We would like to highlight a recent change in the IRS’ policy with respect assessing statutory late filing penalties related to certain international information forms. Of particular concern to international businesses is the revised policy that the $10,000 penalty may be systematically applied during the initial processing of a Form 5472 that is attached to a late filed Form 1120. Thus, the IRS is now automatically assessing an initial penalty of $10,000 for each failure to timely file a Form 5472. A separate Form 5472 is required to report each related party with which the taxpayer had a reportable transaction during a taxable year. Thus, penalties can multiply quickly.
As more fully discussed below, a penalty also applies for failure to maintain records as required under U.S. tax law. The automatic assessment represents a departure from previous IRS procedure where penalties were assessed at the discretion of an examiner after a return was selected for examination. While the penalty provisions have always been available to the IRS, they have been inconsistently applied in our experience. With a significant number of International companies having cross-border transactions with related parties in the United States, it is likely that the potential exposure for such penalties in the International marketplace is high.
Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, is required as an attachment to Form 1120, U.S. Corporate Income Tax Return (and certain other returns), if the reporting corporation had a reportable transaction with a foreign or domestic related party during the tax year.
The due date for filing Form 5472 with the IRS is the same as the due date of the corporation’s Form 1120, including extensions. For purposes of filing Form 5472, a reporting corporation is either a 25% foreign-owned U.S. corporation (i.e., a corporation with at least one direct or indirect 25% foreign shareholder at any time during the tax year) or a foreign corporation engaged in a trade or business within the United States.
If a reporting corporation fails to furnish (within the time prescribed by regulations) any necessary information, or fails to maintain records as required, it is subject to a penalty of $10,000 for each taxable year with respect to which such failure occurs. The continuation penalty is $10,000 for each 30-day period (or fraction thereof) during which such failure continues after the expiration of a 90- day period. U.S. tax law provides that certain failures (including not timely filing Form 5472) may be excused for reasonable cause.
A taxpayer may file a penalty abatement request based on reasonable cause after a penalty notice has been received. The taxpayer must, in a written statement containing a declaration that the statement is made under the penalties of perjury, make an affirmative showing of all the facts demonstrating that it had reasonable cause for failure to timely file Form 5472, and prove that it acted in good faith. To show that reasonable cause exists, the reporting corporation must have filed for all open years (excluding the current year on extension). Importantly, reasonable cause does not apply to penalties assessable after the taxpayer was notified of the requirement to file or was requested to provide specific required information. Treasury Regulations provide a separate reasonable cause exception for small corporations. The provision states that reasonable cause will be applied liberally in the case of a small corporation that had no knowledge of the requirements imposed by Internal Revenue Code Section 6038A, has limited presence in (and contact with) the United States, promptly and fully complies with all requests to file Form 5472, and promptly and fully complies with all requests to furnish books and records relevant to the reportable transaction. A small corporation is defined as corporation whose gross receipts for a taxable year are $20 million or less.
Taxpayers should review their previously filed returns and consult with their tax advisors as necessary to determine whether they are in compliance with the information reporting requirements with respect to foreign corporations in which they may have certain levels of control or reportable transactions. Any outstanding or late Forms 5472 should be filed as soon as possible with a persuasive well-analyzed request for penalty abatement, as appropriate, based on reasonable cause.
If you have any US connections and have a non-U.S. bank account, you may have recently received a letter from your bank asking for your tax information. This may seem odd or new to you but lately banks everywhere want to know if you are compliant with the IRS. Basically, the entire world is helping the IRS.
Since January of 2014, those holding accounts in foreign banks throughout the world have received Foreign Account Tax Compliance Act (FATCA) letters from their financial institutions. These letters are sent to account holders whom the institution believes have a link to the United States that would give rise to tax reporting and payment obligations.
A ‘FATCA letter’ is a letter from your foreign bank requesting certain information about your US tax status (and requesting you complete either a W-9 or W-8 form). The letter usually also offers an incomplete discussion of the Foreign Account Tax Compliance Act (FATCA) legislation) which requires the bank to share your name, address, and other account details with the IRS.
These letters will request that the recipient provide information regarding their disclosures, if any, to the Internal Revenue Service (IRS). These disclosures typically include whether certain documents have been filed, including a Report of Foreign Bank and Financial Accounts (FBAR) and a 1040 personal return, and whether the individual has availed himself or herself of the Offshore Voluntary Disclosure Program (OVDP) administered by the IRS to resolve tax compliance problems.
Below are some Frequently Asked Questions received from our clients:
Why did I receive a FATCA letter?
If you have received a FATCA letter, you may already be on the IRS’ radar. FATCA requires foreign banks to identify accounts with a link to the US A link could mean a US address, US telephone number, US residence, frequent transfers to/from the US, or any other evidence of a connection to the US.
Depending on the jurisdiction and the Intergovernmental Agreement (IGA) that is in effect, the bank or qualifying financial institution may be required to submit this information to the IRS or face significant fines and penalties. Understanding the agreements in effect in your jurisdiction can help you better understand the risks you face.
How will my information reach the US government?
For FATCA purposes, there are two main models of IGAs: Model 1 IGAs and Model 2 IGAs. A Model 1 IGA is distinctive in that the banks can directly turn over an American account-holder’s information to the jurisdiction’s taxing authority. The foreign jurisdiction’s taxing authority will then pass that information along to the IRS.
