What’s a Statutory Resident and a Domicile?

Statutory Resident

A New York resident by law because you stayed in the state to long.  You’re now screwed.  New York will be sending their bill soon.

Domicile

A domicile is the place that an individual intends to be his or her permanent home—that is, the place to which the individual intends to return whenever the individual may be absent. If a person has two or more homes, that person’s domicile is the one that he or she regards and uses as his or her permanent home. A domicile once acquired is presumed to continue until a new domicile is definitely established (NYCRR 20 §105.20(d))

Objective Test for Statutory Residents

You’re a New York resident if:

• You spent more than 183 days in the state during the tax year (members of the Armed Forces are exempt); or
• Your domicile is in New York State. (N.Y. Tax Law  §605(b))
  • Exceptions – You don’t have to pay NY taxes if you meet one of the two following tests:
    • Test A:
      1. You didn’t have a permanent place of abode in New York State this year;
      2. You had a permanent place of abode outside New York State this year; and
      3. You spent 30 days or less in New York State this year. (NYCRR 20 §105.20(b))
    • Test B:
    1. You were in a foreign country for at least 450 days during any period of 548 straight days; and
    2. You spent 90 days or less in New York State during this 548-day period, and their spouses (unless legally separated) or minor children spent 90 days or less in New York during this 548-day period; and
    3. During the nonresident portion of the tax year in which the 548-day period either started or ended, the taxpayers were present in the state for no more than the number of days which bears the same ratio to 90 days as the number of days in such portion of the tax year bears to 548. (N.Y. Tax Law §605(b)(1)(a))

Subjective Test – NYS Domicile

Domicile is the place that you intend to be your permanent home.  But, home is a subjective word because you could have multiple apartments or houses.  When you live in multiple places, you must use the subjective test to determine where your domicile is.  The examples of factors that determine your domicile are the following:

Home (location; whether owned or rented; use; size and value);

Time spent (whether retired or actively involved in business; travel; overall lifestyle);

Items “near and dear” (location of items of significant sentimental value or items that enhance the quality of life);

Active business involvement; and

Family connections (when the first four factors are not conclusive).

Conclusion:

Welcome to your nightmare.  Notice that this is the cliff notes version of the rules.  So, the moral of the story is that if you break any of these rules, then you are screwed!

Tax is a question that many people ask to late for anything to be done. Federal individual income tax states that a resident of the United States is required to pay taxes on all income effectively connected to the US. A US citizen is required to pay income tax on a worldwide basis.

A US resident is defined as a natural person (human) with a green card or situated in the US for at least 183 days (at least 31 days must be within the US in the current year) within 3 years according to a specific formula.

Year 1 = 100% of Days spent in US counts toward the Substantial Presence Test
Year 2 = 1/3rd of Days spent in US counts toward the Substantial Presence Test
Year 3 = 1/6th of Days spent in US counts toward the Substantial Presence Test

Ex. Bob spent 73 days in the US during the current year. Last year he spent 180 days in the US and the year before that spent 120 days in the US.

Year 1 = 73 Days x 100% = 73 Days
Year 2 = 180 Days / 3 = 60 Days
Year 3 = 300 Days / 6 = 50 Days
Total Days Spent Within the US = 183 Days

You’ve just passed the Substantial Presence Test because you’ve been in the country for 83 days or more.

Congrats! You get to pay tax!

Running a business means that you quickly learn that there’s a lot of bs that you have to learn and deal with in a very short amount of time.  The number one issue that your going to hate is accounting and taxation.  You hate both and by extension you’ll probably hate your accountant too. (Yes I am an accountant)

There are 3 fundamental checks for any entrepreneur

Check Daily

Have you recorded your revenues/sales/invoices?

Revenues must be recorded daily, when the transaction occurs because it could have serious effects on your taxes at the end of the year. Ex: Improperly recorded sales after the period of $1,000 dollars is an additional tax of $350 dollars. Imagine the tax when the improperly recorded sales grows ($100,000 dollars = $35,000 dollars in additional taxes).

Have you recorded your expenses/bills/purchases?

