Inbound Estate and Income Tax Planning and Compliance Basics for Immigration Attorneys
David W. Klasing Esq. CPA M.S.-Tax has earned dual California licenses that enable him to simultaneously practice as an Attorney and as a Certified Public Accountant in the practice areas of Taxation, Estate Planning and Business Law. He provides businesses and individuals with comprehensive Tax Representation, Planning & Compliance Services and Criminal Tax Representation. He has more than 20 years of professional tax, accounting and business consulting experience, coupled with extensive knowledge about federal and state tax codes, regulations and case law.
As a former auditor, Mr. Klasing uses his past experience in public accounting to help his clients avoid tax problems before they develop where possible. As a Combo Attorney CPA he aggressively protects his clients’ interests during audits, criminal investigations or in Tax Litigation. Mr. Klasing has assisted thousands of businesses and individuals through the audit / litigation and appeal process, and Mr. Klasing has a proven and sustained record of achieving favorable results for the clients he serves.
Mr. Klasing is admitted to practice before all California State Courts, the United States District Court for the Central District of California and the United States Tax Court.
Mr. Klasing’s education includes a bachelor’s degree in business administration, with an emphasis in accounting, from California State University Los Angeles, a master’s degree in taxation from Golden Gate University and a Juris Doctor from Western State University College of Law.
Having earned a master’s degree in taxation with an emphasis in the gift and estate tax arena, along with having taken classes in Law School on Estate’s, Trusts and California Community Property, Mr. Klasing practices in the estate, trust and accounting areas.
Mr. Klasing’s professional involvement includes serving as the current chair of the California State Bar Association, Tax Procedure and Litigation Committee, the current chair of the Orange County Bar Association Taxation Section. He is also a member of the American Bar Association Tax Section; the Orange County Bar Association, Tax, Business and Corporate Law, Trust & Estate Sections, the California Society of Certified Public Accountants State Committee on Taxation and the American Association of Attorney Certified Public Accountants. He is an “A” rated current member of the Better Business Bureau. He has a 10.0 AVVO rating (Superb).
The War on the Fraudulent Use of Tax Havens by United States Persons:
Evidence gathered under the Offshore Voluntary Disclosure Programs proves that a large number of U.S. Taxpayers have utilized offshore tax havens to evade U.S. taxes.
Income tax evasion is defined as follows and defined under IRC § 7201 as follows: Any person who willfully attempts in any manner to evade or defeat any tax imposed by this title or the payment thereof shall, in addition to other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than 5 years, or both, together with the costs of prosecution.
Note: Each count of evasion under 7201 carries with it a potential 5 year jail sentence. The average government conviction will consist of at least three tax years which bumps the exposure out to 15 years. Most taxpayers when confronted with a strong possibility of conviction for a 15 year sentence will accept a negotiated plea agreement that ranges between 3 to 5 years which usually saves the government the trouble of a trial. If income tax evasion is utilized as a predicate offense for money laundering a single count of evasion can result in a 20 rather than 5 year sentence (although this is highly unlikely given the 3 year investigation commonly used by the criminal investigation division of the IRS)
The historical benefit provided by tax haven jurisdictions to tax evaders was secrecy guaranteed under foreign government drafted bank secrecy laws that made is difficult for the Internal Revenue Service, or any other creditor for that matter, to obtain information regarding the assets and financial affairs of the U.S. person with assets located in the offshore. Also essential to the appeal of a tax haven jurisdiction are efficient and high quality financial services and little or no domestic tax on nonresidents’ passive income. These very qualities are the reason that tax havens are under attack by the IRS Criminal Investigation Division and the Justice Department especially where abusive trust schemes have been allowed to enable tax evasion over the past several years.
Promoters of the use of abusive offshore trusts here at home have also been under attack. For example in United States v. Chappell, the Court of Appeals affirmed the conviction of tax shelter promoter that was advising his clients to place their assets “in a circular series of three domestic and foreign trusts, each a beneficiary of the next” and to fail to report the income earned in the trusts on their individual tax returns, even though they received economic benefit (income) from the trusts. Mr. Chappell’s son then prepared and signed the clients’ tax returns under his supervision.
The Foreign Account Tax Compliance Act (FATCA)
In 2010, largely in response to litigation with UBS, congress enacted the Foreign Account Tax Compliance Act (FATCA) which was drafted in an attempt to prevent U.S. taxpayers from utilizing foreign accounts and entities to evade U.S. tax. FATCA generally requires U.S. taxpayers, banks, brokers and foreign financial institutions that have failed to enter into an information sharing agreement with the Internal Revenue Service (IRS), to withhold 30 percent of certain payments made to a foreign entity unless the transaction qualifies for an exemption or the foreign institution complies with specified reporting requirements. FATCA basically requires foreign financial institutions to disclose account information related to any U.S. individual or in relation to accounts held by a foreign entity that has substantial U.S. ownership.
United States Bilateral Income Tax Exchange of Information Agreements with Tax Haven Nations
FACTA has to date been implemented largely through information sharing agreements with foreign nations. The United States currently has signed thirteen bilateral exchange of information agreements with nations generally considered to be tax havens, and currently has exchange of information agreements signed, but not yet all ratified, with 31 nations.
U.S. INCOME AND TRANSFER TAX PLANNING FOR NON RESIDENT ALIENS
Seeking, Retaining or Relinquishing U.S. Permanent Residence Status or Citizenship Should Only be Contemplated After First Evaluating Tax and Estate Considerations!
Many multinational executives, managers, entrepreneurs, and investors fail to account for the tax and estate consequences that naturally follow from their attainment or relinquishment of U.S. immigration status or a decision as to taking up U.S. residence. Before seeking or retaining U.S. temporary or permanent residence status, a foreign national and their immigration counsel should be aware of the U.S. tax and estate law issues which are associated with that status.
Income and Transfer Tax Consequences Associated with Immigration Decisions
Once an immigrant obtains a green card, he or she faces immediate and profound income and transfer tax issues that should be planned for to avoid the most commonly suffered income and transfer tax pitfalls. With respect to income tax, a permanent resident is deemed to be an income tax resident of the U.S. for as long as the green card is retained even prior to their physical presence in the U.S. All of the permanent resident’s worldwide income becomes subject to U.S. income tax even on assets earned and held entirely outside the U.S. prior to immigrating to the U.S. Because the foreign national is usually a citizen of one or more other countries, he or she may become subject to double or triple taxation. The U.S. foreign tax credit and possible income tax treaties with the country(s) they just immigrated from may provide a level of relief from double or triple taxation but advanced planning should be employed to minimize these effects.
Much less intuitive and often surprising to the permanent resident is the applicability of U.S. transfer taxes, which include gift, estate, and generation‐skipping transfer taxes upon becoming domiciled in the U.S. Once deemed to be domiciled in the U.S., the foreign national will be faced with inheritance taxes on the gratuitous transfer of assets to their spouse, children, grandchildren and others, with generally the same rates of taxation, exemptions and deductions as a U.S. citizen. A transfer to a non‐U.S. citizen spouse will not be subject to the unlimited marital transfer exemption that is otherwise available where the spouse is a U.S. citizen however an estate tax treaty may be available to enhance the available deductions and exemptions.
If the foreign national engages in pre-immigration estate planning they may be able to take affirmative steps before becoming a U.S. domicile for transfer tax purpose and thus avoid the imposition of some or all U.S. transfer taxes.
Nonresident aliens may be able to reduce or avoid U.S. transfer taxes by investing in U.S. debt instruments that pay solely portfolio interest, by holding U.S. situs assets through foreign corporations, by ensuring that U.S. situs assets are community property or the foreign equivalent; and making inter vivos gifts of intangible property to reduce their taxable estate.
The Exit Tax
The taking of a foreign executive or managerial post, need to provide for foreign aging parents, seeking of alternate lifestyle / political factors can result in a decision to return or move abroad permanently and a corresponding decision to voluntarily relinquish permanent resident status or renounce citizenship.
Since June 17, 2008, the United States has imposed a potentially financially devastating “exit” or “expatriation” tax on permanent residents who give up their green cards and on U.S. citizens who renounce their citizenship. For the permanent resident to be subject to exit taxation under this “covered expatriate” regime, they must have held the green card for any part of eight of the previous fifteen years prior to turning in their green card. Additionally, they must have either a worldwide net worth of $2,000,000 or more, or an average U.S. net income tax liability over the previous five calendar years of $147,000 or greater.
The covered expatriate exit tax regime includes both an income tax and an inheritance tax element. The income tax element consists of a deemed “mark‐ to‐market” tax on the inherent gain generally involving all of the covered expatriate’s worldwide assets. The deemed gains are classified as long‐term capital gain, short‐term capital gain or ordinary income. The first $636,000 of gain is exempted via a proportionate allocation among the covered expatriate’s assets.
