- 1 Offshore Asset Protection Trusts
- 2 IRS Offshore Compliance
- 3 IRS Offshore Compliance is Important Asset Protection
- 4 Common International Forms & Penalties
- 5 FBAR (FinCEN 114)
- 6 Form 8938
- 7 Form 3520
- 8 Form 3520-A
- 9 Form 5471
- 10 Form 5472
- 11 Form 8621
- 12 Form 926
- 13 Form 8865
- 14 Additional International Tax General Penalties
- 15 Getting into IRS Compliance – Offshore Disclosure
Offshore Asset Protection Trusts
While an Offshore Asset Protection Trust can be a safe method for protecting your assets, it is crucial that the Trust remain in IRS Compliance.
Why? Because the IRS has made offshore enforcement a key priority. And, the failure to keep your foreign trusts in IRS Compliance (FBAR, FATCA, 3520, 3520-A, 8621) may result in fines and penalties that are so high, that any benefit gained from the foreign trust, offshore trust or international trust would be lost.
IRS Offshore Compliance
Beyond just the ultra-wealthy, there are numerous individuals who have foreign accounts, foreign assets, foreign investments, foreign real estate and other money overseas for any number of different reasons that go beyond mere tax and asset planning (although it still may directly or indirectly be part of the big picture).
For example, a person may have relocated to the United States became either a U.S. Citizen, Legal Permanent Resident, or Foreign National who meets the Substantial Presence Test. Under any one of these aforementioned categories, a person will be required to report their foreign money to the United States on any number of different forms, depending on the type of assets.
Likewise, if a person has foreign accounts or other related assets, they may have to file an annual FBAR Statement. Likewise, if a person has specified foreign assets/investments may have to report on a form 8938 and/or any number of complex forms depending on size of the asset.
Some of these forms include:
- Form 8938
- 3520 Gift or Inheritance or Trust Distribution
- 3520-A U.S. Owner of a Foreign Trust
- 5471 Foreign Corporation
- 8621 – PFIC (Passive Foreign Investment Company)
- 8865 – Partnership
IRS Offshore Compliance is Important Asset Protection
With the introduction of FATCA (Foreign Account Tax Compliance Act), the United States has entered into agreements (IGAs) more than 100 countries. In addition, more than 300,000 Foreign Financial Institutions (FFIs) have agreed to report US account holder information to the IRS.
U.S. Account Holder goes far beyond just U.S. citizens, and typically includes all of the types of individuals identified above, and sometimes even more. While you may have avoided some immediate tax liability by creating an international trust or offshore trust, that does not relinquish your IRS Offshore Reporting Requirements.
And, the penalties for failing to report these accounts are very steep. They range from a warning letter in lieu of penalty, all the way to a 100% penalty during a multiyear audit in which the IRS finds you were willful (or even reckless disregard)
Common International Forms & Penalties
The following is a brief summary of some of the common forms individuals with offshore assets and foreign money may need to the report to the IRS.
FBAR (FinCEN 114)
We start off with the FBAR, because it is one of the IRS International Reporting forms that receives the most amount of press. The FBAR is used to Report Foreign Bank and Financial Accounts on an annual basis.
The form has a relatively low threshold requirement of $10,000. In other words, if you have an annual aggregate total of foreign accounts (including life insurance or retirement funds) that on any day of the year exceeds $10,000, then you are required to report this form. It does not matter if the money is in one account or spread over numerous accounts. And, it does not matter if the account is in your home country of citizenship or if you opened the account before relocating to the United States.
The US government does not look into the semantics that deeply; rather, if you meet the threshold requirement then you have to file the form. Starting in 2017 (to report 2016 maximum balance), the due date coincides with your tax return filing date (including extension).
When it comes to the FBAR, one of the main concerns are the FBAR Penalties.
