The Show, Part 2: Allocation

Larken Rose larken@taxableincome.net 

http://www.861.info http://www.theft-by-deception.com 

(This message is long, complicated, and almost irrelevant... but still important.) 

The following, which I've been meaning to address on this list for some time, is both irrelevant and important. No, that wasn't a typo. Let me explain: 

Suppose you lift the hood on a car to learn how it works, and you see lots of stuff you recognize, and then a big shiny green contraption next to the engine, which is a complete mystery to you. To be sure you know what's going on under the hood, you need to know what EVERYTHING does. You may find that the big shiny green contraption is just a new-fangled air conditioning system. So it is IRRELEVANT to the functions of the engine, but it was still IMPORTANT to know what it is. 

Well, that's the case with the "allocation" and "apportionment" rules found in 861 and its regulations. They are 100% irrelevant to determining WHICH income is taxable, but it is important to know what they ARE about, just so you can be SURE that they have no bearing on the main point. We don't want any weird contraptions under the hood that don't make sense, because any unknowns will be a source of doubt. So here goes: 
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To "allocate" something just means to assign it. No math is required. For example, you might "allocate" $100 in your monthly budget to utility bills. There are no complicated formulas or calculations; you just set aside $100 to pay for utilities. 

To "apportion" something, on the other hand, involves math and fractions. If you have to "apportion" $100 between the gas bill and the electric bill, you might have to give X% of the $100 to the gas bill, with X being determined by the ratio the gas bill bears to both bills combined. Already sounds complicated, doesn't it? 

To see how these principles apply in the law, we'll use an example. Fred Jones is a Canadian citizen (a nonresident alien for U.S. income tax purposes). In one year, Fred had three categories of income: 

1) He did a couple odd jobs while temporarily in Michigan, and was paid $2,000 for them. 

2) He has a carwash in Canada, from which he received $10,000. 

3) He has a little widget company in Canada, and sells widgets in Canada and the U.S., getting around $10,000 from this business. 

With the example in mind, let's look at a couple sections of law: 

Section 861(a)(3) speaks of compensation for services performed in the U.S., which would include the odd jobs which Fred did while in Michigan. And 861(b) says this: 

"From the items of gross income specified in subsection (a) as being income from sources within the United States there shall be deducted the expenses, losses, and other deductions properly apportioned or allocated thereto and a ratable part of any expenses, losses, or other deductions which cannot definitely be allocated to some item or class of gross income. The remainder, if any, shall be included in full as taxable income from sources within the United States." 

Huh?? Okay, let's take it one step at a time. We start with the items in 
861(a), which includes the income Fred got from doing odds jobs in Michigan. From that income he can deduct expenses which can properly be "apportioned" or "allocated" to that income. Fred did some lawn-mowing jobs while in the U.S., and had to buy gas for the mower. Buying the gas is obviously related to the money he received from that job, so that expense can be "allocated" to his odd jobs income from the U.S. 

In contrast, Fred cannot apply his electric bill from his Canadian car wash, and deduct it from his U.S. income. That expense would be "allocated" to his carwash income, which isn't taxed by the U.S. anyway. 
(Congress obviously can't tax a foreigner earning income is his own country, with no connection to the U.S.) 

So far, so good. "Allocation" is a piece of cake. You can subtract deductions (expenses) only from income that they are actually related to, which makes sense. Now, how about "apportionment"? The principle is pretty simple, but the math can get annoying. 

Fred has his Canadian widget company, and he sells widgets to customers inside AND outside the U.S. Only the income from U.S. sales is taxable by the U.S. government. So how is Fred supposed to know what deductions are allowed? The rules can get pretty complicated, but I'll keep this example simple. 

Suppose Fred made $7,000 from selling widgets to Canadians, and $3,000 from selling widgets to U.S. customers (for a total of $10,000). And suppose that Fred's little widget factory has a monthly electric bill of $200. How does he deduct expenses? Well, he has to APPORTION that expense (meaning divide it up) based on how much income he gets from each. If only 30% of his widget-related income is from the U.S., then only 30% of his widget-related expenses can be subtracted (deducted) from his U.S. income. In our example, that would mean he can deduct $60 of his electric bill (which is 30%) from that $3,000 he got from U.S. widget sales. 

Again, the rules can get very complicated (and they take up dozens of pages), but the general idea is pretty simple: you "allocate" (assign or apply) deductions to the income to which they clearly relate, and you "apportion" (divide up) expenses which relate to more than one category of income. 

If Fred didn't have his widget business, he wouldn't need to "apportion" anything (only "allocate"). And if he ONLY had income from the odd jobs in Michigan, "allocation" would be so simple as to be silly. (Having ONE expense, and "allocating" it to your ONE kind of income isn't exactly rocket science.) 

Because 861 and following, and related regulations, give the rules for determining taxable income, both domestic AND foreign, sometimes the rules can get rather complicated. But for most of us, most of those rules aren't needed. And again, figuring out how exactly to apply deductions is a COMPLETELY INDEPENDENT ISSUE from determining which income is taxable to begin with. (Obviously there's no point in deducting expenses from income that isn't taxable.) 

People like Mr. Lynn like to claim that if you don't need to apply the complicated rules, you should skip 861 and its regulations entirely. Why? Treasury Decision 6258 says that those sections are for determining gross income and taxable income from inside and outside the U.S., AND for giving the allocation and apportionment rules. If you don't need to do the complicated rules, it may be a good reason for celebration, but it's not a good reason to ignore the law. 

Peter gave me an excellent example to use. Suppose you hire a couple kids to clean your garage, and agree to pay them $100, which you'll divide between them based on how much each of them works. If one works an hour, and the other works three hours, the first gets $25 and the second gets $75. 

If you make that deal, and then one kid does ALL the work, the "dividing up" rules become really easy. Unless you were a slimeball, you wouldn't say "Sorry, but my deal doesn't apply anymore, because only one of you worked... so neither of you get anything." Instead, you'd say "Well, that makes it simple: all $100 goes to the one kid who did all the work." 

Likewise, if there are some sections for determining taxable DOMESTIC income, and others for determining taxable FOREIGN income (and complicated rules for those who have combination income), it makes it a lot easier if you only have domestic income. It doesn't mean you should IGNORE the rules; it just makes the rules a lot simpler to apply. The fact that there are ALSO complicated rules that SOME people (other than you) need to use doesn't mean you can ignore what DOES apply to you. 

A side issue came up in Friday's show, because in one year (by happy coincidence), Tessa and I DID receive a whopping $30 of foreign-source income, and were entitled to $4 of the foreign tax credit. (Yippee!) After Mr. Lynn AGREED that people who have to do foreign tax credit stuff SHOULD look there, he was suddenly at a loss to explain why my DOMESTIC income doesn't show up there as taxable. 

So now you know what the shiny green "allocation and apportionment" contraption is for, and (if I explained it well enough) you know that it has NOTHING AT ALL to do with determining what income is taxable and what is exempt. What is odd, and borderline delusional, is that when most tax professionals look under the hood, ALL THEY SEE is the shiny green contraption. They don't see the big V8 in front of it, marked "THIS IS THE ENGINE" in big red letters. "Oh, that engine only applies for purposes of the air conditioner. It's not for powering the car." Huh? 

Sincerely, 

Larken Rose

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