Robert Atkins Walker PC, CPA, PhD

Residents of continuing care retirement communities (CCRCs) may take a medical expense deduction for a significant portion of both their entrance fee and monthly fees.  For the entrance fee, this usually results in a large medical expense deduction in the year the fee is paid.  In the first part of the article, we track the history of the CCRC medical expense deduction and examine its tax effects on residents of independent living, assisted living, and nursing care units.

Many CCRCs agree to refund a portion or all of the entrance fee without interest when the resident moves out or dies.  In the second part of the article, we examine two potentially significant tax effects of a guaranteed refund.  First, the refund may be subject to the below-market-rate loan rules and as such may produce imputed interest income for the resident and interest expense for the CCRC.   Second, the refund may reduce the deductible amount of the medical portion of the entrance fee.

Finally, CCRCs are responsible for accurately informing their residents as to the deductible medical portion of the fees.  The computational methods used in practice – the expense category method and the actuarial method – are often inconsistently or illogically applied, resulting in advice that shortchanges the residents and is open to IRS challenge.  In the third part of the article, we critique the two methods and recommend that CCRCs use the expense category method to determine the deductible portion of the monthly fees and the actuarial method for entrance fees.

See full article.

Employees who have been misclassified as self-employed independent contractors need to know how to correct the misclassification and how to avoid paying excessive taxes. This paper focuses on four issues: (1) how misclassified workers may avoid paying any self-employment tax, (2) how they possibly may avoid paying the employee’s half of FICA tax as well, (3) how they may secure reclassification as employees through the help of the IRS, and (4) how they may have their earnings record updated to obtain maximum Social Security benefits after retirement despite paying neither self-employment nor FICA tax on the misclassified earnings. Recommendations are based on recent case law and administrative pronouncements. See full research article.

Yes, if you work outside of the US occasionally. You may treat the proportionate income you earn during your work days in foreign countries as foreign-sourced income for purposes of the foreign tax credit.

Although there is no definition of the type of income to include in gross income on the foreign tax credit form in the Internal Revenue Code (IRC) sections 901 through 905 dealing with the foreign tax credit, the 2008 instructions for Form 1116, Foreign Tax Credit, on page 13, column 1, under the heading, Lines 1a and 1b — Foreign Gross Income, say, “You must include income even if it is not taxable by that foreign country. Identify the type of income on the dotted line next to line 1a. Do not include any earned income excluded on Form 2555.” It refers to earned income, and, since you have not excluded that earned income on Form 2555, it needs to be included on the gross income line of Form 1116.

Instead, the income-sourcing rules are found in IRC sections 861 through 865. They support reporting your foreign earned income on Form 1116. IRC section 862(a)(3) states that gross income from “compensation for labor or personal services performed without the United States” is foreign-sourced income. Treasury Regulation section 1.861-4(a)(1) says that the residence of the recipient, the place of contracting, and the time and place of payment are irrelevant. This regulation deals with US-sourced earned income, though. There is no similar regulation with respect to foreign-sourced earned income. But in the absence of specific guidance or anything to the contrary, I believe you may safely rely on IRC section 862(a)(3) to report your foreign work days yielding foreign-sourced earned income on the foreign tax credit form and to take advantage of your unused foreign tax credit carryovers.

Note: The instructions for calculating the foreign earned income exclusion (Form 2555 and IRS Publication 54) state that you cannot include foreign earned income in the calculation unless your tax home is outside of the US. There is no reference that the foreign-tax-home restriction applies to the foreign tax credit. This restricted definition of foreign earned income is only for the purpose of calculating the foreign earned income exclusion. See Internal Revenue Code section 911 (the section that allows the foreign earned income exclusion), subsection (a)(1), which states, “Definition. For purposes of this section — (A) In general. The term “foreign earned income” …” It goes on to cite the foreign tax home restriction referenced in Publication 54. Therefore I conclude the foreign tax home restriction does not proscribe including foreign-sourced gross earned income on Form 1116 for computing the foreign tax credit.

