Foreign Income & Taxpayers
The IRS has taken aggressive steps to monitor taxpayers’ foreign financial assets as a way to increase compliance. For tax years beginning after March 18, 2010, many taxpayers are required to file new Form 8938, Statement of Specified Foreign Financial Assets. Form 8938, which must be filed in addition to Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (FBAR), as part of the annual tax return for individuals. Form 8938 and its requirements have created controversy since their inception and have caused confusion and difficulties for both taxpayers and their advisers.
Section 511 of the Hiring Incentives to Restore Employment (HIRE) Act, P.L. 111-147, added new Sec. 6038D, which states that a specified person who holds an interest in specified foreign financial assets should attach Form 8938 to that person’s income tax return, provided the aggregate value of the person’s foreign financial assets exceeds $50,000. Notice 2011-55 suspended the requirement to file Form 8938 until the final form and instructions were released. However, just when taxpayers felt comfortable that the form would not be released in time for filing their 2011 returns, Form 8938 and its instructions were released on Dec. 17, 2011. Two days later, temporary and proposed regulations were published under T.D. 9567. These regulations provide more specific guidance to individual taxpayers on how to report their interests in foreign financial assets on Form 8938.
Temp. Regs. Sec. 1.6038D-1T sets forth the scope of reporting. A “specified person” refers to a specified individual or a specified domestic entity. A specified individual is a U.S. citizen, a resident alien of the United States for any portion of the year, a nonresident alien who made a Sec. 6013(g) or (h) election, or a bona fide resident of Puerto Rico or another U.S. possession.
Temp. Regs. Sec. 1.6038D-1T does not define “specified domestic entity.” Prop. Regs. Sec. 1.6038D-6 defines “specified domestic entity” as “a domestic corporation, a domestic partnership or a trust … [that] is formed or availed of for purposes of holding, directly or indirectly, specified foreign financial assets.” Although the filing requirement for a specified individual was enacted for the 2011 tax year, the filing requirement for a specified domestic entity is not effective until additional regulations are released.
Specified Foreign Financial Assets
Temp. Regs. Sec. 1.6038D-3T provides a detailed explanation of the assets covered by Sec. 6038D, namely specified foreign financial assets, as well as the related information that must be disclosed. Specified foreign financial assets include both financial accounts maintained by foreign financial institutions and other foreign financial assets or instruments. They include stocks or securities issued by a non-U.S. person, any interest in a foreign entity, and any financial instrument or contract that has an issuer or counterparty that is not a U.S. person.
To the extent that these assets can be identified, Form 8938 will require disclosure of the name and address of the foreign financial institution, identification of the financial assets, and information regarding issuers and counterparties, if applicable. Additionally, the taxpayer is required to disclose the maximum value of each asset, as well as the currency and exchange rate that was used, if any. The amount of any income, gains, losses, deductions, or credits that derived from the assets reported should be listed, along with the corresponding schedule, form, or return where the amount was reported.
The IRS has granted some relief to specified individuals who hold certain types of assets. Under the regulations, there are exceptions to Form 8938 reporting for assets for which a specified person uses mark-to-market accounting under Sec. 475, financial accounts maintained by a foreign financial institution for which the specified person uses mark-to-market accounting under Sec. 475 for all the holdings in the account, and interests in a social security, social insurance, or other similar program of a foreign government. Furthermore, assets used in an ordinary trade or business are not required to be reported.
Valuing Specified Foreign Financial Assets
Generally, the maximum fair market value (FMV) of an asset during the year is what is to be taken into account when determining the total value of specified foreign financial assets in which a taxpayer has an interest. A third-party appraisal of assets is not necessary to estimate the FMV of the asset. Assets with an FMV less than zero should be assigned a value of zero; offsetting of assets is not permitted. Where the value of an asset is denominated in a foreign currency, the FMV should be determined in the foreign currency and then translated to U.S. dollars using the year-end rate published by Treasury’s Financial Management Service.
Assets held jointly by the taxpayer have special valuation rules. Spouses who file joint income tax returns need only report jointly held assets once on Form 8938. If spouses file separate income tax returns, each spouse must include the maximum value of the entire asset when calculating the total value of foreign financial assets. All other jointly held assets must be taken into account at their maximum value by each owner.