A penalty for failing to file FBARs. United States citizens, residents and certain other persons must annually report their direct or indirect financial interest in, or signature authority (or other authority that is comparable to signature authority) over, a financial account that is maintained with a financial institution located in a foreign country if, for any calendar year, the aggregate value of all foreign financial accounts exceeded $10,000 at any time during the year. The civil penalty for willfully failing to file an FBAR can be as high as the greater of $100,000 or 50 percent of the total balance of the foreign financial account per violation. See 31 U.S.C. § 5321(a)(5). Non-willful violations that the IRS determines were not due to reasonable cause are subject to a $10,000 penalty per violation.
Form 8938 is a byproduct of FATCA (Foreign Account Tax Compliance Act). It is a form that is required to be filed with the tax return each year when a person meets the threshold requirements for filing. Unlike the FBAR, which is an electronic form which is submitted directly to the Department of Treasury (The FBAR is not submitted with your tax return), Form 8938 is part of your tax return.
Form 8938 requires you to provide extensive information regarding foreign accounts and specified foreign assets. For example, with the FBAR, reporting is limited to accounts and insurance policies (although those terms can have a very broad meaning). Conversely, with form 8938, the person must report Income — along with assets and accounts.
Therefore, if you were to own stock of a foreign company, that would be considered a Specified Foreign Asset that would need to be reported on a Form 8938 — but would not be reported on an FBAR.
Moreover, with the FBAR, a person is required to report the maximum balance in the account, but is not required to report any income that is generated from the accounts. The 8938 is more depth than that. Rather, with form 8938, a person must report the account balance along with the annual income that is generated from form 8938 accounts or assets.
Additionally, the income must be broken down by type of income earned (such as royalties, dividends, interest, capital gains) and/or whether the income was earned through a custodial or deposit account and/or it was earned through one of the specified foreign assets.
Form 8938 Penalties
Beginning with the 2011 tax year, a penalty for failing to file Form 8938 reporting the taxpayer’s interest in certain foreign financial assets, including financial accounts, certain foreign securities, and interests in foreign entities, as required by IRC § 6038D. The penalty for failing to file each one of these information returns is $10,000, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return.
A Form 3520 is a relatively benign form, save for the fact that the IRS can issue extensive fines and penalties for failing to report it. The form is used to report the receipt of a foreign gift either from a foreign person, foreign business, or foreign trust distribution.
The threshold requirements for having to report the gift vary. For example, if a person receives a foreign trust distribution, then the distribution must be reported despite any threshold requirement. In sharp contrast, a person would not need to report the receipt of a foreign gift from a foreign person unless the value of the gift exceeds more than $100,000 in either one transaction, or a series of transactions within the same tax year.
Form 3520 Penalties
A Penalty for failing to file Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts. Taxpayers must also report various transactions involving foreign trusts, including creation of a foreign trust by a United States person, transfers of property from a United States person to a foreign trust and receipt of distributions from foreign trusts under IRC § 6048. This return also reports the receipt of gifts from foreign entities under IRC § 6039F. The penalty for failing to file each one of these information returns, or for filing an incomplete return, is the greater of $10,000 or 35 percent of the gross reportable amount, except for returns reporting gifts, where the penalty is five percent of the gift per month, up to a maximum penalty of 25 percent of the gift.
Form 3520-A is a bit different than form 3520. Form 3520-A is required to be filed by a US person if the US person owns a foreign trust. A foreign trust with a U.S. owner must file Form 3520-A in order for the U.S. owner to satisfy its annual information reporting requirements under section 6048(b).
Each U.S. person treated as an owner of any portion of a foreign trust under the grantor trust rules (sections 671 through 679) is responsible for ensuring that the foreign trust files Form 3520-A and furnishes the required annual statements to its U.S. owners and U.S. beneficiaries.
The problem with this form is that if the owner/trustee of the trust does not report the form, then technically the trust may be subject to fines and penalties, which can be very substantial, depending on the facts and circumstances of the reporting.
Form 3520-A Penalties
A Penalty for failing to file Form 3520-A, Information Return of Foreign Trust With a U.S. Owner. Taxpayers must also report ownership interests in foreign trusts, by United States persons with various interests in and powers over those trusts under IRC § 6048(b). The penalty for failing to file each one of these information returns or for filing an incomplete return, is the greater of $10,000 or 5 percent of the gross value of trust assets determined to be owned by the United States person.
