FBAR and Foreign Asset Reporting to the IRS
In this podcast, Jan and Neil discuss the impact of FATCA on US taxpayers worldwide and associated reporting requirements to the IRS. Many US taxpayers are unaware that they are required by law to report all worldwide income, regardless of when or where it is realized, on their annual tax return.
Jan provides insight on the extensive offshore activities, accounts, investments, crypto, foreign trusts and foreign corporate ownership of US taxpayers, as well as important forms such as FBAR and forms 8938 and 5471. If you have earned income in any way internationally or have offshore accounts or assets it is important to understand your responsibilities as a US taxpayer.
Jan
Welcome to our podcast on FBAR and foreign asset reporting to the IRS. I’m Janathan Allen,
Neil
Jan, today we start our conversation on FBAR and foreign asset reporting to the IRS. I guess the first thing we should cover is how does the IRS and the US treasury view income for US taxpayers?
Jan
I think one of the most common misconceptions that we see in our office is that individuals who have income outside of the US don’t believe that it’s taxable here in the states, particularly if they’re foreign nationals that are living here and have assets or income overseas, they are quite surprised to learn that the income that they earn outside of the United States is also taxable here in the states.
Neil
So the US taxes income worldwide, no matter where it’s earned
Jan
It does. Yes.
Neil
And so in about 2014, the United States implemented FATCA. Can you tell me a little bit about FATCA and generally what the goal of it was and what they set up?
Jan
FATCA was an international agreement that was created in order to have an alignment between the United States and other countries around the world, so that they would share information relating to individuals living in their respective countries and the foreign assets that were held in those countries. So what FACA really is, is a mechanism among the foreign countries around the world and treasury in the internal revenue service, as it relates to the reporting of assets that are owned outside of the United States.
Neil
And this is why banks and investment houses, and basically any type of financial or asset related aspect required identification. So they could tell who exactly was the signature or the owner of those accounts and assets.
Jan
That’s correct. And essentially it’s made banking around the world, very difficult for most Americans.
Neil
Do you think that most people understand that these institutions worldwide are providing electronic direct information to the IRS about their accounts and activities?
Jan
I don’t think initially they probably understand that, but when they go into their foreign banks and the foreign banks require information with which to go back and submit to the internal revenue service, I do believe that they are then given the explanation as to why they need to give up the information to the foreign bank so that the foreign bank can then report it to the US.
Neil
So, Jan, what are some of the most important forms that the IRS has implemented to track income and assets worldwide?
Jan
So there are a couple of different forms. Some forms such as the FBAR form itself form 104 is not reported to the IRS, but reported to the department of justice. But other forms such as form 8938 or form 5471 are forms that are actually become part of the filing requirements for individuals and businesses that have foreign income.
Neil
And does the current 1040 still have a question asking about foreign assets and income?
Jan
Yes. The question on form 1040 does ask the question whether or not you have foreign income. In addition to that question is whether or not the taxpayer has invested in crypto. And the interesting overlap here is if an individual has invested, for example, in crypto, in a foreign exchange, that becomes a foreign reporting requirement.
Neil
So who has to file an FBAR or a disclosure of foreign accounts?
Jan
Technically everyone is required to disclose foreign accounts. The manner with which it’s disclosed is dependent on the amount that may be held in an account and the types of accounts held. So for example, an individual may have a foreign bank account in another country and not have over $10,000 in that account. To that extent, the requirement to file form 114 is not required, but the answer to the question, whether or not they have foreign accounts is indeed required to be answered. The addition of form 8938, really overlaps a lot of the foreign information or foreign reporting information on the FBAR. And to the extent that you may not have to report it on an FBAR form 114 you may be required to file that same information on form 8938.
Neil
And that $10,000 threshold you mentioned is that at the end of the tax year, or is that at any point during the calendar year
Jan
That’s at any point during the calendar year and it’s an aggregate number. So a lot of individuals or clients that have come into our office are under the belief that as long as the account itself is under $10,000, if they have several accounts and the aggregate exceeds $10,000, then there’s a reporting requirement.
