Requirements and Penalties for Foreign and U.S. Taxpayers
Cross-border business and investment activities give rise to a host of reporting and filing obligations under both the Internal Revenue Code (IRC) and various other statutes, such as the Bank Secrecy Act of 1970 (BSA). Once CPAs are aware of an individual's cross-border activities, they must ensure compliance with all reporting obligations. Failure to properly report such activities can result in draconian consequences, far more severe than the penalties that are ordinarily assessed for unfiled or late tax returns.
For example, the opportunity to make an IRC section 871(d) election-to treat real estate activities in the United States as effectively connected with a trade or business in the country and, therefore, taxable on a net rather than gross basis-is jeopardized if an accurate (IRC sections 874[a] and 882[c]) and timely (Treasury Regulations sections 1.874-1 [b][l] and 1.882-4[a][i]) return is not filed. (The Tax Court held that the timeliness requirement of the Treasury Regulations is invalid because it is inconsistent with the plain meaning of the statute, which requires only that the return be filed in the "manner" required by the statue; however, this decision was overturned on appeal [Swallows Holding Ltd. v. Comm'r, 515 F.3d 162 (3d Cir. 2008), rev'g 126 T.C. 96 (2006)]).
A willful failure to file a Foreign Bank Account Report (FBAR), required under the BSA, can result in penalties as high as 50% of the highest balance in the foreign account for each year (31 USC section 5321[a][C] and [D]). In addition, a willful failure to file can result in criminal prosecution for both taxpayer and advisor (31 USC section 5322[a]). Given the breadth and diversity possible in cross-border transactions, some might require the filing of forms not specifically discussed in this article. As such, this article provides guidance for the most critical forms that CPAs should be aware of in order to ensure compliance with the reporting requirements. It is also important to understand that any relevant, applicable treaty provisions between the United States and a foreign person's residence may supersede the default provisions of U.S. law related to reporting requirements.
Foreign Taxpayers' Filing Obligations
Foreign persons are subject to tax filing and payment responsibilities in the United States if they are engaged in a trade or business in the country (IRC section 871 [b]) or if they receive specific types of income from a U.S. source (IRC sections 871 [a] and 881 [a]). For example, the receipt of fixed, determinable, annual, or periodical (FDAP) income from a U.S. source by a foreign person subjects that individual to U.S. tax filing obligations.
Foreign persons must file a U.S. tax return on Form 1040NR, U.S. Nonresident Alien Income Tax Return, if they are-
* nonresident aliens who engaged in the conduct of a U.S. trade or business at any time during the taxable year, even if they had no U.S. source income and all income was exempt from tax;
* nonresident aliens who were not engaged in a U.S. trade or business during the year and had U.S. source income subject to tax, and not all of the tax owed was withheld from that income;
* the executors or personal representatives of a deceased nonresident alien who would have been required to file; or
* representing an estate or trust that is required to file Form 1040NR. (See the instructions for Form 1040NR, p. 3.)
Foreign persons who rely upon an income tax treaty to reduce or modify their U.S. tax obligations must file a separate treaty-based return position disclosure form for each position taken (IRC section 6114[a]); the disclosure is made on Form 8833, Treaty-Based Return Position Disclosure under Section 6114 or 7701(b). (For a discussion of when and how to file Form 8833, see the 1RS article, "Claiming Benefits," http://www.irs.gov/Individuals/ International-Taxpayers/Claiming-TaxTreaty-Benefits.)
U.S. Taxpayers' Filing Obligations
The following sections describe the filing obligations for U.S. taxpayers with foreign bank accounts, securities accounts, or other financial accounts or financial interests.
