices.  Take a page from Ron Popeil and ask “but what would you pay?  $500? $250?, $125? but wait, there’s more!”

The Wealthy Freelancer

Start By Pricing Low?

My experience is that the new entrepreneur is often terrified of pricing themselves out of the market and seeks to gain market share by undercutting the competition’s prices.  This seems like a safe strategy, with less experience you should charge less, right?  Well, maybe, but do keep in mind the dangers of underpricing:

• It basically says to potential clients, “Hey, we don’t do as good of work and so, to make it up to you, we are charging less.”
• It sets a bad precedent for future work with that client, who will forever consider you the “discount provider.”
• In the words of a client I was pursuing, “we decided to go with Super Big and Famous Firm X because, although they charge twice as much, we know they won’t nickle and dime us every time we have a question or want something from them.”

Charge by the Hour?

Most entrepreneurs and independent professionals start off charging by the hour.  After all, most of us start our our careers as employees and we are accustomed to thinking of our time as having a price.  “Time is money,” as they say and we want to make a certain amount of money per hour.

Charge Them What You’re Really Worth!

Steve Slaunwhite of “The Wealthy Freelancer” makes a great case for a matter true to my heart, ending outdated thinking of charging by the hour and start charging by the result.

• Clients don’t want your time, they want a a job done!  They come to you because they have a need that needs met and are indifferent to your actual input of time.
• The client looks at hourly billing as a “blank check” for you and worries about the meter ticking.
• It sets an artificial ceiling on your earning power.  As you earn greater efficiencies and produce better work, your income cannot expand accordingly.

However, even though you, as a savvy professional, as charging your clients by the job you still need to track your hours spent on each project.  Your time is a finite resource and you need to manage it carefully.  Tracking the time you spend helps you to price future jobs and shows what lines of work are most profitable .  Finally, it should help you find efficiencies and show what areas need you need to spend less time on.  Two tools recommended by “The Wealthy Freelancer” are www.traxtime.com and www.freshbooks.com.

Determining What Price to Charge

Most new entrepreneurs stumble into pricing the wrong way.  They start off marketing and then get to pricing only when when they are asked about it, figuring that they will take what the client offers.  Well, often the client doesn’t really know what the “correct price” is and they are certainly not going to lead off with their best price.  Besides, nothing says amateur like not even having a ballpark figure of what you intend to charge!  So your first step, according to Steve Slaunwhite of “The Wealthy Freelancer,” is to create fee schedule for the services you offer.  The schedule should set out a range of prices for each service or product and gives you a beginning price.

“But if I don’t have much experience, how much should I charge?” I can hear you ask.  Well, in the Internet age, you should be looking up the fee schedules of your competitors and using that as a basis for how much to charge.  Adjust the price accordingly as you get experience and get a better idea of what your unique customers are willing to pay.

Don’t accept low-ball prices; if you really want the work compromise with them but get something in return, more time, money up front, a reduction in the output., a commitment for multiple purchases.  Remember that every job sets a precedent for all future work with that customer.  If you set yourself up as the bargain basement option then that is what you will always be to that client.

Fire Loser Customers!

My longtime readers know what a huge fan I am of Steve Wilkinghoff and his book, “Found Money”.  One of the highlights of Steve’s book is his “Customer Profitability Map.”  The basic premise is this, evaluate your customers by two criteria, profitability and pleasure of doing business with.  Plot them out on a grid and take the quarter that are both least pleasant to do business with and least profitable and fire them!  The quarter that are both the most pleasurable to do business with and most profitable try to cross-sell and up-sell.  At the very least, keep in close contact with them and follow what they are up to.  Meet with pleasurable but less-profitable clients and determine if there is work that could help them become more profitable.  Be wary of more profitable but less pleasurable clients.  They may be worth the hassle but keep an eye out for hidden costs and potential drains on your time and efforts.  Finally, if they should ever fall into the less profitable category, fire their asses!

I Can’t Recommend Enough

Tax debt can be a serious concern for people as IRS will find a way out to retrieve the owed amount from the debtors. Are you struggling to pay your IRS tax debt and frantically looking for debt help? Then an effective debt relief solution can help to eliminate your tax debts. Here are some other options to settle your tax obligations.

