An updated version of choices for non-Americans can be found in a new series of blog posts.
Check here for Part IV of the series. At the bottom of that posting, you can find links and a description to Parts I-III of the series.
Before you know it, tax returns will be due. Many Americans living overseas have not filed tax returns or so-called FBARs for many years, even though they were required to do so. The IRS crackdown on tax evasion through the use of foreign accounts and entities has understandably frightened many of these Americans. Many did not knowingly avoid or evade US tax, nor did they intentionally disregard their tax filing duties. They simply did not understand the tax filing requirements when living and working abroad, or they obtained incorrect tax advice. In fact, in many instances, the typical client I assist owes little, or no tax after taking into account foreign tax credits and foreign earned income and housing exclusion amounts. The problem is that when a taxpayer has a duty to file tax returns, accompanying information returns or FBARs, but does not do so, he is potentially subject to huge penalties.
Pressing upon such taxpayers is the “FATCA Factor”. Commencing this year, under certain provisions of the “Foreign Account Tax Compliance Act” (FATCA), ”foreign financial institutions” will be required to collect information that will be relayed either directly (or indirectly through their local government authority) to the IRS about assets held by US persons with that institution. The FATCA rules will make it very easy for the IRS to cross-reference the information provided by the foreign financial institution with the taxpayer’s Form 1040 to determine whether taxes and reporting on foreign financial assets have been properly undertaken. The first information reports are due to the IRS next year. If the IRS learns of a taxpayer’s noncompliance from the financial institution (e.g., the taxpayer’s non-US bank), the taxpayer will not be eligible for entry into a Voluntary Disclosure initiative. For those with potential criminal tax exposure, this can mean the difference between serving prison time or staying out of jail.
While other approaches or variations on approaches exist, the non-filer generally had two major options to come into compliance with the US tax laws: entering one of the IRS Voluntary Disclosure Programs (there have been different programs in 2009 and 2011 and now, a continuing program that started in 2012) or, so-called “quiet” filing of the delinquent returns and / or FBARs for a certain number of prior years (typically 6 years).
Voluntary Disclosure Program
Each of the IRS Offshore Voluntary Disclosure programs has required the filing of 8 years’ of back tax returns and FBARs. In addition, volumes of supporting documentation are required. Choosing this option is very time-consuming and generally is very expensive, both in terms of professional fees and penalties. These programs, however, are a welcome relief for taxpayers who face a real likelihood of criminal penalty sanctions. More information on the most recent program, the 2012 OVDP, can be accessed here. Here is a broad overview of the OVDP terms:
Generally, by entering the OVDP, a taxpayer is subject to the payment of tax deficiencies and interest on the back taxes due for the OVDP Time Period, which is generally 8 years. Interest is compounded daily.
For each year in the OVDP Time Period, the taxpayer is subject to the normal failure to file and failure to pay penalties (which is basically 50% of the tax due each year) and/or the accuracy-related penalty which is 20% of the tax due.
In place of all other tax or information return penalties that may be applicable, a 27.5 percent “in lieu” penalty on the highest aggregate offshore account / asset value in any year covered by the OVDP. The offshore penalty is intended to apply to all offshore holdings that are related in any way to tax noncompliance. Thus, the value of a home purchased abroad with untaxed salary would be dragged into the penalty base; similarly the value of an overseas apartment on which rental income had not been reported by the taxpayer.
Certain taxpayers may be eligible for a reduced “in-lieu” / “FBAR” penalty. Under the general terms of the program, as mentioned, this “in lieu” penalty is assessed at 27.5% . The ability to reduce it to 12% or 5% is a huge benefit. All of the exceptions are not possible to discuss in a blog posting, and professional advice should be sought in order to obtain the best information as it applies to a particular taxpayer’s set of facts. In my practice I am using the 5% reduced penalty provision with some success. This provision has been very significant for US persons living in a country where they have been paying tax (e.g., Switzerland), or living in a country, typically in the Middle East region, where many jurisdictions have no individual income tax or have a tax asserted by withholding (e.g., on bank account interest). The ability to use this provision also means the taxpayer may be able to remove any real estate, business interests, and other assets from the penalty base.
Under the IRS announcement pertaining to OVDP, a reduced 5% penalty can apply if the individual is a non-US resident and meets all of the following requirements for all relevant years in the voluntary disclosure:
“taxpayer resides in a foreign country; taxpayer has made a good faith showing that he or she has timely complied with all tax reporting and payment requirements in the country of residency; and taxpayer has $10,000 or less of U.S. source income each year. For these taxpayers only, the offshore penalty will not apply to non-financial assets, such as real property, business interests, or artworks, purchased with funds for which the taxpayer can establish that all applicable taxes have been paid, either in the U.S. or in the country of residence. This exception only applies if the income tax returns filed with the foreign tax authority included the offshore-related taxable income that was not reported on the U.S. tax return.”