Neil
So if it goes over $10,000 for all of them, they all have to be responded to and reported.
Jan
That’s correct.
Neil
And so you briefly touched on it, but who has to file the form 89 38, which is a statement of specified foreign financial assets,
Jan
Anyone that has those specified foreign assets. And as I indicated earlier, there is an overlap between assets that are reported on the FBAR. And those that are reported on form 8938, but form 8938 can encompass other types of assets besides bank accounts. And those would include retirement accounts, potential insurance accounts, trust accounts, any type of financial asset that is similar to investments that you’d find here in the US, but are actually owned outside of the US.
Neil
So basically generally speaking, if a taxpayer has accounts or assets outside of the United States, they at least need to have a conversation with us to find out what their reporting requirements are
Jan
Correct. That would be in their best interest. Yes.
Neil
And what if a taxpayer has failed to disclose accounts or assets in the past?
Jan
That used to be a very delicate question because prior to the streamlined submissions that we file now, there was a program called OVDP and the OVDP was a very punitive program. It was a program designed by the internal revenue service to really go back and punish those that had those foreign accounts that hadn’t reported them. But the IRS found that it’s always better to coax someone with honey than with a flyswatter. And that’s good as a result, essentially what occurred was the OVDP, the offshore voluntary disclosure program was replaced, streamline reporting submission, which is a much easier program to get through and far less punitive in terms of penalties and interest,
Neil
And is ignorance, You know, I just didn’t know I needed to do that, Is that going to stand up in front of the IRS?
Jan
Unfortunately, no, the ignorance question, the I didn’t know that I had to do this, is not an excuse under the law.
Neil
So my understanding is the IRS takes the position that it is the responsibility of a US taxpayer to fully understand their reporting requirements under the law for both the IRS and for their states and local interests,
Jan
Correct. The internal revenue service does take that stance. Yes.
Neil
And what are the penalties for a failure to file an FBAR or the form 8938 or other disclosure forms?
Jan
They can be quite extensive if the regular code is used in terms of just assessing penalties for failure to file failure to report. Those penalties are far in excess of what the current streamlined submission program requires. So for example, if you fail to file an FBAR for any particular given year, the penalties could run as high as $10,000 per account per year.
Neil
Wow.
Jan
And please note that the penalty itself is one measure, but then there are the interest that’s associated with that as to when it is the reporting should have been done. And as a result, a $10,000 penalty can easily exceed $15,000, $20,000 within a matter of a couple of years.
Neil
And I’m sure the penalties are much more harsh if people are falsifying or knowingly providing false information on these forms.
Jan
Well then of course you open up the whole area of civil and criminal fraud. And we have seen in terms of lawsuits that have been filed lately, particularly in the crypto world, where people have failed to go back and report the fact that they had cryptocurrency and they failed to report it. And the IRS is now going back and sending out letters to those individuals. And there are several lawsuits that have followed those letters because of the failure to report. So the same thing occurs in the FBAR situation. A failure to report can lead to either civil or criminal fraud filings from the internal revenue service,
Neil
Which carry harsh penalties for sure.
Jan
Oh, absolutely.
Neil
Financial and potential jail time.
Jan
Absolutely.
Neil
So that leads us naturally to a conversation of an area that’s become quite hot under the law and within the IRS code, which is the concept of willful versus non willful conduct on the part of a taxpayer. Do you want to take a cut at trying to help us to understand what’s the difference between willful and non willful conduct?