In contrast, a Model 2 IGA, permits the direct transfer of information from the foreign bank or financial institution to the IRS. The IGA specific to your jurisdiction may also require special action for recalcitrant account holders or deem certain entities as “deemed-compliant foreign financial institutions” or “exempt beneficial owners.”
What are the potential consequences of FBAR non-compliance or other tax problems?
If a US taxpayer has failed to comply with his or her FATCA, FBAR, or other income tax reporting requirements, he or she could face significant penalties. When the non-compliant taxpayer’s account information is received by the IRS, he or she has likely already lost the right to participate in the various voluntary disclosure programs such as OVDP. A US taxpayer must avail themselves of the voluntary disclosure process prior to an investigation, or they will no longer potentially qualify for criminal amnesty or reduced civil fines.
Non-compliance with tax obligations can also lead to a civil tax action or criminal tax charges. A non-willful violation of FBAR obligations can result in a $10,000 fine for each violation. A willful FBAR violation can carry a penalty of the greater of $100,000 or 50% of the account balance for each violation. Criminal tax penalties can include significant prison sentences and fines that exceed the value of the accounts.
Contact Patel Law Offices if you have received a FATCA letter
If you have received a letter from your foreign bank or financial institution, it is not advisable to ignore it. By delaying action, you may eliminate certain voluntary disclosure options that could have led to a more favorable resolution than would be possible otherwise. Furthermore, if you have received a FATCA letter you are already on notice that your account is likely to attract further attention from the IRS.
If you have received such a letter, it is you must seek the advice of a tax legal professional. Failure to do so can result in significant civil penalties or a referral for criminal tax prosecution. Patel Law Offices can explain your legal situation and present potential solutions.
The Bureau of Economic Analysis (BEA) is an agency of the U.S. Department of Commerce and is currently conducting a benchmark BE-10 survey which entails the filing of a BE-10 report by any U.S. person that directly or indirectly owned or controlled a foreign affiliate at any time during the 2014 fiscal year.
A BE-10 form must be filed with the US Bureau of Economic Affairs by all U.S. persons who owned at least 10% of a foreign corporation, trust, estate or other unincorporated entity, at any time during the 2014 year. U.S. persons can refer to anyone who is a resident of the United States or subject to its jurisdiction, including expatriates, limited liability companies, partnerships and corporations.
Form BE-10 is a benchmark survey that provides data regarding U.S. investment abroad to provide a complete and comprehensive picture of the global impact of U.S. investment on the worldwide economy. The form is unrelated to taxes. It is part of the US Department of Commerce’s efforts to conduct surveys every five years of US direct involvement in foreign business enterprises. In previous surveys, a US person only had to complete the form if they were requested to do so by the BEA. But a recent and unpublicized change in the law now requires that all US persons meeting the reporting requirements must complete the form whether or not the BEA contacts them.
The information obtained and filed pursuant to this survey is confidential and is used only for analytical and statistical purposes. The BEA is prohibited from granting another agency access to the data for tax, investigative, or regulatory purposes. The information reported on this form cannot be disclosed to the Internal Revenue Service for tax compliance purposes.
The BE-10 report was due no later than May 29, 2015 for U.S. persons required to file less than 50 forms. However, the BEA recently granted an extended due date of June 30, 2015 for all filers who have not previously filed a BE-10 report.
Failure to file can result in civil and criminal penalties. Civil penalties can range from fines of $2,500 to $25,000, in addition to injunctive relief requiring compliance. Willful failure to file can result in a penalty of no more than $10,000 and up to one year in prison for an individual filer, or both.
Below are answers to some frequently asked questions concerning the BE-10 report.
Why haven’t I heard about the BE-10 form before?
Previously, the BE-10 form was only mandatory for those U.S. persons who were directly contacted by the BEA. A recent change in the law now requires that the form is mandatory for every U.S. person who owned or controlled a foreign affiliate at any time during the 2014 fiscal year, even if they are not contacted.
Do I have to file a BE-10 report if I own real estate that generates rental income in a foreign country?
Yes, unless there is a unique exception in your individual case. As discussed above, a BE-10 report must be filed by any U.S. person which owns or controls a foreign affiliate. For the purpose of the survey, real estate located in a foreign country is considered a foreign affiliate. However, if the real estate in question is held exclusively for personal use then a BE-10 does not need to be filed. For example, a primary residence abroad that is leased to others while the owner is a U.S. resident, but which the owner intends to reoccupy, is considered real estate held for personal use.
How do I calculate my ownership interest in a foreign affiliate?
Ownership interest can be directly held and indirectly held. Your ownership is directly held if you directly hold the ownership interest in a foreign affiliate. Your ownership is indirectly held if you hold ownership interest in another foreign affiliate that owns that primary foreign affiliate.
What if multiple U.S. persons own more than a 10% interest in the same foreign affiliate?
For example, if eight U.S. persons each own 12.5% of a U.S. limited liability company that, in turn, owns 100% of a foreign affiliate, then the U.S. limited liability company will file the complete BE-10 report, and each of the eight U.S. members of the U.S. limited liability company will file a partial BE-10 report in accordance with the instructions, making proper reference to the U.S. limited liability company’s complete BE-10 report consistent with the rules discussed in the preceding question and answer.
