Foreign Reporting Obligations
Globalization has made it more common for Americans to have financial assets abroad. Such taxpayers should be aware that there may be foreign reporting obligations associated with their offshore assets even if they do not generate income. The following forms are mere information returns, meaning there are no taxes associated with their filing, however, the IRS may assess substantial penalties against taxpayers who fail to file them.FINCEN FORM 114, REPORT OF FOREIGN BANK AND FINANCIAL ACCOUNTS (FBAR)
The Bank Secrecy Act of 1970 authorizes the Department of Treasury to gather information that has “a high degree of usefulness in criminal, tax, or regulatory investigations or proceedings.” 31 U.S.C. § 5311 et seq. Pursuant to this authority, the Department of Treasury has issued regulations requiring each U.S. person “having a financial interest in, or signature or other authority over, a bank, securities or other financial account in a foreign country” to report the relationship to the IRS. 31 C.F.R. § 1010.350(a). If a foreign financial account has a balance exceeding $10,000 a calendar year, a Report of Foreign Bank and Financial Accounts (“FBAR”) must be filed with the Financial Crimes Enforcement Network, which is an agency of the Department of Treasury separate from the IRS.
Failing to comply with the FBAR reporting and recordkeeping requirements may result in civil and criminal penalties depending on the taxpayer’s level of culpability. For willful violations, the maximum civil penalty is the greater of $100,000 or 50% of the balance in the account at the time of the violation. 31 U.S.C. Section 5321(a)(5)(C). Criminal penalties for willfully failing to file an FBAR may result in a fine of at most $250,000 and/or 5 years of imprisonment.
Non-willful violations can be subject to a maximum penalty of $10,000. 31 U.S.C. Section 5321(a)(5)(B)(i). According to Internal Revenue Manual Section 4.26.16-1, non-willful FBAR penalties cannot exceed $10,000 per account, per year unless managerial approval is obtained. Furthermore, the aggregate amount of non-willful FBAR penalties cannot exceed 50% of the highest aggregate balance of the accounts during the year at issue. No penalty will be imposed if a taxpayer can demonstrate that the “violation was due to reasonable cause, and the amount of the transaction or the balance in the account at the time of the transaction was properly reported.” 31 U.S.C. Section 5321(a)(5)(B)(ii). The civil statute of limitations expires six years after the due date of each FBAR.
The term “willful” has not been clearly defined by statute. Many federal courts have found that a taxpayer willfully violates Section 5314 when he or she knowingly or recklessly fails to file an FBAR. A taxpayer is reckless if he or she clearly should have known that there was a grave risk that the filing requirement was not being met and he or she could have found out for certain very easily. The willfulness standard can also be satisfied by willful blindness, which occurs when a taxpayer deliberately avoids learning about his or her tax obligations.
We represent many taxpayers who have been assessed excessive penalties for failing to file an FBAR. We also frequently advise taxpayers who have not yet been contacted by the IRS regarding their failure to file. If you would like to know your options, contact us at (310) 272-7600 to set up an appointment.FORM 8938, STATEMENT OF SPECIFIED FOREIGN FINANCIAL ASSETS
Taxpayers who are required to file an FBAR may also be required to file Form 8938, Statement of Specified Foreign Financial Assets. Specified foreign financial assets include, but are not limited to, foreign bank accounts, foreign securities, foreign partnership interests, foreign investment assets held by a foreign/domestic grantor trust, and foreign-issued life insurance or annuity contracts. Unlike the FBAR, Form 8938 must be filed with a taxpayer’s income tax return, if the taxpayer has specified foreign financial assets exceeding the following threshold:
|Specified individuals living in the U.S.||Total value of specified foreign financial assets|
|Single or married filing separately||more than $50,000 on last day of tax year OR more than $75,000 at any time during tax year|
|Married filing jointly||more than $100,000 on last day of tax year OR more than $150,000 at any time during tax year|
|Specified individuals living outside the U.S.||Total value of specified foreign financial assets|
|Single or married filing separately||more than $200,000 on last day of tax year OR more than $300,000 at any time during tax year|
|Married filing jointly||more than $400,000 on last day of tax year OR more than $600,000 at any time during tax year|
Specified domestic entities must file Form 8938 if their total value of specified foreign financial assets was more than $50,000 at any time during the tax year.
