          
          
          
          
              The $70,000 -- and More -- Offshore Loophole: 
                    Tax Planning For Foreign Employment
          
               If you're a typical cash-poor American, you could
          increase your standard of living dramatically if you
          could avoid throwing away 40% or more of your income on
          taxes each year. Thousands of Americans are doing that
          right now, and many more can. It's one of the clearest
          provisions in the tax code. In 1989, a congressman who
          visited Americans living in Europe told them that if
          the average American knew about this tax loophole,
          Congress would have to repeal it. As you will learn in
          this chapter, the loophole actually is broader, and
          allows you to earn far more tax-free income, than even
          most expatriates realize.
               The loophole is known as the foreign-earned-
          income-exclusion or the "$70,000 exclusion." It allows
          for U.S. citizens who live and work outside the U.S. to
          exclude from gross income up to $70,000 of foreign-
          earned income. In addition, an employer-provided
          housing allowance can be excluded from income. There
          are other tax breaks available: Each member of a
          married couple working overseas, for example, can
          exclude salary of up to $70,000. That's a total of
          $140,000, plus housing allowances.
               It is important to note that this is not a
          deduction, credit, or deferral. It is an outright
          exclusion of the income from gross income.
               Naturally, to get these benefits you have to meet
          certain requirements:

               * You must establish a tax home in a foreign
          country.
               * You must pass either the "foreign-residence
          test" or the "physical-presence test."
               * You must have earned income.

               In the rest of this chapter, we'll discuss these
          tests and give some tips on maximizing tax-free income.
          

          Home is where the money is 

               In the IRS view of the world, your tax home is the
          location of your regular or principal place of
          business. That is, the tax home is where you work, not
          where you live.
               Take a look at what happened recently to one
          taxpayer who did not check the rules carefully. He is a
          flight engineer who lives in the Bahamas, but all his
          flights originate from Kennedy Airport in New York. The
          Tax Court ruled, not surprisingly, that his tax home is
          in New York, not in the Bahamas. The flight engineer
          does not qualify for the $70,000 exclusion.
               But the definition goes further for the foreign-
          earned-income exclusion. This is a trap that catches
          many Americans overseas who think they are earning tax
          free income. If you work overseas and maintain a place
          of residence in the United States, your tax home is not
          outside the U.S. In other words, to qualify for the
          foreign-earned-income exclusion you have to establish
          both your principal place of business and your
          residence outside the United States.
               This trap catches a number of construction and oil
          workers. These workers generally work on a construction
          site or oil platform for three to six months. They get
          a few weeks or months off. Many of them make the
          mistake of leaving their family and personal
          possessions at their U.S. home and visiting this home
          during their vacations. They cant use the offshore
          loophole because they never establish a tax home
          outside the United States. They maintained a place of
          residence in the United States. You need to sell or
          rent your U.S. home and establish a primary residence
          outside the United States.
               After establishing your tax home, you must pass
          one of two additional tests.  

          
          Counting the days

               The more straightforward test is the physical
          presence test. To pass the test, you must be outside of
          the United States for 330 days out of any 12
          consecutive months. The days, of course, do not have to
          be consecutive. That sounds very simple, but there are
          a number of smaller rules that can complicate it. Few
          people begin their foreign assignments on Jan. 1 and
          end them on Dec. 31. Thus for most people, the first
          and last 12 months of their overseas stay will occupy
          two tax years. This requires them to prorate their
          income and the $70,000 exclusion for those tax years.
               In addition, to count a day as one spent outside
          of the United States, you must be out of the United
          States for the entire day. There are exceptions for
          traveling days and days spent flying over the United
          States if the flight did not originate there. The IRS
          has a number of rules on counting days.  
               If you are going to travel back and forth between
          the United States and foreign countries and if you want
          to try to pass this test, you'll have to learn the
          rules and count days very carefully.

          
          An easier way?