If I own an interest in a U.S. entity that owns an interest in a foreign affiliate, do I have to file a BE-10 report?
If you own more than 50% of a U.S. entity that, in turn, owns a foreign affiliate, then the U.S. business, not you personally, must file the BE-10 report. However, on its BE-10 report, the U.S. business will be required to disclose your direct investments in the foreign affiliate.
If you own 50% or less of a U.S. entity that, in turn, owns a foreign affiliate, then both you and U.S. entity will be required to separately file appropriate BE-10 reports.
What is a U.S. domestic consolidated business enterprise?
U.S. corporation that is a U.S. person must file a BE-10 report on a consolidated basis with its entire U.S. domestic consolidated business enterprise. In other words, the parent corporation is not owned by another U.S. person by more than 50%. It must file a BE-10 report on its own behalf and a BE-10 report on the behalf of each U.S. business enterprise that is part of the ownership chain of the parent corporation whose voting securities are more than 50% owned by the business preceding it in the chain of ownership.
It is recommended that a U.S. limited liability company or partnership follow these same consolidation rules even though the instructions only refer to a U.S. corporation being subject to these rules.
What should I do if I am unable to complete the BE-10 report or I do not have the information necessary to accurately complete the BE-10 report?
You should file for an extension of the filing deadline. Extension requests must be received by the BEA no later than June 30, 2015 and enumerate substantive reasons necessitating the extension. The BEA will provide a written response to such requests.
In addition, the instructions to the BE-10 report specifically provide that the data disclosed on the BE-10 reports may be comprised of reasonable estimates based upon the informed judgment of persons in the responding organization, sampling techniques, pro rations based on related data, etc. The instructions require that the U.S. reporter consistently apply estimating procedures used on all BEA surveys.
Once I complete the BE-10 report, will I have any reporting obligations on a moving-forward basis?
Yes. You may have an obligation to report to the BEA on a quarterly basis, annual basis, or every five years, depending on the value of the foreign affiliates that were reported on your BE-10 report. Once you file the BE-10 report, the BEA will send you a list of all follow-up reports required with applicable deadlines.
Do executors or trustees have any reporting obligations?
Yes. Executors of US estates, as well as trustees, beneficiaries and settlors U.S. and foreign trusts may have a BE-10 reporting obligation if the estate or trust in question owns reportable interests in non-US business enterprises.
Any questions about the BE-10 report should be directed to an experienced counsel to better understand the applicable reporting requirements, as well as to ensure proper completion of all applicable BE-10 reports. Patel Law Offices has significant experience with international compliance matters and can assist individuals in ensuring the proper completion of the BE-10 report.
The instructions to the BE-10 report can be found at https://www.bea.gov/surveys/pdf/be10/BE-10%20Instructions.pdf. The BE-10 report and the answers to other Frequently Asked Questions can be found at http://www.bea.gov/surveys/respondent_be10.htm.
Last we spoke at a SABANA tax section bar association educational panel “The U.S. Government’s Global Crackdown on Tax Evasion: Where It Has Been and Where It Is Going” for attorneys in Orlando FL. Fellow panelists included Nanette Davis (US Department of Justice Tax senior litigation counsel), Forrest Knorr (IRS Director, International Field Operations, West International Operations Criminal Investigation Division), Parag Patel (Patel Law Offices), and Jay Nanavati (counsel BakerHostetler).
A few interesting observations are below:
- Nanette Davis echoed earlier comments made at the NYU conference earlier in the month regarding some details of the US DOJ Program for Swiss Banks. She said that the information received from US DOJ Program for Swiss Banks and OVDP will lead to new prosecutions. Davis said that the government is comparing records from the Swiss bank program with OVDP filings and streamlined program certifications of non-willfulness and will likely prosecute some willful taxpayers.
- Davis said that the government is exploring other jurisdictions and new John Doe summons may be issued, and specifically noted that some parts of Asia may be explored.
- Forrest Knorr described in detail the IRS expansive network of IRS global operations in dozens of countries.
We discussed in detail the Offshore Voluntary Disclosure Program (OVDP), which is specifically designed for taxpayers with exposure to potential criminal liability and/or substantial civil penalties due to a willful failure to report foreign financial assets and pay all tax due in respect of those assets. The OVDP generally provides protection from criminal liability and fixed terms for resolving their civil tax and penalty obligations. Presentation materials can be found here: Navigating Foreign Waters- Discussion on the U.S. Laws for Foreign Accounts Compliance SABANA seminar.
Also discussed were the Streamlined Filing Compliance Procedures, which are available to taxpayers certifying that their failure to report foreign financial assets did not result from willful conduct. The Streamlined Filing Compliance Procedures are available to both U.S. individual taxpayers residing outside of the United States and U.S. individual taxpayers residing in the United States.
Last week, the Internal Revenue Service reminded all taxpayers with a filing requirement for a foreign bank account report to report their foreign assets by the June 30 deadline. The IRS has been targeting FBAR compliance over the last several years and has prosecuted numerous non-compliant taxpayers.
FBAR filings have risen dramatically in recent years as the Foreign Account Tax Compliance Act, or FATCA, phases in and other international compliance efforts have raised awareness among taxpayers with offshore assets, the IRS noted.
