Under the law, U.S. citizens, resident aliens and certain nonresident aliens are required to report worldwide income from all sources including foreign bank and financial accounts. Required reporters must pay taxes on income from these accounts at their individual tax rates.
The IRS recognizes that there are many legitimate reasons for U.S. taxpayers to have offshore accounts such as convenience, investing, and to facilitate international banking transactions. However, U.S. taxpayers are prohibited under law from using offshore accounts, including foreign banks, security accounts and trusts, to avoid paying tax. [1]
To fully understand the problem, it is necessary to understand what the reporting requirements for foreign assets are.
FATCA – The Foreign Account Tax Compliance Act
The Foreign Account Tax Compliance Act (FATCA) mandates that U.S. taxpayers, including those living outside of the United States, report their financial accounts held outside of the U.S. It also requires that foreign financial institutions report information to the IRS about their U.S. clients.
The U.S. is also in pursuit of Intergovernmental Agreements with other countries to make sure that the requirements of FATCA are carried out by foreign financial institutions. FATCA was passed on March 18, 2010, as an amendment to an appropriations bill known as the HIRE Act.
FATCA has three main provisions[1]:
- It requires foreign financial institutions, such as banks, to enter into an agreement with the IRS to identify their U.S. personal account holders and to disclose the account holders’ names, TINs, addresses, and the transactions of most types of accounts. Some types of accounts, notably retirement savings and other tax-favored products, may be excluded from reporting on a country-by-country basis. U.S. payers making payments to non-compliant foreign financial institutions are required to withhold 30 percent of the gross payments. Foreign financial institutions which are themselves the beneficial owners of such payments are not permitted a credit or refund on withheld taxes absent a treaty override
- U.S. persons owning these foreign accounts or other specified financial assets must report them on a new Form 8938 which is filed with the person’s U.S. tax returns if the accounts are generally worth more than $50,000; a higher reporting threshold applies to U.S. persons who are overseas residents and others. Account holders are subject to a 40 percent penalty on understatements of income in an undisclosed foreign financial asset. Understatements of greater than 25 percent of gross income are subject to an extended statute of limitations period of six years.It also requires taxpayers to report financial assets that are not held in a custodial account,(i.e. physical stock or bond certificates
- It closes a tax loophole that foreign investors had used to avoid paying taxes on U.S. dividends by converting them into “dividend equivalents” through the use of swap contracts.
Armed with new weapons to make foreign governments and financial institutions comply, the Departments of Treasury and Justice wasted no time in testing out their new powers. The first target was the most obvious – Switzerland.
UBS was the target of an aggressive enforcement action. In the end, UBS was forced to turn over the names and information of 4,000 U.S. taxpayers. In order to settle a corporate criminal action for failure to comply, UBS paid a $780 million dollar fine.
Switzerland’s oldest bank, Wegelin & Co. fared far worse. It paid only $74 million in fines, restitution and forfeitures, but it was dealt the death penalty when its board agreed to cease to do business to avoid criminal liability.
In August of 2013, to avoid further prosecutions, the United States and Switzerland signed an agreement that provides for fines in exchange for non-prosecution agreements for banks that have facilitated American tax evasion.
Given the success in shutting down the Switzerland offshore banking industry for U.S. taxpayers, it is believed that the Treasury and Justice will be launching its next assault on Israel and the Caribbean.
[1] https://www.irs.gov/Businesses/Corporations/Foreign-Account-Tax-Compliance-Act-FATCA
Why Americans Hold Foreign Accounts
There are numerous reasons why many Americans have assets in foreign countries. Some have left established businesses and homes, fleeing persecution in their country of origin. There are those who have fled war-torn regions of the world and left their assets in tax havens; or maintain foreign financial accounts to support family abroad. Other individuals with immigrant roots may have inherited from a relative in the old country who passed away and left them a sum of money abroad.
Of course, American business interests have also grown far and wide across the globe. Multinational corporations and individuals maintain accounts abroad to fund their various business operations and provide for their living expenses.
Since 2002, when the FBAR (A Report of Foreign Bank and Financial Accounts) was first implemented, the methods and means of seeking out these individuals and enforcing reporting obligations has grown tremendously. Due to pressure placed on international banks by the U.S. government, many foreign banks volunteer to disclose information relating to accounts held by U.S. persons.
Although it may not be apparent from the start that an individual has been audited for their foreign account holdings, this motivating factor will often surface at some point over the course of an audit.
What is FBAR?
