Here it is folks. Every year Luke Fairfield puts out these excellent letters that detail all the specific tax issues related to our profession for that tax year. So read through it and contact him or his partner Chris if you have any questions.
The stuff to watch out for this year are audits. Like Luke mentioned below, I have heard of more and more audits happening in our industry. The government is looking for any ‘loose change’ and taxes owed, so it pays to get prepared with this stuff. If you do get audited, contact Luke immediately and let him work the problem. I will keep this letter posted in my Taxes For Contractors page up top in the blue bar. –Matt
For all you ex-teams, ex-pats, ex special forces, security contractors and operators out there I hope this letter finds you well. In an attempt to keep you current with your tax filings I am sending out this letter as a year-end reminder that 2012 is almost over. There are some very important changes this year that could impact many of you as it relates to the IRS’s new audit interest in the foreign income exclusion. If you read nothing else, read the section below updating you on this topic. As always feel free to pass this email on to anyone in your situation who could use the help or anyone that I missed on this email. As always, I will do my best to minimize your tax bill and provide relevant advice for your situation.
Important Updates for 2012:
1) Audits on the foreign income exclusion have greatly increased. If you worked for Blackwater in 2009 chances are you were audited. Count yourself lucky if you were not as you are in the minority. If you have not heard of a teammate or fellow employee who has been through an audit I would be surprised. These audits have spread from ex-Blackwater employees to nearly anyone filing for the foreign income exclusion. As a result, I would recommend being more cautious in claiming the Foreign Income Exclusion in 2012. After a year of dealing with these audits, the below points stand out as noteworthy and important.
a.It is EXTREMELY important that you contact me in the event that you receive an audit notice. Do not make contact with the auditor for the same reason that you do not file your own tax return. Leave it to professionals with experience dealing with these situations; the results will almost certainly be better with less risk to you.
b.If you filed for the foreign income exclusion under the bona fide residency method and your location was Iraq or Afghanistan, under audit, the IRS will likely take the position that you were not a bona fide resident for tax purposes and will disallow the claim. A residency VISA from your host country is not enough to qualify. Yes, I am quite aware that everyone around you tells you they file as bona fide residents and have never had a problem. To that I can only ask if you have ever been fishing and if you have, did you catch all the fish?
c.To qualify under IRS audit guidelines you need to prove that you rent or own a dwelling overseas, do not have an abode in the US, pay foreign taxes, do not maintain a US driver’s license and in general do not have a social or economic tie to the US. In my opinion this is nearly impossible to prove and the IRS is taking full advantage of this fact.
d.The 673 Election Form does not qualify you for the foreign income exclusion and does nothing other than block federal tax withholding.
e.Typical penalty on additional tax due under audit is 20%. It has been possible to have that waived in many cases if combat zone work location can be proved.
f.If you are claiming the exclusion under the physical presence test (330 day rule), some IRS offices are now requiring that your “abode” be outside the US to qualify. Unfortunately this term is not defined in the tax code and the IRS is using some very old court case ruling to say that it is where you maintain your social and economic ties. For those of you with family in the US, this can raise an issue.
g.In summary on this topic, if you plan to claim the foreign income exclusion, be aware of the increased risk. You most likely have a 5-10% chance of audit.
2)In a typical audit, you are asked to provide some or all of the following:
a.A letter from your employer stating your work location and job duties for the year.
b.Letter of Authorization from the DOD stating your qualification to work overseas.
c.Copy of your passport to include any visa stamps.
d.A schedule of days outside the US for the period in question.
e.A copy of receipts for expenses claimed as deductions.
f.A copy of your work contract.
g.If claiming bona fide residency, they want to know where you lived, for how long and if it was your intention to remain overseas for a certain period.
3)Based on these audits, I strongly recommend starting an S Corporation for anyone who is an IC getting a 1099. This appears to greatly reduce audit risk. Additionally, if you do not think you could provide the above information or prove your qualification think twice about claiming it as you will most likely incur a 10 – 20% penalty on the additional tax due.