Form 5471 is generally used when a person has ownership in a foreign corporation. There are various threshold requirements regarding ownership versus control and voting rights as to when a person has to file, but generally a person will file a form 5471, when they own at least 10% of the foreign corporation.
This can become a serious problem for individuals who own foreign corporations in countries in which the purpose of the foreign corporation is more of an estate planning tool than a business tool. This is very common in many countries that utilize the Sociedad Anonima.
For example, many of our clients in Costa Rica may have formed one or multiple Sociedad Anonimas for the purpose of holding rental property instead of putting the property under their own name, because it eases estate planning transfers. Unfortunately, from a US perspective this type of corporation cannot be disregarded and therefore (even if it is dormant), the 5471 may need to be filed in part or whole.
Form 5471 Penalties
A penalty for failing to file Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations. Certain United States persons who are officers, directors or shareholders in certain foreign corporations (including International Business Corporations) are required to report information under IRC §§ 6035, 6038 and 6046. The penalty for failing to file each one of these information returns is $10,000, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return.
Form 5472 is a bit different from form 5471. A form 5471 is filed when a US person has an interest, ownership or control in a foreign corporation. A form 5472 is used (generally) when a US corporation has more than 25% ownership by individuals who are not considered US persons.
This is typical when a foreign corporation, or group of foreign investors, come together to create a US corporation wherein in at least 25% of the corporation is owned by non-US shareholders.
These types of businesses are usually created to function solely in the United States regarding US source income and limited liability or tax liability on a bigger scale.
Form 5472 Penalties
A penalty for failing to file Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business. Taxpayers may be required to report transactions between a 25 percent foreign-owned domestic corporation or a foreign corporation engaged in a trade or business in the United States and a related party as required by IRC §§ 6038A and 6038C. The penalty for failing to file each one of these information returns, or to keep certain records regarding reportable transactions, is $10,000, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency.
IRS Form 8621 (Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund) is an IRS Form required to be filed by individuals who have any interest in a Passive Foreign Investment Company — whether or not they received an Excess Distribution, as long as they are not otherwise exempt from filing.
Unlike IRS Form 5471, there is no minimum ownership requirement. Technically, even if you have “fractional ownership,” of a PFIC you are still required to file — unless you meet one of the very limited exemptions/exclusions.
Moreover, the mere ownership of Foreign Mutual Funds and other foreign passive investments (that you do not technically own in a PFIC company) requires you to file the form.
The form can be daunting, especially when the filer also has a tax liability in accordance with form 8621.
Form 8621 Penalties
Notwithstanding Excess Distribution calculations, the “main non-numerical” penalty associated with form 8621 is completely unfair (you can read here about the sheer horror of the “Excess Distribution calculation“).
Why? Because technically, while there is no specific numerical penalty included regarding non-filing of Form 8621, a tax return is still considered to be “open” until the 8621 is filed. In other words, the statute of limitations countdown for the IRS to audit your tax return (usually 3 years) does not even begin to tick if the 8621 hasn’t been filed.
*Even if you try to argue the return only remains open as to the 8621, but in reality, the IRS will most likely take you to task as to the whole return. Even if you could convince the agent that a post statute audit should be contained to 8621 issues, the IRS would just need to show some relation from the 8621 to other parts of your return to avoid that issue.
A Form 926 is required to be filed when a person transfers property to a foreign corporation. The purpose of this this is so the U.S. can track assets that are being moved offshore, and help determine (now or in the future) whether those assets have previously been reported for tax purposes in the United States or are not subject to taxation (due to the relocation being deemed a “sale”)
For example, does the asset already have a BIG (Built-in-Gain) or other inherent tax liability that the company may be attempting to circumvent or sidestep by shifting the asset offshore.
Form 926 Penalties
A penalty for failing to file Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation. Taxpayers are required to report transfers of property to foreign corporations and other information under IRC § 6038B. The penalty for failing to file each one of these information returns is ten percent of the value of the property transferred, up to a maximum of $100,000 per return, with no limit if the failure to report the transfer was intentional.
