Foreign Inheritance Tax vs. Tax on Income Generated by Foreign Inheritance – Voluntary Disclosure
- 1 U.S. Tax on Foreign Inheritance
- 2 What About the Income Earned on Foreign Inheritances?
- 3 How Does the U.S. Tax the Foreign Asset?
- 4 But Jessica Never Reported the Income or Assets
- 5 IRS Voluntary Disclosure
- 6 When Do I Need to Use Voluntary Disclosure?
- 7 Golding & Golding – Offshore Disclosure
- 8 The Devil is in the Details…
- 9 What if You Never Report the Money?
- 10 Getting into Compliance
It is important to understand that even though you may receive a foreign inheritance, which is generally not subject to U.S. tax (unless the foreign inheritance came from a US person or former U.S. Person), the income that is generated from the foreign inheritance is taxable by the U.S. government.
U.S. Tax on Foreign Inheritance
The rules differ between U.S. and Foreign inheritances, depending on whether the decedent was a U.S. person, former U.S. person, or foreign person.
Rule: In 2017 the Gift and Estate tax exemption is $5.49 million. That means each individual who is considered a U.S. person can gift (or leave at death) up to $5.49 million before that person is taxed.
Example: David is a U.S. person who has an estate worth $5 million. He leaves his estate to Jessica. Since the estate’s value is less then $5.49 million, David’s estate is not taxed (in the United States, technically it is the estate that is taxed and not the recipient of the inheritance — although unlike Federal Law, some states do have an inheritance tax). It does not matter if the property is U.S. Based or Foreign — the total value of U.S. and Foreign Property is $5.49 million.
If David was a foreign person (aka non-US citizen, non-legal permanent resident, and otherwise not subject to U. S. Estate Tax) then he would not be subject two US estate tax law. In other words, if David had an estate worth $20 million (presuming none of the assets were located in the United States aka “U.S. Situs”), even if he left the entire $20 million state to Jessica, David’s estate would not be taxed. Why? Because David is not a U.S. person and therefore the US has no jurisdiction over David.
It should be noted, that receiving inheritance worth more than $100,000 would require Jessica to file a Form 3520 (or else possibly be subject to significant fines and penalties).
What About the Income Earned on Foreign Inheritances?
This is where it gets tricky: Using the example above, let’s say David (a non-US person) left Jessica $20 million overseas. Let’s also say that the $20 million overseas was generating $1 million a year in income. Does Jessica have to pay US tax on those earnings?
Yes. It does not matter that the income is being generated from a tax free event. Rather, Jessica is a U.S. person and the U.S. taxes her or on her worldwide income. Therefore, even though the asset is located overseas, the asset was inherited tax free, and the income being generated is foreign income (possibly tax exempt in the foreign country) – it still must be reported on Jessica’s U.S. tax return in the US has the right the tax Jessica.
How Does the U.S. Tax the Foreign Asset?
It doesn’t. Rather, all U.S. Citizens, Legal Permanent Residents, and individuals subject to the Substantial Presence Test must pay tax on their worldwide income. The tax on the earnings is an income tax – not an inheritance tax/estate tax. In other words, if the asset did not generate any income than the United States would have no right the tax the asset.
But, because the asset is generating income, and Jessica is a U.S. person subject to income tax on her worldwide income, the United States has the right to tax the foreign income. It does not matter that the income is generated overseas — although Jessica is already paying foreign tax on the earnings, she may receive a foreign tax credit.
But Jessica Never Reported the Income or Assets
Beyond just income tax, Jessica now has foreign account reporting rules she must adhere to. Since she has more than $10,000 an annual aggregate total of foreign accounts, she must file an annual FBAR Statement (or be subject to extremely high fines and penalties).
Likewise, because Jessica (a single person who resides in the United States) has more than $50,000 overseas, she also must file a FATCA form 8938 (or be subject to even more fines and penalties).
Jessica has never filed these forms and/or possibly reported the foreign income, she may consider getting to compliance using IRS offshore voluntary disclosure.
IRS Voluntary Disclosure
Offshore Voluntary Disclosure Tax law is very complex. There are many aspects that go into any particular tax calculation, including the legal status, marital status, business status and residence status of the taxpayer.
When Do I Need to Use Voluntary Disclosure?
Voluntary Disclosure is for individuals, estates, and businesses who are out of compliance with the IRS and the Department of Treasury. What does that mean? It means that if you are required to file a U.S. tax return and you don’t do so timely, then you are out of compliance.
