US Tax Guide for Expats
enerally, if you are a United States citizen or permanent resident (green card holder) living outside the US for more than one year, you are called an expatriate or "expat."* Rather than adding to the long list of tax guides that explain the general concepts of expat taxation,** we will focus on the specific requirements to file several US international tax forms, not so obviously required, that carry huge penalties for screwing up.
We will give you a general understanding of the following US tax forms: 1) Treasury Form 114, Report of Foreign Bank and Financial Accounts (FBAR), 2) Form 3520/3520-A, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, 3) Form 5471, Information Return of US Persons With Respect To Certain Foreign Corporations, 4) Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, 5) Form 8858, Information Return of US Persons With Respect To Foreign Disregarded Entities, 6) Form 8865, Return of US Persons With Respect to Certain Foreign Partnerships, and 7) Form 8938, Statement of Specified Foreign Financial Assets. We then discuss ways to comply if you haven't filed.
The requirements to file these forms can apply to all US citizens and permanent residents, regardless of where they live, but the vast majority of those affected are expats. We will describe in plain language the requirements to file, and go over the ridiculously large penalties that the IRS has been given the power to impose for noncompliance. Fortunately, the IRS has programs in place that allow for waiver of these penalties, and we have been successful in helping dozens of our clients become fully compliant, penalty free. These programs are discussed below.
* This is the popular rather than the technical meaning of this term. Although the term is not defined in the Internal Revenue Code, "real" expats are US citizens who have relinquished their citizenship and permanent residents who have ended their residency (expatriated). Tax consequences of expatriation are determined under IRC Section 877A.
** Here's a very thorough guide published by the IRS for that purpose: Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.
International Forms You Might Need to File
I. FinCEN Form 114 (Formerly TD F 90-22.1), Report of Foreign Bank and Financial Accounts (FBAR)
The obligation to report foreign bank and financial accounts to the US Treasury was initially imposed by the Bank Secrecy Act in 1970. The law requires each "United States person" who has a financial interest in or signature authority over any foreign financial account to file an FBAR if the aggregate value of the foreign financial accounts exceeds $10,000 at any time during the calendar year.
Who Is a United States Person?
A United States person includes any citizen or permanent resident of the United States (regardless of where they live) and any foreign national who has passed the substantial presence test (see Your Residency Status). It also includes a nonresident alien making the first year election under Section 7701(b)(4) of the Internal Revenue Code (IRC), but does not include a nonresident alien electing to file a joint return under IRC Section 6013(g) or (h) (as clarified in the Preamble to 31 CFR 1010.350, published Feb. 24, 2011, and in Section 22.214.171.124.1.2 of the Internal Revenue Manual). A United States person also includes a corporation, partnership, limited liability company (LLC), trust, and estate, created or organized in the United States or under the laws of the United States. (IRC Section 7701(a)(30).) This is the same definition for all the forms described on this page, except when exceptions are noted.
What Must Be Reported?
The term "financial account" includes the following:
- Bank accounts such as savings accounts, checking accounts, and time deposits,
- Securities accounts such as brokerage accounts and securities derivatives or other financial instruments accounts,
- Commodity futures or other options accounts,
- Insurance policies with a cash value (such as a whole life insurance policy),
- Mutual funds or similar pooled funds,
- Most retirement accounts, and
- Any other accounts maintained in a foreign financial institution or with a person performing the services of a financial institution.
What Happens If You Don't File?
For over three decades after enactment, enforcement of this requirement was largely ignored by the US Treasury. Since the majority of taxpayers were not even aware of the filing requirement, noncompliance was the norm.* In 2004, the IRS was granted a very big stick when penalties for willful failure to annually file the FBAR form were dramatically increased. Under 31 U.S.C. section 5321(a)(5), the civil penalty for a non-willful failure to report is $10,000 per violation, as adjusted for inflation. The civil penalty for a willful violation is the greater of $100,000, as adjusted for inflation, or 50% of the amount in the account at the time of the violation. For penalties assessed after January 15, 2017, the inflation-adjusted penalty for a non-willful failure to report increased to $12,921, and the inflation adjusted penalty for a willful failure to report increased to $129,210 (31 CFR section 1010.821). Willful violations may also be subject to criminal penalties under 31 U.S.C. section 5322 or 18 U.S.C. section 1001. These penalties are subject to a reasonable cause exception. This exception is discussed below under Delinquent International Information Return Submission Procedures.
*A Report to Congress In Accordance With Sec. 361(b) of the USA Patriot Act, Submitted by the Secretary of the Treasury, April 26, 2002.
II. Form 3520/3520-A, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts
A United States person, as defined for FBAR reporting, (and the executor of the estate of a US decedent) is required to file Form 3520 to report:
- Certain transactions with foreign trusts,
- Ownership of foreign trusts, and
- Receipt of certain large gifts or bequests from certain foreign persons.
Form 3520-A provides information about the foreign trust, it’s US beneficiaries, and any United States person who is treated as an owner of any portion of the foreign trust. If you are required to file Form 3520 and did not receive Form 3520-A from the trustee, you are required to complete this form for the trust. A separate Form 3520 and Form 3520-A must be filed for transactions with each foreign trust. Forms 3520 and 3520-A are filed separately from your tax return.
What is a Foreign Trust?
