The U.S. government claims authority to tax its citizens on their worldwide income, however earned, and wherever derived. This obligation to pay tax on worldwide income includes any interest or dividends earned from foreign bank accounts. In addition to paying tax on any income earned from foreign accounts, U.S. citizens with a financial interest in or signature authority over foreign accounts are required to disclose that interest by checking “yes” on Line 7a, Part III, Schedule B of Form 1040 and filing file Form TD F 90-22.1 (now Form 114), Report of Foreign Bank and Financial Accounts (commonly referred to as “FBARs”).
Overseas assets are not a curiosity reserved for high-net worth individuals. Many ordinary persons have a financial interest in or signature authority over foreign accounts, but the above tax and reporting obligations have been largely overlooked. Taxpayers may have acquired funds while working abroad or inherited assets from a foreign family member and never considered potential U.S. tax consequences. The tax and reporting obligations apply equally to foreign inheritance and rental properties.
Previously this oversight may have gone unnoticed by the IRS, but with the advent of the Foreign Account Tax Compliance Act (“FATCA”) and the DOJ Program for Swiss Banks, the U.S. government is becoming savvy to foreign account information of U.S. taxpayers previously protected by foreign bank secrecy laws. Under FATCA, foreign financial institutions are required to identify U.S. account holders and report this information to their own governments or directly to the IRS.
Willful failure to report and pay tax on foreign accounts can expose taxpayers to liability for back taxes, interest, accuracy related penalties, and annual FBAR penalties as high $100,000 or 50 percent of the account value, whichever is greater. These penalties may be applied for each year of noncompliance and can well exceed the value of a taxpayer’s foreign account. Furthermore, the IRS has shown that they are willing to apply these penalties to their fullest extent. In the recent case of United States v. Zwerner, the jury upheld an FBAR penalty that was 150 percent of the highest account balance.
The IRS has offered several administrative programs which allow noncompliant offshore account holders to substantially eliminate their criminal tax liability exposure associated with past noncompliance, minimize their potential civil liability, and become compliant with U.S. tax law. The two primary programs currently offered are the Offshore Voluntary Disclosure Program (“OVDP”) and the Streamlined Filing Compliance Procedures (“SFCP”).
The OVDP requires taxpayers to file eight years of amended tax returns and delinquent FBARS and pay (i) all tax on previously unreported income; (ii) either a 20 percent accuracy-related penalty or failure to file/failure to pay penalties of up to 47.5 percent on the full amount of the underpayment of tax; and (iii) interest on the tax and penalties. In addition, taxpayers are required to pay a one-time offshore penalty equal to 27.5 percent of the highest aggregate account balance during the eight year disclosure period. While the tax and penalties can be quite steep, it offers assurance against criminal prosecution and a lesser civil liability than would be available outside the terms of the OVDP.
On June 18, 2014, the IRS updated the SFCP. Any taxpayer entering the SFCP must certify that their failure to report and pay tax on their foreign accounts was non-willful. Non-willful conduct is conduct that is due to negligence, inadvertence, or mistake, or conduct that is the result of a good faith misunderstanding of the requirements of the law.
Domestic taxpayers in the SFCP are only required to file three years of amended tax returns and six years of delinquent FBARs, as opposed to the eight years required under the OVDP. In addition, the offshore penalty is reduced to 5 percent of the maximum year-end account balance during the six year disclosure period. The penalties are substantially smaller, but there is no guarantee against criminal prosecution. If a willfully noncompliant taxpayer enters the SFCP unsuccessfully their situation could be substantially worse than if they had entered the appropriate program from the start.
With the government’s focus on international tax compliance growing it is no longer a matter of “if” a taxpayer will be discovered, but “when.” The current administrative programs are a grace (although an expensive one) that may not always be available. Noncompliant taxpayers should strongly consider entering an appropriate program and ensuring that their disclosure is timely, accurate, and complete.
If you have any questions or concerns regarding the disclosure of foreign financial assets, or related international tax matters, please contact Daniel L. Tullidge in our office who has the expertise to assist you.