U.S. Tax On Inheritance from Overseas – IRS International Reporting
U.S. Tax on Inheritance from Overseas and the IRS International Reporting Rules are two of the most common inquiries we receive at Golding & Golding.
When it comes to US tax and IRS International Reporting rules, the topics needs needs to be broken down into three different parts
- U.S. Tax on the Inheritance from Overseas
- U.S. Tax on the income generated from the Inheritance from Overseas
- IRS Reporting of the Inheritance from Overseas (FBAR & FATCA)
Sean M. Golding, JD, LL.M., EA – Certified Tax Law Specialist
Our Managing Partner, Sean M. Golding, JD, LLM, EA is the only Attorney nationwide who has earned the Certified Tax Law Specialist credential and specializes in IRS Offshore Voluntary Disclosure Matters.
In addition to earning the Certified Tax Law Certification, Sean also holds an LL.M. (Master’s in Tax Law) from the University of Denver and is also an Enrolled Agent (the highest credential awarded by the IRS.)
He is frequently called upon to lecture and write on issues involving IRS Offshore Voluntary Disclosure.
Less than 1% of Tax Attorneys Nationwide
Out of more than 200,000 practicing attorneys in California, less than 400 attorneys have achieved this Certified Tax Law Specialist designation.
The exam is widely regarded as one of (if not) the hardest tax exam given in the United States for practicing Attorneys. It is a designation earned by less than 1% of attorneys.
U.S. Estate Tax is Limited
For many of our clients, they will be glad to find out that right from the start, unless US situs is involved, a US person who is inheriting a foreign estate from a foreign person who had no ties or residency issues to the United States will not have to pay any tax on the estate.
Typical Example: Brian comes to our office and tells us that he received an inheritance of $3 million from his grandma. His grandparents were very wealthy, and they split a $15 million inheritance over five different grandkids. Luckily for Brian, he stayed in his grandma’s good graces and didn’t do anything during his lifetime to make his grandma revoke the gift (good job, Brian).
Brian is a U.S. Citizen
Brian moved to the United States with his family when he was very young. He obtained his citizenship through his parents as a minor and has been a US citizen for the majority of his life.
As a result, will the United States tax Brian on the estate, since Brian is a U.S. citizen?
No, based on these facts the IRS will not tax Brian on his inheritance.
Estate Tax vs. Inheritance Tax
When a person dies, the first thing the United States will look to see is if the person is a U.S. Person, and what is the value of the decedent’s estate. If the value of the estate is over the exemption amount, and the decedent is a U.S. Person, then the United States may be able to tax the estate that is above the exemption amount — at the alarming rate of 40% per dollar.
Since Brian’s Grandma is a non-U.S. Person with no U.S. Situs, she will not be taxed (See Below)
Peter – U. S. Citizen
Another Example with a Different Outcome: Peter is a US citizen who passed away in 2016. He has never gifted any of his money beyond the annual exclusion amount. When he died, Peter’s estate was worth $10 million. He does not have any charitable trusts, Irrevocable Trusts, a spouse to claim portability…or any other mitigating components to his estate.
Therefore, the estate would be taxed at the amount which is above and beyond the exemption. In the current year, Peter’s estate would be taxed at around $1.8 million (40% of 4.5 million)
Since Peter was a US citizen, the United States has the opportunity to tax the estate on its worldwide assets. Therefore, since Peter has land in the United States as well as multiple other countries, the total aggregate value will be taxed by the IRS. Peter may be able to mitigate the double taxation though, since the United States has estate tax treaties with 16 different countries — and therefore, Peter may be able to minimize some of his U.S. Estate Tax.
Brian’s Grandma – Foreign Person
Brian’s grandma resides in a foreign country. She is, and has always been a non-US person, with no ties to the United States other than the fact that her daughter married a U.S. citizen and they reside in the United States.
**There are very complicated estate tax rules that apply to U.S. Persons or Long-Term Permanent Residents who renounce citizenship or relinquish their Green-Card, relocate overseas, an leave an estate (or gifts) in excess of the exemption amount.
Aside from not being subject to U.S. Tax as a U.S. Person, Brian’s grandma also never invested in the United States and therefore, she does not have any U.S. situs. As such, and despite the fact that her Estate has net worth of $25 million, with many of the beneficiaries qualifying as U.S. Persons, none of the estate is subject to any taxation by the United States. Why? Because as a non-US person with no U.S. investments, the United States does not have any reach over Brian’s grandma.