The IRS is encouraging taxpayers with foreign assets, even relatively small amounts, to check if they have a filing requirement. Separately, certain taxpayers living abroad may also have to file the FATCA-related Form 8938 with their tax returns by the June 15 deadline. (Domestic filers may also be required to file Form 8938, which would have been due by April 15 with their tax returns.)
“The vast majority of taxpayers pay their fair share. The FBAR and FATCA filing requirements make it tougher for that relatively small number of taxpayers trying to hide assets and income offshore,” said IRS Commissioner John Koskinen in a statement. “Taxpayers are encouraged to review the rules and disclose their offshore assets.”
FBAR refers to Form 114, Report of Foreign Bank and Financial Accounts, that must be filed with the Financial Crimes Enforcement Network, or FinCEN, a bureau of the Treasury Department. The form must be filed electronically and is only available online through the BSA E-Filing System website.
Who needs to file an FBAR? Taxpayers with an interest in, or signature or other authority over, foreign financial accounts whose aggregate value exceeded $10,000 at any time during 2014 generally must file. For more on filing requirements, see the current FBAR guidance on IRS.gov. Also see the one-hour webinar explaining the FBAR requirement.
The FBAR filing requirement is not part of filing a tax return. The FBAR Form 114 is filed separately and directly with FinCEN.
FBAR filings have surged in recent years, according to data from FinCEN. FBAR filings exceeded 1 million for the first time in calendar year 2014 and rose nine of the last 10 years from about 280,000 back in 2005.
The Foreign Account Tax Compliance Act was included as part of the HIRE Act of 2010. The law addresses tax non-compliance by U.S. taxpayers with foreign accounts by focusing on reporting by U.S. taxpayers and foreign financial institutions.
In general, federal law requires U.S. citizens and resident aliens to report any worldwide income, including income from foreign trusts and foreign bank and securities accounts. In most cases, affected taxpayers need to complete and attach Schedule B to their tax returns. Part III of Schedule B asks about the existence of foreign accounts, such as bank and securities accounts, and generally requires U.S. citizens to report the country in which each account is located.
In addition, certain taxpayers may also have to complete and attach to their return Form 8938 Statement of Special Foreign Financial Assets. Generally, U.S. citizens, resident aliens and certain nonresident aliens must report specified foreign financial assets on this form if the aggregate value of those assets exceeds certain thresholds. See the instructions on this form for details.
The FATCA Form 8938 requirement does not replace or otherwise affect a taxpayer’s obligation to file an FBAR Form 114. A brief comparison of the two filing requirements is available on IRS.gov.
U.S. Income Tax Obligations
U.S. citizens and resident aliens, including those with dual citizenship who have lived or worked abroad during all or part of 2014, may have a U.S. tax liability and a filing requirement in 2015.
A filing requirement generally applies even if a taxpayer qualifies for tax benefits, such as the foreign earned income exclusion or the foreign tax credit, that substantially reduce or eliminate their U.S. tax liability. These tax benefits are not automatic and are only available if an eligible taxpayer files a U.S. income tax return.
The filing deadline is Monday, June 15, 2015, for U.S. citizens and resident aliens whose tax home and abode are outside the United States and Puerto Rico, and for those serving in the military outside the U.S. and Puerto Rico, on the regular due date of their tax return. To use this automatic two-month extension, taxpayers must attach a statement to their returns explaining which of these two situations applies. See U.S. Citizens and Resident Aliens Abroad for details.
Nonresident aliens who received income from U.S. sources in 2014 also must determine whether they have a U.S. tax obligation. The filing deadline for nonresident aliens can be April 15 or June 15 depending on sources of income. See Taxation of Nonresident Aliens on IRS.gov.
More Information Available
Any U.S. taxpayer here or abroad with tax questions can refer to the International Taxpayers landing page and use the online IRS Tax Map and the International Tax Topic Index to get answers. These online tools assemble or group IRS forms, publications and web pages by subject and provide users with a single entry point to find tax information.
Taxpayers who are looking for return preparers abroad should visit the Directory of Federal Tax Return Preparers with Credentials and Select Qualifications.
To help avoid delays with tax refunds, taxpayers living abroad should visit the Helpful Tips for Effectively Receiving a Tax Refund for Taxpayers Living Abroad page.
More information on the tax rules that apply to U.S. citizens and resident aliens living abroad can be found in, Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad, available on IRS.gov.
The IRS has launched new online videos and has expanded other online resources to help taxpayers, especially those living abroad, meet their U.S. tax obligations. They can be accessed here.
Last week, the Internal Revenue Service released interim guidance (SBSE-04-0515-0025) on foreign bank account report (FBAR) penalties to improve the administration of the FBAR compliance program. The guidance contains amendments to the Internal Revenue Manual (IRM), effective immediately, and applies to all open cases in which the FBAR penalties are at issue. Examiners are required to implement these new procedures to help ensure consistent, effective and fair administration of the penalties. A Civil FBAR Penalty Case File Checklist is also included to further establish consistency in FBAR case file information.
We find that the guidance is much needed in light of the lack of uniformity in the IRS’ application of FBAR penalties.
The IRS has the burden of showing that a FBAR violation occurred and, for willful violations, that the violation was in fact willful. Because the FBAR penalty provision only provides maximum penalty amounts, the IRS is tasked with determining the appropriate FBAR penalty amount on a case-by-case basis, taking into consideration the particular underlying facts and circumstances.