• Offer-in-Compromise:

Offer in Compromise is similar to the settlement that you need to propose to the IRS in case you fail to make the tax payment. You offer an amount that is affordable for you to pay off. The IRS will approve or reject the offer after evaluating your financial state. This program saves you from the penalty and interest charges while giving you an opportunity to eliminate your debts.

• Installment Agreements:

Installment Agreement is the best solution to the taxpayers who cannot pay taxes after 120 days of extension. The IRS reviews the financial situation of a taxpayer and then designs a plan accordingly. Paying your tax debt in installment makes it easier for the debtors to pay it off effortlessly. But in this process you are liable to pay off the interest. Time limit of your payment will be legally extended. If you are on installment agreement plan, try to avoid defaulting on your payment because the IRS might terminate your agreement with them.

• Removal of the Penalty:

Penalty charges are levied on the tax debt that you owe to the IRS through an automated process carried out by a computer. Usually these penalty charges are found to be erroneous. In case you find inaccurate penalty charges imposed on your tax debt then you can request the IRS to remove the penalty fee from the owed amount. As a matter of fact, it is advised to consult a tax expert to contest the IRS to remove the wrong penalty charges.

These options can prove to be beneficial to settle your IRS tax debt. You need to select the right option that will be suitable for your financial situation. If you are still confused which option will be perfect for you then consult an experienced and reputable tax debt attorney who will help to make the right choice.

Recently, the IRS has stepped up the aggressiveness of its tactics in pursuing those who hold money overseas, either as individuals or through a corporation or trust, in the hope of catching those who may be evading U.S. taxes or involved in illicit activity.  The IRS has used its clout to play hardball with several foreign banks that have U.S. branches, most famously Swiss bank UBS and English bank HSBC.  In addition, several foreign governments have collaborated with the IRS in revealing the names of U.S. citizens with accounts in their countries.

They

The turning point of these investigations in the requirement by U.S. citizens and residents and the companies and trusts owned by them to file TD F 90-22.1 with the IRS for any year that the combined total of their interest in foreign bank accounts exceeds ten thousand dollars at any moment during the year.  If you are one of the 5 million Americans living overseas or one of the millions more who have signature authority of or an interest in a bank account in a foreign country then you can expect increasing scrutiny from the IRS to ensure that you are fulfilling your legal requirements with the U.S. government; and the penalties for non-compliance can be severe.

Now Is Your Chance to Come Clean

As a consequence of this renewed pressure and increased vigilance by the IRS and to respond to demand, the service has recently launched an amnesty program called the Offshore Voluntary Disclosure Initiative.  In the words of IRS Commissioner Doug Shulman, “as we continue to amass more information and pursue more people internationally, the risk to individuals hiding assets offshore is increasing.  This new effort gives those hiding money in foreign accounts a tough, fair way to resolve their tax problems once and for all. And it gives people a chance to come in before we find them.”

All this honesty comes with a price, however.  The penalty is 25 percent of the amount in foreign bank accounts in the year with the highest aggregate account balance covering the 2003 to 2010 time period; with some taxpayers eligible for special 5 or 12.5 percent penalties.  This is in addition to all back-taxes and interest and penalties for up to eight years.

Who Is Affected

In the words of the IRS, “Any United States person who has a financial interest in or signature authority or other authority over any financial account in a foreign country, if the aggregate value of these accounts exceeds $10,000 at any time during the calendar year. See also Notice 2010-23,  “United States person” includes a citizen or resident of the United States, a domestic partnership, a domestic corporation, and a domestic estate or trust. See Announcement 2010-16.”

A logical question would be, “what the hell does that mean, a ‘financial interest in?’  I own shares of Sony and I’m sure that they have bank accounts all over the world.  Does that mean I have a ‘financial interest in’ those accounts?  I think I’m going get heartburn!”  Well, put down the industrial size Mylanta bottle and stop worrying because, unless your last name is Morita, it is not likely that your interest in Sony stock is sufficient to create a financial interest.  It is generally considered that you must either directly or indirectly own 50% of the account or have signature authority on the account.  An indirect interest means that you own some percent and that the sum of the interests of you and your direct relatives totals to at least 50%. Also, if you control a corporation or other business entity then its interest becomes your indirect interest as well.

