Foreign Asset Tax Compliance and Why It Is Important Right Now

International tax can be a very complex subject but most associate both the topic and the complexity with large multinational businesses. That may be true, but the greatest risk is often borne by individuals who do not properly understand or comply with their U.S. reporting obligations for foreign income, assets, and investments. With the U.S. Internal Revenue Service (IRS) recently declaring that the IRS Offshore Voluntary Disclosure Program (OVDP), which was started in 2009, will close for good on September 28, 2018, taxpayers with unreported or under reported foreign assets should immediately determine if ODVP would benefit them before it is gone for good. At this same time, the IRS has noted that their enhanced enforcement efforts against unreported foreign assets will not end. Thus, the time is now for taxpayers with unreported or under reported foreign assets to formulate a plan for compliance or risk what have been, in certain cases, draconian penalties.

Many individual taxpayers, including those from outside the U.S. who are not educated in U.S. tax reporting rules, own assets located in different countries. Some of these assets are as benign as a bank account they hold with an elderly relative to those with a Swiss bank account fully intended for shelter from the U.S. tax and legal systems. In practice, most all of these cases lean toward the former, however, they all are covered by the same rules and penalty provisions.
This article is intended to provide a quick overview of the issue and the avenues available to taxpayers to maintain or obtain compliance with the rules.

Reporting Basics
It is probably not news to any experienced practitioner that a U.S. taxpayer has to report all of their income on a global basis. It is also probably not news that many individual clients do not fully disclose, or fully understand the law to disclose, each and every nonU.S. income stream. Full disclosure of income, at a minimum, must be done even if it takes some digging to gather all of the appropriate information.

Reporting assets located outside the U.S. is a bit more tricky. Not only from an asset identification perspective but from a where and how to report perspective. Some assets clearly require disclosure but some may not. It is not intuitive. For example, a foreign rental property will require income inclusion on a U.S. income tax return for rental proceeds. However, if it is owned directly by an individual, the physical asset itself, i.e., the rental real estate, is not separately reported. If a trust or intervening legal entity is involved, it may be reported. Make sense?

Foreign Bank Account Reporting (FBAR)
U.S. residents or citizens must report a financial interest in, or signature or other authority over, specified bank and other accounts in a foreign country on Financial Crimes Enforcement Network (FinCEN) Form 114 (the successor to the beloved Form TD 90-22.1), i.e., FBAR, if the accounts aggregate maximum values exceed $10,000 at any time during a calendar year. Please note the “aggregate” and “at any time” language.

FBAR requirements apply to individuals, corporations, partnerships, trusts, estates, and LLCs as well as entities disregarded for tax purposes. The regulations under Sec. 6038D require that a specified person look through a disregarded entity for reporting foreign assets on Form 8938 (discussed below). However, the FBAR requirements impose a separate and independent reporting obligation on such entities.

There are plenty of traps for the unwary here. The most simple may be a U.S. taxpayer who has signatory authority to co-sign with an elderly relative located outside the U.S. More difficult to identify is the reporting obligation of a U.S. corporate executive who has signatory authority, likely along with many others, over a long dormant overseas corporate bank account or accounts exceeding $10,000 at some point during a calendar year. It is a very common situation that is difficult to identify and, hence, ensure compliance. Add fiscal years and foreign currency translation to the equation and you see where the simple becomes very difficult even for sophisticated taxpayers and practitioners.

Form 8938
Specified U.S. individuals with foreign financial assets may need to file Form 8938, also known as the Statement of Specified Foreign Financial Assets, as part of their annual income tax return. A “specified individual” is a U.S. citizen, a resident alien of the U.S., or a non-resident alien filing a joint U.S. income tax return.

The “financial assets” which must be reported includes foreign bank accounts, assets held for investment by a foreign institution, foreign retirement plans, and jointly owned foreign financial assets. It is not uncommon for a business executive who has moved to the U.S. to have an interest in a foreign pension plan from a former employer. Items like this must be considered.

The Form 8938 reporting thresholds range from $50,000 of foreign financial assets on the last day of the year or $75,000 at any time during the year for unmarried U.S. individuals to $400,000 on the last day of the year and $600,000 at any time during the year for married joint filers living abroad. Be sure to reference the detailed Form 8938 reporting requirements once the assets themselves are identified.