4)Audit results have varied and can depend on who the auditor is which is also frustrating. What one auditor allows is often not enough for another and different IRS offices frequently handle issues in different ways. This increases the important of letting us know when an audit occurs.
5)As a result of the above, I would recommend being more cautious claiming the foreign income exclusion in 2012. A common issue I see is contractors who are injured or stop foreign contracting who are then hit with an audit and no longer have the overseas income to cover any potential tax bill. Yes your tax bill will be higher without this claim however it may be a smaller price to pay than an audit 3 years down the road.
6)Afghanistan Tax. In 2011 AGNA was withholding a tax on income earned in Afghanistan by foreign personnel. With AEGIS taking over part of this contract this practice has continued. This is definitely happening if you are an employee and most of you were paid more to cover this tax but that amount is then subject to US tax as well. This brings up some new issues:
a.Tax paid to a foreign country can be claimed as a credit on your US tax return (Form 1116).
b.The credit can be combined with the foreign income exclusion if you qualify but the foreign tax credit is partially reduced when both are used, making this a complex calculation.
c.In general, claiming the tax credit on foreign tax paid can be a better tax break than the foreign income exclusion alone meaning that if you are nervous about claiming the foreign income exclusion, you can skip it and may still get about 85% of the tax break you would have received by claiming both.
7)Indonesian Tax. Triple Canopy employees in Indonesia present for more than 183 days have a whole new set of issues to be aware of.
a.You are currently having something called “Hypo” or hypothetical tax withheld from your paycheck. This amount will cover your US and Indonesian tax obligation in most cases.
b.TC has provided a description of how your tax obligation to each country will be calculated and handled but it is not easy reading and is complex as it varies by situation.
c.The CPA firm KPMG has been retained to prepare both your Indonesian and US returns. If you plan to use this service, I am happy to look over your returns before they are filed to make sure you received all the benefits available to you. KPMG is a huge worldwide firm who may not be overly familiar with the contract security work profession. Secondly, they will not be as responsive to each of you and your individual questions which concerns me as I have always made a point of getting each of you the answers needed immediately.
Based on the most common questions I was asked last year, let me briefly cover the points most relevant to your situation. The following is a rundown of how your tax situation differs from someone working in the states.
1)Generally you will receive the first $95,100 (for 2012) of your income earned in a foreign country tax free provided that:
a.You were physically present in a country other than the U.S. for at least 330 days out of a 365 day period. This does not have to have been completely in the 2012 calendar year as a prorated partial exclusion can be obtained by extending your tax return until the 330 day period is up. You will still only file using the 2012 calendar year income but your test period for the physical presence test may run from June 2011 – June 2012 or any other dates spanning 365 days. What this does NOT mean is that you can have less than 330 days overseas out of a 365 day period and still take a prorated exclusion. This is a persistent myth and is absolutely not true.
b.You were a bona fide resident of a country other than the U.S. during 2012. Many of you have received residency Visas from Iraq this year. This is not enough proof to prove bona fide residency per the IRS. Filing under this method requires that you are a foreign resident for the full year starting Jan 1. No partial year exclusion is available. Based on the current audit situation, using this method has become more risky than in the past.
2)Filing Form 673… all that filing this form will do is exempt you from tax withholding; contrary to rumor it is NOT required to claim NOR does it qualify you to claim the foreign income exclusion. Additionally, some companies now add the cost of travel, incidentals, meals, reimbursements, etc. to the taxable income of employees filing Form 673. This causes you to be taxed on income that you never received. The best alternative to regulate tax withholdings is to file a Form W4 with your payroll department and claim a large number of allowances on line 5. Generally between 9 and 15 allowances will have enough withheld to cover your tax bill but you can also write in “exempt” or claim up to 99 allowances to drop withholding to close to zero if you do not expect to owe any tax.