Furthermore, note that the requirement is for over $10,000 held at any point in time throughout the year in all overseas accounts.  So if you had $9K at your bank in Malta on  July 4th and $1,001 in the bank in Mexico on the same day but immediately turned around and bought an asset with the Malta money on July 5th then yes, you would have to file and yes, when you filed you would have to list all accounts no matter how small the amount.

What Qualifies As a Foreign Account?

First of all, military banks are not foreign and banks based in U.S. territories like Puerto Rico, Guam, and the U.S. Virgen Islands are also not foreign.  Obviously, banks in the 50 states are not foreign and so a foreign account means an account anywhere else.

So now that we know what is foreign, what is an account?  Well, that would be a checking, savings, money market, and securities accounts.  Note that excluded are “Individual bonds, notes, or stock certificates held by the filer are not a financial account nor is an unsecured loan to a foreign trade or business that is not a financial institution.”

When Do I Have to File By?

Your filing of your TD F 90-22.1 needs to be received by the IRS by June 30.  Note that no extensions are given, unlike an ordinary tax return.  Also, there is no tax due upon filing and so the consequences of filing late are uncertain and probably depend on the IRS and how late it is filed.  If you do file late then you are supposed to include a note as to the reason for your tardiness.

What Happens If I Don’t File?

Failure to comply your obligation to file the TD F 90-22.1 is severe, a $10,000 fine per instance and potential criminal penalties.  In words of the IRS, “Taxpayers who do not submit a voluntary disclosure run the risk of detection by the IRS and the imposition of substantial penalties, including the fraud penalty and foreign information return penalties, and an increased risk of criminal prosecution. The IRS remains actively engaged in ferreting out the identities of those with undisclosed foreign accounts. Moreover, increasingly this information is available to the IRS under tax treaties, through submissions by whistleblowers, and will become more available as the Foreign Account Tax Compliance Act (FATCA) and Foreign Financial Asset Reporting (new IRC § 6038D) become effective.”

Catch Me If You Can

The IRS wouldn’t offer an amnesty if there weren’t still tons of accounts out there whose owners have not complied with the disclosure requirements.  Quite frankly, many of these accounts predate the disclosure requirements and are from a time when the IRS was much less aggressive about enforcement.  Also, before banks were much more likely to guard their account holders’ secrecy and were not as intimidated of  the IRS.  But times are changing and the actions of the IRS against UBS and HSBC have been unquestionably noted by other banks around the world.  Sure, there are probably banks in Iran and Venezuela that would die before giving your information to Uncle Sam, but expect increased compliance everywhere else, including once safe havens like Switzerland.   The world is shrinking and international banking is shrinking right along with it.

Is that an IRS Agent I See Down There?!

As an expatriate American, whether you are sipping a sherry on Spain’s Costa del Sol, hoisting a pint in an pub in Newcastle,  or knocking down a tequila in Mexico’s Riviera Maya, it is comforting to know that you are not forgotten back home in the U.S.A.  Why is it that your Uncle Sam will remember you so easily?  Because every year you must file a tax return with the I.R.S., wherever in the world you may live. Fortunately, for most taxpayers, filing abroad is merely a formality, as the first $91,500 of foreign earned income is excluded from their U.S. taxes and they get a credit for taxes paid to a foreign government.  The danger is in failing to file and risk having the I.R.S. pursue you or even file for you.  So lower your glass, pick up a pencil, and take note of what you will have to do to keep yourself in good standing with your uncle.

When You Have to File

The deadline for paying your U.S. taxes is April 15th, irregardless of whether you live in New York or New Dehli.   However, if you are living overseas you automatically get an additional two months to file your return. Note the difference, any tax due must be paid by April 15th or you could potentially be charged interest.  As with all taxpayers, expatriates have the option of filing Form 4868, giving them a six month extension, until October 15th, to file their return.

How You Get it Done

Again, little changes because of your location.  You will file a Form 1040 along with any supplemental schedules.  For expatriate taxpayers common supplemental schedules include the Form 2555, Foreign Earned Income, and the Form 1116, Foreign Tax Credit.  The Form 2555 essentially means that, if you are a qualifying overseas taxpayer, you won’t owe any U.S. tax on the first $91,500 (2010) of income that you earn from employment or from the operation of your business and the Form 1116 reduces your U.S. tax burden for taxes that you have already paid to a foreign government.