Same concept as above, improperly recorded expenses means that you’re losing a tax deduction. If you improperly enter an expense of $1,000 into the wrong period, then you pay $350 dollars in additional taxes due to lost deductions.

Have you recorded the collection of cash?

It’s important to know how much cash you have because without cash, your business is dead. Cash is king and every entrepreneur knows that the value of cold hard cash is very different from “imaginary paper profits.” The value of cash is always assured.

Check Monthly

Have you reconciled your bank accounts?

Your books have to match your bank statements because your books are supposed to be an accurate representation of your current financial position.  The bank statement will have differences due to bank fees (Due to bounced check, insufficient funds and etc) and interest (Due to the bank paying you for letting them hold your money). You won’t know about these changes in your bank accounts until you receive the monthly bank statement, so you must adjust your books to match the real amount that should be in your bank accounts. Books and records that don’t reflect your actual financial position are useless. It’s similar to reading a map that’s upside down and 10 years old.

Check Annually

Have you closed your books? (Have you yelled at your accountant yet?)

Closing entries vary depending on the type of business that you’d be operating. The basic entries that everyone has are amortization (the use of intangible assets such as copyrights, patents and trademarks) and depreciation (the use of tangible assets such as computers, cars and desks). Generally, I’d suggest you yell at your accountant to do this for you because you’d probably get this stuff wrong from years of experience.

Note: If you’ve hired an accountant to prepare your taxes or in general, make sure that they have actually applied the year-end closing entries and adjustments to the books.  A pet peeve of mine is that accountants will often apply the changes to the tax return but fail to transfer the adjustments into YOUR BOOKS. This leaves your taxes done correctly, but your books will be a mess and continue to be a cluster f-bomb.

In order for the plan to be of any use to you, you need to consider the following:

1. The money must stay out of the United States.  If the money were to re-enter the US, then you would be repatriating the income and it would be taxed under US corporate and personal income tax.
2. You should have enough income to maintain your lifestyle within the US or you’d have to distribute enough income from international sources.  The alternative would be for you to live overseas for a majority of your time.
3. You should be comfortable with having your assets held in a foreign country.

Google’s effective tax rate as reported by Bloomberg is 2.4% and everyone has been clamoring about (1) that it’s unethical, (2) Google is evil and (3) how do I do that?  I recently made an offer to provide tax help to startup entrepreneurs and a surprisingly number of people wanted to implement the Double Irish or the Dutch Sandwich tax plan.  I love how they get these sexy names from the newspapers.

I’m here to burst your bubble.  You won’t be getting any sandwiches or doubling down anything.

(1) How long do you think it would take to plan and implement a $3.1 billion dollar tax savings plan across 3 foreign sovereign nations (Ireland, Netherland, and Bermuda) mentioned in the Bloomberg article?

It isn’t unreasonable to assume that it would take two to three years to implement such a complicated tax plan.  It generally took six months in my experience with corporate America to gather enough information to extract the facts necessary to begin researching the tax implications; this is assuming that everything went swimmingly – unrealistic.  (Picture your box of receipts and the sad excuse you call your “books” in QuickBooks that you never update and extrapolate that to a goggle and you’ll understand why.  Accounting is a back office function to a business that is always an afterthought).

Then, add the time it takes for you to negotiate private letter rulings (PLR) and advanced pricing agreements (APA) with the IRS.   Historically, it would take 4 to 6 months per request.  (I will let you assume how often the first try is going to be a winner)  Why would you explain your grand tax scheme to the IRS?  Because, are you going to be the one who takes responsibility for a $9.3 billion dollar gamble?  (After penalties and interest, the rule of thumb is to multiply your tax due by 3 and you’d get an idea of how screwed you are)

PLRs and APAs are guaranties that the IRS gives to taxpayers.  If they say that your transaction is okay, then you’re safe because the auditors must honor the PLR and APA.  But, the IRS withholds the right to recant retroactively the PLR and APA if they feel that the facts and circumstances have “changed.”

(2) How much do you think it cost Google to implement said plan?