Stated another way, it is not as if the United States government gets the opportunity to tax non-US persons with non-US investments solely because the recipient of the estate/inheritance is a US person. Remember, it is the estate that is taxed.
What if Brian’s Grandma did Have U.S. Situs
Currently, the gift and estate tax exemption is around $5.5 million. Therefore, a U.S. person could feasibly pass away with $5 million of U.S. assets, foreign assets, or a mix of the two – but as long as it is under $5.5 million (subject to any gifting that occurred during life) there would be no tax.
Conversely, when a non-US person owns US property and then passes away, the exemption amount is closer to $60,000. Therefore, using this example if Brian’s grandma had US situs that was above $60,000 then that US situs only (not the foreign assets) would be taxed at 40%.
If Brian’s Grandma was considered a U.S. person, she would have to had employed various Gifting, Family Business (minority discounts) and Irrevocable Trust strategies during life in order to try to reduce the value of the estate during life.
Some of the Assets Earn Income
As part of the inheritance, Brian received a mutual fund located in the foreign country. The mutual fund generates significant income for Brian. As a result, Brian will have to report the income to the United States and pay tax on the income as well.
In other words, while Brian’s grandma’s $3 million inheritance to Brian is not taxed as estate tax any future income generated from it would be taxed as income tax to Brian.
IRS Reporting Foreign Inheritance
Continuing from above, since the United States cannot tax the inheritance, they are going to do what they can to force the recipient of the money (Brian) to report the money to the United States government.
Why do they Care?
It is relatively simple and straightforward: Currently, the gift and estate tax exemption is $5.5 million. Let’s say instead that Brian received $10 million from his grandma. Five years later, Brian dies. If Brian was not forced to report the $10 million he received from his foreign person grandma, the IRS would have no way of knowing that Brian had a value of over $10 million.
As a result, the United States would have no way of knowing that Brian estate would be subject to estate taxes of around 2 million.
While you may be wondering (rightfully so) why would Brian report the inheritance if it’s only going to be taxed in the future? The answer simple – if the IRS learns of the inheritance and the lack of reporting, the penalties alone will reduce the value of the estate significantly.
The following is a non-exhaustive list of common IRS International Tax Reporting forms.
Since Brian received a foreign gift (albeit an inheritance) from overseas, he has to report the receipt of the gift on the year he received it, on a form 3520. It is a very simple reporting form, but the failure to file a timely can result in significant penalties. As a result, Brian should file this form timely at the same time he files his current tax return — either in April or on extension.
Since Brian is the owner of foreign mutual funds and other accounts that exceed $10,000 in annual aggregate total, Brian will also have the file an annual FBAR statement. This statement is not necessarily difficult to complete, although the penalties for failing to file a timely FBAR are severe. And, if the IRS believed Brian was Willful, they can try to come after him the full amount of the accounts.
FATCA Form 8938
FATCA is the Foreign Account Tax compliance Act. Is a relatively new law requiring certain individuals significant amounts of specified foreign financial assets to report the form to the IRS. Rhe reason why this form is a bit more menacing than other forms is because it is actually included with your tax return.
In addition, unlike some other forms listed above, FATCA Form 8938 requires the individual to itemize the different types of income that was received, as well as:
- Which accounts generated income
- Whether the accounts were opened in the current year
- Whether the accounts were close in the current year
- If the account of jointly owned
An 8621 is a complicated form involving passive foreign investment companies. We have written numerous blog posts and articles on this issue and have been invited to speak as presenters to different organizations on this issue.
It is tedious and boring, but the most important take away from this form is that the failure to file it leaves your tax return open. In other words, if you do not file this form and is otherwise required, then the statue limitations for the return does not yet begin to run.As a result, the tax return could be audited many years into the future.
In addition, if a person does not make a mark-to-market election, then in years that they received an excess distribution, the tax liability amounts to a penalty tax which can reach 50 to 75%, if not higher of the value of the PFIC.
Unfortunately, it is important for Brian to get into compliance quickly upon receiving the inheritance to avoid any potential pitfalls and landmines in the future. These pitfalls and landmines typically consists of extremely high fines and penalties that the IRS issue against the person for not properly and timely reporting their accounts.
If Brian is already out-of-compliance, he will want to try to get into compliance ASAP.
These penalties as provided by the IRS are as follows:
The following is a summary of penalties as published by the IRS:
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.
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 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.
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.
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.
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.
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 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.
Underpayment & Fraud 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.
Even Criminal Charges are Possible…
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.