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U.S. Expats, Int’l Taxpayers-IRS Warns Comply Now Or Else!
“for those who continue to hide their heads in the sand, the situation will only become more dire”. Although American’s with unreported foreign income will face still monetary penalties, they will not face criminal prosecution provided they voluntarily report previously undisclosed income prior to being contacted by IRS examiners or its Criminal Investigation Division.
This is what IRS Commissioner Doug Shulman had to say when he announced in March that Americans with offshore businesses and/or investments had until September 23 to come forward and voluntarily disclose unreported foreign income. In addition to reporting worldwide income, certain U.S. taxpayers with foreign bank accounts or investments (or signing authority without ownership) are required to annually file Foreign Bank Account Reports (FBARs) using Form TDF 90-22.1. U.S. persons who transfer money and/or other assets to businesses as well as certain persons who invest or have ownership in foreign corporations may probably need to file Form 5471 or 8865 and possibly Form 926. Additionally, foreign persons with ownership in U.S. corporations may need to file Form 5472.
The rules pertaining to who needs to file which tax form as well as the preparation of reports are extremely complex and should be addressed with the assistance of a competent U.S. international tax advisor. Persons who are required to file these reports but fail to do so (or prepare them incorrectly) may be subject to substantial monetary penalties as well as criminal prosecution for intentionally ignoring their responsibilities. Special guidelines for voluntary compliance before September 23 have been established by the IRS for persons who failed to comply with these rules in prior tax years depending on whether they are now voluntarily reporting undisclosed income or merely overlooked filing the required foreign information reports but had no additional income to report. All U.S. international taxpayers are urged to review their prior year and present filing requirements now and if necessary, take steps to correct the situation before the deadline.
WHAT THIS MEANS TO AMERICANS WHO WORK OR OWN FOREIGN BUSINESSES
Where once only multinational corporations and their expatriate executives were usually subject to these complex international tax rules and reporting requirements, over the past decade more and more Americans (including small and medium sized businesses and individual citizens) have sought economic opportunities abroad. Unfortunately, U.S. international tax rules are extremely complex and are beyond the knowledge and comprehension of CPAs and Tax Specialists who have not been exposed to or specialize in U.S. international tax. As a result many U.S. expatriates and small/ medium businesses inadvertently fail to file all required reports and often miscalculate their U.S. income tax on foreign income or business activities. For some this means paying far too much U.S. tax while others substantially understate their U.S. income and employment tax liabilities exposing them to substantial penalties.
Beside the tax rules affecting American expatriates which are discussed elsewhere in this website, foreign corporations owned by U.S. persons are subject to highly complex rules including what is commonly referred to as Subpart F (of the Internal Revenue Code) as well as U.S. tax laws pertaining to credits for foreign income taxes imposed on income that is subject to tax in the U.S. as well as international tax conventions (intended to prevent double taxation). In addition there exist extremely complicated rules regarding U.S. persons (individuals, corporations and partnerships) with ownership or control of foreign corporations that are considered as being Foreign Personal Holding Corporations and Passive Foreign Investment Corporations. Although intended to prevent U.S. tax avoidance on foreign sourced income, these rules can easily penalize a U.S. business or individual who forms a foreign corporation to hold stock or investments in order to maximize foreign tax planning strategies without ever intending to avoid paying U.S. income tax, making them subject to both a myriad of foreign reporting requirements as well as highly sophisticated tax (and interest) calculations.
SOME OF THE U.S. INTERNATIONAL TAX RULES AND REPORTING REQUIREMENTS
Foreign Bank Account Reports (FBARs)- U.S. persons with signing authority or ownership in foreign financial accounts (with certain exceptions) are required to annually file Form TDF 90-22.1 if the aggregate value of all of the accounts combined (in U.S. dollars) exceeds $10,000 at any time during the year. The geographic location of the bank determines whether or not it is foreign. Therefore, a U.S. branch of a foreign bank that is responsible for IRS information reporting is not considered to be a foreign bank for purposes of filing Form 90-22.1. The penalty for not filing the reports could be as high as $250,000 and may possibly lead to criminal prosecution. Due by June 30 of each year and filed separate from the U.S. income tax return.