In regard to willful violations over several years, the memorandum recommends a penalty equal to 50% of the highest account balances for all years with violations. Thus, in lieu a 50% penalty for each year, one 50% penalty is imposed for all years, and it is then allocated across the years based on the balances of each year. The memorandum provides this example:
Assume highest aggregate balances of $50,000, $100,000, and $200,000 for 2010, 2011, and 2012, respectively. The total penalty amount is $100,000 (50 percent of the $200,000 highest aggregate balance during the years under examination). The total of the highest aggregate balances for all years combined is $350,000. The penalty for 2010 is $14,286 ($50,000/$350,000 x $100,000). The penalty for 2011 is $28,571 ($100,000/$350,000 x $100,000). The penalty for 2012 is $57,143 ($200,000/$350,000 x $100,000). The penalty amounts for each year are subject to the maximum penalty limitation in 31 U.S.C. § 5321(a)(5)(C).
Examiners are still free to impose a higher or lower penalty, in appropriate circumstances. In no case will the penalty exceed 100% of the highest balance of the subject accounts in the years of nonreporting. Another notable change is that IRS Counsel review is no longer required except in cases in which willful penalties have been determined.
The IRS examiner has significant discretion however this provides some much-needed guidance to taxpayers and examiners alike for FBAR penalties. Since the actual amount of the penalties is still largely determined based upon “facts and circumstances” there remains a significant opportunity for persuasive legal advocacy to minimize FBAR penalties.
The interim guidance will be incorporated into IRM 4.26.16, Report of Foreign Bank and Financial Accounts (FBAR), and IRM 4.26.17,Report of Foreign Bank and Financial Accounts (FBAR) Procedures, no later than one year from the date of issuance.
Last week, the Internal Revenue Service released interim guidance (SBSE-04-0515-0025) on foreign bank account report (FBAR) (also known as FinCen 114) penalties to improve the administration of the FBAR compliance program. The guidance contains amendments to the Internal Revenue Manual (IRM), effective immediately, and applies to all open cases in which the FBAR penalties are at issue. Examiners are required to implement these new procedures to help ensure consistent, effective and fair administration of the penalties. A Civil FBAR Penalty Case File Checklist is also included to further establish consistency in FBAR case file information.
We find that the guidance is much needed in light of the lack of uniformity in the IRS’ application of FBAR non-willful penalties.
The memo states that a non-willful penalty will not be recommended if the IRS determines that the FBAR violations were due to reasonable cause and the person later files correct and complete FBARs.
In regard to non-willful violations when there are multiple accounts, the memorandum indicates in most cases only one $10,000 penalty should be imposed in each year, not $10,000 per account. The memorandum also notes, however, that lesser penalties (e.g., only imposing the penalty in one year) or greater penalties (i.e., per account penalties) may be imposed when appropriate.
Attachment 1 of the memo states that if conditions for mitigation guidelines are met then:
“examiners should make a preliminary penalty calculation based upon the mitigation guidelines in IRM 126.96.36.199.6.2, except that the penalty for each year will be limited to $10,000. This is the penalty amount, unless the facts and circumstances of a case warrant a different penalty amount.
If the facts and circumstances of a case warrant a lower penalty amount, examiners, with the group manager’s approval after consultation with an Operating Division FBAR Coordinator, may assert a single penalty, not to exceed $10,000, for one year only.” (italics added for emphasis)
This clarifies the old punitive rule that could have been interpreted and applied as $10,000 per account per year. This memo is clearly helpful to taxpayers, since it indicates that maximum penalties should be the exception not the default starting point.
While the IRS examiner has significant discretion this memo provides some much-needed guidance to taxpayers and examiners alike for FBAR penalties. Since the actual amount of the penalties is still largely determined based upon “facts and circumstances” there remains a significant opportunity for persuasive legal advocacy to minimize FBAR penalties.
Also, the memorandum notes that when accounts have co-owners, each shall be attributed the appropriate percentage ownership of the account balances in computing penalties. Co-owners of an unreported foreign financial account don’t necessarily have to be held jointly liable. Separate determinations must be made with respect to each co-owner as to whether there was a violation.
The interim guidance will be incorporated into IRM 4.26.16, Report of Foreign Bank and Financial Accounts (FBAR), and IRM 4.26.17,Report of Foreign Bank and Financial Accounts (FBAR) Procedures, no later than one year from the date of issuance.
There are many U.S. tax consequences to a foreign trust and a beneficiary of a foreign trust who is or becomes a U.S. citizen or resident alien.
In this article it is assumed that the grantor is and always will be a foreign person. For U.S. tax purposes, a foreign trust can be only one of two types – either a “foreign grantor trust” or a “foreign nongrantor trust”:
U.S. Taxation of Foreign Trusts
Foreign Grantor Trust: A trust will be characterized as a foreign grantor trust (“FGT”) only under two conditions: either, the grantor reserves the right to revoke the trust solely or with the consent of a related or subordinate party (and revest the title assets to himself), or the amounts distributable during the life of the grantor are distributable only to the grantor and/or the spouse of the grantor. Under these circumstances, the income of the trust is taxed to the grantor (i.e., the person who made a gratuitous transfer of assets to the trust). U.S. tax is limited generally to U.S. sourced investment income and income effectively connected with a U.S. trade or business will be subject to U.S. income or withholding tax.