Although the Internal Revenue Code refers to trusts in numerous sections, nowhere in the Code is the term "trust" actually defined. Generally, an arrangement will be treated as a "trust" if its purpose is to vest in the trustee responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility, and, therefore, are not "associates" in a joint enterprise for the conduct of a business for profit. Treas. Reg. Sec. 301.7701-4(a). Most trust-like structures have not been officially classified by the IRS. However, most foreign pension plans are likely characterized as trusts for US tax purposes. This includes individual retirement plans set up by the beneficiary rather than an employer, if a trustee is assigned the responsibility to protect and conserve trust assets.
The IRS has provided an exception to filing Forms 3520 and 3520-A for Canadian registered retirement savings plans (RRSPs) and registered retirement income funds (FFIFs). (See IRS Notice 2003-75 in Internal Revenue bulletin: 2003-50.) However, we are not aware of a similar exception for individual retirement plans in any other country.
Who is the Owner?
You are not considered the owner of an "employees' trust." Neither the Code nor the regulations define this term. However, if a foreign pension (i) was created by a foreign employer, (ii) is administered by the foreign employer, and (iii) is more than half funded by the foreign employer, it appears that the foreign pension (trust) would be considered an "employees' trust." If your pension plan meets these conditions, Form 3520 and Form 3520-A are not required. However, if you contributed more to the foreign pension than your foreign employer, you will be treated as the owner of the portion of the plan attributable to your contributions. Treas. Reg. Sec. 1.402(b)-1(b)(6). That means reporting is required.
Receipt of Certain Large Gifts or Bequests From Certain Foreign Persons
If you received as a gift a) more than $100,000 from a nonresident alien individual or foreign estate, or b) more than $15,797 from foreign corporations or foreign partnerships, you are required to complete Part IV of Form 3520.
What Happens If You Don't File?
Unless you can demonstrate reasonable cause, a penalty applies if Form 3520 is not timely filed or if the information is incomplete or incorrect. The penalty is the greater of $10,000 or any of the following that apply:
- 35% of the gross value of any property transferred to a foreign trust for failure by a US transferor to report the creation of or transfer to a foreign trust.
- 35% of the gross value of the distributions received from a foreign trust for failure by a US person to report receipt of the distribution.
- 5% of the gross value of the portion of the foreign trust's assets treated as owned by a US person (under the grantor trust rules in the Code) for failure by the US person to report the US ownership information.
You are subject to additional $10,000 penalty (or 5% of the trust if greater) if the foreign trust a) fails to file a timely Form 3520-A, or b) does not furnish complete and accurate information.
III. Form 5471, Information Return of US Persons With Respect To Certain Foreign Corporations
Filing of Form 5471 is required by certain United States citizens and residents who become an officer or director of certain foreign corporations, and certain United States persons (as defined for FBAR reporting) who are shareholders in certain foreign corporations.* The form is used to satisfy the requirements of multiple sections of the Internal Revenue Code - primarily Section 6038, Section 6046 and Section 957. Since these sections have conflicting rules and definitions, this form is particularly challenging. The requirements are applied to separate categories of filers, each category specifying separate, but sometimes overlapping conditions. There are four categories of filers, numbered 2 through 5. Category 1 requirements were repealed in 2004.
* The foreign corporation may or may not be called a corporation, but this form is required if the foreign entity is considered a corporation for US federal tax purposes. Generally, foreign entities are classified as corporations if all members have limited liability [See Reg. 301.7701-3(b)(2)(B)].
Category 2 Filer
If you are a US citizen or resident, and you become an officer or director of a foreign corporation in which a United States person meets the stock ownership described under Category 3 Filer, you are required to file Form 5471 under Category 2. You need not have any stock ownership yourself in the corporation to meet this requirement. The requirement applies only in the year you become an officer or director, or the stock ownership is met, so you are only required to file once.
Category 3 Filer
This is a United States person who acquires stock in a foreign corporation which, either: a) when added to any stock owned on the date of acquisition, meets the 10% stock ownership requirement (described below) with respect to the foreign corporation, b) acquires stock which, without regard to stock already owned on the date of acquisition, meets the 10% stock ownership requirement with respect to the foreign corporation, c) becomes a United States person while meeting the 10% stock ownership requirement with respect to the foreign corporation, or d) disposes of sufficient stock in the foreign corporation to reduce his or her interest to less than the stock ownership requirement.
Stock Ownership Requirement: For purposes of Category 2 and Category 3, the stock ownership threshold is met if a United States person owns:
- 10% or more of the total value of the foreign corporation's stock, or
- 10% or more of the total combined voting power of all classes of stock with voting rights.
Now, ownership in tax land might be different than your concept, because rules for attribution, or indirect ownership, are always applied in the Internal Revenue Code. However, the concept for one Code section is not necessarily the same as for another. Attribution is defined for Category 3 by IRC Section 6046(c) and Reg. Section 1.6046-1(i): You are considered as owning the stock owned directly or indirectly by or for your brother and sister, your spouse, your ancestors, and your lineal descendants. There is no exception if your family members happen to be nonresident aliens. Also, you do not need to own any shares directly for this rule to apply. However, when stock is treated as owned by an individual through this rule, it shall not be treated as owned by that person for the purpose of again applying such rule in order to make another the constructive owner of such stock.