Failure to file Form 8938 may result in a $10,000 penalty and an additional $10,000 penalty for each 30 days of non-filing after the IRS notifies you of your failure to file. Taxpayers who can affirmatively show the IRS that their failure was due to reasonable cause and not willful neglect will not be assessed a penalty. Taxpayers should note that failing to file Form 8938 will leave the statute of limitations open on the entire tax return until three years after Form 8938 is filed. This means the statute of limitations for assessing taxes and penalties on that tax return may never expire.FORM 3520, STATEMENT OF SPECIFIED FOREIGN FINANCIAL ASSETS
U.S. persons and executors of estates of U.S. decedents may have an obligation to file Form 3520 to report transactions with foreign trusts, ownership of foreign trusts, and receipt of large gifts or bequests from foreign persons. Owners of a foreign trust must file Form 3520 to report the creation of, a gratuitous transfer to, and/or the income and assets of a foreign trust. U.S. beneficiaries of a foreign trust must file Form 3520 to report distributions from the trust. Form 3520 is also required when a U.S. citizen or resident receives a gift or bequest of more than $100,000 from a nonresident alien or foreign estate. Additionally, if you receive a gift of more than $16,388 from a foreign corporation or foreign partnership, you must file Form 3520.
Generally, the due date of Form 3520 is the same due date as your income tax return. Failure to file or a late filing of Form 3520 can result in substantial penalties. If you receive a gift of more than $100,000 from a foreign person and you do not file Form 3520, the penalty can be as much as 25% of the gift. IRC Section 6039F, however, provides no penalty may be assessed if the failure was due to reasonable cause and not due to willful neglect. We draft many reasonable cause statements for our clients who have been unexpectedly assessed severe penalties after receiving a gift from their non-U.S. relatives. The vast majority of our clients who have been assessed Form 3520 penalties have ended up settling with the IRS for much less than the amount initially determined by the IRS.
Furthermore, the IRS may impose a penalty of up to 35% of the gross value of any property transferred to or distributions received from a foreign trust. A U.S. owner of a foreign trust may be assessed a penalty equal to 5% of the gross value of the trust’s assets for the failure to file or late filing of Form 3520. Like Form 8938, the statute of limitations to assess penalties remains open until three years after filing Form 3520.FORM 3520-A, ANNUAL INFORMATION RETURN OF FOREIGN TRUST WITH A U.S. OWNER
A foreign trust with at least one U.S. owner must file Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner, to report various information including its income, beneficiaries, and distributions during the tax year. Form 3520-A is due on the 15th day of the 3rd month following the end of the trust’s tax year. An automatic six-month extension may be granted by filing Form 7004, Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns. If a foreign trust fails to timely file a complete and accurate Form 3520-A, the U.S. owner may be assessed a penalty equal to the greater of $10,000 or 5% of the gross value of the trust’s assets attributable to the U.S. person. A U.S. owner, however, can avoid this penalty if the owner includes a substitute Form 3520-A for the foreign trust with his or her Form 3520 by the latter’s due date. The IRS may assess a penalty for the failure to file Form 3520-A until three years after its filing.TAXPAYER IS THE OWNER AND BENEFICIARY OF A FOREIGN TRUST
What if a taxpayer is the owner and beneficiary of a foreign trust? Wilson v. United States, No. 2:2019-cv-05037 (E.D.N.Y. 2019) involved a taxpayer who was the owner of a foreign trust and its beneficiary. The taxpayer filed Form 3520 late and the IRS assessed a 5% penalty against the taxpayer as the owner of the foreign trust and a 35% penalty against him as the beneficiary of the trust. The District Court ruled that the IRS cannot impose both penalties according to the plain language of IRC Section 6677. Section 6677(a) states if a return required to be filed by a foreign trust’s beneficiary is not timely filed or is incomplete, then “the person required to file such return shall pay a penalty equal to the greater of $10,000 or 35 percent of the gross reportable amount.” In the case of a return required to be filed by a foreign trust’s owner, Section 6677(b) states, “subsection (a) shall be applied by substituting ‘5 percent’ for ‘35 percent’.” The Code does not allow the IRS “to choose between the two or to simply apply a 5% assessment without reference to an otherwise applicable penalty.” Id. at *11. Therefore, the IRS can only assess a 5% penalty against a taxpayer who is the owner and beneficiary of a foreign trust.FORM 5471, INFORMATION RETURN OF U.S. PERSONS WITH RESPECT TO CERTAIN FOREIGN CORPORATIONS
U.S. citizens and residents who are officers, directors, or shareholders of foreign corporations should determine whether they are required to file Form 5471 as the failure to do so can be harsh. Like Form 8938, it is an information return that will leave the statute of limitations open on a tax return for which Form 5471 should have been filed until three years of its filing. The IRS can assess a $10,000 penalty for each fiscal year a taxpayer fails to file Form 5471. If it is not filed within 90 days after the IRS has notified you of your failure, an additional $10,000 penalty can be assessed for each month thereafter. This additional assessment is limited to a maximum of $50,000 for each failure.