If a U.S. grantor establishes a foreign trust for the benefit of U.S. beneficiaries, it is treated as a grantor trust. I.R.C. §679. Upon termination of grantor trust status (i.e., at the death of the grantor or if there are no longer any U.S. beneficiaries), Section 684 imposes a tax on the unrealized appreciation. However, if that occurs because of the death of the grantor, the stepup in basis under Section 1014 should avoid having any gain to which Section 684 would apply. A foreign grantor trust will generally become a foreign nongrantor trust upon the death of the grantor.
Foreign Non Grantor Trust: Any trust that does not meet the definition of a foreign grantor trust is a foreign nongrantor trust (“FNGT”), taxed as if it were a nonresident, noncitizen individual who is not present in the U.S. at any time. U.S. tax is generally limited to U.S. sourced investment income and income effectively connected with a U.S. trade or business.
Foreign Grantor Trust: Distributions to a U.S. beneficiary by an FGT will generally be treated as non-taxable gifts, but may be subject to U.S. tax reporting requirements.
Converting Non-Grantor Trust to Grantor Trust: There are a few possible ways of converting a non-grantor trust to a grantor trust include the following:
- If the trust allows distributions without an ascertainable standard, change trustees so that more than half of the trustees are related or subordinate parties (§674(c)). (This strategy can also be used to toggle between grantor trust and non-grantor trust status.)
- Turn the trust into a foreign trust (§679) [but many other complexities arise with being a foreign trust].
- Actual borrowing of assets from the trust by the grantor without giving adequate security (§675(3)).
Foreign Nongrantor Trust: A U.S. beneficiary will be subject to tax on distributions to the beneficiary of “distributable net income” (“DNI”) from the FNGT. The character of such DNI distributions will reflect the character of the income as received by the FNGT. If a FNGT accumulates its income and distributes the accumulation in later years in excess of DNI, the U.S. beneficiary will be subject to the “throwback rules”, which generally seek to treat a beneficiary as having received the income in the year in which it was earned by the trust, using a relatively complex formula. The beneficiary may be required to pay a “throwback tax” (a “catch up” tax) and an interest charge on the deferral. Furthermore, such throwback distributions will be taxed at ordinary income tax rates. The throwback rules will not apply to amounts accumulated when the trust was an FGT.
Reporting obligations will arise when a foreign trust makes a distribution to a U.S. beneficiary. A U.S. person who receives a distribution from a foreign trust must include Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts) with his or her tax return. Generally, the Trustee should furnish to the U.S. beneficiary a “Foreign Nongrantor Trust Beneficiary Statement”, which will be attached to the Form 3520. (While there is a “Foreign Grantor Trust Beneficiary Statement”, that Beneficiary Statement contemplates a U.S. grantor, who will report the Trust’s income on his or her U.S. income tax return, and therefore may not suitable for an FGT with a foreign grantor.) For a FNGT, the Beneficiary Statement includes the distributable net income for the year, the years to which an accumulation distribution is attributed, and the amounts allocable to each year.
Extremely high penalties may apply for failing to report fully all required information and for failing to report on a timely basis:
(i) If a U.S. transferor of property to a foreign trust, or a U.S. recipient of a distribution from such a trust, fails timely file a Form 3520 to report these transactions, the IRS may impose a penalty equal to 35% of the gross value of the property transferred to or received from the trust.
(ii) If a U.S. donee fails to timely file a Form 3520 to report the receipt of a large foreign gifts, or files the form incorrectly or incompletely, such donee may be subject to a penalty equal to 5%, not to exceed 25%, of the value of the gift or bequest received in the relevant year.
(iii) If a foreign grantor trust fails to timely file a Form 3520-A, or fails to furnish all of the required information, the U.S. owner may be subject to a penalty equal to 5% of the gross value of the portion of the trust’s assets treated as owned by the U.S. person at the close of the taxable year.
(iv) The failure to timely file a complete and correct Form 3520 or Form 3520-A may result in an additional penalty of $10,000 per 30-day period for failing to comply within 90 days of notification by the IRS that the information return has not been filed. The total penalty for failure to report a trust transfer, however, cannot exceed the amount of the property transferred.
Contrary to foreign grantor trusts, foreign nongrantor trusts generally do not have an information reporting requirement. However, U.S. persons who maintain or engage in certain transactions with foreign grantor or nongrantor trusts during the year are generally required report such transactions to the IRS on a Form 3520. Such reportable transactions include: (1) ownership of a foreign grantor trust; (2) transfer of property to a foreign trust (i.e., the U.S. transferor must notify the IRS of the transfer and provide the IRS with the identity of the trustees and beneficiaries); and, (3) receipt of property or distribution from a foreign trust.
Other Tax Consequences:
Special Taxing Regimes: If the foreign trust has investments in foreign corporations, the presence of a U.S. beneficiary may have the unfortunate effect of subjecting the U.S. beneficiary to two special U.S. taxing regimes: those applicable to “controlled foreign corporations” (“CFCs”) and those applicable to “passive foreign investment companies” (“PFICs”). The CFC rules (which generally preempt the PFIC rules) subject certain types of income allocable to a “U.S. Shareholder” (as specially defined) to immediate U.S. taxation, whether or not distributed, and characterize certain gains upon disposition of the stock as ordinary income. Unless certain exceptions apply, the PFIC rules are designed to penalize U.S. taxpayers on “excess distributions” from a PFIC or upon a disposition of PFIC stock, imposing the highest ordinary income rates and an interest charge.