The inheritance tax element applies when subsequent gratuitous transfers occur from a covered expatriate to U.S. citizens or residents. These recipients often include children who have been educated in the U.S. and stay for career or marital reasons. Any lifetime gift or inheritance at death by a covered expatriate will be taxed at the maximum gift or estate tax rate then in effect.
If the covered expatriate chooses to make gifts to U.S. citizen’s or residents through a U.S. domestic trust, the trust will be subjected to inheritance tax upon receipt of such gifts, regardless of the actual citizenship or residency of the U.S. domestic trust’s beneficiaries. If a foreign trust is used to make gifts by covered expatriate’s the U.S. citizen or resident beneficiary will be forced to pay inheritance tax as distributions are received from the trust.
Because of the covered expatriate exit tax regime, careful exit planning should be undertaken before a green card is turned in or citizenship is renounced. While it is often very difficult to entirely remove oneself from the U.S. tax system, with proper exit planning the associated tax bite can be avoided or minimized through the use of trusts and asset transfers.
Abandonment or Revocation of Green Card Status
The right to expatriate can be seen as an important check on the powers of government where expatriates vote with their feet to send a message to the government that its tax regimes may be too onerous. It is settled constitutional and international law that an individual has the right to expatriate from the United States.
The abandonment of a green card will not terminate the alien’s resident alien status for federal income tax purposes unless the abandonment is officially recognized by the U.S. immigration authorities by means of either an administrative or judicial determination. If the resident alien simply ceases using the green card without first informing the U.S. immigration authorities and allows it to become invalid via the mere passage of time he or she will continue to be classified as a resident alien for U.S. tax and information reporting purposes.
Abandon of permanent resident status can take place at a U.S. Consulate or Embassy or at the airport in front of a U.S. Customs and Border Protection (CBP) officer. Each U.S. Consulate or Embassy has its own 6 abandonment procedure including the potential for a mail‐in process. Both methods involve the Completion and submission of an I‐407 abandonment form plus the original permanent resident card.
The execution of the I-407 should best be witnessed by a U.S. government official who will wish to ensure that the abandonment is willingly and knowledgeably made. Any former citizen of the United States who officially renounces United States citizenship and who is determined to have renounced U. S. citizenship for the purpose of avoiding taxation by the U. S. is subsequently inadmissible to the U.S. and this is reflected where a number of visa application forms still ask whether a visa applicant has ever renounced U.S. citizenship for tax reasons. Because the government stands to lose tax revenue as a result of a well-planned expatriation, it may later question the propriety of an expatriation. A person that wishes to ensure that his or her expatriation can withstand subsequent questioning must refrain from acting in any manner that might give a court the opportunity to doubt the non-tax intentions to expatriate. For this reason non‐tax reasons for renunciation, should be recorded on a notarized, contemporaneous affidavit to the I-407.
Revocation of Green Card Status
The permanent resident status of an alien may be administratively or judicially revoked or rescinded. A Green Card is effectively revoked or rescinded for tax purposes when a final administrative or judicial order of exclusion or deportation is issued.
Attaining U.S. Permanent Resident Status
For high net worth individuals, the most common routes to achieving U.S. permanent resident status are via an employment‐based process or via sponsorship by a family member who is a U.S. citizen or lawful permanent resident. Accordingly many foreign nationals arrive in the U.S. under a work visa status. The immigration process for high net worth immigrants involves the expertise nd skill sets of both immigration and tax lawyers because of the many hidden tax and compliance traps that can ensnare even the most diligent immigrant.
Retaining U.S. Permanent Resident Status
To retain U.S. permanent resident status generally involves not spending beyond 180 consecutive days outside the U.S. and not committing crimes. However, permanent residency can be lost by a criminal conviction or plea leading to deportation, returning to live abroad without obtaining a re‐entry permit to proactively register a temporarily foreign residence thus not maintaining sufficient ties to the United States, and by failing to file income tax returns as a resident during years temporarily worked abroad.
The Reach of U.S. Transfer Taxation to Non Resident Non-Citizen Foreign Investors and Policy Considerations
U.S. transfer taxes include gift tax, generation-skipping transfer tax and estate tax and can apply during the life or at the death of a Non Resident Non-Citizen in limited circumstances. The transfer taxation of foreign investors within the U.S. is one of the most sophisticated topics in U.S. taxation. From a policy perspective a balance is attempted to be achieved between the goals of assessing and imposing transfer taxation on nonresident non-citizens on the one side and attracting their investment dollars into the U.S. economy on the other. To this end the Internal Revenue Code contains several statutory exemptions from U.S. transfer taxes for certain types of domestic investments that are held by the Non Resident Non-Citizen. 7 High-net-worth nonresident non-citizens often invest in U.S.-situs investments to maintain a balanced and diversified international portfolio as the U.S. is considered one of the safest places on earth to make investments. They often educate their children at American colleges and Universities or run U.S. businesses, which often results in their having U.S. resident children. It is also common for high-net-worth nonresident non-citizens to spend recreational time within the United States and, therefore, they may own valuable U.S. vacation properties, and other U.S.-situs recreational property such as yachts. As a general rule, U.S. transfer tax code only reaches their property that has U.S. situs, and the code contains several exclusions that further restrain the reach of U.S. transfer taxation. Consequently nonresident noncitizens may be able to plan their financial affairs to reduce or eliminate U.S. transfer taxes. The Non Resident Non Citizen’s domiciliary status is the single most important factor at play in limiting the reach of U.S. transfer taxes as the attainment of U.S. domiciliary status, by becoming a resident of the U.S., opens up the Non Resident Non-Citizen to global U.S. transfer taxation.
DEFINING “RESIDENT” STATUS FOR U.S. ESTATE TAX PURPOSES BASED ON DOMICILE AND HOW IT DIFFERS FROM “RESIDENT” STATUS FOR U.S. INCOME TAX PURPOSES:
The Reach of U.S. Transfer Taxation to U.S. Residents (U.S. Domicile) and U.S. Citizens
A legal determination of whether an individual is a U.S. citizen is made by looking to the U.S. Constitution, the Immigration and Nationality Act, and the cases and regulations found thereunder. Sections 2033 through 2044 of the Internal Revenue Code indicate the types of property interests that are includible in the gross estate of a decedent that are subject to transfer taxes. In general, all property interests, wherever situated in the world, must be included in the gross estate of a U.S. citizen or resident, even if he or she lived and died abroad. Moreover, gift tax applies to all transfers by gift of property, wherever situated in the world, by an individual who is a citizen or resident of the United States. Naturalized U.S. citizens are not treated any differently than native-born citizens. Dual citizens are taxed as U.S. citizens and any other citizenship is generally ignored for U.S. transfer tax purposes. Where a non-U.S. citizen is considered a resident, by being domiciled in the U.S., the Code reaches worldwide to all transfers of his or her property, wherever such properties are located at the time of the transfers whether during life or at death. In addition, the transfer taxes of the state in which such a client is resident or owns property may apply as well.
Regulatory Definition of Domicile
Congress has not specifically defined transfer tax definitions for the terms “resident” and “nonresident.” The internal revenue regulations rather define the concept of “domicile.” A resident for transfer tax purposes is a decedent who, at the time of his or her death, had his or her domicile in the United States,” and a nonresident decedent is a decedent who, at the time of his or her death, had his or her domicile outside the United States. The regulations state that a person acquires a domicile in a place by living there, for even a brief period of time, with no definite present intention of later removing themselves therefrom. They state further that residence without the requisite intention to remain indefinitely will not suffice to constitute domicile, nor will intention to change domicile effect such a change unless accompanied by actual removal. In general, the domicile of an individual is his or her true, fixed, and permanent home and place of habitation. It is the place to which, whenever he or she is absent, he or she has the intention of returning.
The Difference Between Income and Transfer Tax Definitions of Residency
The income tax and transfer tax residency definitions are completely different. The transfer tax sense of the term “resident” focuses on the “squishy” concept of “domicile” within the United States, whereas the income tax definition of “resident alien” focuses on an objective set of finite standards defined under IRC §7701(b). A single individual may simultaneously be a resident alien for income tax purposes but not a resident for transfer tax purposes, and vice versa. Domicile cases to date have generally held that where an alien comes into to the United States for a specific purpose and intends to leave the U.S. after that purpose has been accomplished, but without knowing exactly how long it will take to accomplish his or her purpose, then he or she is not domiciled in the United States for transfer tax purposes because the definite present intention to leave when the purpose is accomplished prevents the stay from being considered indefinite in determining residency. Purposes to be in the U.S. that indicate non-domicile status include, in the U.S. to; obtain medical care, to fulfill a temporary job assignment with a definite termination date, to avoid temporary political strife in his or her home country or simply to take a vacation. Although intention constitutes a state of mind, the courts look to objective criteria to make the determination. The two objective factors courts focus on are (1) the length of stay, and (2) the situs of interests. The situs of interests is a more comprehensive analysis of the person’s situation. Among the factors to consider are the locations of:
- the person’s business;
- where the person is licensed to drive;
- where he belongs to church, social or communal organizations;
- where he has declared his residence to be in, for example, a Will or Trust, an application for a visa or for permanent residence, or tax declarations;
- where he owns a burial plot;
- any residence or residences owned by the person (and their degree of use by the person);
- the person’s family and close friends, and;
- the person’s personal possessions.