What Information You Will Need

If you are working overseas for a U.S.-based employer, then you will probably receive the same documentation that you would receive if you were based in the States.  If you believe that you will not owe any U.S. tax because your income will meet the requirements of Form 2555 and will therefore not be taxable to the U.S. then it is your responsibility to inform your employer of this so that they will not be required to withhold estimated taxes on your income.  Depending on your country of residence and any tax treaty it may have with the U.S., your employer will withhold payroll taxes just as if you were in the U.S.

On the other hand, if your employer is not a U.S. company then they are not subject to U.S. reporting requirements and will, most likely, provide you only with the documentation required for declarations to a foreign government.  Some common issues are:

• documentation in a foreign language, possibly requiring translation.
• documentation reporting income not on a calendar year, meaning that you will have to do a little extra work to compute your income from January to December..
• income reported in a foreign currency, which must be converted to U.S. dollars for filing purposes.

If You Are Self-Employed

If you own your own business or are self-employed then you may want to finish that drink now, because it gets a little more complex.  Basically, there are two ways to structure your business and each has its own tax consequences.

One way to do it, and probably the most common way, is to run your business through a foreign corporation.  In that case, you are responsible for reporting the wages paid to you (as earned income therefore not subject to U.S. taxes if they meet the requirements of Form 2555) and the dividends (anything paid to you that wasn’t a wage and therefore will be subject to U.S. taxes).  The corporation is a foreign entity and does not have to file and owes no U.S. tax on its income; although you as the owner will have to report your interest it it on Form 5471.

The other possibility is just running your business as a sole-proprietor and not incorporating it.  If your business is not incorporated then you will need to calculate your income and include it on Schedule C of your income tax return.  The income can be excluded on Form 2555 just as income from employment, however it will be subject to self-employment taxes.

Give Me My Drink Back and Get Me Some Help

Most U.S. C.P.A.s and tax preparation services would either turn up heir noses in disgust or run away in fear if presented with the tax return of a U.S. expatriate.  The fact is, it is a specialized service due to the many additional complications that come with filing abroad.  The smart taxpayer makes certain that their provider has the necessary experience before beginning the process.

Basically, there were three big tax acts in 2010: the HIRE Act, the Patient Protection and Affordable Care Act, and the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010.  The last of these, we’ll call it the Tax Relief Act, basically kept in place all of the so-called Bush Tax Cuts through 2012.  The second, we’ll call it Patient Protection, will primarily promise higher taxes for some taxpayers in future years, and the first, the HIRE Act has some sweet short term discounts to encourage hiring.

The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 in brief

This act was passed primarily to continue most of the tax cuts put in place during the Bush Administration until 2012, an election year.

• 2009 individual income tax rates will be continued for 2010 and through 2012 for all taxpayers.
• 2009 rates on capital gains and qualified dividends will be extended through 2012.
• Payroll rebate – 2% Social Security rebate for employees – The employee’s share of Social Security taxes will reduce from 6.2% of wages to 4.2% for 2011.  Self-employment tax will decrease to 10.4%.  The best part of the deal is that social security benefits will not be affected by discount, although, at some point in time some taxpayers will have to foot the bill for it.
  • What employers have to do – employers “must implement the new rules as soon as possible but no later than January 31,” in the words of the IRS.  If you don’t catch this by the first payroll then you can make an adjustment to the second to compensate.
  • What employees have to do – absolutely nothing.  It is your employer’s responsibility to comply.
• AMT Patch - the exemption amount for the Alternative Minimum Tax is increased to $47,450 for individuals, $72,450 for married taxpayers filing a return jointly and $36,225 for married but filing separately couples.
• Estate Tax – Among the biggest dramas of 2010 has been whether George Steinbrenner’s heirs would inherit his estate without owing any estate tax (“death tax” to you tea party types).  Well, thanks to this bill I can confidently tell you maybe, but probably not.  For 2010 estate managers will have the option of selecting the new regime of a $5 million dollar exclusion with a 35% rate thereafter or of opting under the system that would have a 0% rate but would have denied the “step-up” in basis that inheritors have received under the previous rules.  It gets complicated and few of my readers are passing on >$5 million estates in 2010 (unless you plan on dying tomorrow) but if you want further detail I recommend this excellent resource from CCH.
• Bonus Depreciation – what’s sexier than 50% bonus depreciation?  Try 100% bonus depreciation!  For select fixed assets placed in service from September 9, 2010 through the end of 2011, 100% of the purchase price of the asset may be depreciated in the year of purchase.  For the entrepreneurs with smaller businesses this is important because you can take bonus depreciation even in a loss situation whereas Section 179 cannot put you into a loss.  Also, bonus depreciation could be advantageous with the purchase of a vehicle used for business purposes.