Additionally, under Reg. Section 1.6046-1(i), stock owned directly or indirectly by or for a foreign corporation or a foreign partnership is considered as being owned proportionately by its shareholders or partners. Therefore, any United States person who is a member of a foreign partnership that becomes a shareholder in a foreign corporation, shall be considered to be a shareholder in such foreign corporation to the extent of his/her proportionate share in the partnership.
Maria, a citizen of Brazil, came to the United States in 2018 and passed the substantial presence test. In 2018 she married Carlos, a US resident, and they filed a joint resident return. Neither Carlos nor Maria have ever had any ownership in a foreign corporation. However, Maria's father, a nonresident alien of the United States and a resident of Brazil, owns 100% of the stock of five corporations in Brazil, Corporation A, B, C, D and E. Maria owns by attribution 100% of the stock her father owns under Category 3, so Maria is required to file a separate Form 5471 for each of the five corporations as a Category 3 filer, since Maria became a United States person while meeting the 10% stock ownership requirement with respect to the five corporations. Carlos is not deemed to own any stock in the five corporations, because there is no attribution to Carlos from Maria's deemed ownership.
Category 4 Filer
This is a "United States person" who had "control" of a foreign corporation for an uninterrupted period of at least 30 days during the annual accounting period of the foreign corporation.
United States Person for Category 4: The rules under Category 4 are governed by IRC Section 6038 rather than Section 6046, and some definitions are a little different. For example for Category 4 purposes, "United States person" includes a nonresident alien for whom an election is in effect under IRC Section 6013(g) or (h) to be treated as a resident of the United States. See Reg. Section 1.6038-2(d)(3). These individuals are not considered "United States persons" under Categories 2 or 3. Domestic partnerships, corporations, estates and trusts are included in the definition under Category 4.
Control: This happens, for Category 4 purposes, when a United States person owns, at any time during their tax year, more than 50% of the total combined voting power of all classes of stock of the foreign corporation entitled to vote, or more than 50% of the total value of shares of all classes of stock of the foreign corporation.
Ownership: You guessed it, there are attribution rules for Category 4, but they are different rules than for Category 3. For Category 4, IRC Section 318(a) determines family ownership. Under Section 318(a)(1), an individual is considered as owning the stock owned by his spouse, children, grandchildren and parents (but not brother or sister). See Reg. Section 1.6038-2(c). Also, under Reg. Section 1.6038-2(l), you are not required to file Form 5471 if 1) you do not directly own shares in the foreign corporation and 2) you are required to furnish information solely by reason of attribution of stock ownership from a nonresident alien. Conversely, apparently if you own any shares in a foreign corporation, and by attribution you own more than 50% of shares, even if the attribution is from a nonresident alien, you are a Category 4 filer.
For Category 4, Maria in Example I would be considered in control of the five corporations owned by her father by attribution. However, since Maria does not directly own stock in the corporations, under the exception in Reg. Section 1.6038-2(l), Maria is not required to file Form 5471 for any of the five corporations.
Assume the same facts as in Example I, but rather than owning no shares, Maria was gifted 5% of the stock of Corporation A in 2017, with her father owning the remaining shares, and Maria and her sister, Juanita, were each gifted 50% each of the shares of Corporations B, C, D and E in 2017. In 2018, Since Maria owns some stock in Corporation A directly, and all of her father's shares by attribution, Maria is in control of Corporation A for Category 4 purposes. The exception to filing Form 5471 under Reg. Section 1.6038-2(l) does not apply because Maria owns shares directly. Therefore, Maria is a Category 4 filer and must file Form 5471 each year she meets the control test. Maria is not in control of Corporations B, C, D and E, because even though she owns 50% of the stock of those corporations directly, she does not own the stock of Juanita under the attribution rules governing Category 4. Since Maria does not own more than 50% of the stock of these corporations directly or indirectly, she is not required to file Form 5471 as a Category 4 filer for Corporations B, C, D or E.
Category 5 Filer
This includes a "US shareholder" who owns stock in a foreign corporation that is a "controlled foreign corporation" for an uninterrupted period of 30 days or more during the tax year of the foreign corporation, and who owned that stock on the last day of such year. Form 5471 is required to be filed each year these conditions apply.
US Shareholder for Category 5: This generally includes only a United States person (generally as defined for FBAR filers) who owns (directly or indirectly), 10% or more of the total combined voting power of all classes of voting stock of the foreign corporation. (In other words, if you own less than 10% of the stock, either directly or indirectly, you are not a US shareholder.)
Controlled Foreign Corporation: This term is defined in Section 957 of the Code as any foreign corporation if more than 50% of 1) the total combined voting power of all classes of stock of such corporation entitled to vote, or 2) the total value of the stock of such corporation is owned by US shareholders on any day during the taxable year of such foreign corporation.
Indirect Ownership of Stock: Yes, here we go again. For Category 5, there are different attribution rules. Generally, an individual is considered as owning the stock owned by his spouse, children, grandchildren and parents (but not brother or sister). However, for this purpose, stock owned by a nonresident alien individual (other than a foreign trust or foreign estate) is not considered as owned by a citizen or resident of the US See IRC Section 958(b) and Reg. Section 1.958-2(b)(3).