How the domicile factors are weighed:
The ownership of a home in another country is indicative of a potential intent to return to that home. The fact that a home in the U.S. is rented or a hotel or other transient facility is utilized supports the same inference.
The location of an individual’s family and close friends is a strong indicator of domicile as people are likely to live in the place where their friend and family reside.
The fact that a substantial part of an individual’s personal property is located offshore is indicative of intent to return offshore, while on the other hand, moving these items to the United States may indicate the opposite.
The location of an individual’s principal business activity may be indicative of his or her domicile as one must ordinarily return there often to supervise employees and supervise the business activity.
It is ordinarily advisable for an individual to avoid acquiring documentation and other evidence indicative of long term U.S. residence if his or her objective is to avoid acquiring U.S. domicile status. However this is often unavoidable. Even temporary stays in the U.S. may eventually require a local driver’s license that shows a local address, and the use of a U.S. bank account.
An individual’s involvement with local organizations, including churches, social and community organizations, ect, May be indicative of an intent to remain indefinitely in the U.S. This is even more true where similar ties with a foreign country were severed upon locating to the U.S.
Written legal declaration as to residency such as those contained in a will are indicative of an individual’s intention as to being a resident of a specific local.
The Regulatory Definition of a U.S. Tax Resident
IRC §7701(b) establishes the standards used to determine a resident for income tax purposes as as follows:
- Under IRC §7701(b)(1)(A)(i) an individual who has been issued a “green card” is immediately classified as a resident alien even before he takes up domicile in the U.S.
- Under IRC §7701(b)(1)(A)(ii), (3) via the “substantial presence” test, a nonimmigrant alien is generally classified as a resident alien if he spends 183 days or more in the United States during the calendar year or as determined under a special “lookback” formula that considers the two preceding calendar years and the current calendar year (three years looked at in total). However, both tests contain numerous special rules and exceptions.
See: https://www.irs.gov/Individuals/International-Taxpayers/Substantial-Presence-Test for full details:
Substantial Presence Test
You will be considered a U.S. resident for tax purposes if you meet the substantial presence test for the calendar year. To meet this test, you must be physically present in the United States on at least:
1. 31 days during the current year, and 183 days during the 3-year period that includes the current year and the 2 years immediately before that, counting:
- All the days you were present in the current year, and
- 1/3 of the days you were present in the first year before the current year, and
- 1/6 of the days you were present in the second year before the current year.
You were physically present in the United States on 120 days in each of the years 2007, 2008, and 2009. To determine if you meet the substantial presence test for 2009, count the full 120 days of presence in 2009, 40 days in 2008 (1/3 of 120), and 20 days in 2007 (1/6 of 120). Since the total for the 3-year period is 180 days, you are not considered a resident under the substantial presence test for 2009.
Tax Treaty, Visa Based and Special Rules for Canadian and Mexican Resident Overrides to the 7701(b) substantial presence test
To confuse matters even more an alien who is properly classified as a resident alien under IRC §7701(b) may be none the less be reclassified as a non-resident alien for income tax purposes under the “tie-breaker” rules of a possible income tax treaty between their former country and the United States. This phenomenon usually occurs (if at all) in the year that the alien either moves into or out of the U.S. because of time spent in the U.S. either before or after the move although it may also occur where an alien has lived in the U.S. for the entire calendar year. A tax treaty may also reclassify a U.S. green card holder living abroad as a treaty country resident even where it would violate U.S. immigration laws to take that position which could cause a loss of the green card. Additionally, IRC §7701(b) contains exceptions for aliens in the U.S. under nonimmigrant visas that may override the 7701(b) substantial presence test subject to special rules aliens holding A, F, G, J, M and Q-visas. Lastly, nonimmigrant aliens from Canada and Mexico may be admitted without a nonimmigrant visa under the “visa waiver” program as tourists or as temporary business visitors for up to 90 days a year using a border crossing card.
PRE IMMIGRATION TAX AND ESTATE PLANNING FOR TEMPORARY AND PERMANENT MOVES TO THE U.S.
Temporary Stay in U.S. Estate and Tax Planning
Under the above factors, a resident alien may be “domiciled” outside the United States for many years thus keeping his foreign situs assets from being subjected to U.S. worldwide transfer taxes and thus limiting his or her exposure to the potential estate tax that existed before he or she temporarily moved to the United States surrounding his or her pre-move U.S. Situs Assets.
Temporary stay planning is usually not necessary for students as the ordinarily remain classified as nonresident aliens for income tax purposes for the duration of his or her U.S. studies.
Note: Whenever a foreigner become classified as a resident alien or a newly minted U.S. citizen and has a direct or indirect ownership or beneficial interest in any kind of foreign asset, entity or account such as foreign trusts, partnerships, mutual funds, bank accounts, income producing assets or receives foreign gifts, the applicable U.S. reporting rules should always be carefully considered as potential financially devastating and draconian penalties and associated criminal exposure for income tax evasion and willful non reporting can quickly arise long before the foreigner acclimates to the U.S. tax and reporting regimes. To compound matters only the most sophisticated of U.S. tax advisors will be aware of these requirements so be aware of the negligent referral litigation that has transpired in the past not to mention your own exposure as immigration attorneys. This is the hottest issue before the IRS at present!
Planning for the Exposure to Estate Tax during a Temporary Stay in the U.S.
Temporary stay estate tax planning often involves forming a foreign holding vehicle, entity, trust or company to own any U.S.-situs assets prior to beginning the temporary stay in the U.S. before incurring this expense the non-immigrant alien should first consider the extent to which an existing estate tax treaty might protect him or her from potential estate taxes during his or her U.S. stay and his home countries rules regarding transfers to these vehicles. The types of U.S.-situs assets that may need to be held by a foreign entity include U.S.-situs equities, real property and tangible personal property for example. During the period where a non-domiciled, nonresident alien is effectively exempt from U.S. income tax in his own name, he will not realize any U.S.-source income in his own name and instead only his or her foreign holding company will be subject to income tax on certain U.S.-source income under in its own name. The use of foreign holding companies for estate planning purposes can lead to adverse U.S. income tax complications where the non-domiciled alien owner of the foreign holding company unexpectedly becomes a resident alien for income tax purposes during a temporary stay in the U.S via the substantial presence test. Where a non-domiciled but now resident alien owns the stock of a foreign holding company, the foreign holding company will become subject to the U.S. anti-tax deferral regimes governing controlled foreign corporations and passive foreign investment companies found in Subpart F of the internal revenue code. Note: U.S. real property is always subject to estate tax in the hands of a non-domiciled alien, because no estate tax treaty exempts U.S.-situs real property from estate tax. When a non-domiciled alien transfers U.S.-situs property into a properly structured and maintained foreign trust, the assets transferred should be protected from estate tax if he or she dies unexpectedly during his U.S. stay because the assets are not in his or her own name at the time of his or her death. The transfer of U.S. –situs assets must be conducted in a manner that constitutes a “completed gift” for U.S. gift tax purposes. Ordinarily the grantor will want to be a beneficiary of the trust as to both income and corpus, so that the trust can make distributions of income and corpus to him from time to time as needed for personal expenses while he is a resident alien.
Gift Tax Risk if Grantor Transfers U.S.-Situs Tangible Property to a Foreign Holding Vehicle.
The non-domiciled alien grantor should be careful when transferring any U.S. situs property to a foreign holding company, entity or trust that could be subject to U.S. federal gift tax at the time of the transfer. Where gift tax applies it will only be imposed to the extent that the applicable gifts exceed any exemption amount which may be modified by treaty. 12 Note: Under §2501(a)(2), no gift tax is imposed on a gift of U.S.-situs property that is “intangible” property by a non-resident non domiciled alien grantor like stock in a U.S. corporation but if he or she dies holding the U.S. stock in his or her own name, estate tax will be imposed on the stock. Gift tax can be imposed inadvertently in several situations such as where a non-domiciled alien funds a trust before, during or after a temporary U.S. stay. For example prior, during or after, the temporary stay in the U.S., a non-domiciled alien may transfer U.S.-situs tangible property titled in his own name into a foreign trust. Where U.S.-situs property is already owned by the non-domiciled, non-resident alien prior to a temporary stay in the U.S., it may be possible to avoid gift tax through advance planning. If after moving to the United States the grantor of a foreign trust wishes to buy a personal residence in the name of the foreign trust, he or she could first contribute cash to the trust and then arrange for the trust to buy the U.S. personal residence in its own name. If the individual were to first purchase the residence in his or her own name and then contributed it to a foreign trust gift tax would apply.
