U.S. citizens and residents with unreported assets abroad may be feeling a steady increase of pressure these days. The July 1, 2014 effective date of the Foreign Assets Tax Compliance Act (FATCA) is looming. The number of countries that have agreed to enforce FATCA is growing (almost daily). That means the banks in those countries will be required to report U.S. citizens’ assets to the IRS. It seems inevitable that if you don’t report your income and assets, your bank will. This point has been reinforced through bank-issued letters, from foreign banks to their U.S. clients, notifying those clients of the impending reporting requirements. If you want to stick your head in the sand or hide in a dark corner, we feel your pain, but we highly recommend against denial. The consequences of doing nothing could be severe – from staggering monetary penalties to jail time.
Taxpayers who are behind in reporting foreign assets and paying taxes on foreign-based income have a few options before the gloom and doom of the taxman cometh. Since the passage of FATCA in 2010, the IRS has offered citizens three rounds of its Offshore Voluntary Disclosure Program (OVDP), whereby taxpayers can reconcile their status with the IRS through reporting assets, paying past due taxes, interest and penalties. The penalties can be fairly steep – 27.5% on unreported assets alone – but they are preferable to an enforcement action by the feds. For taxpayers considered low risk, i.e. those that owe less than $1500 a year, the IRS offers a Streamlined OVDP that is penalty-free and involves a less onerous reporting process.
Below we provide some additional detail on who should consider making a date with the IRS, what steps to take, and possible consequences of doing nothing.
Who Is Covered:
U.S. citizens and residents with foreign accounts who have failed to file U.S. tax returns, failed to report income from foreign accounts, failed to file a report on foreign assets (FBAR), or failed to file other forms on foreign-based assets (e.g., Form 3520 on foreign trusts, Form 5471 on controlled foreign corporations, Form 926 on transfers of property to a foreign corporation, or Form 8865 on interest in foreign partnerships), need to address what and how to report to the IRS.
Foreign assets that must be reported include (1) accounts containing $10,000 or more of assets at some point during the tax year in which you have a financial interest or over which you have signature authority (FBAR); (2) your interest in assets worth at least $50,000 on the last day of the tax year or $75,000 at any time during the tax year (Form 8938). The problem for many is that what constitutes a foreign asset is somewhat broad and includes not only foreign accounts, stock, and mutual funds but also foreign partnership interests, debt issued by a foreign person, interests in foreign trusts or estates, and certain derivative instruments with a foreign counterparty.
If you have unreported foreign-based income or assets that pass the threshold amount outlined above, the time is right to consider the disclosure options currently offered by the IRS. The IRS’s website provides guidance on several options available to taxpayers, based upon the level of failed disclosure.
- Delinquent FBAR Filing: Those who reported all taxable income, but were not aware of the need to file an FBAR on foreign assets can file an FBAR with an explanatory statement. There will be no penalty for those who fall under this category.
- Delinquent CFC/Foreign Trust Filing: Those who reported and paid tax on all taxable income associated with a controlled foreign corporation or foreign trust, but failed to file Forms 5471 or 3520, may file these forms with an explanatory statement. (The IRS notes that Form 5471 should be submitted with an amended return.) Provided there were no underreported taxes, the IRS will not impose any penalties.
- Streamlined OVDP: Non-resident taxpayers (i.e. only citizens living abroad) owing less than $1,500 per year in taxes may file delinquent returns and related information returns for the last three years, and delinquent FBARs for the past six years, including tax and interest due. These taxpayers will also need to file additional information for the IRS to ascertain compliance risk. The IRS will review these submissions to confirm they are low-risk (i.e. that amount owed is less than $1,500 per year). If confirmed, the IRS generally will not impose any penalties beyond interest owed. If the IRS determines you are a higher risk, then you may be subjected to a more intensive review, including additional tax years, and may be required to file according to the standard OVDP (below).