Assume the same facts as in Example III and assume Juanita is a US resident. Corporation A is not a controlled foreign corporation, because 95% of the stock is owned by Maria's father, a nonresident alien, and the father's stock is not deemed to be owned by Maria. Therefore, Maria is not a Category 5 filer. Even if over half the stock of Corporation A was owned by unrelated "US shareholders" (under the Category 5 definition), since Maria owns only 5% of the stock she would not be defined as a US shareholder. Corporations B, C, D and E are controlled foreign corporations, and Maria is a US shareholder, so she is a Category 5 filer for each of them.
What Happens If You Don't File?
Each category of Form 5471 carries a penalty of $10,000 for failure to file the form by the due date, or failure to show all the information required. Like all the other penalties, these penalties are forgiven for reasonable cause. See Code Sections 6679(a) and 6038(b).
IV. Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund
What Is A PFIC?
A foreign corporation is a passive foreign investment company (PFIC) if it meets either of the following two tests:
- 75% or more of its gross income for the taxable year is passive income (generally investment income such as interest, dividends, royalties, rents and annuities), or
- At least 50% of its assets are held to produce passive income.
This definition describes most foreign mutual funds, since mutual funds outside the United States tend to be organized as corporations (or organizations deemed corporations under US tax law). PFICs can also be ETFs, bond funds, currency tracking funds, precious metal funds, investment trusts, hedge funds, private equity funds, startups and more. Many expats own PFICs, either directly or indirectly, without understanding their toxic treatment under US tax law.
Why Is It The Worst Investment You Can Possibly Own?
Rather than trying to explain the technical tax rules, which would be even more sleep inducing than the rest of this stuff, we will explain the rationale for the punitive tax treatment of PFICs and the general results. US mutual funds essentially pass through current taxation of the investment income to mutual fund shareholders. However, foreign corporations, which hold foreign mutual funds, can accumulate investment income for the benefit of the shareholders without current taxation to the shareholders. Therefore, in order to create a rough parity in tax treatment between shareholders of US and foreign mutual funds, Congress enacted the PFIC rules. (IRC Sections 1291 - 1298). In doing so, the intent was clearly to discourage investing in foreign mutual funds.
As an example, there is a default calculation for what is called a section 1291 fund. Two alternative calculations are available by election, 1) the "qualified electing fund" (QEF) election, and 2) the mark-to-market election. Treatment under these elections is generally less harsh than the section 1291 fund calculation, but the QEF election is restrictive, and either election must be timely. See Instructions for Form 8621.
Under the "default" section 1291 fund calculation, "excess distributions" are determined on a per share basis and allocated to each day in the shareholder's holding period. The portion of the excess distribution allocated to the current year is taxed as ordinary income. A separate tax and interest charge is computed for the portion of the excess distribution allocated to prior years of the PFIC. The tax is computed hypothetically for each prior year of the PFIC, at the top rate for individuals. Interest is then charged (again, hypothetically) as if the tax was due on the due date of each prior year. See IRC Section 1291. The net result is a very large amount of tax and interest.
Because each reinvested dividend or new purchase is considered a separate block of stock, and because the section 1291 fund calculation must be performed separately for each block of stock, the computations required for one PFIC can fill several worksheets. For that reason, even top-of-the-line practitioner tax software is incapable of performing the detailed calculations required. We employ special PFIC software to handle this task, to ensure the calculations are performed correctly.
Form 8621 Filing Requirements
IRC Section 1298(f) says, "Except as otherwise provided by the Secretary [in regulations], each United States person who is a shareholder of a passive foreign investment company shall file an annual report containing such information as the Secretary may require." [Form 8621.] Therefore, if you are the owner of a PFIC, either directly or indirectly, you must file Form 8621 annually. If you 1) recognize gain on a direct or indirect disposition of PFIC stock, 2) receive certain direct or indirect distributions from the PFIC, or 3) are making an election reportable on the form, you might have a tax obligation.
Indirect Ownership: Generally, indirect ownership includes ownership as the beneficiary of a foreign estate, trust or retirement plan, but not a retirement plan that is exempt from US taxation. Unfortunately, most foreign retirement plans are not exempt from US taxation. If you are the "owner" of a foreign trust, including a foreign pension fund, you are considered an indirect owner of any PFIC owned by the trust. You are not considered the owner of an "employees' trust." Neither the Code nor the regulations define this term. However, if a foreign pension (i) was created by a foreign employer, (ii) is administered by the foreign employer, and (iii) is more than half funded by the foreign employer, it appears that the foreign pension (trust) would be considered an "employees' trust." If your pension plan meets these conditions, Form 8621 is not required. However, if you contributed more to the foreign pension than your foreign employer, you will be treated as the owner of the portion of the plan attributable to your contributions. Treas. Reg. Sec. 1.402(b)-1(b)(6). That means if the trust owns PFICs, reporting is required, unless the trust is a foreign pension fund, income from which is exempt by treaty until distributed. Temp. Treas. Reg. Sec. 1.1298-1(b)(3)(ii).
Exemption From Filing: PFIC shareholders subject to the interest-charge rules (the section 1291 fund calculation) are not required to file Form 8621 under §1298(f) if the following conditions are met:
- The shareholder is not subject to tax under §1291 on an excess distribution received (or treated as received) from the PFIC during the shareholder's tax year; and
- The shareholder has not made a QEF election with respect to the PFIC, and either: 1) the aggregate value of all PFIC stock owned by the shareholder at the end of its tax year does not exceed $25,000 ($50,000 for married taxpayers filing a joint return); or 2) the PFIC stock is owned by the shareholder through another PFIC, and the value of the shareholder's proportionate share of the upper-tier PFIC's interest in the lower-tier PFIC does not exceed $5,000. (Reg. Sec. 1.1298-1(c)(2)).
