The term “offshore accounts” is often used as shorthand to suggest that such account holders are trying to dodge tax responsibilities. Especially after the Panama Papers, many observers are quick to assume the worst when someone holds assets outside of the United States.
In reality, many, if not most, taxpayers who hold foreign assets do so in good faith for a variety of legitimate reasons. However, depending on the type of property in question and the taxpayer’s overall situation, keeping the Internal Revenue Service adequately informed can prove challenging. Foreign accounts are a popular target for legislation and regulation, so taxpayers should make an effort to stay abreast of new developments.
Given the often steep penalties for failing to report foreign assets or reporting them incorrectly, many taxpayers may want to seek professional guidance on when and how to report their holdings. Never hesitate to ask a potential adviser or accountant about his firm’s experience with international tax issues. Lawmakers have taken a keen interest in tracking down tax dodgers, and untangling oneself from filing mistakes can be difficult.
Clearing The FBAR
If you are a U.S. citizen or resident and you have a financial interest in, or signature authority over, a non-U.S. bank or securities account, you must report it on FinCEN Form 114, more often known as the FBAR. The only major exception is if the aggregate value of your foreign accounts never exceeds $10,000 during the calendar year. This rule also applies to U.S. entities, so corporations, partnerships, limited liability companies, estates and trusts also should file if the entity owns or has signature authority over such accounts. In addition to filing an FBAR if you maintained foreign financial accounts that totaled more than $10,000 at any point in the calendar year, you must indicate this fact on Form 1040, Schedule B of your income tax return.
Signature authority, for the IRS, means that you can control the disposition of assets in the account directly. For instance, a financial adviser who can buy and sell investments within the account but who cannot distribute assets does not have signature authority. Nor does approving a disbursement that a subordinate employee actually orders count toward signature authority. If this seems unclear to you, you are not alone. The Treasury Regulations are often opaque, and it generally pays to err on the side of caution.
Such caution is necessary because improperly filing the FBAR can trigger civil fines of up to $10,000 per violation. The penalty for willfully failing to file is the greater of $100,000 or 50 percent of the account balance, with the potential for criminal penalties as well. These harsh penalties make clear that federal tax authorities take the potential of tax evasion through foreign accounts very seriously.
However, while you should be careful with your FBAR filing, do not let the process intimidate you. Consider consulting a tax expert, especially one with experience in international tax compliance. He or she will be able to assist you in preparing and filing your FBAR electronically; unlike most of the forms discussed below, the FBAR must be filed from FinCEN’s online system with the Department of the Treasury, rather than attached to the taxpayer’s annual return. It is also worth noting that the due date for the FBAR recently changed. It is now due at the same time as Form 1040 (usually April 15).
Specified Foreign Assets
U.S. citizens and residents who own “specified” foreign assets must report them to the IRS on Form 8938, which is attached to their annual tax returns (and due at the same time). Nonresident aliens who elect to be treated as resident aliens on a joint tax return must also file Form 8938 if they own specified foreign assets. The term “specified” covers any financial account maintained by a foreign financial institution, but also a few other particular types of foreign assets:
- Stock or securities issued by a non-U.S. person;
- Interest in a foreign entity;
- Financial instruments or contracts in which the issuer or the counterparty is not a U.S. person.
Specified foreign assets do not include foreign real estate unless it is held through a foreign trust, partnership or other entity, in which case the interest in the foreign entity itself is reportable. Foreign currency is also excluded, as are U.S. financial accounts that hold foreign securities. For example, if you own shares in a U.S. mutual fund that holds foreign stock, you do not need to report it on Form 8938.
Like the FBAR, Form 8938 has a value threshold for filing. For unmarried taxpayers living in the United States (or married taxpayers filing separately), the total value of specified foreign assets must be 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 jointly, these thresholds are $100,000 and $150,000, respectively. Taxpayers living abroad have higher thresholds: $200,000 and $300,000 for single filers, and $400,000 and $600,000 for joint filers. Note, however, that you must be a bona fide resident or physically present in the foreign country for at least 330 days in the year to qualify.