If the IRS discovers that you are out of compliance, you may become subject to extensive fines and penalties – ranging from a warning letter all the way up to tax liens, tax levies, seizures, and criminal investigations. To combat this, you can take the proactive approach and submit to Voluntary Disclosure.
Golding & Golding – Offshore Disclosure
At Golding & Golding, we limit our entire practice to offshore disclosure (IRS Voluntary Disclosure of Foreign and U.S. Assets). The term offshore disclosure is a bit of a misnomer, because the term “offshore” generally connotes visions of hiding money in secret places such as the Cayman Islands, Bahamas, Malta, or any other well-known tax haven jurisdiction – but that is not the case.
In fact, any money that is outside of the United States is considered to be offshore; the term offshore is not a bad word. In other words, merely because a person has money offshore (a.k.a. overseas or in a foreign country) does not mean that money is the result of ill-gotten gains or that the money is being “hidden.” It just means it is not in the United States. Many of our clients have assets and bank accounts in their homeland countries and these are considered offshore assets and offshore bank accounts.
The Devil is in the Details…
If you do have money offshore, then it is very important to ensure that the money has been properly reported to the U.S. government. In addition, it is also very important to ensure that if you are earning any foreign income from that offshore money, that the earnings are being reported on your U.S. tax return.
It does not matter whether your money is in a country that does not tax a particular category of income (for example, many Asian countries do not tax passive income). It also does not matter if you are a dual citizen and/or if that money has already been taxed in the foreign country.
Rather, the default position is that if you are required to file a U.S. tax return and you meet the minimum threshold requirements for filing a U.S. tax return, then you have to include all of your foreign income. If you already paid foreign tax on the income, you may qualify for a Foreign Tax Credit. In addition, if the income is earned income – as opposed to passive income – and you meet either the Bona-Fide Resident Test or Physical-Presence Test, then you may qualify for an exclusion of that income; nevertheless, the money must be included on your tax return.
What if You Never Report the Money?
If you are in the unfortunate position of having foreign money or specified foreign assets that should have been reported to the U.S. government, but which you have not reported — then you are in a bit of a predicament, which you will need to resolve before it is too late.
As we have indicated numerous times on our website, there are very unscrupulous CPAs, Attorneys, Accountants, and Tax Representatives who would like nothing more than to get you to part with all of your money by scaring you into believing you are automatically going to be arrested, jailed, or deported because you have unreported money. While that is most likely not the case (depending on the facts and circumstances of your specific situation), you may be subject to extremely high fines and penalties.
Moreover, if you knowingly or willfully hid your foreign accounts, foreign money, and offshore assets overseas, then you may become subject to even higher fines and penalties…as well as a criminal investigation by the special agents of the IRS and/or DOJ (Department of Justice).
Getting into Compliance
There are five main methods people/businesses use to get into compliance. Four of these methods are perfectly legitimate as long as you meet the requirements for the particular mechanism of disclosure. The fifth alternative, which is called a Quiet Disclosure a.k.a. Silent Disclosure a.k.a. Soft Disclosure, is ill-advised as it is illegal and very well may result in criminal prosecution.
We are going to provide a brief summary of each program below. We have also included links to the specific programs. If you are interested, we have also prepared very popular “FAQs from the Trenches” for FBAR, OVDP and Streamlined Disclosure reporting. Unlikes the technical jargon of the IRS FAQs, our FAQs are based on the hundreds of different types of issues we have handled over the many years that we have been practicing international tax law and offshore disclosure in particular.
After reading this webpage, we hope you develop a basic understanding of each offshore disclosure alternative and how it may benefit you to get into compliance. We do not recommend attempting to disclose the information yourself as you may become subject to an IRS investigation insofar as you will have to answer questions directly to the IRS, which you can avoid with an attorney representative.
If you retain an attorney, then you will get the benefit of the attorney-client privilege which provides confidentiality between you and your representative. With a CPA, there is a relatively small privilege which does provide some comfort, but the privilege is nowhere near as strong as the confidentiality privilege you enjoy with an attorney.
Since you will be dealing with the Internal Revenue Service and they are not known to play nice or fair – it is in your best interest to obtain an experienced Offshore Disclosure Attorney.
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Sean holds a Master's in Tax Law from one of the top Tax LL.M. programs in the country at the University of Denver. He has also earned the prestigious IRS Enrolled Agent credential. Mr. Golding's articles have been referenced in such publications as the Washington Post, Forbes, Nolo, and various Law Journals nationwide.