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The ‘FATCA effect’: A case study

Make sure your clients understand U.S. tax rules regarding foreign income and assets.
June 29, 2022

By Olaf Barthelmai, CPA

United States taxpayers are somewhat unique in the world, as the U.S. taxes its citizens on their worldwide income regardless of where they reside. According to the Tax Foundation, the African nation of Eritrea is the only other nation that taxes based on citizenship, while all other countries tax income based on residency. For the United States, taxing based on citizenship extends to “green card” holders, permanent residents of the United States, and of course residents based on physical presence in the United States.

Therein lays, in large part, a lack of familiarity among taxpayers and tax preparers with foreign account reporting —thus resulting in a lack of compliance, ranging from many expatriates not filing tax returns to simply just not filing all required forms. However, this lack of information also extends to taxpayers living and working in the United States, especially regarding foreign bank accounts and other foreign assets.

I would like to tell the story of one taxpayer’s difficulties in dealing with the complexities of compliance and explain some of the rules along the way. In addition, having signature authority over foreign bank accounts also requires the filing of Form FinCEN 114, which is overlooked even more frequently than the filing when taxpayers own foreign accounts.

By now, most CPAs should know about the Foreign Account Tax Compliance Act (FATCA), passed by Congress in 2010, but few have been intricately involved in preparing Form FinCEN 114 (also known as FBAR, formerly form TD F 90-22.1) or Form 8938 (Statement of Specific Foreign Financial Assets). And even fewer are aware that although U.S. Internal Revenue Service (IRS) is the civil enforcement agency entrusted with assessing penalties for failure to file or filing incomplete or incorrect forms, it is the Financial Crimes Enforcement Network, another part of the U.S. Treasury Department, that brings criminal cases regarding foreign financial accounts and other specific foreign assets.

Ultimately, this means the agency in charge of compliance is prosecuting criminal cases and thus generally assumes taxpayers who are not in compliance are hiding criminal enterprises or have evaded U.S. taxation on foreign source income. While some are, the vast majority of taxpayers are simply uninformed.

The penalties can be high. Civil penalties are generally a minimum of $10,000 per year per violation, and as much as 100 percent of the foreign assets for “willful” violations. Some cases have resulted in large penalties, including the case of Florida resident Mr. Zwerner, whose penalty was 50 percent of the foreign account value each year for multiple years (200 percent total), and who recently settled for 100 percent of the foreign account value, losing all of his assets outside the US. Being accused of willfully failing to file could not be overcome without appealing, and the 87-year old Zwerner did not want to spend the time it would take at his age, so he settled with IRS for $1.8 million.

For the last two years, I have been working on a case which illustrates the compliance problems arising in this context. Every U.S. taxpayer (citizens, permanent residents and “tax residents”) is required to complete Form 1040 Schedule B Part III (if more than $1,500 of interest and dividend income) and file Form FinCEN 114 (FBAR) online/electronically by June 30 of the following year if the taxpayer has a total of $10,000 or more in foreign bank and financial accounts at any time during the year. This form is filed with the Financial Crimes Enforcement Network either by individual filers at http://bsaefiling.fincen.treas.gov/NoRegFBARFiler.html, or institutional filers at http://bsaefiling.fincen.treas.gov/Enroll.html. Tax preparers must file as institutional filers unless the filing of FBAR forms is integrated into their tax filing software.

The due date for the FBAR form is changing, however. As a result of the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015, the FBAR form due date moves to April 15, 2017, after being due on June 30 for the last time in 2016.

The case I handled involved a taxpayer who immigrated to the United States many years ago, but whose parents stayed abroad. As a result of the parents’ deaths a number of years ago, the taxpayer inherited a foreign variable life insurance policy, which included underlying investments in securities, as well as an investment account with mutual funds. The taxpayer was able to “step in the shoes of the deceased” under foreign law, and thus the life insurance was not paying any taxable income under foreign law.

