Patrick J. McCormick authored the cover article of the August issue of Practical Tax Strategies, a national tax journal published by Thomson Reuters (and distributed electronically through RIA Checkpoint). The following article has been republished with permission from Practical Tax Strategies.
International tax is a rapidly expanding area, no longer an esoteric topic exclusively relevant to multinational corporations. As a result of expanding globalization, more and more clients maintain international ties, whether through dual citizenship, having previously worked overseas, or from having family members in other countries. Increased emphasis on reporting requirements by the Internal Revenue Service in the international context also exists. Familiarity with the overarching concepts of international tax is thus vital in order to intelligently and appropriately converse with clients on these issues. This article is intended as an overview of issues most commonly presented by clients seeking advice in regards to international reporting requirements.
At a basic level, the United States imposes income tax on the worldwide income of United States citizens under I.R.C. § 1. The term “worldwide income” generally carries the meaning one would expect: Citizens and residents are taxable on all income wherever sourced (actual amounts of tax can be reduced by other factors to be discussed herein). Any person born or naturalized in the United States and subject to its jurisdiction is a citizen, under Regs. § 1.1-1(c). Additionally, a person is born a citizen even if not born in the United States if they had a parent or parents who were United States citizens at the time of their birth (and have their parents meet certain other requirements). Persons becoming United States citizens under this method will sometimes be deemed “accidental citizens”.
Accidental citizenship can create unanticipated tax filing consequences. Consider an individual born in Germany to parents both of whom are dual citizens of the United States and Germany; the parents met in the United States in college, then moved to Germany full-time after school and currently have no plans to return (save a vacation home they maintain in Connecticut). The child becomes a United States citizen at birth, even though she was not born in the United States (and her parents have no plans of residing in the country at any point going forward). Fast forward thirty years: the accidental citizen has become a successful doctor in Germany, and received the Connecticut vacation home from her parents as a gift for graduating medical school (and as part of the parents’ tax planning strategy recommended by German financial advisors). From a technical standpoint, the German doctor has a requirement to file Form 1040 for every year, and to report income earned by her worldwide (even though it was all German-sourced). Worse, now that she has a significant asset (the vacation home) in her name, the United States has an asset located within its borders which is ripe for assessment by the Service.
As with citizens, residents are taxable on their worldwide income under I.R.C. § 1. Residency standards are provided under I.R.C. § 7701(b). An individual is classified as a resident of the United States for a given year if they (i) are lawfully admitted for permanent residence, (ii) meet substantial presence requirements, or (iii) make an election to be treated as a citizen. The first requirement is relatively straightforward: it is met when the individual maintains a green card in the United States. Importantly, the individual maintains a tax filing requirement as a resident for all years in which they maintain a green card (even if not present in the United States).
The most complicated determination comes from the substantial presence test, which requires calculating an individual’s presence in the United States over the relevant period. An individual is considered a resident of the United States (and subject to tax on their worldwide income) in a given year if they were present in the United States for at least 31 days during the current year and the sum of days spent over the last three years, after use of applicable multipliers, is 183. The applicable multiplier for the current year is 1, the applicable multiplier for the first preceding year is 1/3, and the applicable multiplier for the second preceding year in 1/6. For test purposes, the individual is classified as “present” in the United States on any day in which they maintain a physical presence in the country at any time, with certain limited exceptions (i.e. an inability to leave based on a medical condition, or days spent in the United States as a teacher, student, athlete, or foreign government employee). It is also important to note that, under the formula provided, an individual will be considered a resident in any year they spend 183 days in the United States regardless of their presence in prior years. Conversely, an individual with no presence in the United States in a current year will never be considered a United States resident, even if they spent every day in the previous two years in the United States.
The test can be illustrated by the following example: Say Larry spent sixty days in the United States in the current year, and spent three hundred days in the United States in the prior two years. To calculate his presence, the following equation is used: (60) + (300 x 1/3) + (300 x 1/6) = 210. Larry would thus be classified as a resident for the current year for filing purposes, even though he spent far under half his days in the current year in the United States. Suppose that, instead, Larry spent sixty days in the United States in the current year, but only two hundred ten days in the prior two years. Larry’s presence would thus be (60) + (240 x 1/3) + (240 x 1/6) = 180, meaning that Larry would not be classified as a United States resident.
