PFIC Lawyers – Foreign Trusts Classified as Foreign Corporations
One of the most burdensome IRS Tax forms a US taxpayer may have to file is an 8621 form. It is an informational return that is used to summarize the activities of a Passive Foreign Investment Company.
For many unsuspecting taxpayers, they may not realize at first glance that their foreign investment such as a foreign mutual fund or other investment vehicle is a PFIC. This is because the PFIC rules only apply to “foreign corporations” and the mutual investment may be held in a trust instead of a corporation.
Nevertheless, the IRS is aware that foreign jurisdictions are getting more sophisticated in trying to coerce US taxpayers into investing in foreign funds by representing that the foreign fund is a Trust and not technically a foreign corporation and therefore not subject to the harsh PFIC rules; this is incorrect.
In Private Letter Ruling 200752029, the IRS refers to Treas. Reg. § 301.7701-4(b) which provides that there are other arrangements which are known as trusts because the legal title to property is conveyed to trustees for the benefit of beneficiaries, but which are not classified as trusts for purposes of the Internal Revenue Code because they are not simply arrangements to protect or conserve the property for the beneficiaries. These trusts, which are often known as business or commercial trusts, generally are created by the beneficiaries simply as a device to carry on a profit-making business which normally would have been carried on through business organizations that are classified as corporations or partnerships under the Code.
As a result, if a foreign investment pool is classified overseas as a trust, but otherwise is a profit-making business which are otherwise be considered a corporation or other similar business organization under US law, then it will be included as a foreign corporation for PFIC purposes.
Dangers of Foreign Investments
When it comes to foreign investments, there appears to be two major misconceptions by individuals seeking to invest overseas:
- Merely investing in a foreign company or fund means you are trying to evade tax
- Foreign investments can go undetected by the Internal Revenue Service (IRS)
There are plenty of valid reasons why a person may invest in foreign funds or foreign companies such as a foreign mutual fund or Passive Foreign Investment Company – especially the US taxpayer is from a foreign country. Investments in foreign countries tend to have a higher ROI (Return on Investment) and if you are not a US citizen or otherwise subject to US income tax you may be able to avoid taxation on passive income.
With that said, there are also many pitfalls to worry about when you are investing overseas. Under the new tax laws such as FATCA (Foreign Account Tax Compliance Act) FBAR Reporting (Report of Foreign Bank And Financial Accounts) and other reporting requirements, it is very difficult to remain under the radar of the IRS, DOT, or DOJ as it was 20 years ago.
Account & Investment Disclosure Requirements
In the last 10 to 15 years the Internal Revenue Service has really ramped up enforcement of international tax compliance and reporting. There are various forms that need to be filed when a person has certain investments overseas. Moreover, there are distinctions for classifying foreign investments which do not apply to their US counterparts (such as all for mutual funds being classified as PFICs Passive Foreign Investment Company)
The following is a summary of certain forms that may be required if you have foreign investments:
This is one of the more complicated tax forms in existence today and it is a requirement for almost all PFICs. What makes this form so complicated is that many foreign investments fall into the PFIC category without intending to be classified as a PFIC For example, as indicated above a foreign mutual fund is almost always a PFIC, since in a foreign mutual fund will meet either of the two following tests:
- Income Test. 75% or more of the corporation’s gross income for its taxable year is passive income (as defined in section 1297(b)).
- Asset Test. At least 50% of the average percentage of assets (determined under section 1297(e)) held by the foreign corporation during the taxable year are assets that produce passive income or that are held for the production of passive income. Basis for measuring assets.
The reason why this form is so dreaded Congress because there are complicated tax equations depending on whether the PFIC (which may have never intended to be a PFIC) is a 1291 fund, elected to be a (QEF) Qualified Electing Fund or made an MTM (Market-to-Market) election. If no election was made, then taxation is generally at the highest tax rate in addition to additional taxes and interest for excess distributions. Moreover, even the smallest percentage of ownership of a PFIC by a U.S. Taxpayer will require filing this form (unlike a CFC in which there are higher threshold requirements for reporting)
*In other words, this is a lot to go through for the simple investor who wants to own a foreign mutual fund.
A Form 5471 must be filed by individuals who own a certain percentage of foreign corporations. Whether or not a person qualifies as being required to file this form will depend largely on the percentage of ownership, whether they are director or shareholder, and other qualifying factors. Unlike the prior form, when it comes to a 5471 normally only one form needs to be filed per Corporation and the following requirements are not as comprehensive as the 8621.
3520 and 3520-A
These forms must be filed in accordance with the receipt of foreign gifts as well as the receipt of foreign gifts for businesses and ownership in foreign trusts. It is the latter that causes the biggest headache since many individuals invest in foreign trusts to avoid detection by the IRS. Now that a person has to come forward and disclose all the information regarding foreign trust, not only is it a big headache, but it essentially defeats the purpose of the trust – unless the grantor is a foreign person and it is a grantor foreign trust so that it is only the grantor who is being taxed.