Jan
The differentiation really comes down to a very subjective term and that’s the, whether or not someone knew or should have known what it was that they were doing was proper or improper, but under the law, it’s difficult to prove intent. And of course, what the law has gone back to recognize over a period of time is the longer period of time you fail to report. The more likelihood you are to have some sort of criminal or civil suit brought against you for fraud by the internal revenue service. So for example, if you failed to report something or a year, the IRS wouldn’t likely go back and administer or file a criminal or civil complaint against you for fraud. But if you extend that time limit to 2, 3, 4, or higher number of years in which you failed to report, the likelihood is far higher. The longer, the time that you fail to report that such a filing of fraud could be made by the IRS.
Neil
And you mentioned the concept of being able to prove intent. So for our clients, the people that we’re representing, does that strengthen your hand and give you more room to negotiate a more successful outcome for our clients?
Jan
Yes. The sooner that they go back and realize, or, or figure out that they need to file. And the sooner that that filing is made, the better it is for the client, the longer period of time it takes, the more difficult that argument becomes.
Neil
So Jan, if the taxpayer doesn’t tell them about their offshore accounts and assets, how does the IRS find about them?
Jan
Well, that goes back to FATCA that we discussed earlier. Essentially, there’s a lot of information that’s flowing in the financial world back to the internal revenue service. There are always deals that have been made with IRS and treasury for reporting. And so information relating to an individual in their foreign accounts could be reported to the IRS and that individual may or may not know that.
Neil
And so the IRS looks at it and says, okay, this taxpayer is supposed to have this account. Have they disclosed it on their FBAR or their other forms?
Jan
Well, essentially, yes. It matches the information that it obtains from foreign sources to the individual’s tax return. And in the event that there’s no match where they don’t see the alleged account on the individual’s return. Then of course, that raises a red flag as to whether or not the taxpayer failed to report it intentionally, or it was not meant to be reported, or they forgot about it.
Neil
And there’s movement in Congress to extend that to crypto, as we speak,
Jan
Yes, the confluence between crypto and FBAR is merging together. So I believe that the types of information that’s being requested by the internal revenue service relating to foreign accounts is going to extend to crypto as well.
Neil
So, Jan, generally speaking, what’s the process for catching up past FBAR reporting and foreign assets.
Jan
That process is a streamlined submission. As it’s currently known in today’s vernacular. It’s a voluntary disclosure program whereby the taxpayer goes back and files amended returns for three years FBARs for seven years, and then submits that information along with a non willful statement to the internal revenue service in a package that streamlined package essentially catches the taxpayer up, regardless of how many years they may or may not have had foreign assets. And the IRS goes through it evaluates the information, given it evaluates the non willful statement. And if it’s accepted, then the IRS will go back and allow what is essentially a much more modest penalty under the streamline program. Then there was under the offshore voluntary disclosure program when the offshore voluntary disclosure program ended, the highest penalty was 28% on the highest balance of assets held over seven year timeframe that has now changed under the streamline program to a 5% penalty on the assets over a seven year timeframe. So it’s quite a bit of difference.
Neil
So Jan, what’s your advice to those who have either missed accounts that they should have reported or have now come to be aware of them?
Jan
I think for anyone who has become aware of the filing requirements and any questions that they have, they should seek out professional advice. And it’s always good to know what it is that you are facing in terms of potential liability, rather than sticking one’s head in the sand. I’m a firm believer that it’s more important to know what I don’t know than to not know what I don’t know.
Neil
And one of the crucial issues here, Jan has to be the protections of the attorney client privilege. If they ask their CPA or financial advisor or tax preparer, the IRS can get at all of that information. Can you tell us a little bit more about the protections of the attorney client privilege in this context,
Jan
The information that’s provided by the client comes in under the attorney client privilege because of the legal representation that they have with our firm, to the extent that there is a differentiation that’s provided by law, the attorney client privilege does not extend to CPAs or to preparers, but it does extend to the attorney client relationship. So to the extent that there’s information that may be provided by the client, to the attorney, to the extent that the IRS makes a request for that information, it does not necessarily mean that that information can or would be turned over.