Even if meeting the requirements of the above test, an individual can still be treated as a nonresident alien if they are deemed to have a “closer connection” to a foreign country. For such a closer connection to exist, the individual must be present in the United States for less than 183 days during the current year, maintain a tax home in a foreign country during the year, and must have a closer connection during the year to that country (i.e. whether more significant contacts exist with that country than with the United States).
For parties who arrive in the United States too late in the year to meet the substantial presence test but still wish to be treated as a resident (based, for example, on the availability of deductions to residents which are not available to nonresidents) may make an election under I.R.C. § 7701(b). To make an election, the individual must have been present in the United States for at least 31 days in the election year, must be present in the United States for at least 75% of the days during the period beginning on the first day of the 31 day period and ending on the last day of the election year, and must qualify as a United States resident (under the substantial presence test) in the subsequent tax year. Generally, an individual is treated as present in the United States on any day he or she is physically present in the country at any time during the day.
Nonresidents are taxable in the United States only on income sourced from the United States under I.R.C. § 871. Sources of income for these purposes include income “effectively connected” with a United States trade or business and fixed or determinable annual or periodic gains, profits, and income (often termed “FDAP Income”). Nonresidents individuals will typically file returns to obtain benefits from available deductions and credits against tax on income (tax is typically withheld on sources of income). Capital gains taxes generally do not apply to nonresident taxpayers, unless capital gains are associated with United States real property or a United States trade or business.
Election for Nonresident Spouses
United States taxpayers with a nonresident spouse can file an election under I.R.C. 6013(g) to have their spouse treated as a resident for tax purposes. One obvious reason for making such an election is to take advantage of the lower tax rates and higher deduction amounts when filing jointly. However, such an election does require paying tax on the worldwide income of the nonresident spouse. The spouses must file a joint return in the first year the election is made (but are not required to file jointly in subsequent years). The nonresident spouse must continue filing until the 6013(g) election is revoked. To make the election, a statement is attached to the joint return filed with the Service for the applicable tax year. The statement should contain a declaration that one spouse was a citizen or resident, the other was a nonresident, and that both choose to be treated as residents for the entire tax year. It should also list the name, address, and Social Security Number for each spouse. This election can be made for the first time on an amended return; however, if proceeding in this fashion, any returns filed after the year for which the choice was made must also be amended.
INCOME TAX TREATIES
The general rules related to reporting are provided herein; however, certain aspects of reporting are modified based on the specific terms of tax treaties between the United States and foreign countries. At present, the Internal Revenue Service lists income tax treaties with over sixty (60) countries; a more limited number of estate and gift tax treaties also exist. As with credits and exclusions available for foreign income (discussed immediately below), tax treaties reduce the burden of double taxation; tax treaties attempt to accomplish this goal primarily by resolving jurisdictional issues between countries as to taxpayers and their income sources. Tax treaties act to reduce the scope of a country’s taxing authority in situations covered by treaty terms. Where treaty terms do not cover a type of transaction (or where no treaty exists between the United States and a relevant country), the United States taxes in accordance with its standard rules.
While contents of specific tax treaties with other countries will vary, the United States maintains a model version of a tax treaty for use with other countries (last modified in 2006), with a technical explanation for the same. Generally speaking, the United States policy is that, while treaty terms can modify the ability of the United States to tax residents of other countries, its ability to tax its own residents and citizens should not be hampered; provisions to this effect are in many treaties (deemed the “savings clause”). Thus, tax treaties often will not reduce the United States tax burden of United States residents or citizens.
Where available, treaty benefits typically are claimed by filing Form 8833, under which a disclosure of the taxpayer’s treaty-based return position is made. Form 8833 is attached to and filed with the taxpayer’s tax return.
FOREIGN INCOME EARNED BY A UNITED STATES TAXPAYER
United States citizens or residents with foreign income will, in most cases, be faced with potential taxes on foreign-source income from both the United States and the country in which the income was earned. For example, assume a citizen of the United States earned $300,000 in England in the current tax year, all from wages. These wages are taxable in England; however, as a United States citizen, her wages are also taxable in the States. To alleviate the potential for a double tax burden, the United States grants relief to taxpayers for taxes owed to other jurisdictions on their foreign income amounts. The two primary methods for obtaining such relief are the Foreign Tax Credit and the Foreign Earned Income Exclusion. Importantly, taxpayers must choose between these two – taxpayers choosing relief through exclusion of foreign earned income cannot also take a foreign tax credit on taxes excluded.
