Real Life Scenarios Part 1
Janathan Allen discusses genuine real life scenarios providing examples of challenges our clients have faced when Allen Barron has been able to provide valuable services to solve our client’s problems and fix integrated legal, tax and accounting issues both domestically and internationally.
Jan
Welcome to AB cast integrating legal tax accounting and business solutions. I’m Janathan Allen. This episode is about real life lessons not to be repeated.
Neil
Jan, this is an exciting couple of episodes here. We’re actually going to be talking about some real life stories and some episodes that you’re hoping won’t be repeated. I guess one of the first things we could talk about is a lot of mistakes are made in the areas of creating or not creating a trust. Can you share with us a real life example of that issue?
Jan
Sure. I can’t explain how many times a client has done an intake call with me and explained that they don’t have enough assets and therefore there’s really no reason to create a trust because there’s a misperception that somehow you have to have a lot of assets in order to create that trust. But what ends up occurring when that type of stance is taken as potentially inevitably a premature death occurs. Hmm. And the chaos that ensues is overwhelming. And I can give you an example. It was during Covid. I had a client who was really sort of a fascinating man. He was older and he was assisting another client and they were doing business deals in Mexico, in and central and South America. And while he was an American, he was living in Mexico, he passed away unexpectedly. He had no trust and he had no will. Unfortunately. So our office was confronted with the task of having to close down the business as we were doing the accounting for that business and the tax returns as well as moving into an estate process because he had no children and no living relatives. Mm-hmm. <affirmative>. But what he did have was a bank account and a business partner who had been funding him. And there was money that was frozen in a business account that has taken us almost two and a half years to kick free because there was no trust or will
Neil
Jan, most people don’t really understand why they need to trust what happens to their house and their belongings and the cost and expense and the time of probate. Can you just quickly summarize why most people who simply own a home here in San Diego need a trust and they need it now and not later?
Jan
Absolutely. The idea is that if you have an asset and you want it to go upon your death to your spouse, then uh, you want to be able to transfer that without having to go to court to do that. So what a trust allows you to do is to place an asset within the trust itself and then the event of an untimely death transfer. Transfer the title to that asset, to the respective beneficiary, whoever you designate that to be. So for example, when you’re dealing with a thing such as a home, one of the reasons that we want to put the asset in trust is in order to get the step up in basis. Because we go back and we check the underlying title holding, move it to community property because most people that we deal with are here in the state of California. And then convert that property into the trust so that in the event of death, then there is no having to go into court to transfer title of the house into the spouse’s name. But also there’s a step up and basis that might not occur depending on the underlying title holding of that particular asset.
Neil
So you had a client where one of the spouses was adamant about putting their residents into their children’s names. So can you talk about that experience and why that may not have been the best of ideas?
Jan
Yeah. It was a client that came in and was fairly adamant that he wanted to remove any assets for risk mitigation purposes into his children’s names. His children were older and my advice at the time, and it would still be again today, is not to do that, although that’s what he ultimately did. He quit, claimed the property into his children’s names. Then what ended up occurring because he was still living in the house, is that the kids that he had transferred title to the house to sold the house. Hmm. So suddenly he no longer has a home to live in. He didn’t have the wherewithal to buy his own house back. And yet what ended up happening is the loss of his home and the financial appreciation that had occurred within that property because of that really unnecessary transfer to his children.
Neil
So Jan, even if we’re passing an asset just from one spouse to another after the unfortunate passing of one of them, can you tell us about what the hassle and cost associated with probate would be if there was no trust?
Jan
When there is no will or trust? What you’re referring to is a person dying in test state? Yes. And what that means is there is no will or no trust with which to go back and transfer the assets of the individual. And that’s where we go into probate court and request of the court the ability to take on the responsibility, the fiduciary responsibility to take on those assets, marshal them, identify them, and then take and distribute those assets according to what is the probate code and the order of beneficiaries that are outlined within the code as opposed to what the person’s wishes might have been. So for the probate process, the probate process again is just a fancy term for transferring title of assets. But in order to do that, you have to hire an attorney. Generally you have to go into court. There’s a marshaling of the assets.