The FBAR is a simple form which is only required to be filed by individuals who have an annual aggregate total of more than $10,000 in overseas bank accounts. There are several different types of accounts which qualify reporting, which is summarized on our website. Under FBAR rules, a person is required to report the maximum balance in each account for the year, noting that if that information is not available the FBAR must still be filed but it can be done without the maximum balance included.
While the FBAR is file directly electronically online with the Department of Treasury, the 8938 is the Tax Return version of the FBAR (which is submitted along with the Tax Return). The filing requirements for 8938 have much higher thresholds and therefore not everyone who is required to file an FBAR will be required to file an 8938 and it usually does not include individuals who merely have signatory authority. As with most of the other forms indicated above, there are significant penalties associated with a person’s failure to file these forms.
Just because a person has an investment in a foreign country which is considered a tax haven does not mean they are guilty of a crime – it just means Internal Revenue Service is going to utilize heightened scrutiny in evaluating investment. In fact, foreign investments was listed on the IRS dirty dozen tax schemes.
As provided by the IRS: Offshore Tax Avoidance: The recent string of successful enforcement actions against offshore tax cheats and the financial organizations that help them shows that it’s a bad bet to hide money and income offshore. Taxpayers are best served by coming in voluntarily and getting their taxes and filing requirements in order. The IRS offers the Offshore Voluntary Disclosure Program (OVDP) to help people get their taxes in order. (IR-2015-09)
Offshore Disclosure Programs
If you are out of compliance with foreign reporting there are two main programs you can enter to try to get compliant. They are OVDP and the IRS Streamlined Offshore Disclosure Program, which are summarized for you below:
OVDP and IRS Streamlined Program
If you or your business has unreported or undisclosed foreign accounts, offshore assets, or foreign income then you may be considering whether you should enter the Offshore Voluntary Disclosure Program (OVDP) or the IRS Streamlined Offshore Disclosure Program, and what the definition of “Willful” is.
Whether or not you enter Offshore Voluntary Disclosure Program (OVDP) or the IRS Streamlined Offshore Disclosure Program will depend on the facts and circumstances of each taxpayer’s situation. Not two tax situations are identical, and the failure to properly submit to the correct program can have serious consequences for the unsuspecting taxpayer.
Why Comply with IRS Foreign Disclosure Laws?
Because if you fail to comply with FATCA (Foreign Account Tax Compliance Act) as well as general IRS Foreign Disclosure Laws, the IRS has the authority to penalize you upwards of 100% of the value of your offshore assets and accounts as well as:
- Collect Taxes for prior tax years
- Collect Interest on outstanding tax liability for prior years
- Penalize you for the failure to report foreign accounts on the tax return (Schedule B and 8938)
- Penalize you for the failure to report foreign gifts (3520)
- Penalize you for the failure to report foreign Trusts (3520 and 3520A)
- Penalize you for the failure to report ownership in Foreign Corporations (5471 and 5472)
- Penalize you for the failure to report ownership in a PFIC (8621)
- Genera Negligence and Fraud Penalties
- Investigate you for Criminal Tax Fraud & Criminal Tax Evasion if you willfully failed to report your assets & foreign income.
The reason why international tax law compliance has taken center stage is because under the new FATCA (Foreign Account Tax Compliance Act) laws, foreign countries are actively reporting the bank and financial accounts of US citizens and US legal permanent residents. If a foreign country is interested in working with the United States, the foreign country will enter into an “ Intergovernmental Agreement” (IGA) with the United States. These agreements are reciprocity agreements, which means that not only will the foreign country report the information to the IRS, but the IRS will also reciprocate by providing the same information to foreign country tax authorities.
Why Enter either OVDP or the Modified Streamlined Program?
Individuals and businesses who are trying to avoid 100% FBAR penalties and/or Criminal Prosecution may seek to voluntary disclose, pay a penalty (unless abated), and avoid criminal prosecution.
There are the only two approved programs by the Internal Revenue Service that can bring a taxpayer into compliance. Instead of entering the programs, a taxpayer may qualify to directly report under the reasonable cause exception, in which the taxpayer directly submits the forms with a statement explaining why they were not properly filed instead of paying a penalty.
*The IRS is not known to be sympathetic, and if the IRS does not believe you and audits you and/or you are under examination, you are disqualified from entering either the OVDP or Streamlined Program AND the IRS is now informed regarding all of your undisclosed accounts.
**If the taxpayer submits the forms to the IRS without submitting to the IRS Disclosure Programs, it can be considered “silent disclosure” or “quiet disclosure.” If the IRS learns of the Quiet or Silent Disclosure, he IRS will penalize you heavily as well as consider initiating criminal proceedings against you. In this scenario, not only will the IRS seek to take all of your money and assets through the implementation of penalties and levies, but you may be spending the next 2 to 20 years in prison for tax evasion or tax fraud.
What is the Difference between OVDP and the Streamlined Program?
Before making a decision regarding voluntary disclosure, it is important to understand the difference between the two main programs.
OVDP (Offshore Voluntary Disclosure Program Requirements)
In accordance with OVDP filing requirements, The Applicant will then be required to pay the outstanding tax, along with estimated interest, a 20% penalty on the outstanding tax, as well as an “FBAR” Penalty. The Penalty is 27.5% (or 50% if any of the foreign accounts are held at an IRS “Bad Bank”) on the highest year’s “annual aggregate total” of unreported accounts (Accounts which were previously reported are not calculated into the penalty amount).