               The subjective test, known as the foreign-
          residence test, is probably easier for most taxpayers
          to pass. You must establish yourself as a bona fide
          resident of a foreign country or countries for an
          uninterrupted period that includes an entire taxable
          year, and you must intend to stay there indefinitely.
          If you do not pass this test, you are considered by the
          IRS a transient, or sojourner, instead of a foreign
          resident, and will not qualify as a foreign resident.
               According to the tax law, your residence is a
          state of mind. It is where you intend to be domiciled
          indefinitely. To determine your state of mind, the IRS
          looks at the degree of your attachment to the country
          in question. A number of factors, none of them decisive
          or significantly more important than the others, are
          examined. The bottom line is that you establish
          yourself as a member of a foreign community. The
          factors include the following:
               Sleeping quarters: A transient is more likely to
          sleep in a hotel; a resident likely owns housing or
          signs at least a year-long lease.
               Personal belongings: The more you take to the
          foreign country, the more you seem to be establishing a
          foreign residence. Leaving most of your personal
          belongings in temporary storage in the United States
          indicates an intention to keep that country as your
          residence.
               U.S. property: Owning a U.S. residence that you
          leave vacant is a sign of an intention not to establish
          a foreign residence. But selling or renting your U.S.
          residence indicates an intention to establish a foreign
          residence.
               Local documents: It is helpful to obtain a foreign
          drivers license and foreign voter registration when
          possible. But maintaining your U.S. license and voter
          registration won't kill your chances.
               Local involvement: You should show involvement in
          local social and community activities to the same
          extent you were involved in such activities in the
          United States It is also helpful to let U.S. club
          memberships lapse while you are overseas, or to join
          similar clubs overseas.  If you want to keep U. S.
          memberships in clubs that are hard to rejoin, see if
          you can convert them to a non-resident membership for
          the duration.  (You may save on dues as well.)
               Foreign taxes: Foreign countries tax on the basis
          of residence. If you claim exemption from local taxes
          because you are not resident in that country, the IRS
          will conclude that you are a U.S. resident and do not
          qualify for the foreign-earned-income exclusion under
          the foreign-residence test. Thus some people prefer to
          qualify under the physical-presence test rather than
          under the foreign residence test. With the physical-
          presence test, you might be able to claim that you are
          not a resident of the foreign country and thereby
          exempt from their taxes. At the same time, you can
          claim exemption from U.S. taxes.
               Bank accounts: This does not seem to greatly
          affect residence status. But if your case seems to be
          borderline, it is a good idea to open at least a local
          checking account even if a U.S. account is maintained.
          Many U.S. expatriates maintain U.S. accounts because it
          is easier to have their U.S. employers deposit
          paychecks directly in the U.S. account.
               Permanent address: You will occasionally complete
          documents, such as passport applications, that ask for
          a permanent address. It is best to list a foreign
          address or some address of convenience, such as a
          friend's or relative's, from which your mail can be
          forwarded.
               Once your foreign residence is established, you
          must show that it is for an indefinite duration. If you
          have plans to return to the United States after a
          definite time has passed, you are not a foreign
          resident. In deciding whether or not the foreign
          residence is indefinite, the IRS generally looks at
          your employment contract. (Note that it is permissible
          to have a vague intention to return to the U.S.
          someday. But if you have in mind a definite limit to
          your foreign stay, you will have problems establishing
          that you are a foreign resident.)
               Generally, if your employment contract lasts for
          one year or less, that is an indication that you have a
          definite intent to return to the United States after a
          short period of time. You would not be able to qualify
          as a foreign resident. But if the contract is
          indefinite, open-ended, can be renewed, or is likely to
          lead to a new job, you probably can qualify as a
          foreign resident. It is best to have a contract that
          does not pertain to a definite project. If there is no
          written contract, the IRS will examine the nature of
          the job, the employer's personnel manual, and any other
          facts that indicate the intentions of you and your
          employer.
               After establishing the residence, you can make
          occasional trips to the United States for business or
          vacations without losing your foreign-residence status.
          Just be certain that the trips are temporary, and that
          you do not disturb any of the factors that qualify you
          as a foreign resident.