- Standard OVDP: Taxpayers who have failed to report foreign accounts and income, especially those who seek to avoid criminal prosecution, may participate in the OVDP, which is structured like a civil settlement. Those taxpayers will pay an offshore penalty (instead of other penalties at the IRS’s disposal). This program involves several steps: (1) the taxpayer must submit a request to the IRS to be accepted into the program; (2) once accepted, the taxpayer must submit many items, including amended tax returns with schedules outlining unreported income for past eight years, FBARS, and information returns for the previous eight years; (3) the taxpayer must submit full payment of all tax and interest due along with penalties (including a penalty of 27.5 percent of the highest aggregate balance of foreign assets held over the last eight years, and a penalty of up to 40 percent of taxes owed on unreported income from foreign accounts). Note that if you disagree with the penalties, you may opt out of the settlement and request a mitigation of penalties (in limited circumstances, some taxpayers will qualify for a five percent or 12.5 percent penalty). You may also choose to opt out if statutory penalties would be lower under relevant laws (which should be reviewed on a case-by-case basis). Taxpayers who opt out are still protected from criminal prosecution.
- Quiet Disclosures: A final option, which is neither offered nor suggested by the IRS, but which some taxpayers attempt, is to simply start disclosing foreign assets and follow normal reporting requirements without addressing delinquent reports from prior years. Some taxpayers may choose to file amended returns under normal reporting procedures. These quiet disclosures are generally not recommended, as they do not safeguard the taxpayer from an IRS enforcement action, including criminal prosecution. They may at least trigger an IRS audit, which can come with stiffer penalties than those incorporated in the voluntary disclosure programs.
A Couple of Caveats:
If the IRS has already contacted you requesting information or already initiated an investigation, it is too late to follow any of the programs outlined above. As the name suggests, the programs are strictly “voluntary.” Also, the IRS may choose to close down its voluntary disclosure programs at any point. Many out there are warning taxpayers to file with the IRS right away before it is too late.
Although, a minor point of observation: while it is possible that the IRS will determine that it will get all the information it needs through FACTA bank disclosures, it is also likely that the agency will be happy to let the taxpayers do the work for them: to volunteer information and pay fines without the need to expend resources on investigators and prosecution. However, the more delinquent you are in taxes owed, the more likely the IRS will seek stiffer action and penalties. Therefore, if you are significantly behind on taxes owed, be aware that you are a more likely candidate for criminal prosecution. See, for instance, the growing list of former UBS clients who have faced incarceration and hefty fines for tax avoidance.
Why Make A Disclosure?
Some taxpayers may have a high risk tolerance and choose to take a chance that their foreign accounts will not be reported. Or they may think the IRS will be sufficiently inundated with new information from FATCA-compliant countries that it will take years for the IRS to identify them… and by that time perhaps FATCA will be repealed. While a number of activists and politicians have been working hard to repeal FATCA, the reality is, it is probably here to stay. Because dozens of international agreements have been signed, and once the legislation takes effect, it will be very, very difficult to unweave this work and convince the government to relinquish its new power. Taxpayers should presume FATCA is here to stay and reconcile their finances with Uncle Sam.
As of May 2014, more than 50 countries have agreed to comply with and enforce FATCA. (Some countries are enforcing the American law as a part of information share agreements with the U.S. whereby the U.S. will also report information on those countries’ citizens. Other countries are enforcing the American law to avoid the harsh withholding penalties that non-compliant countries would otherwise face.) This means that the financial institutions in these countries will be required to report income and asset information to the IRS. Finding a place to park your money outside of Uncle Sam’s purview is nearing impossible.
And the consequences of the IRS initiating an audit or enforcement proceeding against you are invariably going to be more severe than the voluntary disclosure programs (otherwise, what would be the incentive to disclose?). For those severely behind in IRS reporting, the protection from criminal prosecution should be one of the biggest carrots of the voluntary disclosure programs, especially as the IRS steps up its initiatives to help offset a perilous budget deficit. In the last five years, federal prosecutors have brought more than 100 criminal cases against taxpayers with unreported income overseas. FATCA enforcement will likely increase this number significantly. Regardless of political, philosophical, or moral objections you may have to accept Uncle Sam’s reach abroad, unless you want to risk your estate and possible jail time, the time is right to make an appointment with counsel to address your situation with the IRS.