Foreign Tax Credit – Form 1116
Statutory framework for the foreign tax credit is provided under I.R.C. § 901-909. The foreign tax credit is generally available to citizens and residents of the United States for taxes paid to foreign jurisdictions. Regs. 1.901-2(a)(2) states that a foreign levy is considered a tax if “it requires a compulsory payment pursuant to the authority of a foreign country to levy taxes. A penalty, fine, interest, or similar obligation is not a tax, nor is a customs duty a tax.” I.R.C. § 903 provides that payment made in lieu of a tax on income imposed by a foreign country is considered a tax for foreign tax credit purposes. Taxes also must be validly owed by an individual for a foreign tax credit to be taken. Where a taxpayer claims a foreign tax credit for taxes paid, then subsequently receives a refund for all or part of those taxes, the taxpayer is required to file an amended return in the United States reducing the foreign tax credit for the year at issue.
Generally, the foreign tax credit amount is limited to the amount of foreign tax paid or accrued or, if smaller, the foreign tax credit limit. The foreign tax credit limit for these purposes is an individual’s total United States tax liability multiplied by a fraction, the numerator of which is the individual’s taxable income from sources outside the United States and the denominator of which is total taxable income from United States and foreign sources. Foreign taxes available for credit but not able to be used because of the foreign tax credit limit can be carried back to the previous year or carried forward for up to ten years.
Where a United States taxpayer is a partner in a foreign partnership, the United States individual can claim a credit for the proportionate share of foreign taxes paid by the partnership under I.R.C. § 901(b)(5). In accordance with Regs. 1.904-5(i), limited partners who own less than a 10% interest in the partnership (and who do not actively participate in the partnership) are permitted to categorize their distributive share of foreign source income from the partnership as passive income (a similar rule applies for S corporations). Nonresidents (subject to tax on effectively connected income) can receive a credit for any tax paid to a foreign jurisdiction with respect to their effectively connected income, pursuant to I.R.C. 906(a).
The foreign tax credit is typically claimed on a taxpayer’s Form 1040 by filing Form 1116 with the return (in certain narrow circumstances, the tax credit can be claimed on Form 1040 without having to file Form 1116). Form 1116 can be filed by individuals, estates, or trusts. Foreign income taxes paid are deducted on Schedule A of Form 1040. Amounts of foreign taxes paid are reported in dollars, with the conversion rate typically being the rate of exchange in effect on the day the individual paid the foreign taxes (unless foreign income taxes are accounted for on an accrual basis, in which case the average exchange rate for the tax year is normally used).
A separate Form 1116 is filed for each category of foreign source income; the categories of income are passive category income, general category income, section 901(j) income (regarding foreign taxes imposed by and paid or accrued to certain sanctioned countries), certain income re-sourced by treaty, and lump-sum distributions.
FOREIGN EARNED INCOME EXCLUSION – FORM 2555
I.R.C. § 911(a) provides that taxpayers by election may exclude their foreign earned income and their housing cost amounts. For 2015, up to $100,800 of foreign income can be excluded from earnings. The maximum foreign housing exclusion for 2015 is $14,112. If using the exclusions, a taxpayer must determine the tax on nonexcluded income using the tax rates which would have applied had the exclusions not been claimed. For these purposes, amounts received as pensions and annuities are not classified as foreign earned income, as per I.R.C. 911(b)(1)(B).
To claim the foreign earned income exclusion and the foreign housing exclusion, a taxpayer must have foreign earned income, must have their tax home in a foreign country, and must be one of the following:
- a United States citizen who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year,
- a United States resident alien who is a citizen or national of a country with which the United States has an income tax treaty in effect and who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year; or
- a United States citizen or resident alien who is physically present in a foreign country or countries for at least 330 full days (which do not need to be consecutive) during any period of twelve (12) consecutive months.
An individual’s tax home is the general area of their main place of business, employment, or post of duty, regardless of the location of the individual’s family home; the tax home is where the individual is permanently or indefinitely engaged to work. Where the taxpayer has no fixed place of business, the tax home can be where the taxpayer primarily resides.
As to the three tests enumerated above, the first two tests contain subjective requirements vis a vis bona fide residency, while the third test contains an objective standard (and does not hinge on whether the taxpayer has become a bona fide resident of the country). As to bona fide residency, the Service notes that an individual does not automatically become a bona fide resident of a country by spending a year there; rather, determinations are made based on the facts and circumstances involved (with the taxpayer’s intentions, the purpose of their trip, and the nature and length of their stay abroad among relevant factors).