          
          Which income to exclude

               Once you have qualified for the offshore loophole,
          you must identify the kind of income that qualifies.
          Not all income qualifies for the exclusion -- only
          foreign-earned income.
               Foreign-earned income is income paid for services
          you have performed in a foreign country. This includes
          salaries, professional fees, tips, and similar
          compensation. Interest, dividends, and capital gains do
          not qualify.
               Self-employed people must adhere to some
          additional rules. Professionals who do not make
          material use of capital in performing their services
          can qualify all of their net income for the loophole.
          But when both personal services and capital are used to
          generate income, no more than 30% of net profits will
          be considered eligible for the exclusion. Note that for
          self-employed individuals and for partners, the net
          income is the amount that is applied toward the
          exclusion limit, not the gross income.
               Other types of income that do not qualify for the
          loophole include the following: employer-provided meals
          and lodging on the business premises, pension and
          annuity payments, income paid to employees of the U.S.
          government or its agencies, non-qualified deferred
          compensation, disallowed moving expense reimbursements,
          income received two years or more after you earn it.
          But some of these paymentssuch as employer-provided
          meals and lodging on the business premisesare tax-free
          under regular U.S. tax rules and retain that status.
          This is one way you can earn more than $70,000 tax-
          free.
               The $70,000 limit on the offshore loophole applies
          to individual taxpayers. So if you are married, you and
          your spouse potentially can exclude up to $140,000 of
          foreign-earned income. But you cannot share each
          others limit. For example, if one of you earns $80,000
          and the other earns $30,000, you exclude only $100,000
          on the return ($70,000 plus $30,000).

          
          Don't close the loophole

               Too many U.S. expatriates inadvertently close the
          offshore loophole. There are several ways of doing
          this.
               One way is not to realize that the provision has
          requirements that must be met. Many Americans assume
          that since they are living overseas, everything they do
          is free from U.S. tax. That's not so. You've seen some
          examples of that in this article already, and there are
          other regulations for taxpayers in different
          situations. Special situations include not being
          overseas for the full year and receiving advance or
          deferred payments of income, bonuses, and other special
          income items. It is well worth your while to discuss
          the matter with a tax attorney or accountant who
          understands the offshore loophole. Go over your
          situation and your plans in detail before leaving the
          United States. That way, you'll be sure to qualify for
          and make maximum use of this loophole.
               Another way people close this loophole is by not
          filing tax returns. To get the exemption, you must file
          a tax return and claim the exemption on Form 2555. The
          IRS has had success in recent years contending that
          anyone who does not file the return loses the loophole,
          even if he meets all the requirements. Be sure you file
          the return and properly claim the loophole. The
          loophole exempts your foreign-earned income from tax,
          but it does not exempt you from the filing requirement.
               Recent tax laws, plus some heavy criticism from
          the General Accounting Office, have caused the IRS to
          increase its monitoring of U.S. citizens overseas. The
          IRS now reviews passport applications and renewals to
          ensure that you not receive or renew a passport unless
          your tax returns are filed and paid up. The IRS is also
          looking for expatriate Americans and informing them of
          their tax obligations. It is estimated that about two-
          thirds of expatriate Americans are not filing any U.S.
          tax returns, and the IRS aims to change that. Be sure
          to file your tax returns.

          
          Tax credit option

               Instead of excluding income from taxes, you can
          take a deduction for foreign taxes paid on the income.
          But the foreign tax credit can get complicated, and in
          almost all cases, you'll find that it makes more sense
          to exclude income than it does to take the credit. But
          if your foreign-earned income exceeds the $70,000
          limit, look into taking the credit for taxes paid on
          the income that exceeds the exclusion amount.

          
          Beware those other taxes

               The disappointing part of the $70,000 exclusion is
          that it applies only to federal income taxes. The
          Social Security tax might still apply to salaried
          employees, and the self-employment tax might still
          apply to self-employed individuals. The self-employed,
          for example, still figure their net self-employment
          income on Schedule C. The net income up to $70,000
          still is excluded from gross income. But it also is
          used on Schedule SE to compute the self-employment tax.
          For salaried workers with U.S.-based employers, the
          employer is supposed to withhold Social Security taxes.
          Possible exemptions are discussed later in this
          chapter.