1. Social Security Taxes (FICA/Medicare)

All H visa holders are subject to social security taxes per Internal Revenue Code § 3121. The only visa types exempted from social security taxes are nonresident aliens temporarily in the US under an F, J, M, or Q visa (IRC § 3121(b)(19) and Rev. Rul. 92-106, situation 3 (1992-2 C.B. 258)). Note: There is one minor exception as if you cared. H visa holders who are residents of the Philippines performing services in Guam are exempt from social security taxes (IRC § 3121(b)(18)).

Their employers are also subject to paying their half of social security taxes per IRC §§ 3111(a) and (b) and 3301.

No refunds are available to either employers or employees, but the employees can eventually draw social security benefits if they have paid in for the requisite quarters of coverage (40). Note that a quarter of coverage is defined as earnings of $920. So, for example, earnings of $3,680 ($920 x 4) in January 2005 would yield four quarters of coverage for the year.

2. Federal Unemployment Taxes (FUTA)

All employers of H visa holders are subject to Federal unemployment taxes per IRC §§ 3111(a) and (b), 3301 and 3306. The only visa types that are exempted from unemployment taxes are nonresident aliens temporarily in the US under an F, J, M, or Q visa (§ 3306(c)(19) and Rev. Rul. 92-106, situation 3 (1992-2 C.B. 258)).

3. Federal Withholding Taxes

The wages paid to nonresident aliens including those under H-2B visas for services performed in the US are considered effectively connected with the conduct of a trade or business in the US. Therefore the wages are subject to graduated tax withholding rates under IRC § 871(b) and to income tax withholding under § 3402(a).

There is an exception under § 864(b) which applies if the services are performed for a nonresident alien individual or a foreign corporation by a nonresident alien individual temporarily in the US for 90 days or less during the tax year and whose compensation is $3,000 or less.

See also Rev. Rul. 92-106 (1992-2 C.B. 258), titled Withholding of Income, FICA and FUTA Taxes, and IRS Publication 515, titled Withholding of Tax on Nonresident Aliens and Foreign Entities, which explain things in more detail.

4. US Tax Return Filing Status – which form to file: 1040 or 1040NR?

H visa holders are treated as Resident Aliens for income tax purposes and must file Form 1040 if they are physically present in the US on at least 183 days during the 3-year period including the current tax year and the two preceding tax years, aka the Substantial Presence Test. For the 183 day requirement, days are counted by counting all days of presence in the current tax year plus 1/3 of the days of presence in the first preceding tax year plus 1/6 of the days of presence in the second preceding tax year.

If their physical presence in the US is less than the 183-day requirement, they are treated as Nonresident Aliens for income tax purposes and must file Form 1040NR.

Most H-2B visa holders will be better off filing a regular 1040. If for some reason like not wanting to have to include their non-US-sourced income on their 1040, they could avail themselves of the Closer Connection exception to the Substantial Presence Test by filling out Form 8840, Closer Connection Exception Statement for Aliens. On this form they answer a number of questions about the location of their property, social and family ties, income sources, etc. If their position is reasonable that they are more closely connected to their homeland rather than the US, they can file using Form 1040NR with the Form 8840 attached. The IRS will ultimately decide.

If an H-2B visa holder is married, I recommend filing the 1040 return under the Married Filing Jointly status and attaching a properly filled out W-7 for the wife along with the requisite copies of documents such as a certified copy of her passport. If the tax return is filed with the W-7 attached, it must be filed with ITIN Operations, Austin. The specific address is in the W-7 instructions.

The W-7 requires the wife’s signature and proof of her information such as a certified copy of her passport or other documents as specified in the instructions for the W-7. This could be a hassle for the H-2B holder to get this, but it could save the couple a lot of tax. The same is true for the H-2B holder’s children. W-7s and the required documents would need to be attached for them, although the father could sign for them as their delegate if they are under age 14.

Note, however, that in order to file jointly, the visa holder will have to choose to treat his nonresident wife as a U.S. resident. This means that the visa holder and his wife will be treated as U.S. residents for the entire year in the first year that the visa holder qualifies as a U.S. resident under the substantial presence test. It also means that the spouse will have to report all her world-wide income for the year on their joint 1040 return in addition to her husband’s worldwide income. This could be a problem for some H-2B visa holders whose wives are working in México, for example.

