Why is Tax-Free Foreign Income Subject to U.S. Tax – Voluntary Disclosure Options
This is a question we receive often.
Here is an example of a common scenario: Jessica is originally from Hong Kong. She resides in the United States as a Legal Permanent Resident with every intention of becoming a U.S. citizen.
Thus, at this time, Jessica is not a US citizen but still a citizen of Hong Kong.
Jessica came to the United States when she was 43 years old; thus, she had already amassed significant earnings in Hong Kong before relocating to the United States. In fact, she has two million ($2,000,000) dollars in foreign accounts throughout Hong Kong and China. (By Foreign, we simply mean accounts located outside of the United States.)
Since that income is not taxed in Hong Kong or China, she earns about $40,000 a year tax-free, which has been accumulating in the accounts overseas.
She has not brought any of that money to the United States and has not transferred any of her US earnings to the foreign bank accounts; in her mind, the Hong Kong in Chinese income stays abroad, and the US income is subject to US tax.
Unfortunately for Jessica, that is not how the US tax system works. In the United States, taxes are generally based on citizenship (including Legal Permanent Residence and Substantial Presence).
The United States taxes individuals on their worldwide income. It does not matter if an individual resides in the United States or abroad in a foreign country – if they have a responsibility to file a US tax return (as Green Card Holders do), they have a responsibility to report their worldwide income.
Even though Jessica resides in the United States and pays tax on all of her US source income, she is also required to pay tax on all of her foreign sourced income as well. If she was paying tax in a foreign country on foreign earnings, then she would usually receive a Foreign Tax Credit to ensure she is not doubled-tax. But, since the foreign countries identified above generally do not tax individuals on passive income such as bank account interest, Jessica has not paid any foreign tax on the earnings.
Therefore, Jessica is subject to US tax.
Green Card/U.S. Citizenship Status
In order to become a U.S. Citizen and/or continue being a Green-Card Holder/Legal Permanent Resident, person must stay within tax compliance. Since Jessica has not been paying any U.S. tax on her foreign source income, she is out of tax compliance — which may impact her ability to renew the green card or obtain citizenship in the United States.
In order to get into compliance, Jessica may consider entering into IRS Offshore Voluntary Disclosure in order to get herself into tax compliance before she is audited or examined by the U.S. government — which may potentially result in Jessica being subject to excessively high fines and penalties.
Want to learn more about Offshore 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.
Call Now; We Can Help.
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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