The maximum value of financial accounts can be determined by using the periodic statements of account, unless the taxpayer has reason to know that the statements do not provide a reasonable estimate of maximum value. Interests in foreign trusts are valued as being equal to the sum of the value of all of the cash and other property distributed during the tax year to the taxpayer who is a beneficiary and the value of the beneficiary’s right to receive mandatory distributions as of the last day of the tax year based on the valuation tables under Sec. 7520.
Foreign estates, pension plans, and deferred compensation plans are valued in the same manner. The maximum value is the FMV on the last day of the tax year. If the FMV is unknown or the taxpayer does not have reason to know the FMV, then the maximum value is the amount of any cash and property distributions made to the taxpayer during the year. If no distributions were made, then the asset should be valued at zero.
The threshold for filing Form 8938 was set at $50,000 in Sec. 6038D. However, Temp. Regs. Sec. 1.6038D-2T furnishes more specific guidelines on the filing thresholds for Form 8938, which are dependent upon the taxpayer’s filing status. Under Temp. Regs. Sec. 1.6038D-3T, a specified individual must file Form 8938 if the individual has an interest in one or more specified foreign financial assets and those assets have an aggregate FMV exceeding either $50,000 on the last day of the tax year or $75,000 at any time during the tax year. Similarly, the threshold for married specified individuals who file a joint return and live in the United States is $100,000 on the last day of the tax year, or $150,000 at any time during the tax year. For a specified individual who is a qualified individual residing overseas, the threshold for filing Form 8938 is increased to $200,000 on the last day of the tax year, or $300,000 at any time during the tax year. A qualified individual and his or her spouse living outside of the United States who file a joint return are not required to file Form 8938 unless the aggregate value reaches $400,000 on the last day of the tax year or $600,000 at any time during the tax year.
Sec. 911(d)(1) is applied to determine whether a taxpayer lives inside or outside the United States for the purpose of determining which threshold applies. A person lives outside the United States if he or she has a tax home in a foreign country and is either: (1) a U.S. citizen and bona fide resident of a foreign country for at least one year; or (2) a U.S. citizen or resident who is present in a foreign country for at least 330 full days during any period of 12 consecutive months.
The penalty for failure to file Form 8938 is $10,000. If a taxpayer does not file Form 8938 within 90 days of the IRS’s mailing a notice of failure to file the form, an additional penalty of $10,000 is imposed for each 30-day period or part of a 30-day period after the initial 90-day period the failure to file continues, up to a maximum amount of $50,000. In addition to a penalty for failing to file Form 8938, an accuracy-related penalty may be imposed. Taxpayers are subject to a penalty equal to 40% of the underpayment of tax if the underpayment results from a transaction that involved undisclosed specified foreign financial assets. Lastly, taxpayers must pay a penalty of 75% of the underpayment if the underpayment is due to fraud.
The penalties for failure to file Form 8938 are significant. However, Sec. 6038D(g) provides for a reasonable-cause exception. Where the failure to file Form 8938 is due to reasonable cause and not willful neglect, no penalty is imposed for failure to file. The taxpayer must affirmatively demonstrate that the failure was due to reasonable cause and not willful neglect. This claim must be supported by the facts. Unfortunately, reasonable cause is not fully defined, and no examples are given. The instructions to Form 8938 state that not reporting specified foreign financial assets in order to avoid criminal and civil penalties imposed by foreign countries for disclosing the information is not reasonable cause.
The IRS announced in January that it was starting a third Offshore Voluntary Disclosure Program (OVDP) to allow taxpayers with undisclosed foreign accounts to come forward, pay reduced penalties, and avoid criminal prosecution. At that time, it provided little guidance on the deadlines and rules under the program. In June, the IRS posted online questions and answers, listing the requirements for the program, which include providing complete and accurate amended federal income tax returns for all tax years covered by the voluntary disclosure, including, for years after 2010, Forms 8938.
Duplication of Existing Reporting
The primary critique of Form 8938 is that it is duplicative of the information required to be reported on the FBAR. American Citizens Abroad (ACA) stated in an April 4, 2012, comment letter to the IRS on the proposed Foreign Account Tax Compliance Act (FATCA) regulations that it is “incomprehensible . . . why two separate reports on foreign financial assets, both carrying heavy penalties for non-reporting, have to be filed with the Treasury Department.”