For OVDP, the annual aggregate total is determined by adding the “maximum value” of each unreported account for each year, in each of the last 8 years. To determine what the maximum value is, the taxpayer will add up the highest balances of all their accounts for each year. In other words, for each tax year within the compliance period, the application will locate the highest balance for each account for each year, and total up the values to determine the maximum value for each year.
Thereafter, the OVDP applicant selects the highest year’s value, and multiplies it by either 27.5%, or possibly 50% if any of the money was being held in what the IRS considers to be one of the “bad banks.” When a person is completing the penalty portion of the application, the two most important things are to breathe, and remember that by entering the program the applicant is seeking to avoid CRIMINAL PROSECUTION!
When it comes to the Streamlined Program, the penalty is limited to 5% on the highest “year-end” balance for the last 6-years. The reason is that if the person was non-willful, they should not be overly-penalized if there was an artificial increase in the value of the bank accounts – such as from the sale of a home during the tax year.
(A complete breakdown of OVDP requirements can be found on our OVDP Page, by Clicking Here)
OVDP is Unfair for Non-Willful Taxpayers
Before the implementation of the modified streamlined program, it was difficult for individuals who were non-willful (no specific definition, but generally without intent to deceive or defraud) to become compliant. Why? Because if you are non-willful, you still had to go through the filing procedures as if you were willful, and then opt out of the penalty structure and open yourself up for audit.
Not such a big deal, except for the fact that you also had to pay 20% penalty on the outstanding taxes that you owed along with a 27.5% penalty on the highest year’s annual aggregate (unless you successfully “opted out” from the penalty structure – which came with a whole other set of headaches). As you can imagine, for individuals who simply inherited some money overseas, had no international dealings, and had no idea that they were required to report foreign passive income (Interest income) in a country that does not tax its own citizens on passive income earnings — providing this information to the IRS was a huge burden.
What is the Modified Streamlined Program?
In order to avoid “non-willful” applicants from having to go through the entire OVDP process before opting out, the IRS and Department of the Treasury modified a small program in existence, called the streamlined program, which was very limited. The IRS expanded the program to basically allow anyone who was non-willful to enter the program.
The program reduced the amount of documentation that applicants were required to file to only three years of amended tax returns and six years of FBAR (Foreign Account Reporting Statements). In addition, there was no penalty on the tax amount that was due and no penalty on the value of income generating foreign real estate that was not previously disclosed. Moreover, the 27.5% penalty was reduced down to 5%, or completely waived if the foreign residence requirements were met.
Penalty Waiver: there is a small facet of the modified streamlined program called the Modified Foreign Offshore Program. If a person qualifies for the modified stream of program (which means they acted non willfully) and they can prove they lived overseas for a total of 330 days out of the tax year in any year within the last three years, then they may qualify to have the penalty waived.
The Streamlined Programs sounds great, right? Well it is, unless you are attempting to wrongfully evade the 27.5% penalty by entering the program when you knew you were willful.
What if you are caught trying to sneak into the Streamlined Program?
I cannot stress to you enough to not try and enter the Streamlined Program if you were willful. If you knowingly enter the streamlined program and it is found that you acted willfully in your failure to disclose and report your overseas and foreign assets and income you will most likely be prosecuted by the IRS.
The IRS made this fact known in a recent public relations statement. From the IRS’ perspective, if you wrongfully enter this program in order to avoid paying the full penalty amount what you have done is stolen 27.5% or 50% of the penalty amount due to the IRS – and this does not make the IRS very happy.
Even worse is that you may be subject to criminal prosecution. And, since you have already disclosed all the foreign financial information in your Streamlined Program application, you will be in a tough position to try and defend yourself.
Why is the Modified Streamlined program in Jeopardy?
Just like in everything in life, a few bad apples spoil the whole bunch. The IRS has learned that several individuals who were willful in their failure to report undisclosed foreign tax and bank information have been caught trying to sneak into the modified streamlined program in order to pay a reduced penalty – or avoid the penalty altogether This contradicts the IRS’ intention which was to modify and expand the Streamlined Offshore Disclosure Program to assist taxpayers who otherwise would be overburdened by having to enter the OVDP and opt out of the penalty structure.
There is No Reason to be Scared of the OVDP or the Streamlined Programs
The goal of this article is not to scare you. Rather, it is to warn you to just be cautious if you are entering into these programs. Way too many inexperienced and unscrupulous attorneys, CPAs and enrolled agents see these programs as a way to scare individuals.
If You are going to enter a Foreign Disclosure Program, use an Attorney
While CPAs and enrolled agents (who are not also attorneys) may charge less than an attorney is important to note that you do not have an attorney client privilege with CPAs and enrolled agents. What that means, is that if it turns out you wrongfully entered the streamlined program and the IRS wants to speak with your representative, unless your representative is an attorney, there is no privilege between a CPA and Taxpayer when a Criminal Matter is at issue.
Here is a link to recent article we authored “OVDP – Frequently Asked Questions”