If the visa holder is married and chooses not to file jointly because, e.g., the documentation for his wife is too hard to get or he doesn’t want to report his wife’s income on their joint return, he will need to file under the status Married Filing Separately. In that case there is a further complication involving community property. Because Texas is a community property state, the visa holder filing under the Married Filing Separately status will report half his income and expenses as a U.S. resident on his Form 1040 and will need to report the other half of his income and expenses as a U.S. resident on a Form 1040NR return for his spouse.

If he is single or is married and chooses to file under the Married Filing Separately status, in the first year of residence, the visa holder will have dual status and be a nonresident alien for part of the year and be a resident for the remainder of the year as explained in more detail next.

Once a single individual or a married individual who chooses to file under the Married Filing Separately status is granted a visa and such individual meets the physical presence test in the U.S., the visa holder needs to file two returns in the first year in which he becomes a U.S. resident under the substantial presence test. Similarly he will also need to file two returns in the last year when he ceases to be a U.S. resident under the substantial presence test:

1. Form 1040NR or 1040NR-EZ labeled at the top, “Dual Status Statement,” reporting only U.S. source income for the part of the year that he is not a U.S. resident under the substantial presence test, and
2. Form 1040 labeled at the top, “Dual Status Return,” and on which his worldwide income is reported for the remaining part of the year that he is a U.S. resident under the substantial presence test.

Between the dual status years, file Form 1040 as long as the physical presence test continues to be met.

Note: If the substantial presence test isn’t met for the first year such individual is in the U.S. but is met is the next year, he can make a “first year choice” to be treated as a resident for tax purposes in that first year. See IRS Publication 519, U.S. Tax Guide for Aliens, Chapter 1, for details.

Further note: There is considerable misguidance or lack of clarity on the Internet about which form to file. Some sites advise filing Form 1040NR without any further clarification. Other sites, e.g., http://www.visapro.com/, imply filing Form 1040NR by stating, e.g., “As a nonresident alien in the U.S. on a H-2B visa, you must file income tax returns.

Most of the litigation on this issue occurred in the 1930s and 1940s, and there has been little since then. The weight of legal authority leans against deducting a loss on surrender of a life insurance policy. The primary reasons are:

1. The transaction (purchase of the policy) was not entered into with the intent to make a profit.
2. The loss is not deductible because the policy contains two features – insurance protection and investment – and “[t]here was no separation of the premiums … as one part paid for protection only and the balance as a reserve investment.” London Shoe Co. v. Commissioner, 80 F.2d 230 (3rd Cir, 1935).
3. Genworth Financial opined recently (without offering any judicial support) that the loss is non-deductible because it is a personal rather than business or investment asset. Losses on personal assets such as houses are not deductible, although losses on personal investments are deductible.

But, in a case where separation of the amounts paid for insurance protection and for investment was possible, a capital loss was allowed on surrender of the policy. Cohen v. Commissioner, 44 BTA 709 (1941). See the relevant text from the case below.

I think Cohen provides good precedent. There is support for calculating the loss on the investment portion. The insurance protection portion of the policy may be computed by totaling the term life premiums that would have been charged on a term-only policy. For example, say that the premiums paid on the life insurance policy total about $346K. Assuming the term premiums that would have been paid since inception in 2002 would have been $60K, the adjusted cost basis of the investment portion of the policy would be about $286K. Subtracting the adjusted cost basis from the $239K cash surrender value yields a $47K capital loss. Also, I believe there is an intent to profit on the investment portion. Hence, I would deduct the loss on the investment portion.

MOSES COHEN, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT, 44 B.T.A. 709 (1941): “Therefore, in the instant proceeding we do not think we should overlook or fail to take into account the dual factors of investment and insurance protection which are inherent in the policies here involved. That portion of the premiums paid for mere insurance protection is of course a personal expense and as such is not deductible. Sec. 24(a)(1), Revenue Act of 1936. That portion of the premiums paid by reason of the investment feature of the contract is a capital expenditure and as such is not deductible. Sec. 24(a)(2). Petitioner is not contending for the deduction of any of the premiums paid. He contends that he lost a part of his capital investment, namely, $3,556.86 of the cash surrender value of the policies, and that such loss is deductible under section 23(e)(2), supra. For reasons above stated, we sustain this contention.” (Emphasis added.)