The U.S. Government Accountability Office (GAO) determined in a February 2012 study that there are duplicative foreign account reporting requirements and that requiring two separate forms “creates additional costs to the government to process the same or similar information twice and enforce reporting compliance with both requirements” (GAO, Reporting Foreign Accounts to IRS (GAO-12-403) (February 2012). However, the GAO acknowledged that the extent of these costs is not currently known. The IRS denies that there is any duplication. An attorney for the IRS stated during an AICPA webcast on March 20, 2012, that “[t]hey’re two totally distinct reporting regimes. They’re like two circles that touch each other, but they don’t overlap.”
The tension stems from the requirement of both forms that certain foreign bank accounts be listed, including the account numbers and account balances. As discussed earlier, the items required to be reported on Form 8938 go far beyond just foreign bank and financial accounts, which is the extent of reporting required on the FBAR. The forms are filed at different Treasury offices and at different times. The FBAR is a stand-alone form that is mailed in by itself, whereas Form 8938 must be attached to a tax return.
Different purposes are served by each form, and each was promulgated under a different law. The FBAR rules were developed by the Financial Crimes Enforcement Network (FinCEN) arm of Treasury under the Bank Secrecy Act, P.L. 91-508. The goal of the FBAR is to help identify financial crimes like money laundering and terrorist financing. This information is not shared with other departments within Treasury, such as the IRS. Form 8938 is a part of the HIRE Act and was codified in Sec. 6038D. The purpose of the form is to find foreign investments and the income they produce to ensure that the income is being properly taxed by the U.S. government.
A point to be wary of is the difference in preparer liability with regard to foreign assets going forward. Because Form 8938 is part of Form 1040, the preparer who signs the return is responsible for the foreign financial asset information reporting, and Circular 230 rules apply. Previously, the preparer only needed to inquire about foreign bank account information to be able to complete Schedule B and advise the client of the need to file an FBAR and the consequences of failing to file an FBAR. The FBAR is not attached to a return and does not need to be signed by a return preparer.
The IRS has provided additional easing of duplicative reporting with respect to assets that are already reported on other informational forms, specifically, Forms 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts; 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations; 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund; 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships; and 8891, U.S. Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans. For assets reported on one of these forms, the maximum value of the assets is still used to calculate the total foreign financial assets of the taxpayer. The informational form used to reflect the assets must be identified, along with the number of that type of form that has been filed, but the assets do not have to be separately listed.
Discrimination Against Expatriates?
The ACA noted in its April 4, 2012, comment letter to the IRS that U.S. citizens living outside the United States perceive FATCA as “discriminatory” and an “unjustified invasion of privacy.” The temporary and proposed regulations acknowledge that individuals residing outside the United States “can reasonably be expected to have a greater amount” of foreign assets and provide higher thresholds for reporting on Form 8938. This is not always helpful because non-U.S. residents may have to engage in the same amount of information gathering regardless of the increased threshold to verify that they are below the threshold.
The second prong of FATCA is causing even more frustration for expatriates. In addition to the new reporting requirement of Form 8938, the FATCA legislation requires foreign financial institutions (FFIs) to report to the IRS information about the financial accounts held by U.S. taxpayers and by foreign entities in which U.S. taxpayers have a substantial interest. The FFIs must take steps to identify the U.S. account holders and report those account holders annually to the IRS. FFIs that do not comply with the reporting requirements will be subject to withholding, and FFIs that do comply with the requirements will be required to withhold on payments to account holders and entities that do not supply the necessary information. The president of the Canadian Bankers Association has stated that, although the intention of the law makes sense, he protested it, stating that it effectively makes Canadian FFIs an enforcement arm of the IRS.
As noted by the ACA, there have been numerous reports of FFIs closing the investment and retail banking accounts of U.S. clients to avoid having to comply with FATCA. U.S. citizens working outside of the United States are purportedly losing foreign pension plans and life insurance. Expatriates are being disproportionately affected by these FFI reactions because they are the ones who need greater access to foreign financial products.
The new legislation surrounding foreign financial assets is complex and not completely clear. Despite the controversy, the temporary regulations will be around for the foreseeable future. To assist taxpayers and their advisers, the IRS posted a list of questions and answers on its website on Feb. 29, 2012, and again on June 7, 2012, which provide helpful guidance related to Form 8938. Practitioners need to be aware of these new requirements and confirm that clients are properly reporting their assets and income.
Frank J. O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, Ill.
For additional information about these items, contact Mr. O’Connell at 630-574-1619 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.