There is the dealing with financial institutions, mortgage companies, pension plans, if the spouse had pensions and doing all of the legal work that it takes to transfer title of an asset to someone else. One of the things that we do in our office is when we create an in vivos or living trust, is that we fund the trust. And what that means is we go back and we transfer the title of the assets that the individuals own into the trust. And I can’t tell you how many times I’ve reviewed a trust that someone has brought to me because it’s been uh, a period of time and that needs to review and there’ll be a segment of the trust that’s been prepared by some other firm that shows the individuals how to fund the trust. And inevitably they don’t get through the funding process. Because it is complex, it takes time and it’s complicated. So for us, the idea of going back and creating a trust, funding that trust, transferring the assets into the trust is probably one of the most worthwhile processes that an individual can go through in order to assure a smooth transition in the event of their death.
Neil
Jan, you mentioned the hassles of probate. How long does it usually take to get a case through probate and how are the costs of probate calculated?
Jan
Well, probate before covid, my answer would’ve been something different. But the advent of covid and the impact on the courts within the California system and really nationwide has been fairly adverse. So the length of time can be anywhere, and in a good year, probate could be 9, 12, 15 months. And now it’s almost double that in terms of trying to get things done. So it’s not only just the fact that you have to wait that long, it’s what is it that you do in the interim with the assets that you don’t really have title to and that you can’t really do anything with until you have the ability and the courts okay to distribute. So the cost is not only the cost of the probate, which is a certain percentage of the value of the assets that are being probated, but the time that it takes and the lost opportunities as well because of the waiting for the transfer of the title of the asset to be able to distribute it, to sell it or exchange it.
Neil
And you just hit on a really key issue there, Jan, that it’s not, the cost of probate isn’t based on the value of the equity in the asset, it’s based on the, the value of the asset itself. So in an example, if I’ve got a million dollar house, but I’ve only got $150,000 equity, the fees are based on a million dollars not on the $150,000 that is the equity interest in the property. Correct?
Jan
That’s correct.
Neil
Another major aspect of what we do is tax planning, international tax planning and transactional tax planning. Why is it important to plan in the international tax arena and do you have a life story that you could share with us about in examples of what we might want to avoid?
Jan
The international arena is a fairly, a fairly interesting arena, although it can be really fraught with a lot of missteps that people don’t recognize simply because transactions that occur outside of the United States don’t necessarily adhere to the same sort of types, processes and protocols that we have here in the States. So for us, the idea is we want to be able to harmonize what’s happening here in the US with what it is that someone may want to do outside of the country. So to be able to do that, you have to have an understanding not only of what’s happening in the US from a legal tax and accounting perspective, you also need that same perspective in other countries. So because we have done international transactions for over 20 years, we’re fairly well-versed in terms of transactions that occur in Europe, in Asia Central and South America, Canada of course, and Mexico.
So the idea of going back and ensuring that the harmonization between the countries and not creating a conflict because of the differing rules and regulations that occur between the US and the rest of the world don’t find themselves creating obstacles for a company or an individual that’s doing business outside of the us. And I think the chief example of that is, I’ll give you a really good example when I look at the financial statements and you can go online and s sec.gov and take a look at Disneylands financial statements. One of the things that we do here in the United States, for example in accounting is we record financial assets on the balance sheet at their cost. So if you can imagine Walt Disney going and purchasing the land in Anaheim for 40, $50,000, you know, 30, 40 years ago, that’s a cost that’s still reflected on the financial statements that you see today in Europe and the rest of the world.
When they do financial statements, they record the assets at fair market value. And what that does is because the fair market value can vary from year to year, say you’re in a recessionary period or say you are in a a period of high growth or inflation, the value of those assets change. So you’ll see gains and losses that you won’t see on a financial statement, for example, in the us. So it’s the idea that we do things a certain way here in the US that are not necessarily adhered to in the rest of the world, which makes the international transactional planning and execution far more interesting and more complex than I think most people recognize.
