As Global Tax Enforcement by the United States is on the rise (FATCA, FBAR, OVDP, etc.) so are the number of U.S. Taxpayers residing overseas (Contractors, Consultants, Expats) who are being audited by the IRS.
International tax enforcement has become a major issue for the Internal Revenue Service. That is because the Internal Revenue Service has collected billions of dollars against individuals involving foreign tax related matters.
IRS Audits Expats Overseas
While much of the conversation these days revolves around FATCA (Foreign Account Tax Compliance Act) and OVDP (Offshore Voluntary Disclosure Program), one of the main ways the Internal Revenue Service enforces tax law against individuals is through an audit.
The Internal Revenue Service does not care where you reside. You are required to file IRS tax returns no matter where you live, and if you have a tax liability than chances are the IRS is going to come after you. Moreover, the IRS actually likes auditing individuals and businesses that take residence overseas since they know these individuals and businesses are less likely to know their rights and/or want to fight the audit.
If you reside overseas and you have been audited, it is very important that you retain experienced international tax lawyer with audit defense experience before speaking with the IRS. An experienced expat tax lawyer can assist with both representation in the United States for the audit, as well as help in strategizing an effective defense.
*The following is a case study of how one individual’s failure to obtain tax representation can have a severe impact on his and his family’s life:
Case Study: David
David is a US citizen who recently relocated to China. David has an import/export business which he operates as an S corporation. For those of you unfamiliar, an S corporation is a smaller type of corporation that is very common amongst small business. It provides protection to the business as well as having flow-through income instead of two levels of tax. Thus, wile a Corporation is taxed at the corporate level for monies earned, as well as at the shareholder level when money is distributed, with an S corporation there is only one level of tax to the shareholder at the shareholder level.
David’s U.S. (IRS) Tax Responsibilities
Even though David resides in China, he still responsible for paying U.S. tax just as if he resides in the United States. The reason for this is that the United States taxes U.S. citizens and legal permanent residents on their worldwide income. Thus, the United States does not care where David resides – he still has an absolute duty to file tax returns just as if he was living in the United States (unless otherwise exempted).
It should be noted that David might have certain options to him to avoid paying the same tax that he paid overseas in the United States, but that does not relieve David of his responsibility to file taxes.
If David had filed taxes correctly, he would have two options available to him to try to reduce his tax:
Foreign Earned Income Exclusion vs. Foreign Tax Credit
Despite having to pay US tax on foreign earnings, it is important to keep two tax tools in mind – foreign earned income exclusion (FEIE, 2555) and foreign tax credits (FTC 1116).
We will leave you with a brief summary of these two types of tax tools that individuals use to avoid paying US tax on income they earned overseas and/or obtaining tax credits for income taxes paid in a foreign country:
What is the Foreign Earned Income Exclusion?
While the specifics of the foreign earned income exclusion can be somewhat daunting, the general requirements are not too difficult. An individual who resides overseas and qualifies for either the physical presence test or bona fide residence test may qualify to exclude certain portion of their income from taxation in the United States. In addition, if the individual receives housing allowance, then generally around $14,000-$16,000 of that allowance can be excluded as well.
How Do I Qualify for the Foreign Earned Income Exclusion?
Due to the great benefits provided by this exclusion, often people attempt to meet the qualifications even if they do not qualify. Each fact scenario is different, but generally, if you reside overseas (it does not matter if it is one country or 50 different countries) and can qualify for the physical presence test, which requires that you reside outside of the United States for 330 days (does not need to be January through December, it can be any 330 day period) then the first hundred thousand dollars of your income is excluded from tax as well as a portion of your housing allowance. If you do not qualify for the physical presence test then you can attempt to qualify for the bona fide residence test, which is much more difficult to meet. Generally, overseas government contractors do not qualify under any circumstance.
How do I qualify for a Foreign Tax Credit?
Alternatively, you may qualify for foreign tax credit instead. Usually, people opt for the foreign earned income exclusion when they have had to pay tax in a foreign country and should not have to pay the same tax in the US as well.
- Here is a simple example of the foreign tax credit:if you earn $100,000 overseas and were subject to 25% tax, which you paid, then you will get a $25,000 tax credit for the same income tax you would have to pay in the United States. If instead you only had to pay $15,000 of tax in the United States of course the United States does not refund the difference. Conversely, if you paid $25,000 in tax overseas but your US tax rate was 30% and therefore you would’ve had to pay $30,000 US tax – you are required to pay the difference.
- Depending on the specific facts and circumstances of each case it will determine whether a person qualifies for either Foreign Tax Credit or Foreign Earned Income Exclusion and which of these would work better in a particular situation.
IRS Audit Examination
One day when David goes outside to check his mail, when he notices a letter from the Internal Revenue Service. It turns out that David has not filed taxes for several years, and the IRS wants to know what is going on.
Moreover, the IRS received notice from China that David has several bank accounts under his name and Social Security number which is not reported to the Internal Revenue Service.
David can face serious IRS Tax Consequences
David is in a very difficult situation and has the following issues to contend with:
David has not filed tax returns in several years
When tax returns have not been filed for more than two years it begins to smell like fraud to the IRS. Under these particular facts though, David does not appear to have committed any tax fraud. That is because David has dutifully been paying taxes in China, since that is where his business is based. Usually, if David was committing tax fraud, he y would not be paying taxes in any country at all. Those, David could be in a position to try to avoid penalties.
David may Still Owe U.S. Tax
Just because David paid tax in China does not mean that David is off the hook in the United States. While David may be able to prove he qualifies for either the foreign earned income exclusion or foreign tax credit explained above, it is not automatic. In other words, once David files his tax returns it may result in him owing more in tax. In addition, the IRS Will usually issue penalties, so it will require that he provide a statement as to why he should not be held responsible for these outstanding penalties.
David has not Disclosed Foreign Accounts
In accordance with rule surrounding FATCA (Foreign Account Tax Compliance Act), FBAR (Report of Foreign Bank and Financial Accounts) and OVDP (Offshore Voluntary Disclosure Program), the Internal Revenue Service is taking a heavy hand against individuals who have not disclosed foreign accounts. Since David is currently under audit examination he does not qualify for the offshore voluntary disclosure program and/or streamlined program(s). That is because a person cannot enter the program if they’re currently under audit examination.
- In David’s particular situation, since he has resided outside of the country for more than 330 days during at least one tax year in the last three tax years that he has filed, he qualifies to streamline offshore foreign program. This is a small offshoot of the mainstream of program with the added benefit that under this program all penalties are waived.
Assets subject to Penalty, Lien, Levy and Seizure
Just because David resides outside of the United States does not provide him much more in the way of protection of his money and assets. That is because under FATCA the United States has many more weapons available to it to try to lien, levy, overseas David’s foreign assets and money. This is especially true if David is parking his money in a foreign branch of a US bank.
Moreover, David is concerned about his US assets. David intended on returning to the United States at some point in the future and therefore has bank accounts and properties that he rents in the United States. Once the IRS gets wind of these assets the IRS may try to lien, levy, overseas David’s U.S. assets and money as well. The mere fact that David resides overseas does nothing in the way to protect his assets.
It is NOT Too Late for David to get IRS Tax Compliant
While David’s situation may seem dire, the fact of the matter is David did not act willfully or any intent to defraud the IRS and United States. An experienced international tax attorney should be able to work with David to represent him before the IRS and facilitate a fair and reasonable settlement plan in order to get David compliant and protect his US and foreign assets.