Reporting Foreign Income
Foreign Income and U.S. Tax: Each year, Taxpayers are required to complete a Form 1040 U.S. tax return when they qualify as a U.S. person and have sufficient income to file a tax return. The U.S. tax returns are used to report both foreign and domestic income top the IRS. That is because the U.S. follows a worldwide income model. Therefore, when a U.S. person is either a U.S. Citizen, Legal Permanent Resident or Foreign National who meets the substantial presence test, they are required to file a Form 1040 to report global income.
The Reporting Foreign Income rules can be complex. In addition, the Internal Revenue Service has taken an aggressive position towards foreign accounts compliance as well.
Reporting foreign income includes earned income, retirement income, investments and more. Even if a person is generating income from a foreign life insurance policy or foreign mutual fund, that income may have to be reported as well.
If the Taxpayer is out of compliance, they may consider tax amnesty, which is collectively referred to as voluntary disclosure.
How to Report Overseas Income to the IRS
When a Taxpayer is required to file a 1040 vs. a 1040NR, they are taxed on their worldwide income.
It does not matter if the person resides in the United States and earns income abroad, or if the person resides abroad and earned income from countries that are not the United States.
A U.S. person Taxpayer still must report all of their income on their U.S. Tax Return.
Taxpayers may be able to apply Foreign Tax Credit for taxes already paid on the foreign income, and/or may qualify for the Foreign Earned Income Exclusion if they meet either the Bona-Fide Resident or Physical Presence Test.
Who is a U.S. Person?
A U.S. person is all-encompassing for International Tax/Worldwide income related purposes. Do not be fooled by the term Citizen-Based Taxation – it is more broad than that.
A U.S. person individual includes:
- U.S. Citizens
- Legal Permanent Residents, and
- Foreign National other non-US person that needs the Substantial Presence Test.
*The Substantial Presence Test is an unnecessarily difficult math equation that breaks down the time required to be spent in the United States over a three-year period to make a person qualify as being subject to U.S. Tax on their Worldwide Income.
IRS Form 1040 Foreign Income Basics
A basic summary about how income is included on your US tax return.
Deductions such as medical expenses, charitable donations, mortgage interest, property tax, etc. are taken on Schedule A. There are nuances when the deductions are foreign income, but they are still allowable.
Foreign interest and foreign dividends are reported on the 1040 and Schedule B. Even if it is below $1,500, since the interest and/or dividends will (usually) originate from a foreign financial account, Schedule B is filed for Part III of the form.
If you have a foreign business that qualifies as a sole proprietorship (or disregarding the entity), then it would be included on Schedule C, along with other documents that would need to be filed.
If it is capital gain many goes on Schedule D, unless it is capital gains distributed from a fund and that it may go on Schedule B.
Schedule E, Page 1
If you have for the rental income from property, it would be included on page 1 of schedule E.
Schedule E, Page 2
If you are a member of a foreign partnership or other company, then your tax return becomes unnecessarily complicated and not only that you have to include the information on schedule E, page 2 — but you may also have to report it on a variety of different forms such as a form 5471, 8621 or 8865.
**Whether or not you may be able to disregard the entity is a much more complicated discussion beyond the scope of this basic article.
Foreign Tax Credit — Paying Foreign Taxes – (Form 1116)
The IRS recognizes taxes paid in a foreign country (some of the time) and therefore will allow you to use a foreign tax credit to offset taxes you already paid in a foreign country, and report it on an IRS Form 1116.
If you paid less tax in the foreign country then you would have paid in the US on the same income, then you pay the difference on your U.S. tax return. If you paid the same amount, then no taxes are due, and if you overpaid, then you are entitled to a foreign tax credit to be used against foreign income (not domestic) earned at a future date.
**The reason why the United States will not let you apply additional left-over foreign tax credits to U.S. income, because that would mean that the United States is losing out on tax revenue that would have been paid to the IRS had it not been paid to the foreign country, and the IRS does not like that.
Foreign Earned Income Exclusion – (Form 2555)
For individuals who reside overseas and earn income from overseas, they may be able to avoid paying U.S. tax on a portion of that income. It is limited to earn income such as wages or self-employment, but it does also include housing in certain situations. The exclusion is reported on IRS Form 2555.
There are two tests in which a person can qualify for the foreign earned income exclusion, and the tests are relatively simple to apply – if not difficult to meet. The two different tests are the Physical Presence Test (330-day) and the Bona-Fide Resident Test (which is a much more complicated test and more subjective than mere physical presence).