A Form 8865 is similar to a Form 5471, except that the form 8865 is used to report foreign partnership interest, whereas form 5471 is used to report ownership of foreign Corporation. If you know anything about partnerships, you know that the reporting requirements such as basis and proportionate shares is a very complex undertaking. That is because unlike the Corporation which has its own entity, a partnership is not an entity to the same degree that, for example, a corporation is an entity.
As such, as with a partnership the individuals still directly owned the assets, even though they are being owned through the partnership (in other words, there is no entity that distinguishes between the owners and the partnership aside from the “partnership” which is a pass-through for tax purposes, but is reported separately.)
The reporting requirements for a partnership can the intense and therefore it is very important to understand these reporting requirements when submitting a form 8865.
Form 8865 Penalties
A penalty for failing to file Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships. United States persons with certain interests in foreign partnerships use this form to report interests in and transactions of the foreign partnerships, transfers of property to the foreign partnerships, and acquisitions, dispositions and changes in foreign partnership interests under IRC §§ 6038, 6038B, and 6046A. Penalties include $10,000 for failure to file each return, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return, and ten percent of the value of any transferred property that is not reported, subject to a $100,000 limit.
Additional International Tax General Penalties
Fraud Penalties imposed under IRC §§ 6651(f) or 6663
Where an underpayment of tax, or a failure to file a tax return, is due to fraud, the taxpayer is liable for penalties that, although calculated differently, essentially amount to 75 percent of the unpaid tax.
A Penalty for Failing to File a Tax Return imposed under IRC § 6651(a)(1)
Generally, taxpayers are required to file income tax returns. If a taxpayer fails to do so, a penalty of 5 percent of the balance due, plus an additional 5 percent for each month or fraction thereof during which the failure continues may be imposed. The penalty shall not exceed 25 percent.
A Penalty for Failing to Pay the Amount of tax shown on the return under IRC § 6651(a)(2)
If a taxpayer fails to pay the amount of tax shown on the return, he or she may be liable for a penalty of .5 percent of the amount of tax shown on the return, plus an additional .5 percent for each additional month or fraction thereof that the amount remains unpaid, not exceeding 25 percent.
An Accuracy-Related Penalty on Underpayments Imposed under IRC § 6662
Depending upon which component of the accuracy-related penalty is applicable, a taxpayer may be liable for a 20 percent or 40 percent penalty.
Possible Criminal Charges related to Tax Matters include Tax Evasion (IRC § 7201)
Filing a false return (IRC § 7206(1)) and failure to file an income tax return (IRC § 7203). Willfully failing to file an FBAR and willfully filing a false FBAR are both violations that are subject to criminal penalties under 31 U.S.C. § 5322. Additional possible criminal charges include conspiracy to defraud the government with respect to claims (18 U.S.C. § 286) and conspiracy to commit offense or to defraud the United States (18 U.S.C. § 371).
A Person Convicted of Tax Evasion is subject to a prison term of up to five years and a fine of up to $250,000
Filing a false return subjects a person to a prison term of up to three years and a fine of up to $250,000. A person who fails to file a tax return is subject to a prison term of up to one year and a fine of up to $100,000. Failing to file an FBAR subjects a person to a prison term of up to ten years and criminal penalties of up to $500,000. A person convicted of conspiracy to defraud the government with respect to claims is subject to a prison term of up to not more than 10 years or a fine of up to $250,000. A person convicted of conspiracy to commit offense or to defraud the United States is subject to a prison term of not more than five years and a fine of up to $250,000.
Getting into IRS Compliance – Offshore Disclosure
If you are out of compliance and looking to get back into compliance than one of the safest and most effective methods for doing so is through the IRS offshore voluntary disclosure programs.
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, and has also earned the prestigious Enrolled Agent credential. Mr. Golding is also a Board Certified Tax Law Specialist Attorney (A designation earned by Less than 1% of Attorneys nationwide.)
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