Most important, filing an FBAR does not relieve you of the responsibility of filing Form 8938 and vice versa. Many taxpayers will file both.
Transfers And Transactions
The FBAR and Form 8938 cover many of the foreign accounts and assets U.S. taxpayers tend to hold. But the IRS also wants to know about property that U.S. taxpayers and entities give to or receive from foreign corporations, foreign trusts and foreign individuals.
If a U.S. person or entity transfers property to a foreign corporation, including, but not limited to, cash and securities, the transferor must file Form 926, “Return by a U.S. Transferor of Property to a Foreign Corporation.” The form will ask for details including the date of transfer, the transferee’s information, the property’s fair market value at the time of transfer and any applicable basis. If the transaction is an exchange, you will also need to report details on the transfer and amount of gain recognized. Forgetting to file is costly; the penalty for failing to file is 10 percent of the fair market value of the property. While the penalty is capped at $100,000, this limit does not apply if the taxpayer intentionally disregarded the requirement. Like Form 8938, this form is attached to the taxpayer’s annual tax return and is due at the same time.
If the transaction is with a foreign trust, rather than a foreign corporation, you must report any transfers, whether you are the donor or the recipient. In this case, you will use Form 3520, “Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts.” This form also covers certain large gifts from foreign persons to U.S. taxpayers. For transactions with foreign trusts, any amount is reportable. Bequests from foreign estates or gifts from nonresident alien individuals must be reported if they exceed $100,000, as must gifts exceeding an annually adjusted threshold ($15,671 in tax year 2016) that come from a foreign corporation or partnership. Form 3520 is also due along with your income tax return, including any extensions.
Unlike some of the other forms discussed, Form 3520 comes with a relatively complex formula for determining penalties. If you fail to timely file the form, or file it with incorrect or incomplete information, the penalty is the greater of $10,000 or the following, as applicable:
- 35 percent of the gross value of property transferred to a foreign trust or
- 35 percent of the gross value of distributions received from a foreign trust or
- 5 percent of the gross value of the portion of trust assets treated as owned by a U.S. person under the grantor trust.
For a gift from a foreign individual, the penalty is 5 percent of the gift amount for each month you fail to report, capped at 25 percent total.
Passive Foreign Investment Companies
Owning shares of a passive foreign investment company, or PFIC, subjects U.S. taxpayers to a complicated set of rules enacted in the 1980s in order to eliminate beneficial tax treatment for certain offshore investments. Under the current rules, in most cases PFIC distributions are taxed as ordinary income, rather than as long-term capital gains or dividends.
This raises the question: What counts as a PFIC? According to the law, a corporation fits the definition if it meets either the income test or the asset test. In the first instance, if 75 percent or more of the corporation’s gross income for the taxable year is passive, the entity qualifies as a PFIC. Alternately, a PFIC may be a corporation in which at least 50 percent of the corporation’s assets produce passive income or are held for that purpose.
PFIC shareholders must file Form 8621, “Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund,” if they receive direct or indirect distributions from the company in a given tax year. They must also file, however, if they: recognize a gain on disposing of PFIC stock; make an election reportable in Part II of the form; or meet several other reporting requirements. Since PFIC reporting can become relatively complicated, most taxpayers to whom the rules apply will want to involve professionals to ensure that they meet their responsibilities where such assets are concerned.
U.S. Transfer Taxes
Gift, estate and generation-skipping transfer (or GST) taxes occasionally involve foreign property. These taxes may change or vanish under the new administration, but as of this writing, gross estates valued above $5.49 million and annual gifts above $14,000 are still subject to federal gift and estate tax. It is important to note that these totals include assets and real property held outside of the United States. There is no separate form for reporting foreign assets in these cases, but all such property must be included on Form 706 for estates and Form 709 for taxpayers who have made gifts in excess of the threshold.
U.S. taxpayers may own foreign assets or accounts for a variety of reasons ranging from investment opportunities to the convenience of local banking when living abroad. Because regulators have developed rigorous reporting requirements for many kinds of foreign assets, approaching such accounts with careful attention will ensure that you can meet your obligations and demonstrate that you are not ignoring Uncle Sam.