Reducing your US taxable income for the first five years in Spain

If you are taking advantage of the 24% special rate for expats in Spain and are a US citizen, you may be in a somewhat sucky situation where you need to “top-up” your US taxes to whatever marginal rate you pay in the US.

Eventually you will run out your 6 years and then you will be back to paying much more in Spanish taxes than US. Unfortunately you can only carry back any extra credits one year, so you may end up paying a bunch of US taxes for the first five years, and then pay extra taxes in the following years in Spain.

If you are salaried employee and don’t have a lot of deductions, there aren’t a lot of options (unless you own a house with a big mortgage). Here are the ways you can reduce your income for the first five years (and potentially shift it to the years following your Spanish tax increase when you can credit against what you are paying already):

• IRA Individual contribution: $5000 that is deductible from your income as long as you are not covered by a US qualified retirement plan.
• HSA (Health Savings Account) contribution: $6450 per family. This is pretax and can be spent on any qualified medical expense. It can also be invested pretty much like an IRA or 401K (search for HSA brokerage). If you use this for non-qualified expenses, you pay a 20% penalty. In order to qualify, you need to only have a high-deductible insurance plan. Not sure whether the fact you are covered by the public system in Spain would affect that.
• Childcare tax credit: if both spouses work, you can get a tax credit of up to $1200 for qualified child care expenses. This can include a nanny and doesn’t have to be a US citizen (or have a US provider number) if you live outside the US.

I didn’t find that earned income exclusion helped in reducing my taxes (since you have to also exclude any credit for taxes paid on the excluded income). Some people take the foreign exclusion and then don’t reduce their foreign tax credits according to the instructions and end up paying zero taxes, but that’s just cheating. The new harsher penalties around with foreign income make it an especially bad idea.

Remember that for year six, you still have to pay your US taxes as always, but once you finish year seven, you can carry back any excess foreign tax credits to the year before and file an amended return to get your money back. Be especially careful not to make any mistakes on your US return for the final year at 24%, since filing an amended return to get a big refund is likely to expose you to extra scrutiny.

Form 8938 Draft Instructions released

The son-of-FBAR 8938 now finally has some instructions. A couple quick points that might be of interest to Americans living abroad:

• Filing jointly means you get double the limits before you need file.
• There are much higher limits for Americans that live abroad: the threshold is $200,000 of foreign assets on the last day of the year and no more than $400,000 during the time of the year.
• Accounts held by “US payer” are exempt, which includes foreign branches of a US financial institution. (Citi is the only US bank that I know of in Spain)
• Accounts maintained by dealers or traders in securities or commodities if all holdings are subject to mark-to-market accounting rules. Being considered a trader is very tough, and you pretty much have to a full-time daytrader in order to qualify (otherwise you are an investor, not a trader).

Non-willful FBAR violations: don’t worry about it

I recently talked to an American who was living and Spain and freaking out about the fact that he had never filed an FBAR form (any US person is required to file it every year if you have more than $10,000 in total financial assets outside the US).

If you read the law, you could think that you are in deep shit… up to $10,000 fines per account per year, even if you never knew you needed to file. In order to take advantage of the overly honest, the IRS launched a “voluntary disclosure” program, which lets you come clean, pay your fine, and promise not do it again.

Should you join the voluntary disclosure program? Personally, I’d avoid it. Firstly, if it was unintentional, the FBAR penalties cannot be collected via the IRS (from Jack Townsends blog):

I also think there is an important distinction to be made between proving that a taxpayer willfully failed to report income and that a taxpayer willfully failed to file an FBAR. The FBAR was a form few practitioners heard of pre-UBS. To prove a taxpayer’s knowledge of the FBAR and his obligation to file the form will not be an easy task for the government as few accountants told their clients of their FBAR obligation. Additionally, the FBAR is a penalty that arises out of Title 31 of the United States Code and not Title 26 (Internal Revenue Code). As a Title 31 penalty, the IRS can assess the penalty but it cannot collect it under the Internal Revenue Code with lies and levies and other IRS collection tools. Instead, the IRS is treated just like any other creditor. To collect the FBAR penalty, the IRS must make a referral to DOJ’s Tax Division, which then must seek a judgment in US district court against the taxpayer. Once in court, the taxpayer may assert a lack of willfulness as a defense and have his day in court.