Planning to Ensure Non-Domiciled Alien Status
It is paramount to ensure that the grantor of the foreign trust is classified as a non-domiciled alien on any date on which he makes contributions to the trust. If not, gift tax could be imposed on even foreign-situs property or U.S.-situs intangible property which would ordinarily be exempt from gift tax where the contribution is made by a non-domiciled alien. Note: It may not be desirable for an alien to be classified as a non-domiciled alien in all situations. For example, where a non-domiciled alien dies and owns only U.S.-situs property in his own name, only the first $60,000 is exempt from estate tax under IRS §§2101–2102, whereas if the alien is considered a domiciled alien for estate tax purposes, a $5,250,000 estate tax exemption will apply. Although there are no safe harbor rules that define how long a non-immigrant alien without a green card can remain in the U.S. and still be considered not to have established domicile here, the longer he or she remains in the United States the greater the likelihood they will be held to be domiciled here for transfer tax purposes.
Planning for a Permanent Stay in the U.S. for Income and Transfer Tax Purposes
If a high net worth non-U.S. citizen plans to move permanently to the United States, he or she will generally have the same objectives discussed above as the individual who plans to only move temporarily to the United States. They universally desire to shelter his or her pre move foreign income or excludable U.S. income from U.S. federal income and transfer tax for as long as possible so the structure he or she forms will ordinarily have to remain in place until he or she dies or longer if a dynasty trust is contemplated. Although it is generally possible for the individual to avoid U.S. transfer taxes through a properly structured estate plan established well before the move to the U.S., it often proves much more difficult for him or her to legally avoid income tax on his or her pre move foreign or excludable U.S. income, because he or she will become a “United States person” for income tax purposes following the move. A foreign holding company or entity generally will not be effective to protect him or her from U.S. transfer or income taxes once he has becomes a domiciled resident alien or U.S. citizen. The reason for this is that at some point following the move, U.S. transfer and income taxes will attach to his or foreign-situs assets as well as on his U.S.-situs assets, and his foreign-situs assets will include the ownership of the foreign holding company or entity. 13 The most effective way to avoid U.S. transfer taxes (but not income taxes) will be if while he or she is still a non-domiciled non-resident alien a trust if funded in a manner where its corpus will not be included in his or her gross estate upon death. Both U.S.-situs and foreign-situs assets should be funded in this manner but watch out for any applicable gift tax on U.S.-situs assets. The grantor’s control over the trust and interest in the trust’s income must be minimized so as to reduce the exposure to an attack by the IRS that the grantor is a de facto owner of the trust which would expose the trust’s assets to the U.S. gift, generation-skipping and transfer taxes regimes during the grantor’s lifetime and especially at death. As a result of this exposure, the noncitizen immigrant will have to give up substantial legal control over the assets funded to the trust, and can never regain full control over the trust corpus or income.
Pre-Immigration Tax Planning
As noted above, the U.S. subjects its citizens and permanent residents to federal income tax on their worldwide income, which includes foreign source income. However, that income is not subject to tax prior to becoming a citizen or resident. Therefore, the strategy for pre-immigration income tax planning involves accelerating the realization of foreign source income prior to immigration to avoid U.S. income tax, and deferring losses and deductible expenses until after immigration so that they may be used to offset post immigration gains. If the immigrant’s current place of residence or country also unfavorably taxes income, then the use of an intermediary tax haven should be used as a temporary place of residence and divestiture before immigrating to the U.S. Accelerating income typically involves collecting outstanding amounts that may be due, such as accounts receivables, stock options, accumulated earnings from foreign entities, taxable deferred compensation plans, and notes held from installment sales. Where practical, these assets may also be sold at their present fair market value and the proceeds transferred to the individual before immigration. In addition, where the immigrant has foreign assets with substantial built in gain, those assets do not receive a step up in basis upon obtaining U.S. citizenship or permanent residence status. Consequently, those assets should be disposed of and reacquired at a higher cost basis prior to immigration to avoid U.S. taxation on the built in gain. However, in order for the sale to be respected the transaction should be entirely bona fide and well documented, with no implied obligation for repurchase or cancellation. In direct contrast to accelerating realization of built in gain and income, built in losses and deductible expenses should be deferred until U.S. residency status is achieved in order to shelter post-immigration income and gain. This includes disposition of loss property and (where practical) deferred incurral or payment of deductible expenses, as business expenses are generally only deductible in the year in which they are paid or incurred.1 As mentioned previously, the U.S. taxes its citizens and residents on nearly all types of gratuitous wealth transfers. Therefore, where the value of the immigrant’s gross estate exceeds the applicable exclusion amount (currently $5,250,000 for 2013), the goal of pre-immigration estate planning is to reduce the value of the gross estate of the immigrant prior to residency. This is typically done in several ways.
For U.S. situs tangible personal property such as cash or other valuables, physically relocating such property outside of the U.S. (thereby transforming it into non-U.S. situs property) before transfer ensures avoidance of U.S. transfer taxes. For U.S. situs real property, any gratuitous transfer will be subject to U.S. transfer tax, therefore it is critical that tax planning take place well before acquisition. As U.S. transfer tax does not reach stock held by a non-resident alien in a foreign corporation, planning in this area typically involves the formation of a foreign corporation to acquire and hold U.S. situs property. By converting U.S. situs property ownership into non-U.S. situs property ownership (e.g. foreign stock), U.S. transfer taxes may be avoided. In order for this arrangement to be respected, it must be properly planned, documented, and maintained. Foreign assets can also be gifted directly to future beneficiaries or transferred to a trust prior to residency (free of U.S. transfer taxes) in order to reduce the value of the gross estate. However, given the numerous anti-avoidance rules, transfers to trust should be undertaken with great care to avoid having trust income taxed to the grantor. For example, if a non-resident alien makes a gratuitous transfer to a foreign trust with a U.S. beneficiary and within 5 years of the transfer obtains U.S. citizenship or permanent residence status, any income attributable to the property transferred to the trust will be taxable to the grantor.2 In addition, the general grantor trust rules also apply to pre-immigration trusts. Therefore, even in cases where a pre-immigration trust was funded more than 5 years prior to obtaining U.S. citizenship or residency status, if the grantor has retained any interest as enumerated under Code sections 673 through 677 (e.g. reversionary interest greater than 5%, power of revocation, or power to direct the distribution of trust income or corpus), trust income will be taxable to the grantor under the grantor trust rules. Pre-immigration planning in the above case should therefore involve amending and removing any retained interests in a foreign trust that may result in trust income being taxable to the grantor. Also, where a foreign trust does not distribute all of its distributable net income (“DNI”) for the current year, the undistributed DNI will become undistributed net income or (“UNI.”) The relevance of UNI in an immigration context is that an immigrant who becomes a U.S. beneficiary of a foreign trust with substantial UNI is subject to the onerous tax consequences of the “throwback rule” under IRC section 666 and 667. The throwback rule is designed to cause the U.S. beneficiary of a foreign trust to pay approximately the same income tax that would have been imposed if the trust had distributed all of its DNI on an annual basis as opposed to accumulating income in the trust. The effect of this is that the U.S. beneficiary is subject to ordinary income tax rates on capital gains earned by the trust and interest on any distributions of UNI made after the residency date.3 Pre-immigration planning in this context may include accelerating distributions of UNI prior to residency in order to reduce or eliminate UNI and avoid the throwback rule.
U.S. INCOME AND TRANSFER TAX PLANNING FOR NON RESIDENT ALIENS AND U.S. RESIDENTS WITH FOREIGN ASSETS
Rule of thumb: Anyone who is a resident non-citizen, who is married to a non-citizen, or who has property located in more than one country needs international estate planning!
Non-Tax Considerations in International Estate Planning for Non-Resident Aliens and U.S. Resident with Foreign Assets:
If a client is foreign national (nonresident alien) or U.S. tax resident with property located in a foreign country, unique non-tax considerations affecting their estate plan include the following:
- An estate plan that includes a will or trust prepared under the laws of the United States may not be effective to dispose of the client’s property that is located in another country. Accordingly, if a client has such property, the client will likely need a will or trust prepared under the laws of the foreign country, especially where the client’s foreign property consists of real estate.
- A client ordinarily prefers to have members residing in their foreign home country serve as executor, trustee, or under a power of attorney in executing their U.S. estate planning documents. While ordinarily there are no legal restrictions on a foreign individual serving in these roles within the United States, logistical issues and language barriers can make such service impractical in which case the U.S. estate planning attorney is encouraged to name back-up fiduciaries.
