A perplexing issue for US citizens and resident aliens and foreign nationals abroad is dealing with the US Federal and State income tax authorities. If you are dealing with a technical question or are the subject of an audit you should consider using a Certified Public Accountant (CPA) who is experienced in dealing with the Internal Revenue Service and State tax authorities on international tax matters rather than attempting to do it yourself.

States present a special challenge in that there are numerous ways in which you may be subject to state income tax such as being domiciled or resident in a State or by attending a business meeting in a State.

Internal Revenue Service Audits

Audits of expatriates are handled primarily out of an IRS office in Puerto Rico with occasional audits out of offices in Florida and Virginia. You cannot make the IRS auditors come to you. And you cannot have the site of the audit moved to a location more suitable for you. You can either meet the IRS at location in Puerto Rico or conduct the audit by mail.

Either way is a disaster because they want you to document every single item on your tax return. As an employee you can likely comply with the majority of their requests. As a self-employed person it is unlikely that you have half the information they request. As there is no personal contact it is impossible to establish a rapport with the IRS agent and get them to agree that no one can document 100 per cent of their and request that they settle for less. So you end up dealing with a faceless bureaucrat who can arrive at incomprehensible conclusions.

As an example, on one return we prepared that was audited by an IRS office in Puerto Rico, the US parents who reside in Bermuda claimed their teenage child as a dependent. The IRS office in Puerto Rico requested a copy of the child’s “certified” passport and birth certificate, a report card from school, a letter from the school principal acknowledging that the child attended said school and was the child of Mr and Mrs X, a letter from the soccer coach, a family picture and a letter from the local pastor.

After receiving all of the foregoing the auditor disallowed the child as a dependent. When asked why the reply was that the client had not submitted proof that the child existed. When we inquired as to what else they wanted the reply was “you have to prove the child exists”. A call to the group supervisor to inquire if the auditor was on some type of medication that created hallucinations was of no help. The case had to go to the Court of Appeals who eventually agreed that the auditor’s findings were nonsensical in light of the documents submitted.

While the result was justified it took months to resolve this matter at a significant cost to the client. If an individual attempts to personally handle an IRS audit they likely would be better off sending a signed check to the IRS and asking them to fill in the amount as that is what will eventually happen.

State Income Tax

In our experience you are more likely to be subject to a state income tax audit than a federal audit, primarily because the states desperately need money and realise that most expatriates do not file State income tax returns. Why would you be subject to state income tax if you live in Bermuda?

There are three separate and distinct reasons; domicile, residence and business trips to the US.

Domicile — Under common law every US citizen and resident alien is deemed to have one domicile while recognising that they may have multiple residences. Domicile, while defined differently by each state is usually characterised as your permanent residence and the place to where you will return.

In general, if you move from New Jersey to Indiana and sell your home in New Jersey and sever other relationships and buy a home in Indiana and establish relationships, New Jersey would concede that you changed your domicile. But when you move outside the US most states will argue that your domicile has not changed and that you remain subject to state income tax. So if you move from Massachusetts to Bermuda, Massachusetts will claim that you are still domiciled in the state and subject to Massachusetts income tax.

We have had clients argue that they sold their residence; car and everything else that they owned in Massachusetts and will never go back. OK, the state tax authorities will acknowledge that you did that but will also ask “where is your domicile today?” It is not Bermuda because you are only here on a three-year work permit and Bermuda will clearly assert to a US Court that as of today you do not have a right to reside here permanently.

Another example is a person who moves from a southern state to Bermuda, marries a UK national who owns a home and resides in Bermuda. The southern state conducts an audit and declares that the person was domiciled in such state, has available accommodation in such state (the family home left to her and her brothers when the parents died), does not own a residence in Bermuda and does not yet have Permanent Residence status in Bermuda. It is likely that the southern state will prevail if this matter went to court in the US.

Residence - If you reside in a state and have a home (available accommodation) in a state you are likely to continue to be subject to state income tax while you are on assignment in Bermuda; whether you maintain the home for investment purposes or your family continues to reside in such home while you either commute or visit from Bermuda every few months.

Business Trips to the US — Anyone, yes anyone, who comes to the US on business is likely subject to state income tax (and probably federal) in one of the 43 states that impose an income tax. Isn’t there some minimum amount that you need to earn prior to being subject to state income tax? Yes, in Pennsylvania if you have $40 of income you are required to file an income tax return.

The majority of states have a “unified tax system” where they compute the initial tax on your total income with the ultimate tax being the percentage of your income that was earned in that state.

As an example, suppose you have earned income of $500,000, work 200 days a year ($2,500 per day) and work ten days in New York. New York will compute the tax on $500,000 as being $40,000 and as you worked 5 per cent of the time in New York you owe New York $2,000. New York State recently realised that hundreds of out-of-state executives visit the parent company in New York City every day. Hence, they now require the parent company to withhold New York State income tax on every out-of-town executive who has 12 or more business days in New York state each year.

The individual must then file a New York State income tax return to obtain a refund or pay additional tax due.

Pursuant to the requirements relating to practice before the Internal Revenue Service, any tax advice in this communication is not intended to be used, and cannot be used, for the purpose of (I) avoiding penalties imposed under the United States Internal Revenue Code, or (ii) promoting, marketing or recommending to another person any tax related manner.

The tax advice given by this column is, by necessity, general in nature. You should, of course, check with your own US tax consultant as to how specific transactions affect you since tax advice varies with individual circumstances.

James Paul Sabo, CPA, is the president of ETS Ltd, PO Box HM 1574, Hamilton HM GX, Bermuda. Questions should be sent to: jsabo@expatriatetaxservices.com