So basically, if you are living in Spain, the IRS is severely restricted in what it can do to go after you, especially if you have no assets in the US. Since this is not a “tax”, the US cannot ask the Spanish government to collect this tax on the basis of the US/Spain tax treaty. (but do remember that if you are an American living overseas, the Washington DC District Court has jurisdiction over you)

This is one of the reasons that the IRS is moving away from FBAR towards the “Son of FBAR”, which is part of your tax return, and thus any fines and penalties are much more difficult to avoid.

Of course, now that you know about FBAR, you have to start filing your statements. Sorry about that.

Son of FBAR (Form 8938)

The IRS has really twisted itself into a knot with the new 8938 form, in which you will be required to report extremely detailed information about every financial asset that you own overseas (if you have more than $50,000 in financial assets in total).

According to the bill passed by Congress, you will be required to provide this information as of the 2010 tax year. Unfortunately, the IRS has been slow in creating this form and it is still in the draft stage.

How does the IRS solve the problem that it has created by not providing the form in time? Why, but dumping the problem on you.

In June 2011, the IRS released this wonderful bulletin, which said that it was suspending the requirements to file the form 8938 due to the fact that this form does not yet exist. However, it added this wonderful suffix:

Further, after the release of Form 8938 or the revised Form 8621, individuals and PFIC shareholders for which the filing of Form 8938 or 8621 is suspended by Notice 2011-55 for a tax year will have to attach Form 8938, Form 8621, or both, if required, for the suspended tax year to the next income tax or information return required to be filed with the IRS.

Notice 2011-55 clarifies that the statute of limitation on assessment of tax with respect to periods for which reporting is required under sections 6038D or 1298(f) will not expire before three years after the date on which the IRS receives Forms 8938 or 8621 for the tax year. However, a Form 8938 or 8621 filed for a suspended tax year with a timely filed income tax or information return (taking into account extensions) as required by Notice 2011-55 will be treated as having been filed on the date that the income tax or information return for the suspended tax year was filed.

What does this mean in English? What they want you to do is file the 2010 form with your 2011 return (or whatever year after they finish their form). If you don’t, then they claim they can say that you filed the form 8939 late (and assess penalties, etc), even though it did not exist at the time when you were supposed to file your return.

Do I have to pay Spanish taxes on my IRA distributions?

Spain doesn’t tax deferred compensation for work performed while not a resident of Spain. This also applies to other kinds of deferred compensation, like unvested stock awards. (This is actually kind of cool, because the US doesn't tax stock awards until they vest, so if you move here with a bunch of unvested stock awards, and give up your green card, you may end up paying very little in taxes on your stock awards when they vest)

The bigger problem is whether you have to pay US taxes on your IRA distribution. If you are a US citizen or Green Card holder, sorry, you’re going to get taxed on it (if you have excess foreign tax credits, you might be able to avoid any net additional taxes). And no, the Foreign Earning Income Exclusion does not apply, as pensions are not considered “earned income”.

If you are not a US resident for tax purposes, then make sure you cite the US/Spain tax treaty, which gives Spanish residents the right to have their pensions *only* taxed by Spain (ie not).

Reducing your Spanish taxes as an expat

There are two main options for reducing your Spanish taxes, once your Beckham non-resident rate of 24% expires. (If you are moving here, the Beckham tax rate is generally your best first option, but you need to move quickly. Once you’ve been here for more than six months, you will not be able to apply anymore. The application process is trivial, so it’s better that you do it yourself, rather than risk missing the date due to the incompetence of your human resources department. Yes, Spanish HR departments are among the worst I’ve ever experienced.)