The acronym FBAR stands for Foreign Bank Account Report and refers to a disclosure form that must be filled out by certain taxpayers with respect to financial accounts maintained abroad. Although this is often a concern for the millions of expatriates living and working in foreign countries, FBAR applies to an even broader demographic of taxpayers.
If you are a U.S. person with a foreign financial account in your name, authority to act on another’s behalf for a foreign account, or a financial interest in a foreign account held in someone else’s name, you may have certain reporting obligations to fulfill in compliance with Federal tax law.
Although the FBAR is important, there are also separate information forms that individuals with an international presence should also be aware of for Federal Income tax purposes.
If you have already received a notice, it is best to seek experienced counsel to guide you in your efforts to be forthcoming. If you have not yet been audited but are concerned that you may have failed to make required disclosures for previous years, it is best to be proactive in order to take advantage of the full range of options available to help taxpayers resolve their delinquent foreign account reporting obligations.
The full range of approaches may no longer exist once an audit is opened and the path to a resolution may become considerably more difficult. Criminal sanctions, penalties and available relief may also depend on the factual circumstances involved in the taxpayer’s failure to complete the required disclosure.
The objective of this guide is to inform taxpayers with foreign accounts on whether they may have an obligation to disclose a foreign financial account or other required information returns, how to make those disclosures and what to do if they have previously failed to meet those reporting requirements.
This guide will also discuss the penalties involved, and the programs available to help non-compliant taxpayers fulfill their disclosure obligations and return to a position of good standing.
Let us start with an explanation of who has an obligation to make financial disclosures under the FBAR.
Who is Required to File
As mentioned above, there are a variety of reasons why American citizens and residents have ties to foreign financial accounts. Under the FBAR reporting requirements, A United States person must file an FBAR if that person has a financial interest in, signature authority over or any other authority over any financial account(s) outside the U.S. and the aggregate maximum value of the account(s) exceeds $10,000 at any time during the calendar year.
To make this disclosure you must determine the maximum value using periodic account statements. Then you must convert this figure to U.S. dollars using the end of the year exchange rates and report the figure in U.S. dollars. As of 2014, the report must be electronically filed through FinCEN’s website.The FBAR does not get filed with the federal income tax return.
There are some exemptions to the filing requirement. You do not have to report an account held in a U.S. branch of a foreign bank. Foreign stock or securities which are not held in a financial account do not have to be reported. Foreign partnership interests are not subject to reporting.
Domestic mutual funds that invest in foreign stocks or securities, foreign hedge funds and private equity funds are also exempt. If owned directly, personal property, such as jewelry and art, real estate, currency and precious metals held abroad are all exempt.
Understanding the Statute
United States Person
A United States person refers to both citizens and residents. However, it also includes entities such as corporations, partnerships and limited liability companies and even trusts or estates that are organized under U.S. law.
In fact, even entities that are disregarded for federal tax purposes might still have an obligation to file an FBAR disclosure because FBARs are required under a Bank Secrecy Act provision of Title 31 and not under any provisions of the Internal Revenue Code.
Financial Accounts
Financial accounts include the following types of accounts:
- Bank accounts such as savings accounts, checking accounts, and time deposit
- Securities accounts such as brokerage accounts and securities derivatives or other financial instruments accounts
- Commodity futures or options accounts
- Insurance policies with a cash value (such as a whole life insurance policy)
- Mutual funds or similar pooled funds (i.e., a fund that is available to the general public with a regular net asset value determination and regular redemptions)
- Any other accounts maintained in a foreign financial institution or with a person performing the services of a financial institution
Financial Interest
Financial interest includes being the owner of record or holder of legal title. You are also considered to have a financial interest if the account is in your name, but you are acting on behalf of a United States Person. In that case, you both likely would have an obligation to make an FBAR filing.
A corporation is considered to have a financial interest if a U.S person owns either 50 percent of the total value of shares of stock, or more than 50 percent of the voting power of all shares of stock.
A partnership in which a United States person owns an interest in more than 50 percent of partnership profits or an interest in more than 50 percent of the partnership capital, has a financial interest.
If a United States person has greater than 50 percent present beneficial interest in the assets or income of the trust for the calendar year, they are also considered to have an economic interest.
Additionally, a trust grantor is considered to have a financial interest if they have an ownership interest in the trust for federal tax purposes.
Financial interest also exists for any other entity in which a United States person owns more than 50 percent of the voting power, total value of equity interest or assets or interest in profits.
In all of the above cases, financial interest exists whether the ownership exists both directly or indirectly.