- Where a U.S. court has initial jurisdiction over the guardianship of minor children, it will require a local resident to serve as guardian. Even though it is possible to transfer guardianship to an individual in another country, the process is involved and not straightforward.
Overview of Tax Considerations in International Estate Planning for Non-Resident Aliens and U.S. Resident with Foreign Assets or Non-Citizen Spouses:
If an estate planner has a client that is a resident non-citizen that is domiciled in the U.S. or a citizen who owns property in another country, the estate planner must consider the impact of both U.S. and foreign estate tax laws in designing an estate plan. Three factors are at issue in determining the application of U.S. estate tax laws; 1. Citizenship, 2. Residency, and 3. Situs (or location) of property. As a general rule, U.S. citizens are subject to estate taxation on their worldwide tangible and intangible property, not just on their property that is situs in the United States. This U.S.’s worldwide taxation methodology creates a high probability that an estate asset or assets will be subject to double taxation, once in the U.S. and once in the foreign country. Although several countries have income tax treaties with the United States designed to avoid double taxation on income, relatively few countries have estate tax treaties that avoid double taxation on estates.
Ramifications of Having a Non-Citizen Spouse:
Transfers to Noncitizen Spouses – Disallowance of Federal Estate Tax Marital Deduction
Ordinarily the marital deduction will allow property to pass to a surviving spouse estate tax-free. However, a marital deduction is not available for spouses who are non-resident aliens. If your spouse is a non-resident alien, the marital deduction can only be claimed if property passes to the non-resident alien through the use of a Qualified Domestic Trust (QDOT) that has a U.S. trustee. A QDOT is required to distribute all of its income to the client’s nonresident alien surviving spouse and may permit distributions of its principal to the spouse, but any principal distributions are subjected to federal estate taxation as if the property was part of the client’s taxable estate. At the non-resident alien spouse’s subsequent death, all remaining trust property will be subject to estate tax at the client’s tax rate, and not at the non-resident alien’s tax rate. In order for property that passes to a surviving spouse who is not a U.S. citizen at the date of the decedent’s death to qualify for the marital deduction, the regulations under § 20.2056A-1(a) require the use of a Qualified Domestic Trust (QDOT) that meets the requirements of IRC § 2056A and Regs. § 20.2056A-2 or alternatively, where assets pass to a trust that, although not meeting all of the requirements for a QDOT at the time of the decedent’s death, is timely reformed after the decedent’s death to meet the requirements of a QDOT.
Gift Splitting Considerations – Non-Citizen Spouse
The ability to gift-split by a husband and wife to third parties depends upon citizenship or residence of both spouses at the time of the gift where only citizens or transfer tax residents can gift split. The annual exclusion for the first $14,000 for 2013 gifts of present interests in property to each donee is available to every donor, whether or not the donee is a U.S. citizen or resident. The gift tax unified credit is unavailable to nonresident alien donors and thus they must begin paying gift tax to the extent their gifts of U.S. situs property exceed the annual exclusion amount.
Loans to Non-Citizen Spouses
A loan by a U.S. citizen or resident to a non-citizen spouse may result in a U.S. gift tax liability to the U.S. spouse. Moreover, if the loan bears interest, the interest is taxable income to the U.S. citizen or resident spouse for U.S. income tax purposes. If the loan is deemed to be made at below-market rates of interest the resident spouse is treated as making a gift to the non-citizen spouse in the amount of the foregone interest in addition to the additional interest being subject to income tax
Estate and Gift Tax Unified Credit Limitation of Nonresident Aliens:
Nonresident alien estates are entitled to a unified credit equal to the amount of tax due on a $60,000 estate. No gift tax unified credit is available to nonresident aliens.
Limitation on Expenses, Debts, Taxes and Losses of a Non-resident Alien:
A nonresident alien’s estate is generally entitled to the same types of deductions as those available to U.S. citizens and tax residents. However, there are some differences and limitations on the amounts deductible. Funeral and administration expenses, debts, death taxes, and casualty and theft losses, whether or not attributable to the U.S. gross estate, are allocated on a pro rata basis in relation to the decedent’s worldwide estate. Only the portion allocated to the U.S. gross estate is deductible. This concept is best understood via an example: NRA, a nonresident alien, has a worldwide gross estate valued at $500,000. His U.S. gross estate is valued at $200,000 and thus 40% ($200,000 ÷ $500,000) of NRA’s total expenses for debts, taxes and losses ect. are deductible, regardless of whether they are directly attributable to the administration of the U.S. gross estate, as long as there is full disclosure on the estate tax return. A prerequisite to claiming these allocable type deductions is that the worldwide gross estate must be disclosed on the U.S. estate return and the executor is required to provide evidence of the worldwide liabilities, claims and administrative expenses claimed. Additionally, the charitable deduction is only allowed if the worldwide estate is reported on the estate tax return. Consequently, these deductions occasionally go unclaimed because of the administrative burden or the concerns with confidentiality. A nonresident alien estate is generally entitled to an estate tax credit of only $13,000 which is in stark contrast to the $1,772,800 allowed to a citizen or estate tax resident for decedents dying in 2012 representing the estate tax due on an estate valued at $5,120,000. The $13,000 credit represents the estate tax due on an estate valued at $60,000 U.S.
Nonresident Alien Gift Tax Requirements and Limitations:
Nonresident aliens are subject to gift tax solely on gifts of real and tangible personal property with U.S. situs. U.S. gift tax is generally imposed upon the donor and not the donee. Thus the citizenship or residence of the donee is irrelevant in determining the imposition of U.S. gift tax. A nonresident alien therefore can generally make unlimited gifts to a U.S. person without incurring any liability for U.S. gift tax if the subject of the gift is property with a situs outside of the United States or is so deemed under U.S. gift tax law. Gifts of currency by a non-resident alien (even by check) with U.S. situs are arguably tangible personal property thus a non-resident alien is probably subject to gift tax for such gifts. This can be avoided by making cash gifts offshore but the U.S. recipient should be informed of all of the income tax and information reporting requirements involved with doing so. Attempts to make gifts of U.S. situs property by first converting the property to foreign situs should be avoided as they are susceptible to attack under the step transaction doctrine are thus are risky. If the gifted property is held to have been converted as part of a prearranged plan, the gift will still be treated as one of U.S. situs property. All of the treaties that deal with gift taxes, allow credits against the tax of each country for taxes imposed by the other. Any applicable foreign gift tax credits are not otherwise allowed against U.S. gift tax.
Non-resident Alien Estate Tax Return Filing Requirements:
A nonresident alien’s estate is required to file a U.S. estate tax return on Form 706NA if his or her U.S. situs assets exceed $60,000. A certified copy of the will is required to be attached that has been translated into English. In the event that no U.S. executor has been appointed any person in actual or constructive possession of any of the decedent’s property is required to file the return. Generally, all assets of the decedent’s estate which are situated in the United States are required to be disclosed on Schedule A to Form 706NA.
Income Tax Return Requirements of Estates and Trusts with Nonresident Alien Beneficiaries:
Estates and trusts are generally only obligated to file fiduciary income tax returns when their gross income exceeds $600. However, if the estate or trust has at least one nonresident alien beneficiary, a 1041 is required regardless of the amount of income.
Application of FIRPTA to Sales of U.S. Property by Non-Resident Aliens:
Unless an exception applies, upon the disposition of a United States real property interest by a nonresident alien, the transferee (buyer) must withhold 10% of the gross proceeds (note – not net profit) and remit them to the Internal Revenue Service and will incur personal liability if this requirement is not met.
Foreign Estate Tax Credit Available to U.S. Transfer Tax Residents:
U.S. transfer tax residents are allowed a foreign estate tax credit for foreign death taxes paid in connection with property situated in the taxing country that is also included in the U.S. gross estate thus subject to double taxation.