          
          Expanding the loophole -- exempt more than $70,000

               The $70,000 offshore loophole is generous, but
          savvy taxpayers know how to make it even more generous. 
          In many situations, you can exclude or deduct foreign
          housing costs.  You have an option here. You can
          deduct your housing costs to the extent that they
          exceed a base amount. Or if your employer reimburses
          you for the excess, the reimbursement can be excluded
          from income.
               To get the write-off or exclusion, you must meet
          the same tests as for the foreign-earned income
          exclusion. That means either establishing a foreign
          residence or meeting the physical-presence, test as
          well as establishing a foreign tax home.  
               The all-important base housing amount is 16% of
          the salary of a federal government employee with the
          grade of GS-14, Level 1. You use the salary that was
          effective on Jan. 1 of the year you became eligible for
          the housing loophole. If you are not eligible for the
          loophole for the entire year, the base amount must be
          prorated, just as the income exclusion is prorated in
          that situation.
               When your employer pays or reimburses you for
          qualified housing expenses, you can exclude from income
          the amount of the employers payments that exceed the
          base housing amount. The employer's payments that
          qualify can be made in any of the following forms: part
          of your salary; reimbursements for housing, the
          education of your dependents, or tax equalization, or
          employer-provided meals and lodging that are not
          excluded from income under the regular tax rules. Any
          of these kinds of expenditures also qualify for the
          exclusion if they are made directly to a third party
          instead of to you.
               If you and your employer agree that a part of the
          payments received is for housing, but you have no firm
          agreement as to how much is for salary and how much is
          for housing, you still get to use the housing
          exclusion. The excludable amount is your actual housing
          costs minus the base housing amount.
               The exclusion cannot exceed either your foreign-
          earned income or the employer-provided payments for
          housing expenses. In addition, the exclusion for
          housing expenses is applied before the foreign-earned-
          income exclusion. The effect of this is to make it
          harder to excluded housing expenses against non-earned
          income, such as dividends and interest.
               Suppose you are self-employed, or suppose your
          employer does not provide payment or reimbursement for
          housing expenses. In these cases, instead of excluding
          the amount from income, you can take a deduction for
          the excess housing expenses if you meet the same
          eligibility rules as for the exclusion. The deduction
          is computed the same way as the exclusion. You subtract
          the base amount from your total qualified housing
          expenses, and then you subtract any employer-provided
          payments for housing expenses. Whatever is left over is
          your deduction.
               The deduction cannot be more than the difference
          between your foreign-earned income and the combination
          of the foreign-earned-income limitation ($70,000) and
          any exclusion you take for housing expenses. In other
          words, your foreign-earned income must be above the
          exclusion limit of $70,000 in order for you to take the
          deduction. If you cannot deduct the expenses, you might
          be able to deduct some of them the following year if
          your foreign-earned income exceeds the limit. Consult
          your tax advisor to see if you qualify.

          
          A few limits

               The exclusion or deduction for housing expenses
          applies only to reasonable housing expenses. The IRS
          gives no clear-cut definition of reasonable. Most tax
          advisors say that if your foreign housing is of the
          same standard that you were used to in the United
          States, it should be considered reasonable.
               The following types of expenses qualify for this
          loophole:

               * Rent
               * Fair rental value of employer-provided housing
               * Utilities, except telephones
               * Insurance on real and personal property
               * Occupancy taxes that are not normally deductible
          under U.S. tax law
               * Non refundable lease fees
               * Rent for furniture and accessories
               * Repairs
               * Parking fees

               The following types of expenses do not qualify for
          this loophole:

               * Capital expenditures, such the costs of
          purchasing, constructing, or improving a home
               * Purchase cost of furniture and accessories
               * Domestic labor
               * Mortgage-principal payments
               * Depreciation
               * Interest and taxes that normally are deductible
               * Deductible moving expenses
               * Pay-television subscriptions

          
          The second overseas home loophole

               A few taxpayers are able to exclude or deduct the
          expenses of two homes outside the United States.
               To do this, you must show that the location of
          your tax home, or principal residence, is subject to
          adverse living conditions. That is, the living
          conditions must be "dangerous, unhealthful, or
          otherwise adverse." If the location of your tax home is
          in a state of war or civil insurrection, you are living
          in adverse conditions. A different kind of adverse
          condition is when the employer's business premises are
          a drilling rig, construction project, or similar
          operation; the taxpayer lives there; and it is not
          feasible for the taxpayer's family to reside there. In
          this case, a second overseas home can be established
          for the family, and the expenses qualify for the
          exclusion.
               If you think you might qualify for one of these
          exclusions, consult a tax advisor. There have been
          numerous regulations, cases, and rulings in regard to
          these matters. The tax advisor should be able to make
          sure you meet the requirements for maximum tax
          benefits.
               Like the foreign-earned-income exclusion, the
          allowance for housing expenses is determined separately
          for spouses.