There are 5 categories of Form 5471 filers:
A Category 1 Filer is a U.S. shareholder of a specified foreign corporation who owned the specified foreign corporation’s stock on the last day of the year on which it was a specified foreign corporation.
- A U.S. shareholder is a U.S. person who owns (directly, indirectly, or constructively) 10% or more of the total combined voting power or value of shares of a controlled foreign corporation.
- A U.S. person generally means a citizen or resident of the U.S., a domestic partnership or corporation, or an estate or trust that is not a foreign estate or trust.
- A specified foreign corporation (“SFC”) is a controlled foreign corporation or any foreign corporation with respect to which one or more domestic corporations is a U.S. shareholder.
- A controlled foreign corporation (“CFC”) is a foreign corporation that has U.S. shareholders that own on any day of the tax year more than 50% of the total combined voting power or total value of the stock of the corporation.
A Category 2 Filer is a U.S. citizen or resident who is an officer or director of a foreign corporation in which a U.S. person has acquired at least 10% of its stock. For purposes of Form 5471, a person acquires stock if that person has an unqualified right to receive the stock even if the stock is not yet issued.
A Category 3 Filer includes:
- A U.S. person who acquires stock of a foreign corporation and thereby owns 10% or more of its stock.
- A shareholder who owns any stock of certain foreign captive insurance companies.
- A U.S. person who sells stock of the foreign corporation reducing his or her interest to less than 10% stock ownership.
A Category 4 Filer is a U.S. person who had control, meaning more than 50% of the total combined voting power or value of shares, of a foreign corporation during its annual accounting period.
A Category 5 Filer is a U.S. shareholder who owns stock in a foreign corporation that is a CFC at any time during its tax year and who owned that stock on the last day of that tax year.
The category of the filer determines the type of required information, which can include a balance sheet, income statement, current earnings and profits, transactions between CFC and shareholders, and previously taxed earnings and profits of U.S. shareholders. Due to the intricate rules of Form 5471, you may want to consult an international tax professional like Pedram Ben-Cohen if you are an officer, director, or shareholder of a foreign corporation.FORM 5472, INFORMATION RETURN OF A 25% FOREIGN-OWNED U.S. CORPORATION OR A FOREIGN CORPORATION ENGAGED IN A U.S. TRADE OR BUSINESS
Form 5472 must be filed by a reporting corporation with its income tax return if it had a reportable transaction with a foreign or domestic related party. A reporting corporation is a 25% foreign-owned U.S. corporation, meaning a foreign shareholder owns, directly or indirectly, at least 25% of the total voting power or total value of shares of the corporation. A reporting corporation also includes a foreign corporation engaged in a trade or business within the U.S.
A reportable transaction is any transaction listed on Part IV and Part VI of Form 5472. Generally, reportable transactions affect a reporting corporation’s taxable income. They include monetary, nonmonetary, and less-than-full consideration transactions. Examples of reportable transactions include sales and purchases of inventory or other tangible property, and rents and royalties received or paid.
A reporting corporation must file a separate Form 5472 for each related party with which it had reportable transactions. A penalty of $25,000 may be assessed for the failure to timely file a complete and accurate Form 5472. An additional penalty of $25,000 can be assessed for each 30-day period if the failure continues for more than 90 days after notification by the IRS. The statute of limitations for assessment and collection on the entire tax return does not expire until three years after Form 5472 is filed.FORM 8865, RETURN OF U.S. PERSONS WITH RESPECT TO CERTAIN FOREIGN PARTNERSHIPS
U.S. persons who own an interest in a foreign partnership, a partnership that is not organized under U.S. laws, may have a Form 8865 filing requirement. There are 4 categories of filers:
A Category 1 Filer is a U.S. person who controlled a foreign partnership at any time during the partnership’s tax year. A person has control of a foreign partnership if he or she owns more than a 50% partnership interest. A Category 1 Filer also includes a U.S. person who transfers appreciated property to a foreign partnership and defers the gain pursuant to Section 721.
