Around 10 years ago, the US declared war on a select group of Americans – the nearly 8 million US persons (citizens and green card holders) living abroad.
The IRS quietly and stealthily conducted this war. Its campaign consisted of extortion and intimidation, in an effort to force expats to comply with their US tax obligations.
In my adopted country of Panama, IRS agents fanned out across the country, seeking out non-compliant US taxpayers. At least some of the agents carried firearms in open view. How would you feel if an SUV full of armed men pulled into your driveway and started walking toward your front door?
You may be scratching your head at this point and thinking, "You mean US persons who don't actually live in the US have to pay US taxes?"
Yes, that's right. The US is the only major country with this policy. And US persons living abroad also have the same reporting responsibilities as "homelanders." For instance, US persons – no matter where they live – who have signature or "other" authority over any non-US bank, securities, or "other" financial accounts must report them if their aggregate value exceeds $10,000.
The penalties for failing to file some of these forms far exceed those for merely failing to file a tax return. For instance, the civil penalty for "willfully" failing to file this "foreign bank accounts report" (FBAR) is the greater of $100,000 or 50% of the total balance of the foreign account. Criminal penalties may also apply for willful violations. Non-willful violations are subject to a $10,000 penalty per account per year.
That's just the beginning. US persons who create or fund a foreign trust or any foreign business entity, such as an offshore corporation, must make extensive disclosures. Once again, penalties for failing to do so are draconian.
Recently, I estimated that if the IRS were to impose the maximum civil penalty against US expats for failing to file just the FBAR, it could raise nearly $300 billion… nearly half of the estimated US budget deficit for 2014.
Millions of expats were caught in the crossfire – even those who thought they understood these rules. For instance, a US citizen who had lived in Canada for many years contacted me after receiving a bill from the IRS for $20,000. He thought he was 100% compliant with all US tax and reporting obligations. He'd even hired a big-name US accounting firm to prepare his tax returns each year, at a cost of more than $5,000 annually. He never owed any US tax, because taxes in Canada are higher than in the US, but he still got screwed.
A Canadian educational savings plan account he'd set up for his daughter was the problem. According to US tax rules, he must report the savings plan on the FBAR. Mercifully, the IRS didn't impose a penalty for "willful" FBAR violations. It merely fined him $10,000 for two years of negligently failing to include the savings plan on the reporting form.
Until June 18, there were only a couple of ways that you could avoid these penalties. If you had no underreported tax liabilities, you could file delinquent FBARs and other reporting forms with no penalty at all. And about a year ago, the IRS decided that non-resident taxpayers that it determined were a "low compliance risk" would also be eligible for more favorable treatment. To qualify for this status, you had to live outside the US and owe less than $1,500 per year in income tax. The IRS waived all reporting penalties, but you still had to pay all taxes and interest going back for three years.
Otherwise, the best you could hope for would be to come forward under the IRS's "Offshore Voluntary Disclosure Program" (OVDP). In exchange for signing up for this program, the IRS promised not to prosecute you for criminal tax evasion or to impose its most severe civil penalties. Instead, you had to pay 27.5% of the highest aggregate account values for eight years prior to the disclosure.
This calculation method significantly increased the severity of the penalty. For instance, thanks to the global economic downturn in 2008-2009, an unreported international account worth $1 million in 2007 might have been worth only $600,000 at the end of 2012. Yet the 27.5% penalty would be assessed against the entire $1 million for 2007, increasing the effective sanction to nearly 50% ($275,000 of $600,000). And this is in addition to the penalties for subsequent years.The Newest Offshore Voluntary Disclosure Program
Early last month, IRS commissioner John Koskinen made a speech in which he hinted that the IRS might "enhance" the OVDP. Koskinen told his audience that the IRS might have been too hard on non-resident US persons. He distinguished these citizens – many of whom have lived abroad for decades – from US-resident taxpayers who willfully hide their international investments overseas from IRS scrutiny. In other words, the IRS finally recognized that not every expat with an unreported foreign account is a criminal.
On June 18, the IRS followed through on Koskinen's promise. Effective immediately, expats who agree to disclose their foreign accounts and pay US taxes for the previous three years won't need to pay any penalties. They'll owe just back taxes and interest (if any). The IRS even extended an olive branch to resident Americans. They'll be able to come forward and disclose their offshore accounts for the previous three years and pay only a 5% penalty, not 27.5%.
To take advantage of the "kinder and gentler" IRS approach to international compliance, you'll need to certify that the "the failure to file tax returns, report all income, pay all tax, and submit all required information returns, including FBARs, resulted from non-willful conduct. " The certification forms for US residents and non-residents, respectively, are here and here.
If the IRS decides your failure to comply with these obligations was willful, you could be socked with a 50% penalty, calculated in the same way as the 27.5% penalty under the earlier OVDP. In addition, a recent US court decision made it clear that the 50% penalty could be imposed for each year you had an undisclosed international account. In other words, you could be liable for a penalty far exceeding the amount of money you ever had in the account. As the IRS makes clear in its FAQs for the revised program, that's just the tip of the iceberg in terms of possible penalties you could face. (See FAQs 5 and 6.) And while it's far from clear, the act of making a false certification could itself be considered a crime.
Proving "willfulness," incidentally, is much easier for the IRS than you might think, as I described in this essay.
In addition, there's an important – and not well-understood – "stinger" in these rules. US persons who held accounts at a number of Swiss banks and other companies already under investigation by the IRS aren't eligible. They'll also be socked with a 50% penalty.Don't Forget FATCA!
Today – July 1, 2014 – key information disclosure provisions of the Foreign Account Tax Compliance Act (FATCA) come into effect. "Foreign financial institutions" (FFIs) – i.e., foreign banks and other financial institutions – must be either FATCA compliant or in the process of becoming FATCA compliant. If they're not, interest, dividends, rents, and similar payments leaving the US directed to those institutions will be subject to a 30% withholding tax.
Part of FATCA compliance requires banks to make the IRS aware of any accounts that are owned directly or indirectly by US taxpayers. The IRS has been asking many banks to review their accounts retroactively for at least one year – sometimes longer – to identify US persons who closed accounts during that time. If the IRS thinks you closed your account to avoid FATCA, the possibility of a "willful" violation increases substantially.
And one requirement to enroll in the OVDP is that the IRS doesn't already know about the unreported offshore accounts or income you wish to disclose. Yet once FFIs begin automatically turning over the account details of their US clients to the IRS, it will have all the information it needs to enforce the draconian penalties Congress has imposed for offshore non-compliance.
Do you have unreported offshore income or accounts? If you do and would like to take advantage of the OVDP, consult with a qualified attorney (not an accountant). This arrangement provides attorney-client privilege to keep your discussions private. The attorney can then retain an accountant to prepare the necessary returns and decide whether you should participate in the program.