Both the foreign earned income exclusion and the foreign housing exclusion are elected by completing Form 2555. As with Form 1116, Form 2555 is attached to – and filed with – an individual’s Form 1040. Normally, the foreign earned income exclusion and the foreign housing exclusion must be claimed on either a timely filed return or on a return amending a timely filed return. An election to claim an exclusion on Form 2555 stays in effect for future years until it is revoked. Revocation of an election is made by attaching a statement to the taxpayer’s return in the first year they do not wish to claim the exclusion; once revoked, the exclusions cannot be claimed in the next five (5) tax years without approval from the Service.
A simplified version of Form 2555, Form 2555-EZ, can be used where the taxpayer meets the following seven requirements:
- They are United States citizens or residents;
- They earned wages or salaries in a foreign country;
- They had total foreign earned income of $100,800 or less (for 2015)
- They are filing a calendar year return which covers a 12-month period;
- They do not have self-employment income;
- They do not have business/moving expenses; and
- They do not claim the foreign housing exclusion or deduction.
FORMS REQUIRED FOR REPORTING INTERNATIONAL ASSETS
As indicated, reporting requirements exist for United States persons with international holdings/income; many forms have only recently come into effect (primarily through the 2010 Hiring Incentives to Restore Employment, or “HIRE”, Act). A summary of relevant forms is provided below.
Individuals reporting international interests report income from those assets (and from all other sources) on Form 1040, which is to be filed by citizens and residents (if the amount of their income meets return-filing requirements). Many deductions and credits available for domestic income are also applicable to offset income from foreign sources. Schedule B of Form 1040 is used to report interest and dividends from foreign sources, as well as to indicate the existence of foreign accounts. Nonresident aliens with United States filing requirements typically use Form 1040-NR; this form is also used by United States residents in their year of departure from the United States.
United States citizens and residents living abroad on the date their return is due automatically are granted a two-month extension of time to file their tax return; the extension is obtained by attaching a statement to the return to this effect. Where a taxpayer files a joint return with his or her spouse, the extension is available even if only one of the spouses is overseas on the return’s due date.
In many instances, the factor of greatest importance to Form 1040 in regards to offshore income is the potential for the statute of limitations to shift based on the amount of foreign income. Generally, the statute of limitations period for Form 1040 is three years from the due date for the return or the return’s filing date (whichever is later). However, under I.R.C. § 6508 (e)(1)(A)(ii), where an individual omits more than $5,000 in gross income from “specified foreign financial sources”, the statute of limitations is extended to six (6) years after the filing of the return. “Specified foreign financial sources” generally means assets required to be reported on Form 8938 (discussed below).
FINCEN REPORT 114 (“FBAR”)
Generally, United States persons with financial interests in or signature authority over foreign financial accounts must disclose their foreign holdings on FinCEN Report 114 (the “FBAR”) if the aggregate value of such accounts exceeds $10,000 during the calendar year. Reporting requirements exist for United States citizens, residents, entities (corporations, partnerships, and limited liability companies), trusts and estates. The FBAR is required to be filed electronically, and is filed separate from an individual’s Form 1040. “Foreign financial accounts” include a wide assortment of accounts, including some insurance policies and mutual funds. United States persons include United States citizens and residents, and “persons” includes limited liability companies, corporations, partnerships, trusts, and estates.
The FBAR currently is due on June 30 of each year, and no extension for filing the form is available. However, beginning with FBARs filed for the 2016 tax year, the filing deadline will change to April 15; filing extensions of up to six months will also be available. Under the new law, individuals residing overseas are not required to file the FBAR until June 15.
Penalties for failure to file FBARs are significant. Willful failures to file the FBAR cause an annual penalty of $100,000 or 50% of the total balance of the foreign account per violation, whichever is greater. Where required FBARs have not been filed, the IRS can assess penalties for six years. Nonwillful failures to file carry a penalty of $10,000 per violation. Additional penalties of up to 25% on amounts owed related to foreign assets on an individual’s Form 1040 can be imposed for failure to file returns and failure to pay amounts owed where the failure is nonfraudulent. For fraudulent failures, penalties can reach 75%. An accuracy-related penalty of 20% may also be assessed on foreign income not included on Form 1040. In some instances, criminal charges can also be pursued against taxpayers for a failure to file (though this is rare). A six-year statute of limitations exists for assessments based on failures to file required FBARs.