Neil
So they have a lot more protection. If they’re talking to you versus just a CPA or tax preparer.
Jan
Yes, we would hope that individuals would understand that what we’re trying to get to as we assist them in this process is the truth. It’s difficult to go back and make a filing when you’re not fully cognizant or aware of the information that the client’s providing you and it’s veracity. So to the extent that the clients can feel confident in terms of being able to speak with an individual or an attorney that the information that they’re saying or telling the attorney will not necessarily be reported to the internal revenue service should give them a greater degree of comfort.
Neil
So, Jan, I think us tax payers have been a little surprised over the taxation of investments known as a PFIC, a passive foreign investment company. Can you tell us a little bit more about what constitute a PFIC and why this is a bad thing from a tax point of view?
Jan
Well, I think it’s a bad thing from a taxpayer’s point of view because of the computational issues that arise when they hold a passive foreign investment and a passive foreign investment can be something as simple as an investment in a mutual fund in a foreign country. So here in the United States on a yearly basis, if you invest in a mutual fund, you get those large 1099s at the end of the year that carve out the interest income, the dividend income, the short long term capital gains, et cetera. And it’s all computed for you because the company that you’ve invested in does that computation for you, the rest of the world, however, doesn’t tax mutual funds, the way that the US does in the rest of the world, those computations are not made until the investment is actually sold. We in the United States or the internal revenue service takes a different stance in terms of how it is that they’re going to tax that particular investment.
So the investment is taxed on a yearly basis, not on a transactional basis or when it’s sold. So that means in the United States, those 1099s come out on a yearly basis. If you have the same sort of mutual fund in a foreign country, and you don’t have the company going back and doing the computations for the interest dividends and capital gains, then that means your tax preparer is going to have to do that. And it may be easy if the investment is a small one and in just a couple of say, stocks or foreign stocks or, or investments, but if it’s a larger fund, then those computations can become very, very complex and very lengthy. And hence it’s the length of time that it takes a traditional us tax preparer to make that computation in order to report the gains, the losses, the interest, and the dividend income from those foreign mutual fund investments.
Neil
So are PFICs taxed at a higher rate than the same type of mutual fund here in the US.
Jan
It depends on the type of investment and the way and the elections that are made relating to that investment. So the computation of the gains and losses can be far more costly for a taxpayer because if they’re holding the investment over a period of time, the way that the PFIC computation is done is it takes a look at that investment on a yearly basis. So there are differing elections that can be made that can lower the tax effect of the PFIC computation, but it’s important that an individual that holds a foreign investment such as a foreign mutual fund contact their tax advisors in order to be assured that the computation that’s being used results in the lowest possible tax for that individual.
Neil
So, Jan, what are the tax consequences for a US taxpayer with an interest in a foreign trust
Jan
That can be a very complex answer and to break it down, there are differing types of trusts. And the trust that the IRS is looking for trusts that have been created by an individual with assets that are transferred and the trust is held outside of the US. In most instances, the taxation on that foreign trust owned by an individual. And those are also known as grant or trust is very punitive. So for example, if you had assets that you had transferred into a foreign trust and that foreign trust had income, whether or not it was distributed to you, it would be imputed to you and taxed in the US at a 55% tax rate. So it’s incredibly important for individuals that have an ownership interest, or are thinking about creating a foreign trust that they seek the advice of council prior to going back and creating that trust, because there are methodologies and processes with which to go back and protect assets, to set up assets so that they can perform without having to necessarily create a foreign trust because the foreign trust in the United States can throw off some very disadvantageous tax rates for the unwitting taxpayer.
Neil
And so that’s why Allen Barron is such a great solution for those that have international investments.
Jan
Absolutely. We do a lot of international work, whether with clients that have companies outside the US or foreign nationals that are doing business here in the states, our office is designed and promotes services for those doing business, whether domestically or internationally.
Neil
Thanks, Jan.
Jan
Thanks Neil.
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