HIRE Act

The HIRE Act was only in effect for 2010 and provided employers with an incentive to hire previously unemployed persons by giving them a 100% reduction on the employer portion of the payroll tax of the qualified hiree.  Furthermore, if the employee remained hired for 52 consecutive weeks then the employer could be eligible for a credit of up to $1,000 per employee.  While it is too late to hire a new employee if you hired someone eligible for the credit don’t forget to apply for the $1,000 credit when they hit 52 weeks!

Tax Planning in 2011

The oldest trick in the book for tax planning is for cash-basis (as opposed to accrual basis) taxpayers, like most of you, to accelerate expenses into the current year through a number of tactics, including accelerated depreciation (like Section 179 or the 100% bonus depreciation available in 2011) or through the purchase of goods and services in the current year that won’t be needed or utilized until the subsequent year.  Alternatively, the taxpayer could delay the receipt of revenue by not sending out billings until the subsequent year.  This is the “kick the can down the road” strategy for taxes; the income will eventually have to be recognized (nerdy accountant speak for saying that taxes will be owed on it) but we would rather that day came later instead of sooner.  Well, the problem with this strategy comes in times of increasing taxes, such as we are likely to enter soon.  All of the above mentioned laws that provide or extend tax benefits are temporary measures that will expire in 2012, an election year.  Most of the political junkies who follow these things would guess that taxes will have to rise in order to keep pace with the gigantic debt the United States is ratcheting up.  If this is the case then in 2011 you could actually find yourself in the position of wanting to prepay your taxes by accelerating revenue or deferring expenses.

An additional tax bill that has already been passed into law, as part of the Patient Protection and Affordable Care Act, and the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, will tack on an additional 0.9% Medicare tax for married filing joint taxpayers earning greater than $250,000 and for single taxpayers earning greater than $200,000 for the 2013 tax year by 0.9%.   In addition, those same taxpayers will be charged a 3.8% Medicare tax on earnings on investments; which were previously not subject to employment taxes.

In conclusion, 2010 was a year of great uncertainty and apprehension regarding taxes for the productive class.  In the end, most tax hikes and any tax reform was pushed further down the road; leaving us with something rather like 2009.  Certain tax hikes are already in the books, albeit not taking effect until further down the road, and taxpayers can expect additional uncertainty in 2012 when the current tax rates expire.

If you need more information that is specific to your problem then contact Tyler here. Remember, it only costs a little bit of time to ask, but the cost of not asking could be devastating.

Tyler Wells, CPA

Watch Your Wallet by Jarnocan

The U.S. citizen and permanent legal resident has the unusual distinction of being one of the only persons on this planet that is taxed on any foreign earned income no matter where she may have earned it.  In fact, legend has it that the first person to greet alien abductees in update New York upon their return to the Earth was an IRS agent, wanting to know what they had received “anything of value or that felt good” during  their abduction and reminding them to include it on their returns.

While the IRS may be led and staffed by life-force sucking Dementors straight out of H… Harry Potter, they do have a practical side and realize the limits of their influence and of the difficulty of getting someone to actually declare the income they have earned abroad.  Therefore, with Congressional support, an exclusion for foreign earned income of potentially 91,500 plus a housing allowance is available for the smaller fish, letting the IRS focus on the larger fish.  And focus they have, increasingly tightening the screws with greater reporting requirements and a less generous exclusion for those who go over the limits.

What is earned income, and how do I know if it is “foreign?”

Earned income basically means that you traded your time and talents for compensation.  That compensation could be in the form of wages, commissions, tips, professional fees, or bonuses.  For it to be foreign you have to have made your “tax home” in a foreign country and have to be either a bona fide residence or physical presence test.  If you meet the tests, then you are allowed to exclude from income for your tax return of up to $91,500 (in 2010) and some housing allowances.  This gets tricky, and I have already covered it in depth in my article on Form 2555.  What is emphatically not the case is that just because you happened to be outside the United States when you earned or were paid income does not mean it can be excluded.