Form 8938 is used to report specified foreign financial assets where the total value of all specified foreign assets in which the taxpayer has an interest is more than the appropriate reporting threshold. For unmarried individuals (or married individuals filing separate returns) living in the United States, the reporting threshold is satisfied if the total value of their specified foreign financial assets is more than $50,000 on the last day of the tax year, or more than $75,000 at any time during the tax year. For married taxpayers filing joint returns, the threshold is $100,000 on the last day of the year, or $150,000 at any time during the year. For unmarried taxpayers (or married taxpayers filing separate returns) living overseas, the threshold is $200,000 on the last day of the year or $300,000 at any time during the year; for married taxpayers filing jointly, the threshold is $400,000 on the last day of the year or $600,000 at any time during the year.
Specified foreign assets include financial accounts maintained by a foreign financial institution. They also include stock or securities issued by someone that is not a United States person, any interest in a foreign entity, and any financial instrument or contract that has an issuer or counterparty that is not a United States person, if any of these assets are held for investment and not held in an account maintained by a financial institution.
Failure to file Form 8938 carries a $10,000 penalty if the form is not filed by the due date of the taxpayer’s tax return (including extensions). If Form 8938 is not filed with the IRS within 90 days after the Service mails the taxpayer a notice of the failure to file, the taxpayer is subject to an additional $10,000 penalty for each 30-day period during which they continue to fail to file (up to a maximum of $50,000).
Importantly, a failure to file Form 8938 (or failure to report a specified foreign financial asset that is required to be reported) can cause the statute of limitations for the tax year to remain open for all or a part of the income tax return itself. The statute of limitations remains open until three years after the date on which Form 8938 is filed.
FORM 8621 AND ADDITIONAL FORMS
While many practitioners maintain familiarity with the FBAR and Form 8938, other typically less familiar forms exist for reporting foreign interests; such forms can be problematic. One such form is Form 8621, filed by taxpayers who are holders of interests in passive foreign investment companies (“PFICs”). Foreign corporations are classified as PFICs if either (i) 75% or more of the corporation’s gross income for its taxable year is passive income or (ii) at least 50% of the average percentage of assets held by the foreign corporation during the taxable year are assets which produce passive income (or that are held for the production of passive income). Importantly, most non-United States mutual funds are classified as PFICs (as the funds make investments and generate passive income, with the fund’s assets being held for the production of passive income).
Investments in PFICs are generally subject to high tax rates, with losses in PFICs unavailable to offset gains in non-PFICs. Reporting rules are also onerous: each separate PFIC investment is reported on Form 8621. Reporting itself is complicated, and can be extremely difficult to navigate. The combination of sizeable tax amounts owed and arduous reporting requirements (with associated significant costs for preparing required forms) causes the majority of professionals to advise clients to avoid foreign mutual funds (or other assets which necessitate PFIC reporting). Unfortunately, practitioners are often unaware such investments have been made until after the fact.
Form 8621 is attached to and filed with the individual’s tax return; the form can be directly filed with the Service if no tax return is required for the taxpayer in the given year. No specific penalties are provided either by the regulations issued regarding Form 8621 or the instructions for the form. However, as with Form 8938, failure to file Form 8621 can cause the statute of limitations to remain open until filed, at minimum for foreign assets which should have been reported on the form (in accordance with I.R.C. § 6501(c)(8)).
Form 3520 is filed by United States persons primarily to report certain transactions (mainly comprised of “reportable events”) with foreign trusts, ownership of foreign trusts, receipts of distributions from foreign trusts, and receipts of foreign gifts/bequests from foreign persons. Reportable events include the creation of a foreign trust by a United States person, the transfer of any money or property to a foreign trust by a United States person, and the death of a United States person who either was treated as the owner of a foreign trust or had a portion of a foreign trust included in his or her gross estate.
The primary reason for filing of interest to individual taxpayers is often the receipt of foreign gifts or bequests. Filing requirements exist where an individual received either more than $100,000 from a nonresident alien individual or foreign estate which were treated as gifts or bequests, or more than $15,358 from foreign corporations or partnerships (which were treated as gifts).