Report of Foreign Bank and Financial Accounts (“FBAR”) Filings: FBAR filings on Form TD-F 90-22.1 are generally required to be made by U.S. persons who have reportable financial interests in or signature authority over a foreign financial account (“FFA”). A U.S. person who has more than a 50% present beneficial interest in a trust’s income or assets may be deemed to have an FFA interest and may be required to make an FBAR filing. A trust beneficiary of a foreign nongrantor trust may receive an exemption from FBAR reporting if a trustee who is a U.S. person makes an FBAR filing disclosing the trust’s FFAs and provides information as required.
Foreign Account Tax Compliance Act (“FATCA”)
FATCA Entity Reporting: FATCA imposes a 30% withholding tax on payments to “foreign financial institutions” (“FFIs”) that do not comply with certain disclosure requirements about their U.S. account holders. A foreign trust that invests (directly or indirectly) in securities and other financial interests may, under certain circumstances, be treated as an FFI if the trustee is a trust company or if an entity, such as a bank or other financial institution, is acting as the investment advisor. In that case, the trust may have to register with the I.R.S. and receive a global intermediary identification number.
FATCA Individual Reporting: A U.S. person who holds an interest in a specified foreign financial asset must disclose such interest on Form 8938 if the aggregate value of all such assets exceeds certain threshold amounts (e.g., in the case of an unmarried individual, $50,000 on the last day of the tax year, or $75,000 at any time during the year). A foreign financial asset includes an interest in a foreign trust, although special valuation rules may apply. Typically, assets are reported only when and as a trust makes a distribution to a U.S. beneficiary, the amount of the distribution being the reportable asset. This disclosure requirement is in addition to the FBAR requirement described above. Items reported on Form 3520, described above, do not have to be reported on Form 8938, but Part IV of Form 8938 must be completed to indicate the Form 3520 filing.
The presence of a U.S. beneficiary in what had been a purely foreign trust presents tax challenges. In addition to the imposition of additional U.S. taxes and enhanced reporting requirements, the presence of a U.S .beneficiary may have unexpected tax consequences depending on the nature of the assets held by the foreign trust. It is important to preventatively identify these issues early in the process, as it may be easier to address and resolve some of these issues before the beneficiary becomes a U.S. taxpayer.
The “United States Permanent Resident Card”, also known as a Green Card, as a work and residence permit for the USA of unlimited duration and as an immigration visa, constitutes an admission ticket to the USA. However, possession of a Green Card confers more obligations than just benefits on its holder.
Many clients with Green Cards have asked us whether expatriation is a viable solution to getting out of the onerous US tax system. Unfortunately, US tax law prevents US taxpayers avoiding US tax liability by renouncing their US citizenship or by relinquishing their Green Card. The relevant US tax (known as “expatriation tax”) relates to individuals who renounce their US citizenship and also to certain long term Green Card holders. You are a long term Green Card holder if you were a lawful permanent resident of the United States in at least 8 of the last 15 tax years ending with the year your residency ends. In determining if you meet the 8-year requirement, do not count any year that you are treated as a resident of a foreign country under a tax treaty and do not waive treaty benefits.
Whether the expatriation tax applies will depend on the satisfaction of at least one of the following three conditions:
- Where the relinquishment of the Green Card occurred in 2010, the average assessed US taxes for the five years prior to the relinquishment of the Green Card must amount to more than $145,000. This amount is adjusted on an annual basis.
- The worldwide assets of the taxpayer are assessed for the purposes of the application of the “US expatriation tax” rules. The criteria will have been met where the value of the worldwide assets exceeds $2,000,000 at the date of the relinquishment of the Green Card.
- The taxpayer must show that he or she has complied with his or her obligations in respect of US taxation (for example, the submission of US tax returns) during the five years prior to the relinquishment of the Green Card.
The expatriation rules apply to you if you meet any of the following conditions.
- Your average annual net income tax for the 5 years ending before the date of expatriation or termination of residency is more than:
- $139,000 if you expatriated or terminated residency in 2008.
- $145,000 if you expatriated or terminated residency in 2009 or 2010.
- $147,000 if you expatriated or terminated residency in 2011.
- $151,000 if you expatriated or terminated residency in 2012.
- $155,000 if you expatriated or terminated residency in 2013.
- $157,000 if you expatriated or terminated residency in 2014.
- Your net worth is $2 million or more on the date of your expatriation or termination of residency.
- You fail to certify on Form 8854 that you have complied with all U.S. federal tax obligations for the 5 years preceding the date of your expatriation or termination of residency.
- You expatriated before 2014 and you:
- Deferred the payment of tax,
- Have an item of eligible deferred compensation, or
- Have an interest in a nongrantor trust.
Exception for dual-citizens and certain minors. Certain dual-citizens and certain minors (defined next) are not subject to the expatriation tax even if they meet (1) or (2) above. However, they still must provide the certification required in (3) above.