So you’ve been here for six years, what do you do now?

First, if you live here without your family, and you have more connections back in the US (other countries with a lower tax rate and a tax treaty with Spain may also work), you can use the “tie-breaker” provision in the tax treaty to be a tax resident in only the US. The US/Spain tax treaty states:

Where by reason of the provisions of paragraph 1, an individual is a resident of both Contracting States, then his status shall be determined as follows:

(a) he shall be deemed to be a resident of the State in which he has a permanent home available to him; if he has a permanent home available to him in both States, he shall be deemed to be a resident of the State with which his personal and economic relations are closer (center of vital interests);

(b) if the State in which he has his center of vital interests cannot be determined, or if he does not have a permanent home available to him in either State, he shall be deemed to be a resident of the State in which he has an habitual abode;

(c) if he has an habitual abode in both States or in neither of them, he shall be deemed to be a resident of the State of which he is a national;

(d) if he is a national of both States or of neither of them, the competent authorities of the Contracting States shall settle the question by mutual agreement.

This means that if you are a US citizen, with a home back in the US available to you, and your family lives in the US, you have a pretty good case for being treated as a US resident for tax purposes, which means you are a NON-resident in Spain (and you continue paying 24%). Note that if you have your spouse or children living with you in Spain, this argument generally doesn’t work. You also need to get a certificate of tax residency from the US consulate.

Secondly, if your work involves a lot of travelling, you can exclude a big chunk of your your income if you perform work for a company or entity that is not resident in Spain. This only helps if the country you work for has a lower tax rate than Spain (or in the case of the US, income you already have to declare if you are American). Our helpful friends at KPGM explain:

Income generated from employment for services rendered in a foreign country is tax exempt up to a limit of €60,100 (2009), provided that the work is performed for a company or entity non-resident in Spain, or for a permanent establishment located in a foreign country and provided that a tax similar to the Spanish Personal Income Tax is applied in the territory where the work is performed. In addition, the territory must not be considered a ‘tax haven’ by the Spanish tax authorities. At present, the UK Dependent Territories of the Channel Islands and the Isle of Man, as well as the UAE, Hong Kong and Singapore, are all included on a ‘blacklist’ of tax havens maintained by the Spanish Tax Authorities.

Put your excess foreign tax credits to work

If as an American you’ve live in Spain long enough that your Beckham tax rate has expired and you are back to the marginal 45% tax bracket, your US rate will be lower than your Spanish. This means that effectively you won’t be taxed at all in the US on your Spanish income, and will in fact have an excess foreign tax credits.

Unfortunately you can’t use foreign tax credits against purely US income, so you may end up with more than you can use if you live here for a while.

One other limitation is that there are two baskets of foreign tax credits, “passive” and “general category”, which are each limited by the amount of income you have in that category. This can be somewhat annoying in Spain, since your salary, which is “general category” is taxed higher than interest, which is “passive” category.

What are these good for?

• If you US paid taxes on foreign income in the last two years, you can file an amended return and “carryback”. Since amended returns get extra scrutiny from the IRS, make sure that your returns for years when you expect to get a carryback are bulletproof. For example, the last two years of your “Beckham tax” status.
• The US/Spain tax treaty states that pension income is only taxed in the country of residence.
• IRA distribution or Roth conversions are considered “pension income”
• Spain does not recognize the concept of deferred income
• As a US citizen, you must still include the IRA distribution taxable income
• However, you can use the US tax treaty to treat the IRA income as Spanish income, and then apply any excess foreign tax credits against taxes you’d pay in the US.
• If you are under 65, you may want to do a Roth IRA conversion, rather than a withdrawal in order to avoid the 10% penalty.

If you have a substantial IRA, you can use this strategy to use the higher taxes you pay in Spain to offset taxes that you’d have to pay in the US.

Overseas audit of US citizen taxpayer

Pity the expat US citizen who has to continue filing US taxes no matter where they live. I´ve always wonder what would happen if things when wrong, would the IRS come after me overseas?