If the person meets the test, then even though the income is reported, it is also excluded from taxation – but with a twist. Let’s say David earns $150,000 overseas and therefore can exclude the first hundred thousand dollars of tax.
David will only pay tax on the $50,000 that is remaining, but she will pay the tax as if he earned $150,000 (higher tax bracket) – which is a relatively recent change in the text. It used to be David would be treated as if you only earns $50,000
Additional Foreign or Offshore Reporting
At Golding & Golding, we limit our entire law practice to IRS Offshore Voluntary Disclosure of undisclosed or unreported foreign income, assets, accounts, investments, real estate, and the like.
The following are a few examples:
Reporting Foreign Accounts (FBAR)
If you are a U.S. Person, it does not matter whether or not you have to actually file a U.S. tax return to determine if you have to file an FBAR.
The threshold question is whether you have an annual aggregate total of foreign/offshore bank accounts, financial accounts, retirement accounts, etc. that when combined, exceed $10,000. If so, you are required to file the FBAR Form and report all of the accounts.
It does not matter if the money is all in one account, or in 15 different accounts. It also does not matter if the majority of the money is in one account, with minimal amounts of money in the remaining accounts – rather, once you meet the threshold requirements, you have to report all the accounts.
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.
FATCA Form (8938)
FATCA is the Foreign Account Tax Compliance Act. For individuals, it requires reporting of financial accounts and certain specified foreign assets (ownership in businesses, life insurance, etc.). There are different threshold requirements, depending on whether a person is Married Filing Jointly (MFJ) or Married Filing Separate (MFS)/Single, and whether a person resides in the United States or outside of the United States.
The penalty starts at $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.
Foreign Gift Form (3520)
If you receive a gift or inheritance from a foreign person that exceeds $100,000 either in a single transaction, or a series of transactions over a year, you are required to report the gift on this form. You have the file this form, even if you are not required to file a tax return (although it is normally filed at the same time as your tax return).
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.
Foreign Corporation or Foreign Partnership (5471 or 8865)
The rules are somewhat different for these two forms, but essentially the same (with the 5471 being much more commonplace for U.S. investors). If you own at least 10% ownership in either type of business, you required to report the information on either a form 5471 or 8865. Both of these forms require comprehensive disclosure requirements, involving balance statements, liabilities, assets, etc. Moreover, the forms need to be filed annually, even if a person does not have to otherwise file a tax return
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.
Passive Foreign Investment Company (PFIC)
One of the most vilified type of financial assets/investments (from the U.S. Government’s perspective) is the infamous PFIC. A PFIC is a Passive Foreign Investment Company. The reason the United States penalized this type of investment is because it cannot oversee the growth of the investment and income it generates. In other words, if a U.S. person invests overseas in a Foreign Mutual Fund or Foreign Holding Company — the assets grows and generates income outside of IRS and U.S. Government income rules and regulations.
As a result, the IRS requires annual disclosure of anyone with even a fractional interest in a PFIC (unless you meet very strict exclusionary rules)
The Penalties for not filing an 8621 run concurrent with the 8938 penalties (see above).
Foreign Trust (3520-A)
A Foreign Trust is another type of Foreign Investment that is frowned upon by the IRS. From the IRS’ perspective, the only purpose behind a Foreign Trust is to illegally avoid US reporting and income tax requirements by moving money offshore. While there are many people who may operate illegally in this fashion, there are various legitimate reasons why you would be a trustee or beneficiary of a Foreign Trust (Your cool grandma really loves you and placed $5 million in trust for you overseas). Form 3520-A is a relatively complex form, which must be filed annually by anybody that owns a foreign trust.
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.
Foreign Real Estate Income
Even if you are earning rental income from property that is located outside of the United States, you still must report the income on your U.S. taxes (even it is exempt from tax in the foreign country). Remember, United States taxes individuals on their worldwide income. Therefore, the income you are earning from your rental property(s) must also be included on your US tax return.
A few nice benefits of reporting the income is that the United States allows depreciation of the structure – which many foreign countries do not allow. Moreover, you can take the same types of deductions and expenses that you otherwise take the property was located in the United States.
Varies, depending on the Nature and Extent of the non-disclosure.
What Can You Do?
Presuming the money was from legal sources, your best options are either the Traditional IRS Voluntary Disclosure Program, or one of the Streamlined Offshore Disclosure Programs.
Golding & Golding: About Our International Tax Law Firm
Golding & Golding specializes exclusively in international tax, and specifically IRS offshore disclosure.
Contact our firm today for assistance with getting compliant.