          
          The Social Security offshore loophole

               Not many people know this but the U.S. has
          agreements that exempt overseas workers from either the
          U.S. Social Security tax or that of the adopted nation.
               Most developed countries have some form of social
          security tax. The problem for many U.S. expatriates in
          the past was that many foreign social security taxes
          are far broader and have far higher rates than does the
          U.S. Social Security tax. In some countries, it is
          equivalent to our income tax, with rates above 30%.
               The agreements, known as totalization agreements,
          dictate that U.S. citizens who are temporarily working
          overseas are subject only to the U.S. Social Security
          tax and are exempt from the host countrys tax. The
          United States has signed such agreements with 12
          countries so far: Belgium, Canada, France, Germany,
          Italy, the Netherlands, Norway, Portugal, Spain,
          Sweden, Switzerland, and the United Kingdom. A much
          larger number of countries will exempt you from paying
          the local social security tax, without a treaty,
          provided you present both proof that your employment is
          temporary, and that you are covered by U.S. social
          security. 
               To be exempt from the host country's tax, you must
          qualify as a "detached worker." A detached worker is
          one whose assignment in the host country is expected to
          last five years or less. The wording differs somewhat
          in each treaty, so be sure to have that checked out
          before accepting a foreign assignment. If you are not a
          detached worker, you are exempt from U.S. Social
          Security tax and are subject to the host country's tax.
          The treaties also work for self-employed individuals.
          Many U.S. employers who send their employees overseas
          do not even know about these treaties; this ignorance
          prevents employees from minimizing taxes on their
          foreign assignments.
               To qualify for the exemption, you must obtain a
          certificate from the U.S. Social Security
          Administration before the foreign assignment. You can
          apply for a certificate and get other information about
          these agreements by contacting the Social Security
          Administration, Office of International Policy, P.O.
          Box 17741, Baltimore, MD 21235. Pamphlets about
          agreements with individual countries are available from
          the same address.
          
          
          The Puerto Rico Loophole

               Some U.S. citizens find tax benefits by
          establishing residence in Puerto Rico. Since Puerto
          Rico is a commonwealth of the United States and has a
          similar tax system, the United States exempts income
          earned in Puerto Rico if you establish a bona fide
          residence there.  
               A residence is established as in the case of the
          foreign-earned-income exclusion: You must establish a
          permanent attachment to Puerto Rico and demonstrate an
          intent to stay there indefinitely, but in addition
          Puerto Rico requires that the residence be for the
          entire calendar year in question.
               If you qualify, under Section 933 of the tax code
          you can exclude from U.S. income tax all income derived
          from sources within Puerto Rico.  (Note that this
          exemption is all Puerto Rican-source income, not just
          earned income.)  But this exclusion will prevent you
          from taking otherwise allowable deductions on your U.S.
          income tax for the income earned in Puerto Rico. Also,
          interest paid by Puerto Rican branches of U.S. banks
          does not qualify as Puerto Rican income.
               You should check out the Puerto Rican tax
          situation before trying to qualify for this provision.
          You will be subject to Puerto Rican taxes, and Puerto
          Rico is not a tax haven. You might, in fact, find the
          country a tax liability, as its rates are now generally
          higher than in the U.S.
               The one particularly interesting exception,
          however, is that dividends paid from a Puerto Rican
          company that has a tax holiday (such as the ten year
          exemption granted to new factories) is free of Puerto
          Rican tax.  One U. S. couple owned a small
          manufacturing business in Puerto Rico.  In the tenth
          year, they sold the business, but not the corporation,
          and paid a liquidating dividend from the corporation. 
          Just before the tenth year, they established residence
          in Puerto Rico, and maintained it for the entire
          calendar year in which the liquidating dividend was
          paid.  Total exemption from tax on the final payout!.