Here´s a report from an accountant that went through one. In this case, the triggering event was that the taxpayer filed an amended return. You should never, ever, file an amended unless you talk to a compentent international tax lawyer. Amended returns are individually examined and the chance of audits are high unless you have all your ducks in a row.

There are basically two schools of thought regarding how to deal with mistakes: "quiet" disclosure, where you just file next years return correctly and forget about the past, and "noisy" where you go for the full confessional. The main trap in the noisy route is that you have to disclose absolutely everything that could possibly come up. If you leave out anything, this is far worse than going the quiet route, since they will most definitely be looking for problems. There are no points for partial effort.

One interesting mistake was that the taxpayer had used his US address as filing address (even though he lived abroad). If you use a foreign address, it makes the IRSs audit more difficult, since you can choose to have the audit at your place of business, which will require them to travel overseas.

Applying for “beckham-tax” (Royal Decree 687/2005) status

If you’ve lived outside Spain for more than 10 years (even if you are Spanish) and you are moving to Spain for work, you may qualify for the special regime 24% tax rate for 6 years.

You need to act fast, since you only have 6 months from the day you register as a resident to apply, and they are pretty strict about enforcing this.

First thing you need is a letter from new your employer’s HR director stating these four important points:

1a: Que D. MAX MUSTERMANN con NIE numero X0123456 y domicilio en [where you live] está prestando sus servicios en GRAN EMPRESA S.R.L. desde el día 1 de Abril del 2010 como empleado par cuenta ajena con contrato de trabajo ordinario por tiempo indefinido.

2a: Que la dirección del centro de trabajo en el que D. MAX MUSTERMANN presta sus servicios es en [address of your office].

3a: Que el trabajo de D. MAX MUSTERMANN se realiza en territorio español.

4a: Que D. MAX MUSTERMANN está cotizando a la Seguridad Social española siendo la fecha de 1 de Abril del 2010.

Now fill out a Modelo 149 and take this together with your letter, NIE papers and passport to the big tax building in Plaza Doctor Letamendi. Go to the third floor and ask for the extranjero desk. They will take your forms (ask them to look them over to make sure there are no obvious mistakes) and put them in the queue to be processed.

Technically the law says they should get back to you in 10 days, but in reality, it may take as much as 6 months. Ask them which month they are currently processing to get an idea of how long it takes.

If all went well, a letter should arrive about six month later either at your employer or at your home (to us we got one of each). This letter proves your status and you can give a copy to your bank and employer to allow them to give you this special status.

Remember that the status is not tied to your job. If you take another job, you get to keep your status.

Once your six years are over, you might consider moving to Holland, where there’s a 30% tax ruling for expats.

Better taxation in Spain

There's (finally) talk about raising the taxes on the rich in Spain. Compared to the US system, taxes in Spain are painfully easy to avoid. When I came here, I sat down with a Spanish tax advisor who walked me through all the ways that the wealth tax (which was still there at the time) and income taxes could be avoided to a large extent.

Given the level of tax evasion in Spain, I think it's unfair to raise taxes without significantly increasing enforcement.

Here's what Spain could do:

• All those loopholes? The US closed them as much as 20 years go. Go plagiarize the US tax code.
  
• Get rid of the 4 year statute of limitations for tax fraud. The US has a 3 year statue of limitations for unintentional mistakes (6 years for mistakes larger than 25% of income), but has NO statute of limitations for fraud. In Spain, as long as you stonewall investigators for a couple years in court (pretty easy with the slow court system if you have a decent lawyer), escaping prosecution is almost too easy.
  
• Require a government certificate for non-resident status. This would be similar to a NIE, but only for tax identification purposes. Allowing people to register bank and investment accounts just by passport number is stupid. Eg if you have good enchufe at your bank, it's still possible to get a non-resident account, even as a Spaniard. If you have a non-Spanish passport, even easier.
  