Signature Authority
Signature authority exists when an individual has control over assets held in a foreign account and can exercise that control by direct communication (including but not limited to a communication in writing). Whether or not they have ever previously exercised the authority would not matter.
For example, a U.S. resident who has a power of attorney for his elderly father’s accounts in Mexico would be required to file an FBAR if the power of attorney gives him signature authority over his father’s financial accounts and the aggregate maximum value of the accounts exceeds $10,000.
It is important to have a clear understanding of these terms because you will need them when completing and filing the required forms and schedules to accompany your 1040/1040a.
Calculating the Aggregate Maximum Value of a Foreign Financial Account
The first step is to determine the maximum account value for each of your foreign accounts. The maximum account value is a reasonable approximation of the greatest value of currency or non-monetary assets in the account during the calendar year. Once you have determined the maximum account value for each account, use the exchange rate on the last day of the calendar year to convert each value into U.S. dollars.
This should be done using the Treasury Reporting Rates of Exchange. Lastly, you add up each of your converted maximum account balances. If the total amount of all your account maximum values exceeds $10,000, all the accounts must be reported on the FBAR.
For example, a U.S. person owns foreign financial accounts X, Y and Z with maximum account balances of $200, $9,000 and $4,000 respectively. This individual would be required to file an FBAR because the aggregate value of the accounts would be $13,200, which is greater than the $10,000 threshold in the statute.
All three accounts would have to be reported on the FBAR, and it does not matter whether an account is individually less than the threshold.
Deadline to File/Postpone Filing
An FBAR must be filed by April 15 of every year. You must continue to file the form on a yearly basis, even if you have no new accounts to report. If needed, you may also get an extension to file until October 15.
Bear in mind that you must also likely file Form 8938. This form is one of a few different information reports that is an attachment that must be filed along with your Federal income tax return. Notice that this is different from the FBAR, which is submitted separately and has its own due date.
Examples of other forms that pertain to international tax which you may be required to file along with your federal income tax return are Form 5471, 5472 and 3520/3520A. We will briefly touch on all of the required forms and hone in on specific questions below.
As part of the Coronavirus pandemic relief effort, the IRS issued notice 2020-23 which has extended the federal income tax filing deadline to July 15, 2020 for the 2019 tax year. Because the forms discussed above must be filed attached to the tax return, the due date for these schedules has also been postponed to July 15, 2020.
If you have any doubt whether you are required to file, err on the side of precaution and make the filing. The amount of penalties can be severe if you fail to file either a Form 8938 or FBAR when you were required to do so.
If you believe that you have failed to meet your filing requirements for previous years, it is best to be proactive in taking measures to correct non-compliance for reasons that will be discussed below.
Required Forms and Specific Questions
To get started, we will focus first on the very basics — your Federal tax form — whichever version of Form 1040 that you are required to file.
1040/1040-SR — Schedule B
Individuals who meet the requirements set out by the Internal Revenue Service are required to file income tax returns on a yearly basis. This requirement is completed by filing a 1040 or a 1040A. Typically, taxpayers must fill out and attach Schedule B to their income tax return (1040/1040A) if they had any interest or dividends regardless of whether the source was foreign or domestic.
If the taxpayer had a foreign account or received a distribution from, created or contributed to a foreign trust, they are required to complete section III of Form B. Section III is comprised of two questions (four if you count subparts). These four “simple” questions lead to a world of confusion.
1040 Schedule B — Question 7a
The first question, question 7a, requires you to report if you had a financial interest or signature authority over a financial account in a foreign country. The term financial account includes but is not limited to:
- Securities, brokerage accounts
- Savings accounts
- Demand accounts
- Checking accounts
- Deposit accounts
- Time deposit accounts
- Other accounts maintained with a financial institution or other person performing the services of a financial institution
- Commodity accounts
- Futures accounts
- Options accounts
- Insurance policies with cash value
- Annuities
- Shares in mutual funds or similar pooled funds
1040 Schedule B — Question 7a Line 2
If you answer “yes” to the first part of question 7a, you are then asked if you are required to file FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR.) A logical person would probably search the IRS’s incredibly well-developed website for Form 114. This would leave the taxpayer confused.
While there are vague references to the form on the IRS site, the form itself is not there because it is not an IRS form. FinCEN is officially known as the Financial Crimes Enforcement Network. It is a separate division of the Department of Treasury. FinCEN’s mission is to safeguard the financial system from illicit use and combat money
laundering and promote national security through the collection, analysis, and dissemination of financial intelligence and strategic use of financial authorities.[2]
FBAR is designated as Form 114 in the FinCEN system.