The taxpayer paid foreign income taxes out of the securities account, but did not report the income or foreign taxes paid in U.S. returns. The taxpayer was unaware of any U.S. reporting requirements regarding income, as well as FBAR or Form 8938. When the taxpayer learned of the FBAR reporting requirement, she did not consult with her CPA, who was unfamiliar with the rules, but instead called the IRS. The agent advised her to enter the 2011 Offshore Voluntary Disclosure Initiative (OVDI), which is a way to “come forward” for taxpayers and pay all relevant income taxes, penalties and interest without facing criminal prosecution.

What the IRS agent did not mention was the mandatory 25 percent penalty (in lieu of the $10,000 per year and interest) that taxpayers agree to pay when entering the program. CPAs and tax preparers need to be familiar enough with the requirements around foreign account reporting and how to disclose if any reporting has been missed, as my case will show. Initially it took the IRS about five months to accept the taxpayer into the program, but the long list of requested information was overwhelming. The taxpayer sent some of the information in her possession over the next year, but only after we discussed the case when the taxpayer asked me to represent her did she even become aware of the penalties she agreed to. The 25 percent penalty applies to the highest balance in all foreign accounts for the past seven years prior to entering the program.

Since Tax Year 2011, U.S. taxpayers with a certain amount of specific foreign financial assets must also file Form 8938 with their tax returns, and CPAs may be held liable under Circular 230 if reasonable inquiries have not been made regarding foreign assets. For residents living in the United States, the filing threshold is $50,000 (single) or $100,000 (married) at year-end or $75,000 (single) or $150,000 (married) at any time during the year, and these thresholds are significantly higher for U.S. taxpayers living abroad.

Specific foreign financial assets include:

1. Financial accounts maintained by a foreign financial institution.

2. The following foreign financial assets if they are held for investment and not held in an account maintained by a financial institution:

          a. Stock or securities issued by someone that is not a U.S. person (including stock or securities issued by a person organized under the laws of a U.S. possession),

          b. Any interest in a foreign entity, and

          c. Any financial instrument or contract that has an issuer or counterparty that is not a U.S. person.

The civil penalties are similar to not or late filing the FBAR form.

After determining all information needed by IRS, our case mainly involved establishing that the foreign life insurance would qualify as life insurance under U.S. law, as it otherwise represented another foreign investment. Because of its passive nature in underlying corporations, this is called a Passive Foreign Investment Company, which is subject to additional penalties and filings. In the end, we could not persuade the IRS regarding the life insurance issue despite good evidence — but we could not agree to the 25 percent penalty, since the taxpayer had not done anything purposely to avoid paying U.S. taxes. The only way she could avoid paying the 25 penalty, was to opt out of the program and leave it up to the discretion of IRS to fully audit her and still assess civil penalties.

When we re-calculated the past returns required to be filed as part of the offshore voluntary disclosure, we discovered that although some additional tax was due in some years, other years resulted in refunds, which were of course outside the statute of limitations. If all returns had been filed correctly, the taxpayer would have received additional tax benefits overall during the seven-year period.

The IRS threatened a full audit and was unclear regarding the civil penalties, and despite the taxpayer’s facts fitting the Q&A criteria of no penalty under the newest OVDI, there was a risk of penalty assessment. Finally, in June 2014, the IRS issued new streamlined procedures to deal with cases like this, resulting in a reduced 5 percent penalty. Without going into all details, this still required the taxpayer to pay all taxes and penalties as well as interest on any returns with tax due, but facing audits and a long process it was the best option.

The “moral of the story” is to ensure you know your clients well enough to be sure all information returns related to foreign accounts have been filed!

 

Olaf Barthelmai, CPA, CGMA, is CEO at Barthelmai Tax & Export Consulting, Inc., in Salem. He is a member of the Disclosures Editorial Task Force. Connect with him on Twitter @IC_DISC_Expert and www.linkedin.com/in/barthelmai