• Require deductible business expenses to be paid by bank transfer or credit card. Sure, businesses can still hide cash income, but at least their business customers have the incentive to not pay in cash.
  
• Require bank transfers (at least within Spain) to be free of charge.
  
• Don't allow big ticket items like cars to be paid for in cash.
  
• Institute a "finders-fee" for reporting tax fraud. Snitches would get paid a percentage of taxes recovered.
  

Tax guide for Americans and Green Card holders living in Spain

I've created a set of notes for Americans and Green Card holders.

Please let me know if I'm missing anything important.

Inheritance tax in Spain

Something to keep in mind when living (even temporarily, but as a resident) in Spain is that Spain has a very weird system of inheritance taxes. From a political policy perspective, I'm generally in favor of inheritance taxes, since the incentives don't tend to be too disruptive (it's not like people will stop dying) and it reduces overall inequality in society by taxing what is essentially unearned income for relatives of rich people.

However, in Spain, when a husband or wife dies, any assets of the dead spouse are subject to inheritance tax by the surviving spouse. Any assets that are owned jointly, are considered owned 50% by the dead spouse and are taxed accordingly. The rates are actually quite high, which I assume means that the wealthier families in Catalunya has already figured out a way around this, but this requires structuring your assets with the help of a good lawyer. Alternatively, it's probably cheaper just to buy life insurance to cover the tax (for us for example, it's a couple hundred euros a year, which is much less than a good lawyer would charge).

Joint real-estate is also taxed, but according to its catastral (property tax) value, not the actual estimated value (which tends to be much higher, at least for now). If you have a mortgage, this gets deducted off the value.

In addition, upon the death of a joint account holder, all bank accounts are frozen until the appropriate taxes are paid. This would suggest that each partner have at least a small account only under their name with some emergency money to pay the rent, mortgage, etc.

In theory, assets worldwide are subject to this tax as well, although until now the authorities have not made much effort to track them down.

The specifics of the law are actually controlled by the region of Spain you are living in, for example, in Madrid, they've gotten rid of taxation for spouses. In Catalunya they didn't eliminate the tax, but they did lower the rate significantly in 2008 (apparently all the rich couples just registered themselves in Madrid to avoid this situation).

This is a good blog entry regarding one of the various schemes touted to save on inheritance tax.

One avoidance technique I found particularly amusing was just to lie low and wait for 5 years until the statue of limitations for paying taxes has passed.

Back home again

It took quite a bit of effort to get the kids out of bed this morning... jet-lag had them jumping around until way too late last night.

Looks like not much has changed in here while I was gone.

Garzon is still on the verge of being suspended, Messi is still scoring an amazing number of goals, unemployment is still too high (although I've heard from several people that most of the "unemployed" are unofficial working until their unemployment insurance runs out), and Greece still on the verge of bankruptcy.

The supreme court decision about the Statute of Catalunya that was a big deal around Christmas? Still nothing.

Now I've started working on my US taxes...

Forms filled out so far:

• 1040 US Resident Tax Form
  
• Schedule B Interest and Dividends
  
• Schedule D Capital Gains and Losses
  
• Schedule E Rents, Royalties, Partnerships, etc
  
• Form 1116 Computation of Foreign Tax Credit (4 copies)
  
• Form 2210 Underpayment penalty (oops!)
  
• Form 2441 Child and Dependent Care Credit
  
• Form 2555 Foreign Earned income (2 copies)
  
• Form 6251 Alternative Minimum Tax
  
• Form 8621 Return by a Shareholder of a Passive Foreign Investment Company (2 copies)
  
• Form 8891 US Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans
  
• Form 8833 Treaty-Based Return Position Disclosure under section 6114 or 7701(b)
  

Sources of tax advice for Americans in Spain

I'm a bit of a tax geek and have always prepared my taxes myself (except one year, and the tax preparer made a mistake and got us audited). Since both of us have a green card, it means that we need to file taxes in the US on our world (ie Spain) income. Since the US and Spain have a tax treaty, most Americans in Spain won't owe any US taxes (since rates here are higher), but you need to file anyway.