The due date for Form 3520 is generally the same as the due date for the individual’s tax return (including any extensions). Where Form 3520 is not timely filed, the time for assessment of any tax imposed with respect to any information required on Form 3520 will not expire until three (3) years after filing of the Form 3520. Penalties for a failure to file Form 3520 are the greater of $10,000 or either (i) 35% of the gross value of any property transferred to or received from a foreign trust or (ii) 5% of the gross value of trust assets treated as owned by a United States person. For failure to report foreign gifts, I.R.C. § 6039F imposes a penalty equal to 5% of the value of such gifts for each month the failure to report continues (with the penalty not to exceed 25%). Reasonable cause exceptions apply to penalties imposed for failure to file Form 3520.
Forms 5471 and 8865
Form 5471 is required to be filed by relevant officers, directors, and shareholders of specified foreign corporations under I.R.C. § 6038. The form is required to be filed by United States persons who are officers and directors in a corporation in which a United States person has acquired either 10% of the stock of the company or an additional 10% of the stock of the company (measured in value or voting power). United States persons acquiring 10% of the stock of a foreign corporation also must file, as must United States persons treated as shareholders of such a corporation. A united States person must also file when disposing of sufficient stock in the foreign corporation to reduce their interest to less than the stock ownership requirement. Persons classified as in “control” of a foreign corporation (owning 50% or more of the stock of a foreign corporation) for 30 days or more and owners of stock in a controlled foreign corporation for 30 days or more (who also own such stock on the last day of the year) also must file. Different categories of filing exist based on the individual’s interests in the corporation.
Form 8865 imposes similar requirements for United States persons with interests in foreign partnerships. Filing requirements exist for individuals who controlled a foreign partnership at any time during the year, owned 10% or greater interests in a foreign partnership controlled by United States persons, contributed property to a foreign partnership in exchange for an interest in the partnership, or had “reportable events” (acquisitions, dispositions, and changes in proportional interests) during their tax year.
Both Form 5471 and Form 8865 are attached to and filed with an individual’s income tax return. Where the forms are required and not filed, penalties can depend on the category of filing required, and penalties of $10,000 can be imposed for each failure to file. If the forms are not filed with the IRS within 90 days after the Service mails the taxpayer a notice of the failure to file, the taxpayer is subject to additional $10,000 penalties for each 30-day period during which they continue to fail to file (up to a maximum of $50,000).
RETROACTIVE DISCLOSURE OPTIONS FOR INTERNATIONAL ASSETS
Often, individuals with foreign assets will only discover the full extent of their reporting requirements after maintaining the assets for a number of years. This leaves the individuals open to assessment of the numerous significant penalties discussed above. Given the relative unfamiliarity with offshore reporting requirements of many individuals, the Service has offered various programs for taxpayers to retroactively comply with reporting obligations. The two primary programs offered by the Service are the Offshore Voluntary Disclosure Initiative (“OVDI Program”) and the Streamlined Filing Compliance Procedures (the “Streamlined Program”).
Offshore Voluntary Disclosure Initiative
The stated purpose of the OVDI Program is to allow taxpayers with undisclosed foreign accounts and/or undisclosed foreign entities into compliance with United States tax laws. Versions of the OVDI Program have existed for a number of years. The first version of the Program was announced in 2009, with a second version made available in 2011. Both programs were short-term, lasting about three months. In 2012, an open-ended version of the Program was announced, with amendments to this version made in 2014.
In lieu of the penalties which otherwise could be assessed for a failure to meet tax obligations related to foreign assets, taxpayers in the OVDI Program agree to pay a 20% accuracy-related penalty (and also pay failure to file and failure to pay penalties where applicable). However, instead of the $100,000/50% of account value penalty which could apply in willful situations (or the $10,000 per account penalty applicable in nonwillful ones), the taxpayer agrees to pay the miscellaneous Title 26 offshore penalty, a one-time penalty which normally is 27.5% of the highest value of foreign assets in a year during the period covered by the voluntary disclosure (subject to exceptions noted below). The disclosure period is the eight most recent years for which the due date has already passed (but does not include current years for which there has not yet been non-compliance).