This is a gray area in the tax law that you may use to your advantage. IRS Publication 575 says that you must report the loss as a Schedule A miscellaneous itemized deduction subject to the 2%-of-adjusted-gross-income limit. The IRS is on thin ice here, I believe, because the U.S. 5th Circuit Court of Appeals has held in McIngvale v. Commissioner that a loss on a private annuity is a capital loss, hence deductible on Schedule D.

Because the IRS and the Court are split on the treatment of a loss on a variable annuity, I recommend deducting the loss either on Schedule A as a miscellaneous itemized deduction or on Schedule D as a capital loss depending on where you’ll receive the greater tax benefit.

As published in Austin Monthly, April 2003 (amended February 2005)

Yes and no. Although the credit isn’t available for non-business use of gasoline-powered boats, it is available for non-business (personal) use of diesel-powered boats. Also you can take the credit for diesel (but not for gasoline) used in personal-use motor homes when you’re running the diesel-powered engine or auxiliary (e.g., powering the air conditioner) off-road (e.g., in a camp ground) and also in personal-use minibikes, snowmobiles, lawnmowers, and stationary machinery like compressors, generators and pumps.

To take the 24.3 cents per gallon undyed diesel fuel credit on Form 4136, fill in the number 8 on line 3a, column (a). The definition of number 8 in the Form 4136 instructions is incomplete. The more complete definition is in 2008 IRS Publication 510, page 19 (No. 8). Be sure to keep your diesel fuel receipts as proof.

Internal Revenue Code section 4041(1)(A) imposes an excise tax on diesel fuel, but is silent on boats. Nowhere else in section 4041 are boats mentioned. Therefore, without digging further, I’m inclined to believe diesel fuel used in boat engines and some other non-highway uses is exempt and, hence, creditable.

As published in Austin Monthly, March 2003 (updated October 2009)

Here are 4 ideas:

1. Although PMI (Private Mortgage Insurance that is included in your mortgage payments) is currently deductible as interest, the special tax provision that permits this deduction may expire. I believe PMI is deductible as mortgage interest in addition to your regular mortgage interest regardless of the special tax provision. Per a well-reasoned treatise on the issue in the New York University Law Review and legal analysis in Tax Notes, PMI fits the legal definition of interest because you pay it for the benefit of your lender and because it relates to the size, term and risk of your mortgage. therefore it is deductible as mortgage interest.
2. Some of the fees you paid as paid as part of the closing process on a refinanced mortgage should be deductible as interest expense. These fees include mortgage lending fees other than points (loan origination costs) which may be amortized over the term of the mortgage. On your tax return, treat these fees as mortgage interest not reported to you on Form 1098 (the mortgage interest form the mortgage companies send to you after year end). The Federal Truth in Lending Act requires mortgage lenders to disclose and treat these fees as additional interest in their report to you of the highest interest yield spread on the mortgage. They do not, however, report this additional interest on your Form 1098.
3. If you have an office in the home, you capitalized (included in your house purchase cost) many of the closing costs. The capitalized closing costs from your original house purchase attributable to your home office may be deducted in the year of refinancing less the depreciation taken on those closing costs.
4. Texas residents: Sold a house in the past year? Don’t forget to deduct real estate taxes for the part of the year that you still owned the house. Your share of that year’s real estate taxes will be reported on your settlement statement (HUD-1 form).

A personal loan to someone who defaults, even to a family member, is deductible as a short-term capital loss. To deduct it, it’s best to have a signed promissory note showing an interest rate and payment terms. You also need to write down the efforts you make to collect the debt and why you conclude the debt is worthless.

Food and other items you provide for church or school events are deductible as charitable contributions. The related car mileage is also deductible at 14¢ per mile in 2008. Also if you travel for charitable purposes such as on a short-term medical mission or construction project, you can deduct your travel and lodging expenses as well as a per diem meal allowance based on the U.S. Government’s maximum per diem allowance. These per diem rates may be found at:

http://aoprals.state.gov/web920/per_diem_action.asp?MenuHide=1&CountryCode=0000

For foreign areas, and for domestic areas click:

http://www.gsa.gov/Portal/gsa/ep/contentView.do?contentId=17943&contentType=GSA_BASIC

As published in Austin Monthly, May 2003 (revised October 2009)