You absolutely ARE required to file

Where you may be located geographically has absolutely no bearing on whether are not you are required to file nor does it matter where you earned your income; you must declare it for U.S. taxes.  Usually, you will file a Form 1040 and will have any number of supplementary forms or schedules depending upon the nature of your income.  For the purpose of income earned from a trade or business while living overseas the proper form is Form 2555.  In addition, if you pay taxes to a foreign government then you would report them on Form 1116 to get a credit on your U.S. tax return for foreign taxes paid.

Social Security and Self-Employment Tax

For the most part, even if your foreign earned income is subject to the exclusion for U.S. taxes by filing Form 2555 you will still owe social security on your wages.  This is subject to several criteria, and the U.S. has Totalization Agreements with a number of countries in order to prevent duplication of taxes (i.e. so that you don’t have to pay into two separate systems).  If you own your own business or are self-employed then this could possibly lead to your having to pay self-employment tax to the United States, depending on how your business is organized.  This is a complicated area and it is important that you get your tax planning done right if you want to avoid paying into social security.  Remember that if you don’t pay money into social security then you don’t get any back out.  If you aren’t saving enough for a rainy day or retirement outside social security then avoiding contributions could potentially come back to really haunt you.

In conclusion, determining whether you income qualifies as foreign earned income is important because, if it is, it may qualify for an exclusion from your income for purposes of filing your United States tax return.  Foreign earned income is coming under increasing scrutiny by the Internal Revenue Service and the taxpayer needs a good plan to minimize their tax costs.

If you need more information that is specific to your problem then contact Tyler here.  Remember, it only costs a little bit of time to ask, but the cost of not asking could be devastating.

Tyler Wells, CPA

I had the honor of writing a guest article for Small Business Branding on selling your business.  It’s a lot of fun and with some great pointers to keep in mind, if even you’re not ready to sell yet.

The silver lining of this cloud is that the U.S. congress has given the expatriated (and reluctant) taxpayer two weapons to help fend off the avariciousness of the IRS, the Forms 2555 and 1116.  For those actually living overseas, the 2555 is the big gun in the armory, as it allows a direct exclusion of certain income under certain conditions.  Of course, it wouldn’t be U.S. tax law if it was easy to understand, and so I have included here an emphatically NOT by the IRS guide to the Form 2555.

How the Form 2555 Helps You

In its essence, the Form 2555 means that the first $91,500 of income (for 2010) that you earned while living overseas as a resident of a foreign country is subtracted back out of your U.S. income in your tax computation.  For U.S. citizens who live abroad and who make the vast majority of their income through their labor but aren’t business tycoons, professional athletes, or investment bankers this may result in their U.S. tax return being a mere formality with no money due.  “So Tyler,” you ask me, “I don’t make over 91 grand and I’m sure that I don’t owe anything, why should I have to expend the time and money that it would take to file?”  I’ll admit it does seem unfair, but I have to warn that if you don’t file, the IRS can make up a return for you, and it won’t be in your favor!

The Pitfalls of Not Filing

• The statute of limitations never runs out!  Except in the case of fraud or tax evasion the IRS can only audit a tax return three years from the date of filing.  If you don’t file, they can go back forever.
• The IRS can make up a return for you that can be totally erroneous or only include information prejudicial to you.  For example, they will include income without the offsetting expenses or capital gains without showing any basis on the sale.
• The IRS is a mean sonofabitch as a debtor and can garnish social security benefits or retirement plan income in order to pay back taxes that you probably wouldn’t even have owed if you only would have filed!

Additional Benefits to Form 2555

The $91,000 is per person, so if you and the spouse each work then both will file the form.  Also, Congress is aware that many U.S. corporations provide housing allowances for expatriate workers (which they then must include in income on their W-2) and so has added an exclusion for housing allowances which is added on top of the extant $91.5K.  The trick is that the IRS determines the maximum amount of the exclusion based upon the cost of living in the area that you live.  If, for example, you live in Japan and your employer sends you to Tokyo then you get an allowance of a whopping $295.62 per day for a total of $107,900 per year.  On the other hand, if you get sent to humble little Gifu than the maximum allowance that you can exclude is $29,200.  The complete table is available on the instructions for the Form 2555 and makes for some fascinating reading; especially if you’re about to get sent to Moscow, Russia, and you want to know how the cost of living compares to your current post in Doha, Qatar.