In the US system, there's a big difference between intentionally evading taxes and doing so by accident or ignorance. (The joke being that the difference is approximately five years in jail.) For this reason, elaborate structures designed to evade taxes are quite dangerous, because they show that the tax payer was obviously aware of the rules and tried to evade them. In contrast, someone like Tim "TurboTax ate my taxes" Geithner can become treasury secretary (which runs the IRS), despite "forgetting" to pay 32K in taxes because he claimed that TurboTax didn't to warn him he was making a mistake.

An extremely good resource for me has been an outfit called Offshore Press, which has a number of very well research e-books that approach the issue from the perspective of someone who wants to comply with the rules. They are not trying to sell some magic package that will hide your money from the IRS.

My conclusion so far:

• Generally don't buy non-US mutual funds. US based funds are much more tax efficient and provide you with all the paperwork you need to file. The only exception are funds that qualify for Qualified Electing Fund treatment, and the only ones I've seen that do that are a couple Canadian funds.
  
• Managed accounts (where you get the buy/sell records of each stock) and stocks are usually ok. Finding a broker that will deal with US persons is another matter.
  
• Before you buy insurance or annuities, read about the 1% Federal Excise Tax. It appears that Spain has a tax treaty exemption for some kinds of insurance, but you need to file an 8833 form to claim this exception.
  
• Foreign trusts, corporations, etc are generally more trouble than they are worth. It's unlikely to legally save you much in taxes, and if you want to just not pay, then it's better not to try too hard.
  
• Variable annuities seem to be to only moderately attractive foreign investment (but be careful about the Excise Tax).
  
• Buying non-US dollar bonds at a discount to face value can have unexpected tax implication.
  
• Buying/selling any capital asset means paying capital gains on the cost/proceeds converted in US dollars. This includes houses, stocks, bonds, etc.
  
• Tax advisers are a double edged sword: on one hand, if they give you an opinion and you rely on it and do something illegal, you generally avoid "intent" and won't go to jail. On the other hand, all your communications with the tax advisor can be subpoenaed by the IRS.
  
• File your FBAR (separate from your return) if you have more than $10,000 in accounts outside the US. The penalties are extreme, even for non-willful omissions. The US has had access to the SWIFT system used for interbank transfers for years (in the name of fighting terror and drugs of course), so don't think you can keep a secret.
  
• Try your best, but you will never be perfect. With 16,845 pages of the US tax code, you're probably breaking some rule.
  

The joys of US taxes

The US is one of the few countries in the world that taxes all citizens and permanent residents no matter where they live in the world. Since we still have our green cards and want to be on best behavior, this means we need to file.

I learned yesterday that under no circumstances you should own non-US mutual funds if you have to file taxes as a resident. Even a simple money market fund can get you in serious trouble.

Take this scenario:

You put your life savings into a Euro money market fund that gives you around 2% interest per year. Great, so you just declare your 2% interest as income and you're done, right?

Wrong! You have just bought a PFIC (Passive Foreign Investment Company) and ruined your life. (I prefer to call them PFUCKs).

First, if you don't mention the PFUCK on your tax return, nothing much happens until you sell it. At that point, all hell breaks loose. Not only do you have to pay 4% per year penalty interest, you also have to value your shares in US Dollars (both at the start and end dates whatever the exchange rates were), and any currency difference is treated as regular income (and you don't get to count anything if its a loss).

There is also the option to mention the PFUCK on your tax return and do Mark-To-Market accounting, but currency movements can really screw you over, especially this year, when the Euro peaked around Dec 31st. The third option, known as QEF doesn't generally work in Europe since no funds will give you the accounting information necessary.

On the other hand, if you just stick to certificates of deposit, you get your steady interest payments, can apply Spanish taxes against your US taxes, and live stress free.