Certain dual-citizens. You may qualify for the exception described above if both of the following apply.
- You became at birth a U.S. citizen and a citizen of another country and you continue to be a citizen of, and are taxed as a resident of, that other country.
- You have been a resident of the United States for not more than 10 years during the 15-year tax period ending with the tax year during which the expatriation occurs. For the purpose of determining U.S. residency, use the substantial presence test described in chapter 1.
Certain minors. You may qualify for the exception described earlier if you meet both of the following requirements.
- You expatriated before you were 18½.
- You have been a resident of the United States for not more than 10 tax years before the expatriation occurs. For the purpose of determining U.S. residency, use the substantial presence test described in chapter 1.
Expatriation date. Your expatriation date is the date you relinquish U.S. citizenship (in the case of a former citizen) or terminate your long-term residency (in the case of a former U.S. resident).
Former U.S. citizen. You are considered to have relinquished your U.S. citizenship on the earliest of the following dates.
- The date you renounced U.S. citizenship before a diplomatic or consular officer of the United States (provided that the voluntary renouncement was later confirmed by the issuance of a certificate of loss of nationality).
- The date you furnished to the State Department a signed statement of voluntary relinquishment of U.S. nationality confirming the performance of an expatriating act (provided that the voluntary relinquishment was later confirmed by the issuance of a certificate of loss of nationality).
- The date the State Department issued a certificate of loss of nationality.
- The date that a U.S. court canceled your certificate of naturalization.
Former long-term resident. You are considered to have terminated your long-term residency on the earliest of the following dates.
- The date you voluntarily relinquished your lawful permanent resident status by filing Department of Homeland Security Form I-407 with a U.S. consular or immigration officer, and the Department of Homeland Security determined that you have, in fact, abandoned your lawful permanent resident status.
- The date you became subject to a final administrative order for your removal from the United States under the Immigration and Nationality Act and you actually left the United States as a result of that order.
- If you were a dual resident of the United States and a country with which the United States has an income tax treaty, the date you began to be treated as a resident of that country and you determined that, for purposes of the treaty, you are a resident of the treaty country and notify the IRS of that treatment on Forms 8833 and 8854. See Effect of Tax Treaties in chapter 1 for more information about dual residents.
How To Figure the Expatriation Tax (If You Expatriate After June 16, 2008)
In the year you expatriate, you are subject to income tax on the net unrealized gain (or loss) in your property as if the property had been sold for its fair market value on the day before your expatriation date (“mark-to-market tax”). This applies to most types of property interests you held on the date of relinquishment of citizenship or termination of residency. But see Exceptions , later.
Gains arising from deemed sales must be taken into account for the tax year of the deemed sale without regard to other U.S. internal revenue laws. Losses from deemed sales must be taken into account to the extent otherwise provided under U.S. internal revenue laws. However, Internal Revenue Code section 1091 (relating to the disallowance of losses on wash sales of stock and securities) does not apply. The net gain that you otherwise must include in your income is reduced (but not below zero) by:
- $600,000 if you expatriated or terminated residency before January 1, 2009.
- $626,000 if you expatriated or terminated residency in 2009.
- $627,000 if you expatriated or terminated residency in 2010.
- $636,000 if you expatriated or terminated residency in 2011.
- $651,000 if you expatriated or terminated residency in 2012.
- $668,000 if you expatriated or terminated residency in 2013.
- $680,000 if you expatriated or terminated residency in 2014.
Exceptions. The mark-to-market tax does not apply to the following.
- Eligible deferred compensation items.
- Ineligible deferred compensation items.
- Interests in nongrantor trusts.
- Specified tax deferred accounts.
Instead, items (1) and (3) may be subject to withholding at source. In the case of item (2), you are treated as receiving the present value of your accrued benefit as of the day before the expatriation date. In the case of item (4), you are treated as receiving a distribution of your entire interest in the account on the day before your expatriation date. See paragraphs (d), (e), and (f) of section 877A for more information.
Expatriation Tax Return
If you expatriated or terminated your U.S. residency, or you are subject to the expatriation rules (as discussed earlier in the first paragraph under Expatriation After June 16, 2008), you must file Form 8854. Attach it to Form 1040 or Form 1040NR if you are required to file either of those forms.
Deferral of payment of mark-to-market tax. You can make an irrevocable election to defer payment of the mark-to-market tax imposed on the deemed sale of property. If you make this election, the following rules apply.
- You can make the election on a property-by-property basis.
- The deferred tax attributable to a particular property is due on the return for the tax year in which you dispose of the property.
- Interest is charged for the period the tax is deferred.
- The due date for the payment of the deferred tax cannot be extended beyond the earlier of the following dates.
- The due date of the return required for the year of death.
- The time that the security provided for the property fails to be adequate. See item (6) below.
- You make the election on Form 8854.
- You must provide adequate security (such as a bond).
- You must make an irrevocable waiver of any right under any treaty of the United States which would preclude assessment or collection of the mark-to-market tax.
Patel Law Offices has consulted with hundreds of clients regarding their offshore asset compliance issues and expatriation. Patel Law Offices is a law firm dedicated to helping clients resolve complicated tax, criminal tax, and international tax problems. Our firm assists (and defends) clients and their advisors to legally disclose (and legitimize) foreign accounts.