Besides the individual nature of Form 8938, it is important to note one critical difference between Form 8938 reporting and FBAR. Form 8938 does not require reporting of financial accounts held in foreign branches or held in foreign affiliates of a U.S.-based financial institution. However, such accounts are considered financial accounts for purposes of FBAR reporting because they are located in a foreign country.

Other Common Reporting Forms
The FBAR and Form 8938 are the most widely used foreign asset reporting forms but not the only ones. There are a number of others that capture different kinds of foreign asset activity. These are:

• Form 926,Return by a U.S. Transferor of Property to a Foreign Corporation, for reporting transfers of property to foreign corporations;
• Form 3520,Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts;
• Form 3520-A,Annual Information Return of Foreign Trust with a U.S. Owner, for reporting affiliations with foreign trusts or the receipt of gifts from non-U.S. persons;
• Form 5471,Information Return of U.S. Persons with Respect to Certain Foreign Corporations;
• Form 5472,Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, for reporting interests in foreign controlled corporations and reporting transactions with foreign corporations; and
• Form 8865,Return of U.S. Persons with Respect to Certain Foreign Partnerships, for reporting interests in foreign partnerships. 

Each of these forms captures different types of investments and may apply to both individuals and businesses in different forms.

Penalties
The IRS has identified unreported foreign assets as a key element of U.S. tax evasion. So too have foreign tax authorities. The IRS has enacted significant penalties which, coupled with aggressive and enhanced enforcement, creates a perilous environment for individuals and entities who fail to accurately file these forms. The penalties are very severe especially considering the fact that the IRS has not made it easy for those with foreign assets to clearly understand what must be reported and how. The factual and technical lack of clarity makes this kind of a perfect storm for non-compliance.

The penalties can be very high and reach upwards of $10,000 per form per year. If the IRS establishes that the taxpayer willfully decided not to file the form, there can be criminal penalties as well as civil penalties reaching upwards of millions of dollars depending on the value of the overseas assets.

For practitioners who know, or reasonably should know, of these unreported or under reported foreign assets, Circular 230 still stands to require disclosure with its penalty provisions. A foreign income stream on a tax return but no reported foreign assets? It is very difficult for the practitioner to plead lack of technical understanding here.

Resolution Options
Once the issue is identified, the appropriate course of action must be determined. If the IRS has identified the issue first or the taxpayer has engaged in willful failure to report, the only option is constructing a legal defense. Those that have experienced this know it to be a potentially very costly experience and even more so if criminal penalties are involved.

The most reasonable option to those who otherwise have unreported or under reported foreign assets is the OVDP program. Taxpayers who voluntarily come forward and provide the IRS with the nature and extent of their undisclosed foreign assets and income are given assurances that the IRS would recommend against criminal prosecution of these taxpayers. In addition, taxpayers are required to pay all outstanding taxes, interest, and a 20% penalty on the amount of previously unpaid taxes for up to 8 years of noncompliance. Other various penalties apply depending on the form and the facts and circumstances of the individual case.

These OVDP penalties, while still sometimes steep, pale in comparison with potential penalties if the taxpayers do not enter into the OVDP and are identified by the IRS. In addition to potential criminal sanctions, taxpayers could pay up to a 75% fraud penalty for any previously undisclosed income and the greater of $100,000 or up to 100% of the entire foreign bank account balance for each year of willful noncompliance with FBAR requirements.

It is important to note that the OVPD is not the only option available as the Streamlined Procedures Program still exists. The appropriate option for the taxpayer depends again on the facts and circumstances.

What to do Now
As noted above, the IRS fully intends to continue increasing the number of criminal prosecutions of taxpayers involved in failing to report overseas assets. Additional disclosure methods continue arising and include foreign banks, e.g., the UBS tax evasion settlement with the IRS, continuing to enter into non-prosecution agreements with the U.S. Department of Justice. Additional tools ranging from international tax information sharing agreements to data mining will continue to aggressively identify non-complaint taxpayers.

It is very important for taxpayers and practitioners who believe they may have an issue to immediately determine a plan of compliance and if OVDP is their best option. Failure to fully evaluate their options before OVDP expires this fall could be a very costly mistake.

Frank J. Vari, JD, MTax, CPA is the practice leader of FJV Tax which is a firm specializing in complex international and U.S. tax planning. FJV Tax has offices in Wellesley, Massachusetts and Boston, Massachusetts.The author can be reached via email at frank.vari@fjvtax.com or telephone at 617-770-7286/800-685-2324.