Neil
So Jan, is there a an anonymous client story that we can share that would drive this point home?
Jan
Oh, there are several, but one comes to mind about a client who was a US citizen and had moved to Australia and had married an Australian, had a child, and she was setting up a trust in Australia because in the Australian taxing regime, setting up trust actually leads to tax savings because that’s the way the Australian tax regime works. The unfortunate part of that, for example, for a US citizen is that if you are the beneficiary or the maker of a foreign trust, any income that’s earned in that trust, that foreign trust is taxed at 55%. Hmm. So the assets that she was getting ready to transfer into this trust while it gave her a break in Australia could have created a pretty impressive tax liability here in the states because of the differences in the tax regimes. So it’s important if you’re going to do business and you’re a US citizen and you’re living in or outside of the United States and you’re doing business outside of the United States to really take the time to understand what it is that’s happening and the potential tax implication for you, your family and your company.
Neil
Jan, another of my favorite examples is one of our clients that was, I believe it was a Japanese company and they had set up all these companies vertically, but what they really needed was more of a horizontal alignment in order to maximize profitability and tax. Do you remember that situation? Can you tell us a little bit about it?
Jan
Yes. Several years ago there was a company that came to us and they were creating an entity here in San Diego. And that was really how we became involved. But in going back and looking at the overall structure of the entity, which began with the parent in Japan who had really companies all over the world, but in the potential or in the division that I was dealing with, there was, there were companies that had been created in England, companies had the parent, the Japanese parent had created in Chicago that went back and created a company in England that went back and the English company created a company in Los Angeles, and LA was looking to create the company in San Diego. Wow. And by the time I finished with the tax analysis, what had occurred was, while it made sense from the Japanese perspective, because it was a hierarchically structured, the way that it made sense to them from a US tax perspective, the addition of the creation of the company in Illinois was really the downfall because once Illinois became invested in the company in England, everything that flowed through England was now taxable in the us.
That didn’t make any sense because it didn’t have to be structured that way. So we went through and we did an analysis that took me about 14 months to explain to middle and upper management that it would be in the Japanese parents’ best interest to flatten the holding structure of the companies instead of holding them in a vertical formation that really, really exponentially increase their tax liability because of the insertion of the US companies.
Neil
Hmm. And another one of my favorite examples, common example that we see, Jan is with the American national that marries someone from Europe and then moves there, but they really don’t understand that European financial vehicles and even retirement situations are just completely different than they are here in the United States. And that can lead to PFIC issues, FBAR issues and all sorts of issues from their tax returns point of view. Can you share with us a little about the complications of that scenario?
Jan
Yeah, the fascinating thing about we Americans is we presume that once we leave the shores of the US that somehow US laws don’t apply to US
Neil
<laugh>.
Jan
And of course, if I can get any message across as if you are a US citizen, then you are always going to be taxed on your income worldwide. It doesn’t matter where you go, it doesn’t matter how long you’ve been outside the United States. But it’s fascinating to me that people that marry someone from a foreign country go to live in that foreign country suddenly feel like they have no obligation to the states. And of course that’s not true. So when you are an American expat living outside of the us, your filing requirements become more complex because now there’s foreign reporting obligations that you have that you probably didn’t know about and didn’t do before. And then there’s the obligations of the way that Europe, for example, does business as opposed to the way the states do.
And a common issue that arises is Americans expats will be living abroad and they’ll invest, for example, in mutual funds. And mutual funds are a great way to go back and expand your portfolio as is real estate. But in the US tax code, the way we deal with mutual funds here in the states is you buy a mutual fund, say through your bank or through a broker, and at the end of the year you get these large packets of 1099s and there’s all of these computations. There’s the interest, there’s the dividends, the capital gains, the capital losses because in the United States we tax on a yearly basis. So while in you’re holding a mutual fund, you may not have sold anything in that mutual fund. Any gain that has accrued within that mutual fund is taxed in the year in which it occurs.
