Tuesday, September 24, 2013

Tax Break for Businesses in Antarctica, But Not Employees

Internal Revenue Code section 911(a) allows US taxpayers living in a "foreign country" to earn tax-free up to $97,600 (in 2013) of wages and other earned income.  The US person would only pay the taxes of the country of residence, if any, on the first $97,600 of income.

In the landmark 1968 case of  Martin v. Commissioner, the taxpayer spent around a year working at Byrd Station, Antarctica for the Arctic Institute of North America.  The Tax Court rejected his claim that $7,000 of his wages should be considered tax-free income earned in a foreign country.  The court noted that "the Department of State does not consider the Antarctica region to be under the sovereignty of any government... [and] Antarctica has no territorial waters and that the waters surrounding the Antarctica land area and ice sheets are part of the high seas." 

In a 1993 non-tax case, the Supreme Court concluded that Antarctica is a "foreign country" under the Federal Tort Claims Act.  The Act provides that the US government cannot be sued for claims "arising in a foreign country," so the widow of a carpenter who died in Antarctica on a hike could not sue the US government.

Americans working in Antarctica saw the potential tax planning opportunity, but the lower courts quickly reaffirmed that Antarctica continues to not be a "foreign country" under the Internal Revenue Code, such as in Arnett v. Commissioner in 2007.  One explanation for the inconsistencies is that the taxpayer loses every time.

While American individuals in Antarctica have to pay US taxes as if they were living in the United States, businesses in Antarctica may benefit from a special rule in Internal Revenue Code section 863(d)(2) that could reduce their US tax rates to zero.  Certain special rules (too complex to describe in detail) provide tax benefits to "space or ocean activities," and section 863(d)(2) provides that space and ocean activity "includes any activity conducted in Antarctica."  Restaurants and oil wells in Antarctica are expected to be especially lucrative with the low tax rates.

Tuesday, September 10, 2013

Tax Break for Large Yachts and House Boats

The "home mortgage interest deduction" is one of the most popular tax deductions in the US and costs around $70 billion a year, by allowing taxpayers to deduct the interest they pay on up to $1 million in mortgage loans.  Not as well known is the fact that the deduction is not limited to primary homes and the taxpayer does not have to even live in the home. 

The "home mortgage interest deduction" must be for a "qualified residence," which must be:
1. the taxpayer's primary residence, and
2. one other residence of the taxpayer.

Note that the home mortgage interest deduction is not limited to the taxpayer's first home or main home.   Treas. Reg. 1.163-10T(p)(3)(ii) explains the definition of "residence":
"Whether property is a residence shall be determined based on all the facts and circumstances, including the good faith of the taxpayer.  A residence generally includes a house, condominium, mobile home, boat, or house trailer, that contains sleeping space and toilet and cooking facilities."

 Therefore, a yacht can be a residence, and interest on the yacht is deductible, as long as the yacht has a bed, a toilet, and cooking space, loosely defined.  If the taxpayer has no other residence, interest on up to $1 million of yacht mortgage loans can be deducted.

The regulation then helpfully explains that "[a] residence does not include personal property, such as furniture or a television, that, in accordance with the applicable local law, is not a fixture"  So the yacht owner cannot deduct the credit card interest for buying that big screen TV in the yacht, unless the TV is built into yacht.  

The qualified residence must be used "as a residence."  However, if the residence is not rented at any time during the taxable year, it shall be considered to be used as a residence (even if nobody used it for anything).

Tuesday, September 3, 2013

Using IRA Distributions to Pay Tuition and College Housing

IRAs (Individual Retirement Accounts), 401(k) plans, and other retirement accounts are supposed to be used for retirement purposes, and there is a 10% penalty on early withdrawals to persons younger than 59-and-a-half years old.  For instance, a person who withdraws $500 from a traditional IRA would pay taxes on having $500 of additional taxable income, plus a $50 early withdrawal penalty.

Like many other tax breaks, Congress decided to add a huge number of complicated exceptions to the 10% early distribution penalty.  For example, a "first-time homebuyer" may withdraw up to $10,000 from retirement accounts to buy his or her "first" home, except that a "first-time homebuyer" is defined as someone who has not owned a home in the past two years.

Apparently, helping "first-time homebuyers" sounds a lot better than helping "people who already bought houses but sold or abandoned them 24 months ago," akin to born-again virgins.

A separate exception in Internal Revenue Code section 72(t)(2)(E) provides that IRA distributions can be used to pay for higher education expenses and avoid the 10% early distribution penalty.  Higher education expenses are broadly defined, to include college or graduate school tuition, fees, and room and board, for the taxpayer, a spouse, a child, or a grandchild.  The child or grandchild does not have to be a dependent.  In fact, the IRA distributions do not have to be traced to the higher education expenses and can even be made after the expenses were paid, as long as the distributions are less than the amount of the expenses for the same year.

Even though "higher education expenses" are defined very broadly, the statute imposes an oddly strict limitation at the same time, in that the distributions can only come from IRAs and not from other types of retirement accounts in order to qualify for the education expenses exception.  Congress did not explain its rationale when the exception was created in 1997. Congress at the time was working on "education IRAs," a type of "retirement" account that could be only used for educational expenses (now called Coverdell ESAs), and it decided to throw other IRAs into the pot as well.

In the landmark case of McGovern v. Commissioner, T.C. Summary 2003-137, the under-59-years-old taxpayer received around $28,000 from his employer retirement plan (a Thrift Savings Plan, like a 401(k) plan for federal government employees).  He rolled over part of it tax-free to an IRA, and he used $12,880 to pay for tuition at Villanova law school.

The Tax Court concluded that he had to pay a 10% early withdrawal penalty of $1,288, because the education expenses exception applied only to IRA distributions and not to distributions from other retirement plans.  It did not matter that the taxpayer could have simply rolled over the entire amount tax-free to his IRA, and then used a $12,880 IRA distribution to pay for tuition and qualified under the education expenses exception.  He was liable for the 10% early withdrawal penalty because he paid the law school tuition in one step, instead of pointlessly creating two steps.