Additionally, Foreign insurance policies are usually not considered to be PFICs. (IRC Sec. 1297(b)(2)(B) & (f)). Form 8621 Is not required if the holder of a life insurance contract does not have control over the available investment accounts. (IRC Sec. 1297(b)(2)(B)).
What Happens If You Don't File?
There is actually no penalty for not filing this form when you are supposed to. However, the statute of limitations for assessing penalties is suspended until you do file the form, if required. That means your entire return remains subject to audit until three years after you file the required Form 8621. See IRC Section 6501(c)(8).
V. Form 8858, Information Return of US Persons With Respect To Foreign Disregarded Entities
A United States person who is a direct or indirect owner of a Foreign Disregarded Entity (FDE) is required to file Form 8858. An FDE is an entity that is not created or organized in the United States and that is disregarded as an entity separate from its owner for US income tax purposes under Regulation sections 301.7701-2 and 301.7701-3. This form is used to satisfy the reporting requirements of IRC sections 6011, 6012, 6031, and 6038, and related regulations. If you are required to file Form 5471 as a Category 4 or Category 5 filer with respect to a controlled foreign corporation, and the controlled foreign corporation is the owner of an FDE, you are also required to file Form 8858. You are also required to file Form 8858 if you are required to file Form 8865 with respect to a controlled foreign partnership that is the owner of an FDE.
What Happens If You Don't File?
There is technically no penalty for failure to file, but the IRS might view an associated form, such as Form 5471 or Form 8865, or your income tax return, as incomplete if Form 8858 is not properly completed.
VI. Form 8865, Return of US Persons With Respect to Certain Foreign Partnerships
If you are a United States person for any part of the year, and own an interest in a foreign partnership, you are required to file Form 8865. A separate form is required for each foreign partnership. There are four categories of filers, which classify you according to your ownership and activities in the partnership.
A Category 1 filer is a United States person who owned, directly or constructively, more than 50% interest in the partnership at any time during the partnership's year. Nearly all of the form must be completed by a Category 1 filer, which is equivalent to preparing a US partnership return.
A Category 2 filer is a United States person who at any time during the year of the partnership owned at least a 10% interest, directly or constructively, while the partnership was controlled by US persons each owning at least 10%. However, if the foreign partnership had a Category 1 filer at any time during the tax year, no person will be considered a Category 2 filer.
A Category 3 filer is a United States person who contributed property during that person's tax year in exchange for and interest in the foreign partnership, if that person 1) owned at least 10% of the foreign partnership immediately after the contribution, or 2) the value of all property contributed by such person during the 12 month period ending on the date of the transfer exceeds $100,000.
A Category 4 filer is a United States person that had a reportable event during that person's tax year, which includes acquisitions, dispositions, and changes in proportional interests.
A partnership includes a limited partnership, syndicate, group, pool, joint venture, or other unincorporated organization, through or by which any business, financial operation, or venture is carried on, that is not, within the meaning of the regulations, a corporation, trust, estate, or sole proprietorship. A foreign partnership is a partnership that is not created or organized in the United States under the law of the United States or any state or the District of Columbia.
What Happens If You Don't File?
For Category 1 and 2 filers, a $10,000 penalty applies for each tax year the required information is not filed with the IRS. The penalty is increased to a maximum of $50,000 if information is not submitted after the IRS has mailed notices of the failure. For continued failures, the foreign tax credit could be reduced. See Code Section 6038(b).
For Category 3 filers, failure to properly report a contribution to a foreign partnership is subject to a penalty equal to 10% of the fair market value of the property at the time of the contribution. This penalty is generally subject to a $100,000 limit. In addition, the transferor must recognize gain on the contributed property as if it had been sold for its fair market value. See Code Section 6038B.
For Category 4 filers, a $10,000 penalty is imposed for failure to properly report all the information requested. If the failure continues for more than 90 days after the IRS mails a notice of the failure, an additional $10,000 penalty will apply for each 30 day period (or fraction thereof) during which the failure continues after the 90 day period has expired. The additional penalty cannot exceed $50,000. See Code Section 6679(a).
All penalties are subject to the reasonable cause exception.
VII. Form 8938, Statement of Specified Foreign Financial Assets
If you are a "specified person," Form 8938 is required to be filed with your tax return to report your interest in "specified foreign financial accounts" if the total value of all of your specified foreign financial assets exceeds a threshold. Specified foreign financial assets include cash amounts in foreign accounts, foreign securities, financial interests in foreign entities and retirement accounts. This form requires details about each individual foreign asset, beyond just the total account balance that is included in Treasury Form 114 (FBAR). This does not include foreign rental property or foreign financial assets (currency or securities) that are held in a US financial institution. Here is a Comparison Chart of FBAR and 8938 requirements.
If you are married filing jointly, and if the value of these foreign financial assets was more than $100,000 on the last day of the tax year or more than $150,000 at any time during the year, you are generally required to file this form. However, the filing requirement is increased to more than $400,000 on the last day of the tax year or more than $600,000 at any time during the tax year if you lived outside the United States and qualify for the foreign earned income exclusion.