Under the current version of the Program, a 50% miscellaneous penalty is applicable if either a foreign financial institution at which the taxpayer has or had an account or a facilitator who helped the taxpayer establish or maintain an offshore arrangement has been publicly identified as being under investigation or as cooperating with a government investigation. The IRS makes a list of such institutions and facilitators available to the public at https://www.irs.gov/Businesses/International-Businesses/Foreign-Financial-Institutions-or-Facilitators. This list initially was narrow (including only a half-dozen or so banks), but has significantly expanded since initial publication. Importantly, if the taxpayer maintains accounts at multiple financial institutions, and even one is noted on the aforementioned list, the 50% penalty will apply to all of the taxpayer’s accounts.
To participate in the OVDI Program, taxpayers must not be under examination by the IRS. They must provide copies of previously filed federal income tax returns, complete and accurate amended federal income tax returns (reflecting all previously unreported income), and complete and accurate original or amended offshore-related information returns and FBARs for tax years covered by the voluntary disclosure. Taxpayers must also sign agreements to extend the period of time for assessing Title 26 liabilities (Form 872) and FBAR penalties. Additionally, they must complete foreign account or asset statements and attachments to an Offshore Voluntary Disclosures letter to disclose information on the accounts and assets involved. Full and complete account statements for the applicable period must also be supplied (where available). Taxpayers make three submissions – an initial submission including narrow information, a second submission including account information, and a full submission disclosing all required information. Each submission is approved by the IRS once it is made (and before the taxpayer can make their next submission).
Prior to 2014, the Streamlined Program maintained a narrow scope: it applied almost exclusively to foreign taxpayers (i.e. those living outside the United States with Unites Sates tax reporting requirements). On June 18, 2014, revisions to the Streamlined Program were announced to expand the program’s applicability, making it available to taxpayers residing in the United States as well as those living overseas.
The perceived purpose of the revisions to the Streamlined Program was to disincentivize “quiet” disclosures. A multitude of taxpayers who viewed the OVDI Program’s penalty structure as prohibitive and/or unfair under their circumstances chose to informally submit delinquent FBARs with amended tax returns (reflecting any increases in taxable income resulting from inclusion of their offshore assets). Taxpayers chose to take this approach where the likelihood of a 50% willful penalty upon review of the submission by the IRS appeared low; however, such taxpayers still risked the $10,000 per account non-willful penalty if their submissions were audited. The IRS also made clear that they were flagging “quiet” disclosures for further review, creating greater risk in taking that approach (and greater risk of willful penalty assessment).
The Streamlined Program for United States residents offers a middle approach to the OVDI Program and “quiet” disclosures. To participate in the Streamlined Program, a taxpayer’s failures to file prior year FBARs, include income from foreign assets in Forms 1040, and pay tax on said income must be deemed “non-willful.” For these purposes, the IRS defines “non-willful” as conduct due to negligence, inadvertence, or mistake or conduct that is the result of a good faith misunderstanding of the requirements of the law.
The standards for willfulness (and corresponding standards for non-willfulness) have been partially developed by existing case law; however, ambiguities in the term’s definition still exist. The primary precedent related to willfulness in the FBAR context comes from one case: Williams v. Commissioner, decided by the Fourth Circuit in 2012. The case concerned a taxpayer who was assessed a willful FBAR penalty for his failures to file the form. The Fourth Circuit addressed the issue of whether Williams’s failure to file was willful, and determined that it was. The Court pointed to multiple factors in its determination; however, most troubling from a precedent perspective was its view of Williams’s answer to the foreign accounts question on his tax return.
Williams’s tax return contained a question asking the following: “At any time during 2000, did you have an interest in or a signature or other authority over a financial account in a foreign country, such as a bank account, securities account, or other financial account?” Williams answered “no.” Though his return for 2000 was prepared by his accountant, the Court stated that, by filing his 2000 tax return, Williams had declared “under penalty of perjury that he had examined this return and accompanying schedules and statements and that, to the best of his knowledge, the return was true, accurate, and complete. The Court stated that signing the return creates constructive knowledge of the return’s contents, and provides prima facie evidence that he knew the contents of the return. The Court the stated that the question regarding foreign accounts put him on inquiry notice of the FBAR requirement. Though Williams testified he never read that part of the return, the Court stated his failure to read this portion constituted “a conscious effort to avoid learning about reporting requirements,” and his answer on the return that he had no offshore accounts “evidence conduct that was meant to conceal or mislead sources of income or other financial information.” The Court stated that this conduct “constitutes willful blindness of the FBAR requirement.”