“Quiet” or “Soft” Disclosure
The “quiet” six year approach, while less burdensome, can still be quite expensive. Under this approach, taxpayers basically take the position that they will not go into the offshore voluntary disclosure program and instead, they “quietly” file all the late tax returns paying amounts due and interest; many also file the late FBARs. They hope the IRS will not pull any of their returns for examination. With such a “quiet” disclosure, a taxpayer runs the risk of being audited and faces the potential for criminal prosecution.
Some taxpayers have attempted to follow the IRS guidance from its December 2011 “Fact Sheet” and submitted explanatory letters with their late filings hoping to abate penalties by establishing “reasonable cause”. These kinds of submissions are a midway ground between a true “quiet disclosure” and entry into the full-blown Voluntary Disclosure program. Overall, this approach can take valuable time away from IRS resources because the agency must sift through and process numerous tax returns that yield very little, if any, actual tax revenue.
Perceiving the various problems with the aforementioned options, the IRS announced the “Streamlined Procedure” – a friendlier and less costly approach to bring non-compliant Americans living overseas back into the tax filing system.
Here are the major points:
- Taxpayers will be required to file only 3 years of back tax returns and 6 years of FBARs, and if IRS agrees that the taxpayer is eligible for the Streamlined Procedure, no penalties will be assessed for the late filings.
- A simplified method of obtaining tax treaty relief will be available for certain foreign retirement plans held by the taxpayer.
- Taxpayers will be classified by the IRS as either “low” risk or “high” risk and such classification will affect both the level of IRS review and potential penalty assessment.
- Payment of any federal tax and interest due must accompany the submission.
- This procedure will not provide protection from criminal prosecution if the IRS and Department of Justice determine that the taxpayer’s particular circumstances warrant such prosecution. Taxpayers who are unsure of their potential for criminal sanctions should seek advice from a qualified US tax attorney and most importantly, make sure they preserve the attorney-client privilege. You can read more here see the section titled “Delinquent Tax Returns and FBARs.”
“High” Risk or “Low” Risk Classifications
The intensity of IRS review for “low” risk taxpayers will be low. For these taxpayers, IRS will NOT assert any penalties nor will the agency pursue any follow-up actions. The skeletal information provided by IRS indicates that in order to be “low risk”, the taxpayer will have tax owing of $1500 or less for each year and his tax returns will be simple ones. To date, we do not know exactly what the IRS means by “simple” returns, but high levels of income or assets, or significant amounts of income from US-sources will render a return not “simple”. I believe that the taxpayer’s involvement in foreign entities (e.g., CFC, foreign partnership or trust) will do the same thing.
“Higher” risk taxpayers will be subject to more intensive IRS scrutiny and can be asked for additional information or documentation. Such taxpayers will be subject to the ordinary tax penalties unless they can establish “reasonable cause”. Unfortunately there is no clear, bright-line rule as to what constitutes “reasonable cause”, and all the facts and circumstances will be examined. The IRS has given some broad guidance on this topic in the December 2011 Fact Sheet, referenced above. For example:
Reasonable cause relief may be granted by the IRS when you demonstrate that you exercised ordinary business care and prudence in meeting your tax obligations but nevertheless failed to meet them. In determining whether you exercised ordinary business care and prudence, the IRS will consider all available information, including:
- The reasons given for not meeting your tax obligations;
- Your compliance history;
- The length of time between your failure to meet your tax obligations and your subsequent compliance; and
- Circumstances beyond your control.
Reasonable cause may be established if you show that you were not aware of specific obligations to file returns or pay taxes, depending on the facts and circumstances. Among the facts and circumstances that will be considered are:
- Your education;
- Whether you have previously been subject to the tax;
- Whether you have been penalized before;
- Whether there were recent changes in the tax forms or law that you could not reasonably be expected to know; and
- The level of complexity of a tax or compliance issue.
You may have reasonable cause for noncompliance due to ignorance of the law if a reasonable and good faith effort was made to comply with the law or you were unaware of the requirement and could not reasonably be expected to know of the requirement. Similar considerations are given in the case of FBAR non-filings.
What Should YOU Do?
In many cases, the taxpayer’s facts do not fit neatly into one option or the other. It is at such times that the professional advice of a competent tax advisor should be sought. The taxpayer should obtain a full understanding of the implications and possible penalties under each option. It is advisable that the matter is first discussed with an experienced US tax attorney. Discussion with legal counsel would be protected by attorney-client privilege. This is particularly important if the taxpayer ultimately decides not to make the disclosure to the IRS. In contrast, a consultation with a non-attorney (for example, with the taxpayer’s accountant) is not protected by the privilege. If the IRS discovers the foreign financial accounts or assets, the taxpayer’s accountant or other non-attorney could become a witness for the IRS against the taxpayer or be required to turn over records and documents. This would not be the case if an attorney had been consulted.
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