If you are single or married filing separately, and if the value of these foreign financial assets was more than $50,000 on the last day of the tax year or more than $75,000 at any time during the year, you are generally required to file this form. However, the filing requirement is increased to more than $200,000 on the last day of the tax year or more than $300,000 at any time during the tax year if you lived outside the United States and qualify for the foreign earned income exclusion.
Exception: If you do not have to file an income tax return for the tax year, you do not have to file Form 8938, even if the value of your specified foreign financial assets is more than the appropriate reporting threshold.
Who Is A Specified Person?
This is defined a little differently than "United States person." A specified person could be a "specified individual" or a "specified domestic entity." You are a specified individual if you are one of the following:
- A US citizen.
- A resident alien of the United States for any part of the tax year (under either the green card test or the substantial presence test).
- A nonresident alien who makes an election to be treated as a resident alien for purposes of filing a joint income tax return.
- A nonresident alien who is a bona fide resident of American Samoa or Puerto Rico.
You are a specified domestic entity if you are one of the following:
- A closely held domestic corporation that has at least 50% of its gross income from passive income, or at least 50% of its assets are held for the production of passive income.
- A closely held domestic partnership that has at least 50% of its gross income from passive income, or at least 50% of its assets are held for the production of passive income.
- A domestic trust (described in IRC Section 7701(a)(30)) that has one or more specified persons (a specified individual or a specified domestic entity) as a current beneficiary.
What Happens If You Don't File?
A $10,000 penalty is imposed for failure to file, or properly report all the information requested. If the failure continues for more than 90 days after the IRS mails a notice of the failure, an additional $10,000 penalty will apply for each 30 day period (or fraction thereof) during which the failure continues after the 90 day period has expired. The additional penalty cannot exceed $50,000. See IRC Section 6038D. The reasonable cause exception applies.
Oops! What Happens If You Haven't Filed These Stupid Forms?
There are options to file delinquent forms that could be easier and less financially painful than you think. The IRS has been given large weapons by Congress with an array of huge delinquency penalties, but instead of waving them around wildly, causing noncompliant taxpayers to dive for cover, the IRS would rather coax taxpayers into compliance using the carrot approach. We will briefly explain three programs the IRS currently offers to help taxpayers get caught up: 1) streamlined filing procedures, 2) delinquent FBAR submission procedures, and 3) delinquent international information return submission procedures. For additional information, see Options Available for U.S. Taxpayers with Undisclosed Foreign Financial Assets.
Streamlined Filing Compliance Procedures
The IRS created the original streamlined procedure in 2012. This program was offered only to taxpayers living outside the United States who qualified for the foreign earned income exclusion. It was further restricted to taxpayers with unreported income of $1,500 or less.
In June of 2014, the IRS relaxed and expanded the streamlined procedure to apply to all non-willfully delinquent taxpayers. The new streamlined programs allow taxpayers, living either in the United States or abroad, who failed to disclose their foreign accounts and report their foreign income, to become fully compliant at a much lower cost than entering the now closed Offshore Voluntary Disclosure Program (OVDP) (IR-2014-73). There are now two streamlined procedures. Taxpayers qualifying for the foreign offshore procedures face no penalties at all, while a 5% of highest balance penalty is offered to participants living in the United States who qualify for the domestic offshore procedures. There is no longer an unreported tax threshold (formerly $1,500) that could bar hopeful participants from the program, so participants do not need to worry about being rejected if they have substantial foreign income to report. There was also a risk assessment process under the old program that applicants had to sweat through before being accepted. That is now gone.
The modified streamlined filing compliance procedures are designed only for individual taxpayers and estates of individual taxpayers. The program for taxpayers living in the United States is called the Streamlined Domestic Offshore Procedures, and the program for expats is called the Streamlined Domestic Offshore Procedures. Under both programs, taxpayers are required to certify that the failure to report all income, pay all tax and submit all required information returns, including FBARs (FinCEN Form 114) was due to "non-willful" conduct. The IRS defines this conduct as 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." (IR-2014-73.)
Willful vs. Non-willful: The IRS definition of non-willful covers a lot of territory. Negligence, for example, includes “any failure to make a reasonable attempt to comply with the provisions of the Code” (IRC Sec. 6662(c)) or “to exercise ordinary and reasonable care in the preparation of a tax return” (Reg. Sec. 1.6662-3(b)(1)). Further, “negligence is a lack of due care in failing to do what a reasonable and ordinarily prudent person would have done under the particular circumstances.” (Kelly, Paul J., (1970) TC Memo 1970-250). The court also stated that a person may be guilty of negligence even though he is not guilty of bad faith. So the fact that you ignored the FBAR filing requirements for many years, and failed to report your foreign income, might be negligent behavior, but it’s probably not willful. That means you likely qualify for one of the new streamlined procedures. On the other hand, if you loaded piles of cash into a suitcase and lugged it over to Switzerland to conceal it from the IRS, you don't qualify, because that is willful conduct. If you believe your behavior may have been willful under these guidelines, consult with an attorney before submitting returns through one of the streamlined procedures. We work with attorneys who are experts in this field and we would be happy to provide a referral, free of charge or obligation.
