Taxation on Overseas Income, Bitcoin and Drugs
As a U.S. citizen or subject, such as green card holder, you are liable for tax on income earned abroad.
As a side note, the U.S. is the only country that taxes its citizens or subjects on worldwide income. For an example on how the U.S. government wants its due from overseas earnings, let’s say that you are a U.K. citizen but are in the U.S. on a green card and you earn income in the U.K. You must claim the income from the U.K. in the U.S. and pay any tax due. The U.K., though, like many countries, has a tax treaty with the U.S.
So, using the same example as before, if the U.K. income is taxed in the U.K., the income is claimed here in the U.S., and the amount of tax paid in U.K. is given a foreign tax credit, which is a dollar-for-dollar credit, in the U.S. If there is a difference between the taxes owed here and the taxes paid in the U.K., then the difference is taxed in the U.S.
For example, let’s say that your income in the U.K. is 20 pounds, and the tax paid in the U.K. is 5 pounds. Let’s say after the conversion rate the income is $30, and the tax paid is $10, you would claim the $30 as income in the U.S., and get a tax credit of $10. However, let’s say that the tax in the U.S. on the $30 is $20, then after the $10 tax credit, you would owe $10 in U.S. tax. Usually the tax paid in the other country zeroes out the tax in the U.S., but not always.
If you are a U.S. citizen and you work and live in Spain, and meet certain requirements, you have to claim the Spanish income in the U.S. However, in 2018 there is a foreign earned income exclusion of $104,100, meaning that the first $104,100 of income earned in Spain is excluded from U.S. income. If you made more than the earned income exclusion, the amount is taxable in the U.S.
The question that I’m always asked is, “How does the IRS know about foreign income?” The answer: a couple of different ways.
Every country exchanges information with the IRS on foreign financial accounts. If these accounts meet certain averages that are required for filing in the U.S., they need to be reported to the U.S. but are not taxed. The return is just information. Money in any account needs to be claimed in the U.S. Failure to do so is punishable by a $250,000 fine and five years in prison.
That’s not to mention that every country has a reciprocal agreement with the U.S. to report the income made by the U.S. citizen or subject. Failure to report such income can lead to tax evasion, or perjury, punishable by various fines as well as prison sentences.
The only way to seemingly “hide” income is through cryptocurrency, as it is deregulated and outside the limited scope of John Doe Summonses of the IRS.
However, every transaction of cryptocurrency is made public through the blockchain, which holds a record of transactions. So if the IRS really wanted to know whether you were hiding your assets in cryptocurrency, they can simply check the blockchain and reconstruct your income.
As cryptocurrencies like Bitcoin get more publicity, the IRS will eventually crack down on the various financial accounts known as wallets that hold coin. For now, the IRS has been increasing efforts to report large transactions on exchanges like Coinbase’s.
Interestingly enough income earned from illegal activities are taxable under Internal Revenue Code 64. As to how this taxation works, let’s say that you are convicted of human trafficking. While you are serving your prison sentence, the IRS, based on the facts entered into during the trial, will reconstruct the convict’s income. Upon the convict’s release from prison, the IRS will issue a Notice of Deficiency (NOD) for the amount of taxes the ex-con owes. The only way to fight an NOD is to go to Tax Court.
Now, here is where it gets strange. In Tax Court, the ex-con is allowed to enter into evidence any expenses that they may have had in connection to the income the IRS reconstructed. The strange part is being able to deduct expenses for every illegal business except for drugs. That includes cannabis, which is legal in a state but is illegal on the federal level.
The only thing deductible for a drug dealer is the cost of goods sold (COGS), which is basically what the drug dealer bought the product for. The reason that you can deduct all expenses from a heinous crime like human trafficking but not legal cannabis goes back to 1982, when the U.S. declared the war on illicit drugs and Congress enacted Section 280E, which says you can only deduct COGS. Even though the war on drugs is over, this outdated law is still on the books.
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Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as...