Form 1116 Plays Robin to the Form 2555’s Batman

If you’re a high roller and you’ve exhausted your exclusion of $91,500 plus potentially up to $107,900 in housing allowance then you might figure that you are going to owe your old Uncle Sam a share of the pot.  Not so fast, if you are a tax resident of a foreign country then it stands to reason that you also owe tax to your host country. This is where Form 1116 comes along.  It basically gives you a dollar for dollar tax credit for taxes paid to foreign governments.  Of course, being the U.S. tax code there has to be about ten thousand restrictions on what you actually get the credit for, so check out the instructions first.

Am I Eligible to File Form 2555?

To be eligible to file Form 2555 you have to clear two hurdles: first, your tax home is in a foreign country and second, you have to either be a bona fide resident of that country or have had a physical presence in a country or countries outside of the United States.  This gets tricky, so stay with me.

Tax Home Is a Foreign Country

Your tax home is the principal country or jurisdiction in which you carry out your business or employment.  It would therefore be logical that you can have only one tax home at any given point in time and, to qualify for Form 2555, this tax home must have been outside of the United States for at least a portion of the tax period you are filing for.

Bona Fide Resident Test

Once you have established that your tax home was a foreign country for at least a portion of the year that you are filing for, then you must move on to see whether you were a bona fide resident or you meet the physical presence test.  As a generality, if you had a single foreign country as your tax home for the entire tax period and you were residing in that country for a permanent or indefinite period of time then you will choose to qualify as a bona fide resident.
Some factors that could be important in establishing yourself as a bona fide resident:

• Type of visa you entered the foreign country with; does it need to be said that a tourism visa may raise some eyebrows?
• Visa limit stay?  See above
• Maintain home in US while living abroad? if so disclose and explain.  This isn’t a deal breaker but it could signal that your intention was less than that of a permanent or indefinite nature.

Once you have established yourself as a bona fide resident than it is assumed that you continue to be a bona fide resident until you establish otherwise.

Physical Presence Test

If you don’t meet the criteria for being a bona fide resident of another country, then you can look to the physical presence test.  To qualify, you must have lived outside the US for at least 330 days of any period of 12 months in a row.  There are lines on the form (line 16) that you will need to fill out showing what countries you were resident in and for what dates.  Generally, the physical presence test will be useful to those who have moved outside of the United States but were not established in their country of bona fide residence as of the first day of the tax year, for those who were outside the U.S. but in multiple jurisdictions, and for those who have a job or vocation that has taken them outside the country but who fail to meet the semi-permanent or indefinite period requirement.  An important point to note is that you don’t have to have met the 330 day requirement by the end of the tax year, but by the filing date, including extensions.  Also, if your period outside the United States extends into subsequent periods then you could be allowed a pro-rated amount of the exclusion.  For example, if you move to England on July 1, 2009 and stay there through July 1, 2011 then you could possible qualify for one half of the amount of the exclusion for 2009, the entire amount for 2010, and one half for 2011.  As you can imagine, it is much more complicated than that and you might find that you don’t qualify for any of the exclusion for any of these periods.  See the instructions to Form 2555 and Publication 54 for details.

Can I Exclude Income from My Investments?

No, Form 2555 only helps for income earned from your employment or from your trade or business while qualifying under the tests above.  If you have paid tax to another government on your foreign investments then you may be able to take a credit for that on your form 1116.

In conclusion, the expatriated American has recently earned increased scrutiny from Congress and the Internal Revenue Service.  For most Americans, however, avoiding unnecessary taxes can be a fairly straightforward matter thanks to the ability to exclude their foreign sourced earned income on Form 2555
Please leave your questions or offer your solutions below. As the WebCPA and the author of WebBizFinance.com, my job is to help you grow your business and solve your business finance and accounting problems!

Tyler Wells, C.P.A.

Crazy about Blogging

Hey guys, I have the honor of having a guest post on FitBlogger’s Guide on taxes for bloggers. Actually, I think the principles apply to almost any online business person. So please take a look and leave a comment!