Civil Examination: If the IRS has initiated an audit of your tax returns for any taxable year, regardless of whether the examination relates to undisclosed foreign financial assets, you will not be eligible to use the streamlined procedures, If you are under examination you may consult with your agent about this. Also, you are ineligible if you are under criminal investigation.
Previously Filed Delinquent Returns: If you are eligible to use the streamlined procedures but have previously filed delinquent or amended returns in an attempt to address US tax and information reporting obligations with respect to your foreign accounts (made a "quiet disclosure") you may still use the streamlined procedures. However, any penalties previously assessed with respect to those filings will not be abated.
Valid Taxpayer Identification Number Required: All returns submitted under the streamlined procedures must have valid Taxpayer Identification Numbers. This means a valid Social Security number, or if you are not eligible for a Social Security number, an Individual Taxpayer Identification Number (ITIN) issued by the IRS. If you are not eligible for a Social Security number and do not have an ITIN, the ITIN can be applied for with the streamlined submission.
General Treatment Under Both the Offshore and Domestic Procedures
Tax returns submitted under either procedure will be processed like any other returns. You will not be sent an acknowledgment of receipt and will not be asked to sign a closing agreement. These procedures are not an amnesty program. So while your returns will not be subject to IRS audit automatically, they may be selected for audit under the normal audit selection process. The accuracy and completeness of submissions might be checked against information received from foreign banks, financial advisors, and other sources. Therefore, it is possible that your returns might be subject to IRS examination, additional civil penalties, and even criminal liability, if appropriate.
Qualifying For the Foreign Offshore Procedures
The foreign offshore procedures allow you to become compliant penalty free, so this is the preferred process over the domestic offshore procedures. If you fail to qualify for this process, and you have unreported income, the domestic offshore procedures might be your next option. In addition to meeting the general eligibility requirements, to use the Streamlined Foreign Offshore Procedures you must also satisfy the following requirements.
1) You must meet the non-residency requirement described below. If filing jointly, both spouses must meet the non-residency requirement for at least one of the most recent three calendar years for which the due date has passed.
2) You must have failed to report the income from a foreign financial asset and pay the required tax, and may (not must) have failed to file an FBAR (FinCEN Form 114) and/or one or more international information returns, such as Forms 3520, 3520-A, 5471, 5472, 8938, 926, and 8621. In other words, an international information return that was required to be filed may be filed as part of this streamlined submission, but a delinquent international information form is not a requirement to qualify. If all international information returns have been filed, but gross income from foreign accounts has been omitted, this streamlined program is available.
3) These failures must have resulted from non-willful conduct, as defined above, and you must complete and sign a statement attached to Form 14653 certifying to that.
Non-residency Requirement for US Citizens and Green Card Holders: This requirement is met if you are a US citizen or permanent resident, (or the estate thereof), in any one or more of the most recent three years for which the US tax return due date (or properly extended due date) has passed, did not have a US abode, and was physically outside the United States for at least 330 full days. To read about the meaning of "abode," see IRS Publication 54. This means that even if you were living in the United States for two of these years, you still qualify if you meet the 330 day test in the third year. These criteria mean that you will meet the tests for the foreign earned income exclusion in the year or years of absence from the United States.
Non-residency Requirement for Foreign National Visa Holders: If you are a foreign national who is not a permanent resident, you must meet the substantial presence test to be considered a resident of the United States for tax purposes. If you are not considered a resident, you are generally not subject to the FBAR filing requirements. A foreign national who does not meet the substantial presence test for one or more of the most recent three years for which the US tax return due date (or properly applied for extended due date) has passed meets the non-residency requirement. For more information on the substantial presence test, see Determining Your Residency Status in U.S. Tax Guide for Foreign Nationals.
If you are eligible to use the Streamlined Foreign Offshore Procedures and comply with the filing instructions, you will not be subject to failure-to-file and failure-to-pay penalties, accuracy-related penalties, information return penalties, or FBAR penalties. There are no penalties at all. However, your returns could still be selected for audit under the normal audit selection process. If the IRS determines an additional tax deficiency for a return submitted under these procedures, the IRS may assert applicable additions to tax and penalties relating to that additional deficiency.
What You Must Do: The procedures are to 1) file delinquent or amended returns, together with all required information returns (e.g., Forms 3520, 3520-A, 5471, 8938, and 8621) for each of the most recent three years for which the US tax return due date (or properly applied for extended due date) has passed, 2) for each of the most recent six years for which the FBAR due date has passed, file any delinquent FBARs, and 3) complete and sign a statement on Form 14653 certifying that you are eligible for the Streamlined Foreign Offshore Procedures, that all required FBARs have now been filed, and that your failure to fully comply with US tax laws resulted from non-willful conduct. The full amount of the tax and interest due in connection with these filings must be remitted with the streamlined submission.
Qualifying For the Domestic Offshore Procedures
1) You must have previously filed a US tax return (if required) for each of the most recent three years for which the US tax return due date (or properly extended due date) has passed. (Note that this is not a requirement for using the foreign offshore procedures.)
2) You must have failed to report gross income from a foreign financial asset and pay tax as a result of this failure. If no gross income has been omitted, you are not a candidate for these procedures, but may benefit from the delinquent FBAR submission procedures or the delinquent international information return submission procedures, as described below.