Form 926- Americans who transfer money or certain other tangible or even intangible property to a foreign corporation may be required to file Form 926, especially if the transfer was made in exchange for ownership of 10% or more of the stock of the foreign corporation or if the amount or value exceeds $100,000 (aggregating within any 12 month period). The penalty for non compliance (except where there is reasonable cause) may be 10% of the value of the transfer or $100,000 (whichever is more). In cases where the IRS can prove intentional disregard of the rules the penalty could exceed this amount. In addition, the time in which the IRS can assess income tax against the taxpayer remains open until 3 years after the report has been filed. Due by the extended due date of the income tax return and filed with that return. Download Form 926 Instructions
Form 5471 –U.S. persons who own stock in a foreign corporation, including officers and directors of such corporation, where ownership or voting control thresholds are met in cases involving foreign corporations controlled by U.S. persons need to file Form 5471. Both the rules pertaining to who is required to file the report and how the information reported in the report is determined is extremely complex making it imperative that the assistance of a tax advisor who specializes in U.S. international tax be sought. Failure to comply with the reporting requirements could result in an annual monetary penalty of $10,000 for each report not filed or filed incorrectly. Once the IRS contacts the Taxpayer regarding non compliance, the penalty could reach $50,000. Additionally, failure to file could result in loss of tax benefits relating to foreign tax credits. Due by the extended due date of the income tax return and filed with that return. Download Form 5471 Instructions
Form 8858-Similar to Form 5471, this form is required to be filed reporting comparable information with respect to information pertaining to U.S. persons who own Foreign Disregarded Entities. A disregarded entity is a business comparable to a limited liability company or other association that has been elected to be disregarded for tax reporting purposes by a single U.S. owner. In addition to this form, Form 8858, Schedule M reports transactions between the disregarded entity and the U.S. owner or other related entities.
Form 5472-This report is similar to Form 5471 but pertains to U.S. corporations that are owned by foreign persons. Due by the extended due date of the U.S. income tax return and filed with that return.
Form 8865- Foreign partnerships and its U.S. partners are required to file Form 8865 and report information that is required to be included on the U.S. partnership return (Form 1065 and it’s Form K-1 partner information) as well as much of the information required by Form 5471. Due by the extended due date of the income tax return and filed with that return.
A Word About Controlled Foreign Corporations (CFCs)
Much has been reported recently in the news regarding members of U.S. Congress and the executive Administration regarding perceived abuses and “tax loopholes” as regards the taxation of U.S. owned foreign corporations. The fact is that the U.S. tax statutes and Treasury Regulations pertaining to income earned by CFCs are specifically drafted to prevent tax avoidance and abuses while maintaining parity with tax laws of foreign governments. In fact the reason for these complex rules is that the United States is one of the few countries that imposes an income tax on the worldwide income of its citizens and tax residents. In order to prevent double taxation and maintain parity with our global business and tax treaty partners, these tax laws and rules are time proven to achieve this intent. Unfortunately, political pressure combined with lack of understanding of these rules by members of Congress may lead to an ill conceived revision of the Internal Revenue Code that may well result in unintended damaging consequences on a scale that was worst than experienced by the legislative tax reform in 1976.
An extremely simplified explanation of the existing U.S. rules is as follows. If a U.S. taxpayer owns stock in a U.S. corporation that is profitable, the corporation pays income tax but the shareholder pays no tax until a dividend from the corporation is received. When a dividend is paid the shareholder pays income tax on that dividend. A profitable foreign corporation with U.S. income that is effectively connected with U.S. activities pays tax to the U.S. If it has no U.S. source income it does not pay U.S. income tax. However if the foreign corporation is controlled by U.S. shareholders, the U.S. shareholders are subject to tax on the worldwide income of the foreign corporation, less their respective share of tax credits relating to taxes paid by the foreign corporation to other countries on its income. The U.S. tax laws are carefully written to prevent abuses and to ensure that U.S. shareholders are taxed on income of the controlled foreign corporation. Where the foreign operations do not involve the business of the U.S. shareholder, the shareholder pays tax when a dividend is received from the corporation, net of foreign income taxes paid on that income. So if the foreign corporation pays no foreign income tax, the U.S. shareholder gets no foreign tax credit and pays the full tax on the dividend. If the U.S. shareholder sells something to the foreign corporation, that shareholder pays U.S. tax on the profit when the sale is made. Special rules called ”transfer pricing rules” ensure that the sale to the related foreign corporation is comparable to a sale to a third party and that expenses are properly allocated to avoid abuses. If the foreign company resells the product at a profit within its own country, taxes are paid to the foreign government. The U.S. shareholder pays U.S. income tax when it receives a dividend from the foreign corporation making it economically competitive with foreign businesses. To avoid manipulation, if the U.S. shareholder borrows money from the foreign corporation’s profits for an extended period of time, it is treated as though a dividend were paid from the foreign corporation and U.S. tax is paid by the shareholder. Now, what if the shareholder sells a product to its foreign corporation which then incorporates it into a product which it sells at an even greater profit in a different foreign country (and may possibly avoid paying income tax to its own country as a foreign sale)? This sounds like a way to sell products globally and avoid paying any income tax. U.S. Subpart F rules may treat this as a deemed dividend to the U.S. shareholder and tax it similar to if the product had been produced in the U.S. and sold directly to the third country consumer. What about expenses of the U.S. shareholder that are attributable to the governance of the foreign corporation or products being sold to it? IRC Section 482 again addresses that and denies a tax deduction for these costs and expenses. Form 926 was originally intended to enable the IRS to monitor the transfer of assets to foreign corporations, particularly intangible property such as U.S. developed patent rights where U.S. royalty income should be declared. Form 5471 is intended to disclose changes in U.S. ownership of foreign corporations as well as the financial activities of the foreign corporation, including income subject to the Subpart F rules to prevent U.S. tax avoidance. This is why willful failure to comply with these reporting requirements, including willful reporting of inaccurate information is so harshly penalized.