That doesn’t happen in Europe. What happens in Europe is the transaction is taxed when you actually pull the funds or sell the funds and create a taxable event. So in order to harmonize that as an expat, you have to do what’s known as a PFIC calculation, which means you as the individual filing the tax return or undoubtedly the tax preparer is going through what we call a PFIC computation, which goes back and really replicates what would happen in the US broker’s house when they distribute those 10 90 nines. And those end of year statements, which can be incredibly costly, time consuming, and create a tax liability that most American expats don’t recognize that it’s going to befall them simply because of the type of investment that they’ve made.
Neil
And then you have FBAR reporting requirements.
Jan
Yes. FBAR reporting requirements are of of course the reporting of the foreign bank accounts that an individual may hold. And even more complex is cryptocurrency that people have invested in as well. People presume that cryptocurrency is either US based, but oftentimes if you’re in Europe, you will find a cryptocurrency, for example, that is based in Europe that has a foreign reporting requirement that most people don’t think about. So it’s FBAR the foreign assets when you reach a certain level of investment that have to be reported that are external and called foreign reporting requirements that you don’t have if you’re living in the United States.
Neil
So can you share a story of an expat or a US national who moves abroad and then discovers, wow, I really should have disclosed all of these accounts and or assets on an FBAR and now what do I do? And the challenges that they face?
Jan
Yeah, we do a lot of, it’s called streamline reporting. And the history of streamline reporting was beginning in 20, really, 2011, there was a a program that the I R S created called Offshore Voluntary Disclosure Program. It was called the O V D P, and it was really a draconian program that was put into place by the Internal Revenue Service to sort of drive people into compliance. It was harsh, and the penalties that came from the O V D P were just horrendous. It created an economic hardship for individuals that had foreign assets that was really unnecessary because these individuals that had come to the United States didn’t realize they had the foreign reporting requirement. So about six years later, the IRS really came to its senses and began to ease off the draconian penalties because instead of getting people to do what they wanted, which was to self-report, what it was doing was really driving people further underground.
People would devolve themselves out of the assets and never report them. Some people would just not report period. And so the IRS decided to take a different approach. And from the O V D P program evolved, what’s now known as the Streamlined Foreign Reporting Program. And that program is if you are a US citizen and you’re living in the us, then that’s a domestic streamlined program. If you are a US citizen living outside of the United States, then you can file a foreign streamlined program. And the two programs are identical. That allows you to be, to bring yourselves up to date because of the lack of knowledge that you may or may not have had in foreign reporting. And we file three years worth of tax returns and report any accrued interest, for example, on foreign bank accounts that may not have been reported originally, and any other foreign income that may have been left off of a US return.
We file FBARs if they’re necessary for a period of seven years. And then we file what’s known as a non-willful letter. And that non-willful letter is really an explanation of why you, the America expat or US citizen didn’t go back and report those foreign assets to begin with. The penalties are far, far lower than they were under the O V D P program. And the nice thing about a US expat living outside of the United States is there are no penalties. There are penalties in the US for a US individual if they’re reporting from here in the States, but the penalties are 5% as opposed to the 28% penalties that we found in the O V D P original program.
Neil
So Jan, what’s the difference between someone who willfully makes a disclosure versus when the IRS finds it themselves? And how is the IRS going to find out about this eventually?
Jan
Well, the IRS has put into place a number of programs. Early on a couple years ago, there was a push for FATCA, which is really the taxing authorities of foreign countries, and the agreement with the United States to willingly report US assets or US taxpayers assets outside the country. And what that did was it really necessitated foreign banks not wanting to have to deal with the compliance requirements and the compliance reporting requirements to the Internal Revenue Service. So what you find, if you go to Europe now and you want to open up a bank account, it’s almost impossible unless you find a foreign bank that is willing to go back and acquiesce and agree to the foreign reporting requirements that the I R S has mandated. So to the extent that we are dealing with these types of foreign reporting requirements, the issue that you have particularly relating to FBAR, is the necessity of reporting the foreign accounts that you have.
