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What Did I Learn from My 2005 Tax Return?

Contributed by mm | January 29, 2007 5:29 PM PST

I always have a passion for tax. If you recall, I self-filed my tax in 2003 and 2004, and wrote a few dozen articles on various tax topics in this blog. Therefore, you probably cannot believe that I just filed my 2005 tax return only days ago.

If you follow this blog, 2005 is the year in which our tax situation got really messy: first, our business income really shot up during that year, and second, we moved from Seattle to Shanghai in late 2005, exposing us to tons of new tax rules.

Gladly, as part of the expatriation benefits, KPMG was hired to file tax for us for four years (tax year 2005 to 2008). Although I am fairly personal-finance-literate, I have to admit without KPMG running the show I will not be able to navigate the convoluted tax laws governing foreign residents.

Earlier in 2006, we were advised by our tax preparer KPMG to wait till January 2007 to file for the 2005 tax, so we can be entitled to some tax benefits with regard to foreign taxes. This month, KPMG notified us a tax return has been prepared, and we are due for almost $6,000 in refund! (In retrospect, the tax refund is probably due to the generous tax gross-up for some relocation benefits. In my accounting book, I was expecting to owe $500 in tax at the end of 2005.)

Apart from the temporal happiness of (re)gaining a sizable chunk of money, a study of the final return by the pros (a total of 45 pages) is actually a good learning experience. More importantly, I have two important findings that may affect how I manage our household finance in the future.

1. Our business income will be almost tax-free in the near future.

U.S. tax laws allow foreign tax credit that prevents a taxpayer with foreign residency from double taxing. Since income tax on salary income in China is much higher than that in the U.S., I almost don't have to pay any extra U.S. income tax on my China-based income. For 2005 when I only worked in China for a couple of months, I had accumulated a foreign tax credit carryover for almost $2,000 (read: the difference between higher China tax rate and lower U.S. rate, after applying maximum allowed foreign tax credit for tax year 2005).

When it comes to my business income, U.S. tax law says it is China-based income since I produced the income solely from working in China, even though all incomes are crediting to my U.S. bank account (and I was issued 1099-MISC forms every spring). What's better is I don't have to pay taxes on such income in China either since local tax authority considers it as earned outside of the country.

In summary, my job income will probably create a five-figure foreign tax credit every year that I cannot enjoy without extra non-job income. By recognizing my business income on my tax return, I will be able to apply these extra tax credits and effectively pay nothing extra on my business income. What a nice arrangement to ease my tax burden!

2. SE 401(k) contribution does not necessarily reduce my immediate tax by much.

In late 2006, I made a premature contribution to my Self Employed 401(k) account, in the belief I can reduce my immediate tax exposure. It actually didn't work out exactly as planned. By making a $3,000 contribution, my Adjusted Gross Income (AGI) dropped by the same amount, resulting in a tax gain of $840 (at 28% marginal tax rate). On the other hand, this move reduced my foreign tax credit by more than $500 (and therefore I'm entitled to $500 more in carryover to future years). In total, the immediate tax benefit for my $3,000 contribution is almost less than 10%.

In response to that, I will be more cautious in deciding my SE 401(k) contribution for the tax year 2006. I will calculate numbers in both ways and decide if and how much I should make my contribution.

Alas, the 2006 tax season is around the corner now! Will I be able to get some generous tax refund again?

This Post Has Received 55 Comments. Share Your Opinions Too.

Personal Finance Guide 101 Commented on January 29, 2007

Hello MM,

Congratulations on reaching your family net worth from $81,000 to $500,000 in 3 and half years.

A good post with detailed information on foreign taxes and US tax laws. All your posts have fully detailed information about everything related to finance/personal finance, thanks for sharing.

2million Commented on January 30, 2007

This doesn't sound right - You don't pay US taxes because you earned the income solely in China, you don't pay China taxes because you earned it outside the country? Can you elaborate on this?

If this is true then anyone with a web business should live in China and get their revenue deposited in US bank accounts and its all tax-free?

Guest Commented on January 30, 2007

Yes I agree with the guy above - that sounds dodgy at best and not in the spirit of the tax laws. The tax laws are written such that you should pay tax in either China or the USA - but you should pay tax. Playing one off against the other? I have seen it done before and it end badly. Be careful trying to manipulate the system, and having a third party doing your taxes does not give you immunity. If they mess up your taxes it is still your responsibility.

- Guest

CPA1298 Commented on January 30, 2007

I think MM is saying that he is 'harvesting' his foreign tax credits by recognizing his side business income. I don't think he's avoiding taxation altogether. I think it is similar to people who are engaged in 'passive' activities that generate losses; those losses are only beneficial if one has a passive activity that is actually generating income. In MM's case, the foreign tax credits wouldn't do him any good if he didn't have some tax-generating income. Does this sound right?

MM Commented on January 30, 2007

CPA1298, you are right. This will not be possible if I don't have a day time job that is being taxed almost twice as much in this side of the Ocean as if I would be taxed in the States.

I did report my business income on my federal tax return, and from IRS's standpoint, I did pay my fair share of the tax on my business income, so there is no tax evasion.

Of course, the near tax-free benefit for the extra business income is up to some limit.

2million Commented on January 31, 2007

Ok - recognizing business income to take advantage of foreign tax credits makes alot more sense.

Dang - guess my new plan of heading to China to avoid taxes is out the window ;-).

joewatch Commented on January 31, 2007

Even though you don't get an immediate tax benefit from your SE 401(k), you do get the great benefit of tax-free growth until withdrawal. It works the same for non-deductible IRAs. IMHO, as long as you can afford it (and it sounds like you can), you should always max-out your contributions to all tax-sheltered accounts including the SE 401(k).

helen Commented on February 5, 2007

May I ask you a question?
If all my salary and bonus is from China, and I
pay more tax in China(than in us).Is it going
to help if I try my best to increase my US income?(like investment income, assuming all gains, no lose)I think in that way, my foreign tax credits don't need to sit there. Then tax I should pay for gains will be offset by foreign tax credits.

MM Commented on February 12, 2007

Helen, unfortunately, your U.S. based income cannot be used to monetize your foreign tax credit.

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