This is an overly simplified summary of the way the international income tax rules work, but you can see that because the U.S. taxes the worldwide income of its citizens and resident taxpayers, these rules are necessary to prevent abuses and level the playing field.
CONCLUSION
A shrinking global economy has created new and exhaustive tax requirements for U.S. individuals and businesses, as well as making it more difficult for the IRS to monitor these activities. In an effort to close the “tax gap” created by U.S. taxpayers who have sought to hide their assets and income in foreign countries they have tightened information exchange with our global partners. As a result, U.S. taxpayers with economic activities in foreign countries need to be more vigilant than ever to ensure that they are, not only reporting all of their income, but that they are accurately complying with all U.S. tax information reporting requirements as well.
In 2004 the IRS instituted its first voluntary tax compliance amnesty initiative giving everyone an opportunity to correct their tax filings. Now, for those who still are hiding their assets or have failed to report all of their income, the IRS has relinquished amnesty as far as unreported income is concerned, but will waive criminal prosecution for anyone who voluntarily steps forward before September 23. After that, all bets are off and my guess is that more people who are caught hiding foreign income will go to jail.
We recently spoke with the IRS in the international affairs office in Philadelphia regarding those who have no unreported foreign income but need to file past due foreign information reports such as the TDF 90-22.1, Form 926, Form 5471, etc. It was strongly urged that the past due FBARs be promptly filed as well as amended tax returns that included the other foreign information reports with explanations providing reasonable cause, if applicable, requesting relief from late filing penalties.
At this time there does exist some conflicting information on the IRS website. Last year the IRS began sending out notices to taxpayers known to have foreign financial accounts informing them of their responsibility to file Form TDF 90-22.1. In January the IRS website posted that effective January 1, 2009, late filed FBARs would not be entitled to relief under the reasonable cause provisions. However in a recently written FAQ available on the IRS website following Commissioner Shulman’s memorandum regarding voluntary disclosure it states that “taxpayers who reported income and paid tax for prior years, but did not file FBARs, should file them according to the instructions and attach a statement explaining why the reports are filed late. Copies should also be mailed to the Offshore Identification Unit by September 23 and that the IRS would not impose FBAR penalties.
Although the IRS FAQ does not specifically address other required information reports that are filed late, the agent with whom we spoke with suggested that they will receive the same consideration as the FBARs. Although this was not an official statement and has no legal precedent, we have no reason to question the instructions and information that this IRS agent provided and that the directive of the 2004 amnesty initiative would still be honored in situations where there is no unreported prior year income.
The IRS FAQ is clear, however, that the March 23, 2009 Offshore Compliance Program as announced by Commissioner Shulman is directed toward U.S. taxpayers with unreported foreign income and that the procedures of this new initiative must be followed precisely, and that either not filing or trying to slip this by the IRS (by filing an amended return without disclosure to an IRS office other than the Offshore Identification Unit) will only make things worst and possibly result in criminal prosecution. All IRS agents nationwide have been alerted to this initiative.
The time to determine if you are in proper compliance is now. If you are uncertain or believe that you may be in violation, Powers & Company will review your prior year tax returns and assess your facts and circumstances without charge. Our mission is to help you get back on track as painlessly as possible, but time is of the essence so contact us now, preferably by email using the Contact page on this website. The process of gathering your information and properly preparing the tax returns and reports will take time so don’t wait until it is too late to meet the September 23 deadline.