Thus, the plain language of Williams states that, where a taxpayer signs and files a return which states that he or she did not have an interest in foreign accounts, they commit a willful violation of FBAR reporting requirements if such an account existed. While experts have debated whether this standard will be used going forward (and while this standard seems higher than the IRS’s definition of the term in the Streamlined Program context), the mere possibility of such a low threshold being imposed on the willfulness question is troubling.
In the context of the willfulness discussion above, it is important to note that determinations on willfulness for Streamlined Program purposes will be at the discretion of the IRS. Relevant case law in this context focuses on willfulness related to failures to file FBARs. However, willfulness in the Streamlined Program context is both discretionary and more expansive: it relates to failures to file FBARs, failures to report income from foreign assets, and failure to pay tax on that income. A significant portion of taxpayers seeking participation in the Streamlined Program whose failures to file FBARs were nonwillful will nonetheless not qualify (i.e. because, while they were unfamiliar with the FBAR, they knew they were taxable on worldwide income).
Under the Streamlined Program for United States residents, participants are required only to pay a 5% penalty on the highest aggregate balance/value of their foreign financial assets over the period covered by the Streamlined Program (generally, the most recent six years for which the filing deadline has passed), along with any tax owed on amended Forms 1040 and interest on additional tax owed (unlike in the OVDI Program, no penalties are assessed on tax amounts themselves). Submission requirements are also lessened – taxpayers are required to file only three years of amended Forms 1040, six years of original or amended FBARs, and a certification form with the IRS. Taxpayers are ineligible to participate in the domestic Streamlined Program if they did not submit Forms 1040 for any of the three most recent years for which returns were due.
As a part of the certification form, the taxpayer is required to provide a statement of facts, giving specific reasons for their reporting failures and an explanation of the circumstances involved. This statement of facts is vital as to the ultimate determination of non-willfulness by the IRS, and should be structured to most favorably (and accurately) present the taxpayer’s case. If a taxpayer’s submission is determined to not meet the standards for non-willfulness, the IRS maintains the right to audit the submission and assess penalties on the same (including the 50% FBAR willful penalty). To this end, obtaining advice of counsel practicing in the area (who are most familiar with the case law which helps develop the IRS definitions for the term and the general IRS requirements for a non-willful finding) is of significant assistance.
Unlike with the OVDI Program, where an agent is assigned to the taxpayer’s matter and eventually issues a closing letter, the Streamlined Program submission is made without any interaction from the IRS (unless additional information is needed and/or adjustments to the submission are made). No closing letter is issued under the Streamlined Program; therefore, no definitive statement from the Service that a Streamlined Program submission has been accepted typically occurs.
A congruent program is available for foreign residents with United States reporting requirements; however, under the program for foreign residents, no 5% penalty is owed (the only amounts owed are for taxes due and interest on tax amounts). Reporting requirements under the program for foreign taxpayers is the same as for domestic persons (i.e. three years of amended tax returns, six years of FBARs, and the certification form). Importantly, no requirement exists that the individual must have previously filed tax returns (making the program available for individuals who only recently learned they were subject to any United States requirements). As with the domestic program, if the IRS determines that failures by the taxpayer were not non-willful, the taxpayer is subject to audit.
PROGRAM COMPARISON – OVDI PROGRAM VS. STREAMLINED PROGRAM
Careful contemplation of a taxpayer’s specific circumstances is required before deciding which program provides the best fit. Under the OVDI Program, a taxpayer’s willfulness is not an issue – if the taxpayer is not under examination by the IRS, he or she can almost always be accepted into the program regardless of the underlying facts. Under the OVDI Program, however, no discretion for penalties exist – the same penalty applies regardless of how innocent or egregious the taxpayer’s actions are perceived to be.
A significantly lower penalty applies under the Streamlined Program; however, choosing the Streamlined Program carries at least some level of risk. For one, the taxpayer will not receive a definitive acceptance into the Streamlined Program by the IRS; they also will not receive a closing letter signifying that their offshore matters are resolved. This can lead to stress for wary individuals who want assurances that their offshore reporting issues are completely behind them. More importantly, if questions exist regarding the taxpayer’s level of willfulness, exposure to greater penalties than under the OVDI Program can exist. A taxpayer cannot enter the OVDI Program after making an unsuccessful submission to the Streamlined Program. The taxpayer must determine the level of risk with which they are comfortable, and an assessment of the factors involved should also be made by a qualified professional.