[1]26 U.S. Code § 720126 U.S. Code § 7201
[2]https://www.fincen.gov/about_fincen/wwd/mission.html
1040 Schedule B — Question 7b
For the taxpayer who is still reading, after the grueling determinations under the two parts of 7a, 7b of Section III is a softball question. This question is actually straight forward if you figured out the answer to question 7a line 2.
If you have to file FinCEN 114, you are required to divulge the name of the country in which the financial account or other holding is located. A taxpayer whose primary goal is other than to hide offshore accounts should be able to complete this question simply.
1040 Schedule B — Question 8
If you received a distribution from, created, or transferred money into a foreign trust, the IRS wants to know. They also want to know if you received more than $100,000 in gifts from an individual or foreign estate, or $15,102 from a foreign corporation or partnership.
If you answer “yes” to this question, you must then determine if you need to file an IRS Form 3520. This question is somewhat deceptively simple unless you have generous relatives who reside outside of the U.S.
[1] The Bank Secrecy Act of 1970 31 CFR 1010.350
Form 3520/3520A
If you have an interest in a foreign trust, you may be required to also complete these forms. Form 3520 is an Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts and Form 3520A is an Annual Information Return of Foreign Trust with a U.S. owner.
The instructions for Form 3520 specify who must file. [1] You are required to file the form 3520 if:
1. You are deemed the responsible party for reporting a reportable event. A reportable event is:
- The creation of a foreign trust by a U.S. person
- The transfer of any money or property, directly or indirectly, to a foreign trust by a U.S. person, including a transfer by reason of death
- The death of a citizen or resident of the United States if the decedent was treated as the owner of any portion of a foreign trust, or any portion of a foreign trust was included in the gross estate of the decedent
2. You are a U.S. person who, during the current tax year, was treated as the owner of any part of the assets of a foreign trust.
3. You are a U.S. person who received, directly or indirectly a distribution from a foreign trust, (including uncompensated use of trust property) or a related foreign trust held an outstanding obligation issued by you that you treated as a qualified obligation
4. You are a U.S. person who during the current year received either:
- More than $100,000 from a nonresident alien individual or a foreign estate that you treated as a gift or a bequest.
- More than $15,102 from a foreign corporation or partnership that you treated as a gift.
It should be noted that if you are required to file Form 3520 and it is due on the same date as your income tax return but gets sent to a different address, and not is included with your 1040 income tax filing.
Form 8938
This is the Statement of Specified Foreign Assets Form that you likely will have to file along with your income tax return if you must also complete an FBAR. U.S. citizens, resident aliens and certain non-resident aliens who have an interest in specific foreign financial assets and meet the filing thresholds must file this report yearly with their income tax returns. [2]
Here is a link to instructions provided by the IRS to guide you in completion of the form.
To understand the differences between the FBAR and Form 8938, here is a chart which illustrates the comparison of requirements under both.
Form 8938 is required if the total foreign-held asset value was $50,000 on the last day of the tax year, or $75,000 at any time during the tax year. If you are married and file jointly with your spouse, the threshold is $100,000 on the last day of the year or $150,000 at any time during the tax year.
If your tax home is a foreign country under the IRS’s rules, an unmarried taxpayer is required to report only if their assets were more than $200,000 on the last day of the tax year or more than $300,000 at any point during the year. The threshold for married taxpayers living abroad is $400,000 on the last day of the tax year or $600,000 at any time during the tax year.
You must report the maximum value of the foreign financial assets or financial accounts with foreign financial institutions, and certain other foreign non-account investment assets. The assets are reported in U.S. dollars using the end of the taxable year exchange rates.
Like FinCEN Form 114, there are reporting exemptions, but they differ from those of form 114. You do not have to report an account held in a foreign branch of a U.S. bank. Domestic mutual funds that invest in foreign stocks or securities or private equity funds are exempt. If held directly, personal property, such as jewelry and art, real estate, currency, and precious metals held abroad are all exempt.
[1] Internal Revenue Service Instructions for Form 3520.
https://www.irs.gov/pub/irs-pdf/i3520.pdf
[2] Internal Revenue Service Instructions for Form 8938. https://www.irs.gov/pub/irs-pdf/i8938.pdf
Form 5471
In addition to having an interest in a foreign account, you may own an interest in a foreign entity. If so, you may have obligations to file Form