3) You may (not must) have failed to file an FBAR and/or one or more international information returns, such as Forms 3520, 3520-A, 5471, 8938, 926, and 8621. In other words, an international information return that was required to be filed may be filed as part of this streamlined submission, but a delinquent international information form is not a requirement to qualify. If all international information returns have been filed, but gross income from foreign accounts has been omitted, this streamlined program is available.
4) These failures must have resulted from non-willful conduct, as defined above, and you must complete and sign a statement attached to Form 14654 certifying to that.
If you qualify for the domestic procedures, and comply with the filing instructions, like taxpayers filing under the foreign offshore procedures, you will not be subject to failure-to-file and failure-to-pay penalties, accuracy-related penalties, information return penalties, or FBAR penalties. However, you will be on the hook for a Title 26 miscellaneous offshore penalty (explained below).
The Miscellaneous Offshore Penalty: This is a rather arbitrary penalty, imposed on only those taxpayers who fail to meet the non-residency requirements. The IRS rationale is apparently that those taxpayers residing in the United States should have been aware of their filing requirements and are therefore deserving of a penalty. However, the penalty is only a small fraction of the penalties the IRS is statutorily authorized to impose (and that was imposed through the OVDP programs). The Title 26 miscellaneous offshore penalty is equal to 5 percent of the highest aggregate balance/value of your foreign financial assets that should have been, but were not, reported on an FBAR or Form 8938, or were properly reported, but gross income with respect to the assets was not reported on a return submitted under the streamlined procedures. The penalty is computed by taking the highest aggregate balance/value determined by aggregating the year-end account balances and year-end asset values of all the financial assets subject to the penalty for each of the years in the covered periods, and selecting the highest aggregate balance/value from among those years.
Delinquent FBAR Submission Procedures
If you do not need to use the Streamlined Filing Compliance Procedures to file delinquent or amended tax returns to report and pay additional tax, but:
- You have not filed a required Report of Foreign Bank and Financial Accounts (FBAR) (FinCEN Form 114),
- You are not under a civil examination or criminal investigation by the IRS, and
- You have not already been contacted by the IRS about the delinquent FBARs,
you should simply file the delinquent FBARs according to the FBAR instructions. When you do so, you should include a statement explaining why you are filing the FBARs late, and on the cover page of the electronic form, select a reason for filing late.
The IRS will not impose a penalty for the failure to file the delinquent FBARs if you properly reported, and paid all the tax, on income from the foreign financial accounts reported on the delinquent FBARs. The FBARs will not be automatically subject to audit, but might be selected through the normal audit procedure.
Delinquent International Information Return Submission Procedures
The Reasonable Cause Procedure
We have discussed the "reasonable cause" exception for each of the penalties above. Here is your chance to put it to the test. The IRS provides that taxpayers who do not "need" to use the Streamlined Filing Compliance Procedures to file delinquent or amended tax returns to report and pay additional tax but who:
- have not filed one or more required international information returns,
- have reasonable cause for not timely filing the information returns,
- are not under a civil examination or a criminal investigation by the IRS, and
- have not already been contacted by the IRS about the delinquent returns
can file the delinquent information returns with a statement of all facts establishing reasonable cause for the failure to file. As part of the reasonable cause statement, taxpayers must also certify that any entity for which the information returns are being filed was not engaged in tax evasion.
The IRS does not elaborate on under what conditions taxpayers would not have a "need" to use the Streamlined Procedures. Taxpayers qualifying only under the Domestic Offshore Procedures might feel they do not have the need to subject themselves to the 5% penalty. The IRS clarifies that taxpayers who have unreported income or unpaid tax are not precluded from filing delinquent international information returns under this procedure. See Delinquent International Information Return Submission Procedures Frequently Asked Questions and Answers. The IRS therefore invites anyone who believes they have a reasonable cause for not filing delinquent international information returns to use this procedure. However, the IRS warns that penalties may be imposed under the Delinquent International Information Return Submission Procedures if the IRS does not accept the explanation of reasonable cause.
What Is Reasonable Cause?
Therein lies the rub – the IRS will not tell us precisely what constitutes reasonable cause in its determination. This is a question determined purely by facts and circumstances. However, the IRS does give some clues. For example, Treas. Reg. Section 1.6038A-4(b)(2) provides:
The determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances. Circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of the experience and knowledge of the taxpayer. Isolated computational or transcriptional errors generally are not inconsistent with reasonable cause and good faith. Reliance upon an information return or on the advice of a professional (such as an attorney or accountant) does not necessarily demonstrate reasonable cause and good faith. Similarly, reasonable cause and good faith is not necessarily indicated by reliance on facts that, unknown to the taxpayer, are incorrect. Reliance on an information return, professional advice or other facts, however, constitutes reasonable cause and good faith if, under all the circumstances, the reliance was reasonable.
The courts have also weighed in on this question in umpteen decisions, and taxpayers have generally not fared well. Taxpayers have scored rare victories, however. For example, in one Tax Court case, penalties were not upheld based on reasonable cause against a pro se taxpayer (she had no attorney) who provided credible reason for her claimed exclusion of settlement proceeds, had well-documented support for claimed medical expenses, and wasn't knowledgeable in tax or tax law. (Nancy Huff v. Commissioner, TC Memo 1995-200.)
If you believe you have a reasonable cause argument, we suggest talking to a tax advisor (like us) for help in prudently weighing of your options. For more on coming clean with your delinquent accounts, see Your Unfiled FBARS.