FOREIGN TRUST PLANNING AND COMPLIANCE
Foreign Trust Planning:
Unfortunately, foreign trusts have been historically appealing to many U.S. taxpayers who either mistakenly believe that the use of a foreign trust will help them avoid U.S. income or transfer taxes or have chosen to engage in fraudulent schemes involving foreign trusts for the same ends. Some overly aggressive taxpayers are only too willing to take erroneous or fraud inducing advice to this effect. Nevertheless, the ethical and enlightened international estate planner should be able to identify those planning scenarios where the use of a foreign trust is appropriate. One potentially appropriate use of a foreign trust is in the realm of asset protection where a client seeks to maximize protection from the claims of creditors thorough the use of an offshore trust. Other, legitimate uses of foreign trusts may also be found where the client resides outside the United States, has foreign based assets or has foreign resident family members. However keep in mind that the U.S. includes for estate and gift tax purposes worldwide assets so for U.S. individuals, a foreign trust is of limited use in the estate planning context to reduce estate taxes. Note: (Foreign counsel should always be utilized to form an offshore trust to avoid the unauthorized practice of law in a foreign jurisdiction) A potential malpractice trap related to offshore asset protection trust is where an estate planner fails to clearly inform a client instituting such a trust of the myriad of U.S. international income and estate tax regulations and onerous international information reporting obligations related to the often income producing assets relocated offshore. An overriding principle underlying the U.S. income and estate tax regulations and information reporting requirements is to assure that income derived by the assets of U.S. tax residents funded to a foreign trusts (or entity for that matter) do not become magically removed from the U.S. tax (income, estate or gift) base. In fact, many of the U.S. income and estate tax regulations are overtly written to discourage the movement of U.S. assets offshore through onerous and repetitive information reporting requirements and often times punitive and disadvantages income and estate tax regulations. For example, regulations that require gain recognition on the transfer of assets to a foreign trust under specific circumstances, foreign grantor trust rules, and regulations designed to prevent, recapture or penalize any real or merely perceived U.S. tax deferral exist. On the other hand, regulations exists to provide relief for income that is taxed twice, once by a foreign jurisdiction and once by the U.S., through the granting of a foreign tax credit to offset, reduce, or eliminate the impact of U.S. income tax on income that has also been subjected to foreign taxation. Where a trust is considered a U.S. resident for U.S. income tax purposes, the worldwide income of the trust is included in U.S. gross income of the trust. A foreign trust by contrast is taxed only on certain U.S. source income.
Regulations Drafted to Discourage Foreign Trust Formation and Funding:
Under IRC § 684 gain is generally required to be recognized on the transfer of appreciated property by a U.S. tax resident to a foreign trust or estate under the fiction that the property was sold at its fair market value. The largest exception to the gain recognition rules is where a U.S. person is deemed to be the owner the foreign trust under the grantor trust rules.
U.S. Income Taxation of Foreign Trusts:
Non-Grantor Foreign Trusts:
For U.S. tax purposes, a non-grantor foreign trust, defined as having solely foreign grantors and solely foreign beneficiaries, will be taxed under U.S. tax law similar to how a nonresident alien individual is taxed. Non-Grantor foreign trusts arise where ownership of the trust is not attributed to a U.S. tax resident. Like nonresident aliens, they are only taxed on certain specified types of U.S. source income. If the foreign trust has no U.S. effectively connected business income, the foreign trusts foreign source income is not subject to U.S. tax. However, a foreign trust with certain specified U.S. sources of income, including interest (other than exempted portfolio and bank interest), dividends, royalties, etc., will be subject to a withholding tax of 30% which is paid at source, unless a relevant treaty dictates a lower rate. Lastly, U.S. source capital gains are generally also not subjected to U.S. tax when earned by a non-grantor foreign trust unless the U.S. securities sold were issued by a U.S. real property holding company. A non-grantor foreign trust which is engaged in a U.S. trade or business within the taxable year, will have its effectively connected U.S. income subject to the same graduated rate structure as applied to domestic trusts. However, under Regs. § § 301.7701-2, -4, a trust engaged in U.S. business activities will be considered a partnership or corporation for U.S. tax purposes and taxed accordingly, unless the primary purpose of the trust is to protect and conserve the property for the trust’s beneficiaries without engaging in profit making activities.
U.S. Taxation of Grantor Trusts:
An irrevocable foreign trust created by a U,S. person will be subject to special “grantor trust” rules. A U.S. person who transfers property to a foreign trust with a U.S. beneficiary, will be considered the owner of that part of the trust which can be traced to the property transferred. This ownership attribution results in taxation of any income on that portion of the trust, and the tax treatment of this income is the same as under the domestic grantor trust rules that apply to individuals. The grantor trust rule will also apply where a nonresident alien individual becomes a U.S. resident within the five years prior to attaining U.S. resident status and where a domestic trust formed by a U.S. person later becomes a foreign trust during the trustor’s lifetime. Transfers of property by a U.S. person to a foreign trust occurring after death and property transferred is exchanged for fair market value will not be subjected to the grantor trust rules. The intended result of the grantor trust rules is to prevent a U.S. grantor from placing assets in a foreign trust with the intention of avoiding U.S. income tax if the beneficiary is a U.S. person. A U.S. grantor will be able to avoid the grantor trust rules if the beneficiaries are foreign persons, however if a foreign beneficiary becomes a U.S. resident within five years of a property transfer to the foreign trust, the grantor trust rule will be applicable.
BASIC U.S. INFORMATION REPORTING REQUIREMENTS
Currency Transaction Reporting by U.S. Residents Brining Money into the U.S. from Offshore:
A Currency Transaction Report filed on Form 4789 must be completed by any U.S. person who receives, transports, mails or ships currency or any other monetary instrument into or outside the United States in excess of $10,000. For purposes of Form 4789 A person includes individuals, corporations, partnerships, trusts, estates, stock companies, associations, syndicates, joint ventures or unincorporated associations. A monetary instrument includes currency, traveler’s checks and all negotiable instruments in bearer form. Form 4789 is due at the time of the transporting, mailing or shipping unless otherwise specified by Customs.
Notice by U.S. Persons of Large Gifts Received From Non-U.S. Persons:
U.S. tax residents are required to report annually to the Internal Revenue Service gifts from non-U.S. persons if the value of the aggregate foreign gifts received during any taxable year in excess of $100,000 from individuals and in excess of $14,723 for gifts from corporations or partnerships. Foreign assets and the reporting requirements associated with these assets can often create a trap for the less than vigilant estate planner. Inheriting assets which were held by foreign family members could result in a client’s unintended tax evasion or, in the worst case scenario, an accusation of intentional and knowing tax evasion. There are ways to avoid these possibilities, as well as a program which will be discussed later, which will allow you to give your client to
A. Filing considerations/prerequisites – preparing your client
The FBAR filing requirements, authorized under one of the original provisions of the Bank Secrecy Act, have been in place since 1972. In 2003, the IRS was delegated the authority to enforce FBAR requirements and penalties through the passing of the Patriot Act.
The FBAR form is used to report a financial interest in, or signature or other authority over, one or more financial accounts in foreign countries. No report is required if the aggregate value of the accounts does not exceed $10,000. The value of the account is based on the foreign currency exchange rate (normally on December 31st of a each year).
The FBAR is not filed with a taxpayer’s federal income tax return. The granting, by the IRS, of an extension to file federal income tax returns does not extend the due date for filing an FBAR. You may not request an extension for filing the FBAR. The FBAR is an annual report and must be received by the Department of the Treasury in Detroit, MI on or before June 30th of the year following the calendar year being reported. Beginning July 1, 2013, all FBAR forms must be electronically filed.
1. Who Must File
United States persons are required to file an FBAR if: 21
- The United States person had a financial interest in or signature authority over at least one financial account located outside of the United States; and
- The aggregate value of all foreign financial accounts exceeded $10,000 at any time during the calendar year to be reported.
United States person means:
United States citizens; United States residents; entities, including but not limited to, corporations, partnerships, or limited liability companies created or organized in the United States or under the laws of the United States; and trusts or estates formed under the laws of the United States.
2. What Types of Accounts Must Be Reported?
A person who holds a foreign financial account may have a reporting obligation even though the account produces no taxable income.
A financial account includes, but is not limited to: securities, brokerage, savings, demand, checking, deposit, time deposit, or other account maintained with a financial institution (or other person performing the services of a financial institution). A financial account also includes a commodity futures or options account, an insurance policy with a cash value (such as a whole life insurance policy), an annuity policy with a cash value, and shares in a mutual fund or similar pooled fund (i.e., a fund that is available to the general public with a regular net asset value determination and regular redemptions
A foreign financial account is a financial account located outside of the United States.
3. What is a Financial Interest
A United States person has a financial interest in a foreign financial account for which:
- The United States person is the owner of record or holder of legal title, regardless of whether the account is maintained for the benefit of the United States person or for the benefit of another person; or
- the owner of record or holder of legal title is one of the following:
- An agent, nominee, attorney, or a person acting in some other capacity on behalf of the United States person with respect to the account;
- A corporation in which the United States person owns directly or indirectly: (i) more than 50 percent of the total value of shares of stock or (ii) more than 50 percent of the voting power of all shares of stock;
- A partnership in which the United States person owns directly or indirectly: (i) an interest in more than 50 percent of the partnership’s profits (e.g., distributive share of partnership income taking into account any special allocation agreement) or (ii) an interest in more than 50 percent of the partnership capital;
- A trust of which the United States person: (i) is the trust grantor and (ii) has an ownership interest in the trust for United States federal tax purposes. See 26 U.S.C. sections 671-679 to determine if a grantor has an ownership interest in a trust;
- A trust in which the United States person has a greater than 50 percent present beneficial interest in the assets or income of the trust for the calendar year; or
- Any other entity in which the United States person owns directly or indirectly more than 50 percent of the voting power, total value of equity interest or assets, or interest in profits.