          
          The State and Local Tax Loophole

               The United States government taxes all its
          citizens, wherever they live in the world. Most foreign
          countries tax only their residents or domiciliaries. If
          a British citizen moves to the Cayman Islands and
          establishes residence there, he is not subject to
          British taxes.
               States in the United States tax the way foreign
          countries dobased on residence. Therefore, when you
          establish a residence outside the United States, you
          avoid its state and local income taxes. For residents
          of high-tax states, this is not a minor consideration.
          Around one-third of some people's U.S. tax bill is made
          up of state and local taxes. Take this into account
          when deciding whether or not to take advantage of the
          offshore loophole. But states have a broader definition
          of residence. Some states require you to sever all
          contacts in order to cease residency.

          
          The Foreign Tax Loophole

               U.S. taxes are only part of the picture. Unless
          you move to a no-tax haven, you must examine the tax
          code of the host country to determine your tax
          obligations there.
               Again, most countries tax on the basis of
          residence or domicile. The rules vary from country to
          country, but usually someone who has established a
          place of abode in a country for more than six months is
          a resident or domicile. This often means that you can
          be considered a resident of two countries at the same
          time and can be subject to taxes in both countries. Or
          you can be considered a resident of no country.
               Different degrees of residence are taxed
          differently. For example, the United Kingdom uses the
          terms "domiciled" and "ordinarily resident", along with
          "resident." Someone who is domiciled in the United
          Kingdom is taxed in the United Kingdom on all worldwide
          income. Someone who is ordinarily resident or resident,
          but not domiciled, might be taxed only on the income
          derived from U.K. sources.  The rule is similar in
          Ireland, and a lot of countries whose tax laws derived
          from the United Kingdom.
               We cannot survey the rules of all countries,
          though some are profiled in this report, but you should
          be aware of this potential problem and consider it
          before deciding to take advantage of the offshore
          loophole. You might find ways to eliminate taxes from
          both the United States and the foreign country in
          question, or you might find ways to drastically limit
          the overall tax bite.
               Another consideration is the double-tax
          convention, or tax treaty. The United States has tax
          treaties with about two dozen major countries. The
          intent of the treaties is to ensure that individuals
          and businesses are not fully taxed by two countries on
          the same income. But in many cases, the treaty can
          offer a more substantial advantage than that by
          reducing the total tax bill from what it would have
          been had only one country-in absence of a treaty-had
          taxed the income. Your tax advisor should check any
          treaty before you make a decision about the offshore
          loophole. See the chapter on tax treaties for more
          detail.

          
          The Home Sale Loophole

               If you want to qualify as a foreign resident,
          selling or renting your home is recommended. But
          selling the home is not always required, and many
          expatriates retain their U.S. homes because they plan
          to return someday. Expatriates who sell their homes
          after returning, however, could have some problems.
               Take a look at one IRS ruling: A taxpayer
          purchased a house in Washington, D.C., in 1969 and used
          it as a personal residence. He was transferred out of
          the United States in 1982 and had someone house-sit
          until he returned to the United States in 1986. He sold
          the home in 1987 and moved to New York City. He planned
          to exclude from gross income $125,000 of the gain on
          the sale, since he was over age 55.
               But there was a problem. The tax law requires that
          you own the home and use it as your principal residence
          for at least three out of the five years that
          immediately precede the sale. Since the taxpayer was
          out of the country for most of that period, the house
          did not qualify as the principal residence, and he
          could not exclude the gain (Letter Ruling 8825021).
               He could have avoided the problem by staying in
          the D.C. home for at least another two years, or he
          could have deferred the gain by purchasing a new home
          in New York City. He chose to rent an apartment. He
          could have sold the home before leaving the country,
          deferred the gain by rolling the sale proceeds into a
          home in the foreign country, and then tried to qualify
          gain on the sale of that home for the $125,000
          exclusion when his foreign assignment ended. But he did
          not properly plan for his foreign assignment, and he
          lost the tax benefit.
               A similar problem occurs when people sell their
          U.S. homes before taking an overseas assignment. To
          defer the gain, you normally need to buy a new home
          within two years.  Civilians have 4 years if overseas
          and military members have 4 years (stateside or
          overseas).  This replacement period is suspended while
          military members are stationed outside the United
          States.  Note however, that the replacement period,
          plus any period of suspension, cannot last more than 8
          years after the sale of the home.  So if you are gone
          more than four years and do not purchase a foreign
          residence, the gain is not deferred. You can defer gain
          by purchasing a foreign residence, since there is no
          requirement that the replacement residence be located
          in the United States.
          
          
          
          