The professional fees Google, Microsoft and Forest Laboratories paid to major accounting and white shoe law firms must’ve been at least 20 million starting as a very very conservative estimate.  If I really cared I could’ve gone through the financial statements and dug up the information roughly, but I don’t have that kind of free time.

You may be asking yourself why seek out Ernst & Young, Deliotte & Touché, PwC, or KPMG?  You must consider the risk in the United States as well as internationally.  How are you going to find and trust a foreign professional services provider?  They could be a charlatan in sheep’s clothing.  Thus, you’d need a major accounting firm with an international presence for your own peace of mind.  But, peace of mind comes at a hefty price.

Also, PLRs are 14k a pop ($625 if your making less than 250k) and APAs are 25k a pop.  Google has an entire family of corporations that fold into the parent company and each will need its own PLR and APA.  (Note, if the PLR is exactly the same for entity then its 2k a pop)

Disclaimers, if the IRS thinks your letter is stupid, frivolous, or is a transaction they’re just unwilling to speak about like listed transactions, then you lose your money with no questions asked.  You’re paying for their review of your situation, not a conclusion.  Also, you must renew your APA agreements – yay!

(3) How sure are you that said plan is going to work? Remember everything is fine and dandy till you get audited.

Lastly, you can be sure that implementing such an aggressive tax plan will not go unnoticed for long.  When the IRS begins to audit your books and records that leads to additional fees to the accountants and lawyers.  But, more importantly, there’s always the chance that you may lose the audit and be assessed the tax you thought you saved.  (Win or lose you’ve now become a top 10 favorite on the IRS must audit list)  Nothing is guaranteed and I’ve seen enough tax plans and audits to know that even the best laid plans is for naught when you get punched in the face.

Conclusion.

You probably can’t afford to implement the Google tax plan and it’s not as cut and dry as you were lead to believe.  You’d have to invest millions in professional fees and years in time to finally taste the unguaranteed fruits of your labor.

But…

That doesn’t mean that you can’t utilize a different tax plan. =)

Summary
IRS: Debt = Income
You: …huh?!
IRS: You owe me money (tax).
You: Damn…

Something that always surprises my clients is the concept of “debt forgiveness.”   Think about the following example:

Bob spends $50,000 with his credit card on pizza, ipads and etc., but he realizes that he can’t afford his “ghetto fabulous lifestyle.”  (This is your average American) After a million final collection notices and harassing calls from the debt collectors at the end of the year, the credit card company offers Bob a deal because they know that he’s never going to pay.  If Bob pays the company $10,000, then the credit card company will offer a discount on the debt or they will forgive $40,000 of Bob’s debt. Bob pay the credit card company $10,000 and is forgiven $40,000 in debt.   Now, the IRS calls Bob and lets him know that he’s got a new daddy.

Bob’s Mindset:
I didn’t make any money!  Why do I owe tax on money that I never earned?!  This is BS.

IRS’ Mindset:
Bob spent $50,000 on pizzas, ipads, and other toys on borrowed money.   All of a sudden, Bob magically doesn’t owe the $50,000 anymore, thus he’s “gained or earned something.”   Income in the U.S. is “broadly conceived” and defined as “all income from whatever source derived except as otherwise provided.”   Now, Bob owes tax on $40,000, which is the amount that the company forgave.

Awesome surprise!

There are a few exceptions:
1. Insolvency is when you’re so broke that you have more debt, than assets and income. This is the point where you’re totally screwed financially.
2. Bankruptcy doesn’t count as income because the IRS already knows that you’re broke and can’t afford to pay.
3. Qualified Principal Residence Indebtedness is either your mortgage or your home equity loan. If you’re debt is forgiven because it’s specifically related to the home you live in, then you are allowed to exclude up to 2 million (1 million if married filing separately for the tax year) from income for the years between 2007 through 2012.

Note – I’ve met a lot of people who’ve been hosed in the recent subprime debacle and have used the “Qualified Principal Residence Indebtedness” exception.

Conclusion:
The IRS always gets their pound of flesh, even when on money you didn’t know about.