B. Penalties for Failure to File an FBAR:
Depending on a taxpayer’s particular facts and circumstances, the following penalties could apply:
- A penalty for failing to file the Form TD F 90-22.1 (Report of Foreign Bank and Financial Accounts, commonly known as an “FBAR”). 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 accounts exceeded $10,000 at any time during the year. 23 Generally, 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 account per violation. See 31 U.S.C. § 5321(a)(5). Nonwillful 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 I.R.C. §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 section 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.
- 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.
OTHER INFORMATION REPORTING REQUIREMENTS
Form 8865: Return of U.S. Persons With Respect to Certain Foreign Partnerships
Form 8865 must be filed with the income tax return of the U.S. person for the tax year in which the reportable event occurs. Except as otherwise stated in the Regulations, Form 8865 must be filed by any U.S. person who: 1. Acquires any interest in a foreign partnership. 2. Disposes of any portion of his interest in a foreign partnership. 3. Has an interest in a foreign partnership that changes substantially. A $10,000 penalty is imposed for each failure to furnish the required information within the time prescribed. If the information is not filed within 90 days after the IRS has mailed notice of the failure to the U.S. person, an additional $10,000 penalty (per foreign partnership) is charged for each 30-day period, or fraction thereof. The additional penalty is limited to a maximum of $50,000 for each failure.
Form 8858: Information Return of U.S. Persons with Respect to Foreign Disregarded Entities
Form 8858 is filed by U.S. persons that own 100% of a foreign disregarded entity (“FDE,”) either directly or constructively as a tax owner. An FDE is an entity that is not created or organized in the United States and that is disregarded as an entity separate from its owner for federal income tax purposes. The tax owner of an FDE is the person that is treated as owning the assets and liabilities of the FDE for federal income tax purposes. The following U.S. persons must file Form 8858:
- U.S. persons that are tax owners of FDEs at any time during the U.S. person’s taxable year or annual accounting period.
- U.S. persons that are required to file Form 5471 with respect to a controlled foreign corporation and the controlled foreign corporation is the owner of the FDE.
- U.S. persons that are required to file Form 8865 with respect to a controlled foreign partnership and the controlled foreign partnership is the owner of the FDE.
A $10,000 penalty is imposed for each annual accounting period of each CFC or CFP for failure to furnish the required information within the time prescribed. If the information is not filed within 90 days after the IRS has mailed a notice of the failure to the U.S. person, an additional $10,000 penalty (per CFC or CFP) is charged for each 30-day period, or fraction thereof, during which the failure continues after the 90-day period has expired. The additional penalty is limited to a maximum of $50,000 for each failure.
Form 926: Return by a U.S. Transferor of Property to a Foreign Corporation
Each U.S. person who transfers property to a foreign person in connection with certain exchanges or distributions must furnish to the IRS, at the time and in the manner prescribed by the Regulations, any information about the exchange or distribution that IRS requires.
Reporting is thus required if the U.S. person:
- Transfers property to a foreign corporation in a tax-free exchange.
- Distributes property in complete liquidation to a non-U.S. person.
- Transfers property or cash to a foreign corporation where immediately after the transfer the U.S. person holds directly, indirectly, or by attribution at least 10% (by total vote or total value) of the foreign corporation, or the amount of cash transferred by the U.S. person or any related person to the foreign corporation during the 12-month period ending on the date of the transfer exceeds $100,000.
Taxpayers are subject to a penalty for failing to file equal to 10% of the fair market value of the property at the time of the exchange or transfer. The penalty will not apply if the failure to file is due to reasonable cause and not willful neglect. In addition, the penalty is limited to $100,000 unless the failure to comply was due to intentional disregard.
Form 3520: Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts
U.S. persons are required to file Form 3520 when:
- A U.S. person creates a foreign trust.
- Upon the death of a U.S. person when the decedent was treated as the owner of any portion of a foreign trust under the grantor trust rules, or any portion of a foreign trust was included in the decedent’s gross estate.
- Certain transfers of money or property (directly or indirectly) to a foreign trust by a U.S. person (whether or not another person is treated as owning a portion of the trust under the grantor trust rules), including a transfer due to death. Transfers to foreign trusts are reportable if the transfer is gratuitous, i.e., any transfer other than a transfer for fair market value (FMV) (including certain trust obligations), or a corporate or partnership distribution. A gratuitous transfer also includes any direct or indirect transfer that is structured with a principal purpose of avoiding the I.R.C. § 679 rules for foreign trusts with U.S. beneficiaries or the I.R.C. § 6048 foreign trust information reporting rules.
Generally, the penalty for failure to file is equal to the greater of $10,000 or 35% of the gross value of any property transferred to a foreign trust, or 5% of the gross value of the portion of the trust’s assets treated as owned by a U.S. person.
Form 3520A: Annual Information Return of Foreign Trust with U.S. Owner
A U.S. person who at any time during the tax year is treated as the owner of any portion of a foreign trust under the grantor trust rules, must submit information to the IRS with respect to the foreign trust and is responsible for ensuring that the trust files a return for the year. The annual information return must be made on Form 3520A. Form 3520A must be filed and the required statements furnished to the U.S. grantors and U.S. beneficiaries by the fifteenth day of the third month after the end of the trust’s tax year (or later, if pursuant to an extension of time to file).
If the foreign trust fails to file a timely Form 3520A, or does not furnish all of the information required by section 6048(b) the U.S. owner is subject to an initial penalty equal to the greater of $10,000 or 5% of the gross value of the portion of the trust’s assets treated as owned by the U.S. person at the close of that tax year.
2012 OFFSHORE VOLUNTARY DISCLOSURE INITIATIVE (“OVDI”)
A. Reasons for Participating in the OVDI Program
There are several very good reasons to consider making a 2012 offshore voluntary disclosure regarding your foreign accounts:
- The IRS is actively investigating foreign banks that are suspected of promoting income tax evasion by U.S. citizens via promising not to report the existence of a foreign account or the income that is generated by, or run through the account, to the U.S. Government to induce deposits being made to the foreign bank. This is the complained of behavior that led to the UBS investigation and lawsuit. A tremendous amount of leads were generated by all of the proceeding voluntary disclosures surrounding foreign accounts for the 2008 and 2011 versions of the program.
- Recently enacted legislation called FACTA will basically coerce all foreign banks starting in 2014 into reporting the existence of U.S. account holders or be faced with receiving only 70% of the funds transferred to them by U.S. banks from U.S. residents rather than the full 100%. The difference will be back up withholding of 30% for not offering transparency to the U.S. Government. Moreover, the United Kingdom has finalized a FATCA pact, pending approval by parliament while France, Germany, Italy, Spain, Switzerland and Japan have pending agreements and the Treasury is negotiating with at least 40 other countries for FATCA agreements.
- Taxpayers who do not submit a voluntary disclosure run the risk of detection by the IRS and the imposition of substantial penalties (delineated below), including the fraud penalty and foreign information return penalties, and an increased risk of criminal prosecution. The application of a specific penalty depends on the particular facts and circumstances. Applicable penalties could include, but are not limited to:
- A fraud penalty equal to 75% of the underpayment due to fraud.
- A penalty for fraudulent failure to file a return of up to 75% of the amount of tax required to be shown on a return.
- A penalty for failing to file the FBAR form, Form TD F 90-22.1.
- A penalty for failing to file information returns for foreign trusts and for receipt of certain foreign gifts as required by IRC §§ 6048 and 6039F.
- A penalty for failing to file Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations under IRC §§ 6035, 6038 and 6046.
- 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, as required by IRC §§ 6038A and 6038C.
- A penalty for failing to file Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation as required by IRC § 6038B.
- Failure to file, failure to pay and accuracy related penalties could also be assessed against a taxpayer who does not participate in the initiative.
The biggest hammer that the IRS can hold over the head of taxpayers who do not participate in the 2012 OVDI is the prospect of criminal prosecution if the IRS learns that a taxpayer had unreported offshore income. To wield this hammer effectively the IRS remains actively engaged in ferreting out the identities of those with undisclosed foreign accounts. Moreover, this information is being made increasingly available to the IRS under tax treaties, through submissions by whistleblowers, and will become more available as the Foreign Account Tax Compliance Act (FATCA) and Foreign Financial Asset Reporting (new IRC § 6038D) take effect. Congress has also armed the IRS with the a penalty regime that could easily result in a multiple of the value of any offshore account and offshore assets being assessed, in addition to the potential of doing 5 years in federal prison per count (up to five counts possible for a total of 25 years in jail), as well as having to pay for the cost of prosecution. Generally, there is no de minimis unreported income exception to the offshore penalty. If an account generated even minimal unreported offshore income during the disclosure period, it is subject to the offshore penalty. However, an apparent exception to this rule is noted where the IRS recently announced that non-resident U.S. Taxpayers with less than $1,500 of unreported income will be given an alternate program to enter that offers less harsh terms than those included within the 2012 OVDI.