A Category 2 Filer is a U.S. person who, at any time during the tax year of the foreign partnership, owned a 10% or greater partnership interest while the partnership was controlled by U.S. persons each owning at least a 10% interest. If a foreign partnership had a Category 1 Filer during its tax year, then no one is considered a Category 2 Filer during that tax year.
A Category 3 Filer is a U.S. person who contributed property during his or her tax year to a foreign partnership in exchange for an interest in the partnership and he or she owned, directly or constructively, a partnership interest of at least 10% immediately after the contribution, or contributed more than $100,000 in the previous 12-month period.
A Category 4 Filer is a U.S. person who had a reportable event during his or her tax year. Examples of reportable events include:
- An acquisition in which a U.S. person, who did not own a 10% or greater interest, now owns a 10% or greater partnership interest.
- An acquisition in which a U.S. person increases his or her interest since the last reportable event by at least 10%.
- A disposition in which a U.S. person, who owned a 10% or greater foreign partnership interest, now owns a less than 10% partnership interest.
- A disposition in which a U.S. person decreases his or her interest since the last reportable event by at least 10%.
- An increase or decrease of a U.S. person’s direct proportional interest by at least 10% compared to the last time the person had a reportable event.
Like Form 5471, the category of the filer determines the type of required information, which can include a balance sheet, income statement, partners’ distributive share items, and analysis of partners’ capital accounts. The category of the filer also determines the penalties that may be assessed. For Category 1 and 2 Filers, a failure to file may result in a $10,000 penalty per year and another $10,000 for each 30-day period the failure continues 90 days after the IRS’s notice regarding the failure. The IRS may also reduce your foreign tax credit by 10% for the failure to file Form 8865. Category 3 Filers can be assessed a penalty equal to 10% of the fair market value of the property contributed, up to $100,000. Category 4 Filers are subject to the same penalties as Category 1 and 2 Filers and may be criminally prosecuted for the willful failure to file Form 8865. If convicted, a Category 4 Filer may be fined up to $25,000 and/or imprisoned up to 1 year. Failing to file Form 8865 will leave the statute of limitations open on a tax return for which Form 8865 should have been filed until three years after its filing.
Considering the complexity of Form 8865 and the substantial penalties that can be assessed for failing to file, you may want to consult Pedram Ben-Cohen, a tax attorney and CPA, if you own a foreign partnership interest.FORM 926, RETURN BY A U.S. TRANSFEROR OF PROPERTY TO A FOREIGN CORPORATION
U.S. persons and residents, domestic corporations, and domestic estates or trusts must complete Form 926 to report certain transfers made to foreign corporations. Examples of reportable transfers include:
- Transfers by a domestic or foreign partnership.
- Transfers of cash by a U.S. person if, immediately after such transfer, the person either directly or indirectly holds at least 10% of the voting power or the total value of stock of the foreign corporation.
- Transfers of more than $100,000 by a U.S. person during a 12-month period.
- Transfers of stock or securities for which a gain recognition agreement is filed deferring the gain realized on the transfer.
Transferors making a reportable transfer must include Form 926 with their income tax return. Failure to file Form 926 may result in a penalty equal to 10% of the fair market value of the property at the time of the transfer. The penalty is limited to $100,000 unless the failure was due to intentional disregard. Similar to the other information returns above, a showing of reasonable cause can invalidate the penalty. The statute of limitations for assessing penalties on the transfer expires three years after filing Form 926.
In light of the substantial penalties the IRS may assess for the failure to file certain information returns regarding foreign assets, retaining an international tax professional may be a smart investment. If you were required, but failed to disclose your offshore assets, there are options. Pedram Ben-Cohen is an attorney, CPA, and Board Certified Taxation Law Specialist who has provided various strategic and innovative solutions to sensitive tax problems. Instead of having another sleepless night speculating about your reporting obligations, give us a call at (310) 272-7600 or complete our online form.