In recent years, ownership of foreign investments and financial accounts has become of increasing concern to U.S. taxpayers. For a long time, bank secrecy laws in certain countries turned “offshore” financial institutions into tax havens, enabling U.S. taxpayers to avoid reporting foreign-based income or paying tax on that income. As the result of far-reaching investigations and prosecutions (with the assistance of a whistleblower connected to UBS, a major Swiss bank), the IRS has begun to secure disclosure of formerly secret bank accounts, which enable them to uncover an untapped source of billions of dollars of previously unreported tax, plus interest and penalties.
One weapon that has been available to IRS for some years is the Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (the “FBAR”). A U.S. taxpayer who owns or has “signature authority” over one or more foreign-based bank or investment accounts, with an aggregate value of more than $10,000 at any time during a year, must file a FBAR for that year, identifying all such foreign accounts and the maximum value during the year. This, in turn, can be used by IRS to determine if income from the foreign account was reported on the taxpayer’s income tax return. The penalties for failure to file the FBAR can be extreme, beginning at $10,000 per year and reaching the greater of $100,000 or 50% of the value of those foreign accounts, per year, if the failure to file was “willful,” as well as possible criminal penalties.
Now, Congress has enacted the Foreign Account Tax Compliance Act (FACTA), effective with the 2011 income tax returns. Under FACTA, those taxpayers and foreign assets meeting the law’s criteria must file a new Form 8938, together with their tax return, that identifies those foreign assets, including the applicable value. These rules apply to U.S. citizens, resident aliens, and certain nonresident aliens (such as bona fide residents of U.S. Possessions or those electing to be treated as resident aliens in order to file a joint return). The law also requires certain U.S.-based entities (such as closely-held corporations or partnerships) holding foreign assets to file the form 8938. However, the IRS has not yet formulated regulations to cover this, so, for 2011, only individuals have to file this disclosure form. However, if the foreign financial asset is owned by a disregarded entity, such as a single-member limited liability company, then that asset is deemed to be owned directly by the member and that asset must be reported on the 8938.
The types of “specified foreign financial assets” required to be reported on Form 8938 overlap those covered by the FBAR (basically, foreign bank and investment accounts), but also include many more, such as:
- stock issued by a foreign corporation (and not held through a brokerage account)
- interests in a foreign entity (partnership, limited liability company, trust, estate)
- bonds or promissory notes issued by a foreign person or entity
- interests in foreign pension or deferred compensation plans
- interests in foreign assets held by a child and generating unearned income subject to the “kiddie tax”
The applicable financial assets must be reported even if they do not generate any income, gains, or deductions to be reflected on the income tax return.
The threshold value of assets that triggers the requirement to file the Form 8938 depends on the circumstances. For a single taxpayer, the threshold is total value of $50,000 as of the last day of the tax year or $75,000 at any time during the year; for married taxpayers filing joint returns, the total value is $100,000 as of the end of the year or $150,000 during the year; and there are different thresholds for married taxpayers filing separate returns and for taxpayers living abroad.
The minimum penalty for failure to file the 8938 is $10,000, but that penalty can be increased by $10,000 per month (up to a maximum of $50,000) for continued failure to file after IRS gives notice that the 8938 was not filed (presumably, prompted by following up and matching against income disclosed by the foreign financial institutions). There also is a new 40% penalty for underpaying tax on income (derived from the undisclosed foreign asset) that was not reported, as well as fraud and criminal penalties.
It should be noted that the disclosure through filing the Form 8938 is separate from the FBAR reporting requirements, so a taxpayer still will have to file a FBAR, and be subject to FBAR penalties, in addition to the 8938 requirements.
The impact of FACTA on the taxpayer is increased by a second aspect of the law. Beginning in 2013, all foreign financial institutions well be required to report the accounts and items of income attributed to U.S. owners, regardless of bank secrecy laws. Failure to comply could result in penalties and, in effect, denial of access to U.S. capital. This is likely to be a sufficient deterrent to financial institutions, ensuring that tax havens are a thing of the past and forcing all taxpayers to report and pay taxes on all foreign income.
All of this will impose an additional burden on the taxpayer, and additional cost of tax return preparation, because of the additional information that will have to be assembled, prepared, and reported. Now, the taxpayer will have to be doubly aware of disclosure obligations relating to foreign assets, or face a greater certainty of stiff penalties.