B. Prerequisites to Participating in the OVDI Program
If you still have not made a voluntary disclosure concerning your foreign account or income generating assets or entities, it is still possible to come forward and report them under the OVDI program so long as the following is true:
- All income is from legal sources. Illegal source income may come from extortion, prostitution, and drug sales. Income tax evasion is legal source income for this purpose.
- The government has not already received your name from a whistleblower or from its own sources. If you believe they might already have your name you still might be able to avoid criminal prosecution by coming forward before they act on the information they already have. A pre-check on your ability to enter the program will quickly allay any fear you may have, and qualifies as your entry date into the program before any disclosures are made other than you may have a generalized foreign or domestic reporting problem.
- The IRS has not already opened up an audit against you.
C. Amnesty Under the 2012 OVDI Program
Taxpayers who are accepted into the 2012 OVDI program will be subject to a 20% accuracy related penalty, failure to file and pay penalties (where applicable), and a reduced “offshore” penalty in lieu of the penalties for failing to file FBARs. Further, the offshore penalty under the 2012 OVDI program is 27.5% of the highest aggregate value in the offshore accounts (which may in certain circumstances also include foreign assets) during the covered period, as compared to a 25% penalty under the 2011 OVDI and 20% under the 2009 OVDP. The offshore penalty may be either 5% or 12.5% in limited circumstances.
Tax evasion, the most well known of crimes under the Internal Revenue Code, is a felony defined in §7201 as the willful attempt to evade or defeat any previous tax imposed by Title 26. The basic elements of a prima facie case are: (1) the existence of a previous tax deficiency, (2) an affirmative act constituting an evasion or attempted evasion of the previous tax hit, and (3) willfulness. Even if fraudulent concealment is established, a defendant cannot be convicted of previous tax evasion unless an additional previous tax actually is due. Moreover, absent other evidence of intent, failure to file return by itself does not constitute affirmative act. U.S. v. Litwok, 678 F.3d. 2012 (2d Cir. 4/30/12) (citing U.S. v. Romano, 938 F.2d 1569, 1573 (2d Cir. 1991).
Introduction to Treasury Enforcement Communications System (TECS)
A. Overview of TECS
The Treasury Enforcement Communications System (TECS) is a database maintained by Department of Homeland Security’s (“DHS”) component, US Customs and Border Protection, to share information that include temporary and permanent enforcement, inspection, and operational records relevant to the antiterrorism and law enforcement mission of CBP and numerous other federal agencies. The Internal Revenue Service (the “Service”) shares information with DHS. If a taxpayer has an unpaid tax liability and is subject to a resulting Notice of Federal Tax Lien, the IRS may submit identifying taxpayer information to TECS. The database allows the DHS to identify taxpayers with unpaid tax assessments who are traveling to the United States for business, employment, or personal reasons (Internal Revenue Manual (IRM) § 126.96.36.199). Taxpayers traveling to the United States with unpaid U.S. tax assessments can be detained at the border, questioned, and flagged for follow-up enforcement. The IRS has established procedures to facilitate tax collection from taxpayers who live outside the United States. Taxpayers traveling to the United States with unpaid tax assessments increasingly are being detained at the border. TECS allows DHS to identify taxpayers with unpaid tax assessments who are traveling to the United States for business, employment, or personal reasons.
1. Which “Status” of individuals are covered by TECS?
a. TECS typically applies to non-US Citizens and US citizens living abroad who have an unpaid tax liability. However, US citizens and residents5 may also be added to TECS if the IRS has been unable to contact the taxpayer and they are believed to be travelling outside the US. A U.S. or non-U.S. person whom the IRS has been unable to contact may be unaware of an assessed but unpaid federal tax liability until the person goes through U.S. Customs and is detained by Immigration and Customs Enforcement (“ICE”). Under these rules, even an undocumented (illegal) alien under the immigration laws who satisfy the “Substantial Presence Test” will be treated for tax purposes as a resident alien.
2. Requirements to be entered into TECS (i.e. individuals with a federal tax lien/liability).
a. There are two requirements for taxpayer information to be included in TECS:
(1) The individual taxpayer must live outside the United States7 ; and
(2) The individual taxpayer must have an existing filed federal tax lien (IRM § 188.8.131.52).
3. Consequences for individuals included in the TECS database.
a. Detained at border
b. Questioned at the border about:
(1) Taxpayer’s address while in the US
(2) Nature of the visit
(3) Transportation of any currency over $10,000
(4) Any other available travel or asset information:
(i) Vehicle registration information
(ii) Taxpayer’s employment relationships in the US
(iii) Personal services performed in the US
(iv) Assets held in the US
c. Flagged for follow up enforcement
To help alleviate the compliance problem of collecting delinquent taxes from taxpayers who, because they reside outside the jurisdiction of U.S. Courts, are not subject to ordinary administrative and judicial collection procedures, the Service has a contact program which involves entering the names of certain nonresident delinquent taxpayers in TECS. This assists the Service to contact nonresident delinquent taxpayers who routinely travel to the United States for business, employment, or personal reasons.
The objective of the contact program is to improve tax administration and compliance by:
- Collecting delinquent taxes.
- Securing delinquent returns.
- Identifying cases with criminal potential for referral to CI.
The success of the program depends on timely collection actions by the district offices.
d. Disclosure of an individual’s tax return information.
IRC Sec. 6103 does not specifically authorize the disclosure of return information that already is part of the public record. However, the U.S. Supreme Court ruled in a line of cases that there is no reasonable expectation of privacy for matters that are part of the public record. See Nixon v. Warner Communications, Inc., 435 U.S. 589 (1978); Cox Broadcasting Corp. v. Cohn, 420 U.S. 469 (1975); and Craig v. Harney, 331 U.S. 367 (1947). Consequently, the IRS takes the position that the disclosure of information taken from the public record is not an unauthorized disclosure under IRC §6103. Under this position, information reflected in a properly filed Notice of Federal Tax Lien is part of the public record and may be submitted to TECS without violating disclosure laws.
Taxpayers who reside outside the United States may not be aware of outstanding federal tax liabilities if the address on record for the taxpayer is outdated or otherwise incorrect. Consequently, tax advisers with clients who reside outside the United States should ensure that the correct address for the taxpayer is used on the client’s tax returns and, if the client no longer is required to file U.S. returns, that the IRS still is able to contact the taxpayer to discuss previously filed returns. Taxpayers should be advised that the failure to keep the IRS apprised of a change in mailing address may result in a surprise from DHS when the taxpayer seeks to enter the United States.
4. Removing a taxpayer’s records from TECS.
To remove a taxpayer from TECS, the following must occur:
1. Tax liability is satisfied;
2. Taxpayer enters into IRS approved payment arrangements to satisfy the tax liability, including installment agreement;
3. Taxpayer submits an Offer in Compromise, which has been accepted;
4. Taxpayer is deceased and death is verified
Cross Over’s Between the Tax and Immigration Practice Areas
Taxes and Passports
Generally a passport will not be denied solely where back taxes are owed. The exceptions are found under 22 CFR 51.70. A passport will be denied where:
- The IRS has started court or grand jury proceedings against you and you are subject to a subpoena;
- The IRS has filed criminal felony charges against you; you are out on bond or there is a warrant for your arrest; or if a subpoena was issued by the IRS for a federal civil prosecution.
Cash on Hand Confiscated at the Airport or Dock.
The public is allowed to legally carry or mail any amount of money that they want into or out of the United States, but if it is more than $10,000 at one time, it must first (at a minimum) be reported to U.S. Customs and Border Protection. If not U.S. Customs is likely to confiscate the cash and it is theoretically possible that it never be returned because the transportation of money is a violation of the Currency and Foreign Transaction Reporting Act.
The confiscations usually takes place when a traveler is questioned by a U.S. Customs officer upon arrival at the international airport or dock if he or she was carrying over $10,000 in cash. When the traveler answer “yes”, or the U.S. Customs officer finds that the passenger is lying about the amount of money on hand, the traveler and his or her luggage are searched. If over $10,000 U.S. in monetary instruments, including travelers checks and U.S. or foreign money, is discovered, and the required FINCEN Form 105 has not been previously filed and presented to the examining U.S. Customs officer, all of the money is likely to be seized on the spot!
The traveler is then forced to hire a customs attorney to pursue getting the money back. The administrative petition for this purpose requires proof of the legitimate source of the money and proof of the legitimate intended use of the money are required in the original From 105. Customs typically returns only 90% of the money.
It is important to note that there are no customs duties, taxes or other fees to be paid to U.S. Customs related to the international transportation of money but rather it is merely a reporting requirement to U.S. Customs.