3)Keep a list of job related expenses – these are deductions for you. This can include travel, meals, weapons, supplies, body armor, computer, auto, telephone, postage, etc. A simple spreadsheet with yearly totals is the best way to provide this to me. Please do not send receipts; I can provide a very simple spreadsheet template for you to record your eligible expenses. See #4 below for a caution if you are an employee.
4)Expenses…many of you may have changed from working as an IC to an IE or vice versa. There is a vast difference in what can be deducted. As an IC (you receive a 1099), all expenses related to your work are deductible. As an IE (you receive a W2), only expenses required by your employer but not reimbursed are allowed as deductions and under audit the IRS will require a letter from your company detailing this. Needless to say, this is impossible to obtain from many of the companies. You can continue to deduct work related expenses as an IE but be aware that deducting too much can quickly put you on the radar.
5)You are generally eligible for an additional extension of time to file and pay your taxes. You have 180 days from the time you return to the states to file any missing tax returns without penalty if you were in a combat zone. That being said, file on time if you can; it keeps you off of the IRS radar.
6)If possible, get an address in a tax free state and use this as your U.S. address. This may save you some money on your state taxes. Tax free states are TX, FL, AK, NV, WA, SD, WY and TN. This will not work if you have a house and family in another state. CA, AL, PA and HI are the worst as they do not allow the foreign income exclusion; pay attention if you live here but have the option to claim residency in another state.
7)I am getting a lot of questions about starting S-corps and LLCs for those of you working as ICs. This is a good move in most cases as properly structured it allows you a savings on what you would otherwise pay in self-employment tax
8)Lastly, what will I need from you? Every situation varies but in general I will need W-2s, 1099s, amount added to income due to the 673, list of work related expenses, foreign address and city you worked out of and any other tax documents you receive relating to home mortgages, property taxes, investments and other income.
Now for Academi, MVM, SOC and other ICs working for companies paying you as an independent contractor (1099): Do not forget that the IRS will take 15% right off the top of your net income as self-employment tax. You will also pay regular income tax on the earnings. In addition, the foreign income exclusion of $95,100 does not apply to the self-employment tax calculation even though you will get the exclusion in the calculation of income tax. This can result in a very large, very surprising tax bill. Be aware of this and plan accordingly when saving for taxes.
* For 2012, I am continuing to bill through ACH Withdrawal. I will ask you to provide me with your bank account number and routing number (which many of you do already for refund purposes). Once you approve the invoice, I will have the bank auto draft your account for the fee. This has greatly simplified invoicing for me and hopefully you as well. More importantly it gives me more time to focus on tax issues rather than tracking collections. Of course if you would still like to pay by check or PayPal, just let me know as that is fine as well.
** Secondly, in an attempt to be more efficient and environmentally friendly we are switching to a paperless system to provide you copies of your tax return. This will be in the form of a password protected PDF which will be emailed to you. We will no longer send out paper copies unless it is requested or needed. Payment coupons for tax due and a mailing envelope will still be provided to keep the process easy for you.
*** Thank you all for the countless referrals each and every year. It allows me to keep my prices low for you. It can be difficult to get correct tax advice and tax preparation when working overseas as there is a lot of misinformation, confusion and lack of knowledge concerning your situation. Referrals let me know I am doing a good job for you. Due to work overload, I have been passing some new referrals to Chris Hughes, who is a partner CPA in my office with the same knowledge concerning your situation that I have. I would love to continue working with all new referrals but it will take away from the service level I want to provide to current clients. Working with Chris will be virtually the same as working directly with me. Continue to refer anyone needing help directly to me and I will redirect them as needed based on my workload.
**** Chris and I recently moved into new office space in San Diego and established a new name for our growing firm: “Fairfield Hughes, CPAs, An Accountancy Corporation”. Additionally, we are constructing a website for our clients to access the latest tax information for expats and security contractors. The website will include a section with answers to frequently asked questions. We hope you find it to be an excellent resource. We expect the website to be completed by late January, 2013.
Happy New Year! I look forward to hearing from each of you. Stay safe.
Luke M. Fairfield
Certified Public Accountant