Otherwise, the banks themselves may be reporting, whether you know it or not, in the event that you get an audit notice from the Internal Revenue Service, and for example, say you haven’t reported foreign assets, if you get an audit notice from the I R S, the idea that you can go back and file a streamlined submission is too late. So it’s better if you have these issues and you have foreign reporting requirements that have been unmet. There is a program for you to get caught up and then maintain current reporting requirements, the current foreign filing requirements. But once an audit occurs, and once it starts, then if the I R S discovers the assets that have not been reported, the penalties themselves for the failure to report not only the taxes, but just the failure to report itself can be far higher than the 28% penalties that were found even in the original O V D P program. The civil penalties can be overwhelming.
Neil
Jan, I think across all of these topics we’ve been discussing, one of the things that really holds most people back is simply fear. They don’t know what to do, fear the unknown. They’ve got this feeling like, I really should be fixing this, or I may have some exposure here, but they’re afraid to face, maybe they’re afraid to face it themselves or let alone talk about it and take action on it. Can you share a little bit about the protections of the attorney-client privilege and why you Jan are able to talk to them and help them through thinking about their issues without the worry of it going anywhere or increasing their exposure in some way?
Jan
Absolutely. There is a concept known as the attorney-client privilege that allows a privilege that is extended to the client to divulge things that may be unlawful. For example, the failure to file or failure to report foreign assets is really, it’s illegal under the tax code, but what it does is it allows an individual to talk to an attorney and divulge this type of information without fear of being persecuted. So to the extent that as an attorney, when I speak to a client, the client has an absolute privilege in terms of being able to not have divulged the information with which they’re giving to the attorney. I’ll create a caveat in that the attorney-client privilege extends to a client, but not to the extent that the client is committing a crime,
Neil
Right. Or fraud.
Jan
So if there is an ongoing fraud or ongoing crime, then the attorney really has an obligation to report that. But for the people that I talk to that have failed to file, for example, foreign reporting or foreign assets, the ability to go back and divulge that information, enter into the streamlined program and bring themselves really current is probably one of the major aspects in alleviating the fear that someone may have simply because of the lack of reporting.
Neil
So let’s finish this discussion by comparing, you know, if you have the conversation with you under the protections of attorney-client privilege versus if they have it with a C P A or a tax expert, what’s the level of exposure and why should they feel more comfortable giving us a call and taking advantage of that free consultation?
Jan
Well, the privilege that extends to an attorney doesn’t extend to A C P A. So to the extent that you go back and you, you have a conversation, if you have not filed foreign reporting requirements or you haven’t filed your foreign reporting requirements, if a C P A were to be queried about it, then they are required to divulge that information because the attorney-client privilege does not extend to the client’s C P A. So for particularly for tax programs such as the streamlined program itself, one of the components is a non-willful letter, which is really a signed declaration by the individual client explaining in their own words as to why it is they didn’t report, and how that failure to report was not willful and nor was it intentional. So for the clients, particularly those that are fearful, that they may be found out, the utilization of attorney prevents that because of the attorney-client privilege and the ability to file a streamline submission to the IRS to make themselves current.
Neil
And if you’re handling it, they don’t even have to talk to the IRS themselves, right?
Jan
No. Whenever we deal with a client, we always put in place a power of attorney, and my request to my clients is after a power of attorney is in place, that that allows us to interface with any regulatory body, whether it’s federal, state, or local, on the client’s behalf. And oftentimes when I go through an audit, my request to my client is not to speak to the revenue agents. Not that we’re afraid of something that’s going to be divulged, but there’s a process that you go through, whether it’s an audit or even in an examination or even in an explanation in terms of, of a streamlined program, that it’s important that people understand what it is that they might say that could create more issues for them down the line. And so the power of attorney is utilized to prevent those types of situations from arising.
Neil
That’s got to be a huge relief to our clients, Jan, that they don’t even have to talk to the IRS. They come in, they talk to you, you work through it, you work out a strategy, the problem is solved and we move forward.
Jan
That’s correct.
Neil
Thank you, Jan.
Jan
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