I’ve come to realize that the most important issue to address is the lack of documentation. Taxpayers are required to maintain a healthy record of their transactions to justify their tax deductions. But, this is easier said than done.

I’d like to point out that this is not only directed at the individual taxpayer or small businesses, even major corporations such as Pfizer (among all other Fortune 500) have a hard time keeping their records.

Two years ago, I failed to keep around half of my receipts. After a quick cocktail napkin calculation, I learned that I’ve lost around $15,000 dollars in cash over 3 years because of my forgetfulness.

I never forgot a receipt after that day.

I’ve learned that no amount of calls and reminders can save my clients from themselves because we’re all too busy with other important things (like running a business).

Instead, I’ve begun to automate my clients in order to help track their expenses without them having to remember (too often). With a power of attorney, I’m authorized to act on their behalf and I proceed to do the following:

Conclusion:
You need to automate, consolidate, and forget your expenses.

Offers-in-Compromise (Form 656)

Infomercial: “We’ll make your IRS problems disappear for pennies on the dollar! Call today to find your local douchebag!”

My reaction at 2:47AM Friday, April 30, 2010: What the hell?

This is your textbook fish-and-bait car salesman commercial that gets you in the door, so that they can con you out of your hard earned money. They overpromise and under-deliver.

A taxpayer that has been assessed a tax liability is not a bargaining position to demand tax abatement for “pennies on the dollar.” (Abatement: The IRS forgives a portion of your tax liability, interest or penalties) Would your credit card company offer you a 99% discount on your balance? The IRS is a business like any other credit card company. They are in the business of collecting debt and they’re awesome at their job.

An offer-in-compromise (“the program”) is initiated by filing tax form 656. Generally, you qualify for this program if the IRS (1) made a mistake in their audit process, (2) they took too long to assess your tax liability after your audit, or (3) you under financial hardship. The program is not meant to help people who decided to stiff Uncle Sam for a few tax years.

You must illustrate to the IRS that you have a financial hardship that precludes you from paying the assessed tax liability with interest and penalties in full. Tax form 656 is a detailed form that requires the delinquent taxpayer to disclose a variety of details about their financial and personal life.

The IRS applies a formula that determines your ability to pay the tax liability. According to the formula, the IRS will determine if any part of the tax liability qualifies for abatement.

The Lesson of the Day?

Please don’t believe the infomercials.

Conclusion:

You’re not getting off easy from the IRS.

Do you own a trust or an estate?

Maybe, you should.

Trust and estate tax planning is something mysterious that most people assume is for the rich.  By definition, a trust is a separate legal entity.

But, what’s the point of creating a “separate legal entity” from yourself?

Creating a separate legal entity allows you to save money.  But, more importantly, a trust allows you to create a legacy that will last forever.  There are 2 major considerations when people consider their legacy.  (1) Money and (2) values are the considerations that everyone thinks about when they look into the future.

“Where is my money going to go?”

“Are my children going to become freeloading losers or are they going to live fruitful lives according to my values?”

A trust will help you save money by avoiding the estate tax.  The maximum estate tax rate is generally 55% (for this year alone, there is no estate tax. So, it’s a good time to die? – joking).  The United States was created because the founders of our nation were fed-up with the upper-class inheriting their wealth, thus keeping the money from freely moving through the economy.  The estate tax forces Americans to return their wealth to our economy.

But, paying the estate tax is voluntary.

It is very easy to plan around the estate tax with a trust as a vehicle.  But, trust and estate planning is very complicated, thus it is always vital that you consult with a professional.

More importantly, a trust allows you to create a legacy that embodies your values, ethics, and ideals.

A trust can be structured so that your assets are only distributed to those you feel are worthy of your legacy.  There are a variety of examples that I’ve seen, but here are a few:

The trust is to distribute a portion of my assets for each of the following conditions.

1. Education – My descendent is to complete a Master’s degree in an accredited institution.  The Master’s program must be of substantial quality, thus waterbasket weaving, origami, and beer pong are not acceptable “programs.”
2. Charity – My descendent is to volunteer yearly for a local charity that directly serves the public.  They must physically serve the needy; the duty cannot be assigned or passed off.  (This condition usually causes a lot of complaints…)
3. Independence – My descendent will receive nothing, unless they are able to fully support themselves (rent, utilities, and etc.) until the age of 35.

These are a few examples of how a trust can retain your values for generations.  Thus, trusts not only help you save money, but they’re also an extension of your person.  It helps you to continue to guide and teach your family.

Conclusion:

Trusts are great for everyone.  They help you save money, but they also help you leave a legacy that’ll stand through the years.

In order to prepare for the change, you must understand the change and plan for it so that it doesn’t surprise you like a “silent but deadly cloud” in an elevator.

Penalty

Beginning in 2014, those who do not have health insurance must pay a penalty or fine of $695 dollars or 2.5% percent of their household income, whichever is greater.

After 2016, the penalties will be increased (or decreased) by annual cost-of-living adjustments (inflation).  People will not be required to get coverage if the cheapest plan available costs more than 8% of their income.

The penalties will be collected by the IRS through tax returns.  However, the IRS will not have the authority to bring criminal charges or file liens against those who don’t pay.

Massachusetts is a state that has a healthcare penalty.  Massachusetts charges a penalty for individuals or families that are not covered by health insurance, unless they’re income is under a 150% of the poverty level.

Conclusion:

Get healthcare by 2014 or pay the fine.

Assuming you’ve read the previous post, you understand how annoying it is to incorporate a business and you’ve decided that it is still something that your business needs.

The next question is: Which legal entity should a small business consider?

After googling the topic, a small business owner will quickly come to realize that there are two clear choices – the S Corporation (“S Corp”) or the Limited Liability Company (“LLC”).

Inevitably, every successful small business owner must decide whether to become an S Corp or an LLC.  These two legal entities have a number of similarities such as limited liability protection (note: either entity has its shortcomings in asset protection) and avoidance of double taxation.  But, why has the LLC become so popular, while the S Corp has faded from the public’s eye?

10 second history:

The S Corporation has been around for 50 years compared to the LLC which has become prevalent in the last 20 to 30 years.  The S Corporation is the big brother because it was created first.  Times have changed and the LLC was created to fit the needs of an economy that is constantly evolving.

S Corp

To create an S Corp, you must either have a C corporation or you must create a new C Corporation.  Then, you must file Tax Form 2553 electing to be treated as an S Corp.  Thus, you are a corporation that gets special treatment.  This is an important fact to remember.  The owner of a corporation must maintain a board of directors, maintain minuets to record board meetings, and all the other formalities that come with corporations.  (This is why S Corps are annoying.)

But, the S Corp has an important benefit that keeps it relevant – today.

S Corps allow owners to plan around the Self-Employment Tax.  Self-employment tax is 15.3% of your net income.  Obviously, this quickly becomes a very significant amount on your bottom line.  Generally, this is the sole reason small business owners decide to incorporate as an S Corp.

LLC

Limited liability companies have become popular because they are easy to create, very flexible and require little to zero maintenance.  But, the LLC does not allow small business owners to plan around the Self-Employment Tax issue.

An easy way to understand the difference between the two legal entities is that you’re paying for the convenience of flexibility in an LLC.  (note:  the cost of maintaining your S Corp properly through your tax accountant or attorney and the amount of net income you earn consistently could make the S Corporation’s SE Tax issue irrelevant.)

Bottom-Line

Should you decide to be an S Corp or an LLC?  It depends.  If your company is constantly changing and needs to be flexible with your needs, then an LLC is the right choice.  If your company is stable and consistently earning steady amounts of income and expect little to no change, then you should incorporate as an S Corp.  This is a very difficult decision to make without understanding all of your unique facts.  I always suggest you consult an informed professional (non-idiot).

Lastly, please realize that a business is like a baby with baby clothes.  Companies can very easily outgrow their corporate shells as the business changes.  You should evaluate whether or not your current corporate structure is still the right fit.

Thanks for reading!