The BSA requires a U.S. person to file a Treasury Department Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts, if the individual has any financial interest in (31 CFR section 1010.350[e]) or signature or other authority over (31 CFR section 1010.350[f]) a bank account, securities account, or "other financial accounf ' in a foreign country, with an aggregate value of more than $10,000 at any time during the calendar year. It is important to note that the FBAR regulations under 31 CFR section 1010.350(b) mirror the definition of "U.S. person" found in IRC section 7701[a]. In addition, "bank account" refers to a savings deposit, demand deposit, checking, or any other account maintained with a person engaged in the business of banking (31 CFR section 1010.350[c][l]); "securities accounf' means an account with a person engaged in the business of buying, selling, holding, or trading stock or other securities (31 CFR section 1010.350[c]). A "foreign financial account" includes an insurance or annuity policy with a cash value, as well as an account with a mutual fund or similar pooled fund (31 CFR section 1010.350[c]).
U.S. persons can be required to produce foreign bank records under the BSA, even when the act of production is clearly incriminatory (In Re: Special February 2011-1 Grand Jury Subpoena Dated September 12,2011, no. 11-3799, CA7, Aug. 27, 2012, reversing an unreported DC 111. decision). Under these circumstances, the Fifth Amendment privilege against selfincrimination is trumped by the "required records" doctrine and offers no protection against the filing and recordkeeping requirement established by the BSA. In Shapiro v. U.S. (335 U.S. 1, 33 ; quoting Davis v. U.S., 328 U.S. 582, 589-90 ), the court stated:
[Under the required records doctrine] the privilege which exists as to private papers cannot be maintained in relation to records required by law to be kept in order that there may be suitable information of transactions which are the appropriate subjects of governmental regulation, and the enforcement of restrictions validly established.
Moreover, when "the requirements of the Required Records Doctrine are met, a witness cannot resist a subpoena by invoking the Fifth Amendment privilege against compelled, testimonial self-incrimination" (In Re: Special February 2011-1 Grand Jury Subpoena Dated September 12, 2011). The appeals court in In Re: Special February 2011-1 Grand Jury Subpoena Dated September 12,2011 referred to Marchetti and Grosso v. U.S. (390 U.S. 62 ), which interpreted the required records doctrine as having the following three requirements:
* The purposes of the government inquiry must be essentially regulatory.
* Information is to be obtained by requiring the preservation of records of a kind that the regulated party has not customarily kept.
* The records must have assumed public aspects that render them at least analogous to a public document.
In invoking the doctrine, the court emphasized the voluntary submission-in essence, a waiver of Fifth Amendment protection-by choosing to engage in a regulated activity. The court stated:
The voluntary choice to engage in an activity that imposes record-keeping requirements under a valid civil regulatory scheme carries consequences, perhaps the most significant of which, is the possibility that those records might have to be turned over upon demand, notwithstanding any Fifth Amendment privilege. That is true whether the privilege arises by virtue of the contents of the documents or by the act of producing them. (In Re: Special February 2011-1 Grand Jury Subpoena Dated September 12, 2011)
The FBAR must be received by the Department of the Treasury, not merely filed, on or before June 30 of the year following that in which the account holder meets the $10,000 threshold (31 CFR section 1010.306[c]), regardless of any extensions granted. U.S. persons who are required to file FBARs must also keep records available for inspection that relate to the foreign financial accounts that triggered such filing obligations for five years following the FBAR filing (31 CFR section 1010.420). For each foreign financial account, the filer must keep records showing the name in which the account was held, the type of account, the account number or designator, the name and address of the foreign bank or other persons with whom the account was maintained, and the maximum value of the account during the reporting period (31 CFR section 1010.420).
Financial interest For FBAR purposes, a financial interest is defined by ownership of record or legal title, regardless of whether the account in question is maintained for the benefit of others, even if they are non-U.S. persons (31 CFR section 1010.350[e][l]). The regulations apply a look-through analysis in order to determine whether a U.S. person has a financial interest in an account held in trust. Such a person is considered to have a financial interest in a trust account if it is treated as the individual's account under the IRC grantor trust rules (31 CFR section 1010.350[e][iii]). Furthermore, a U.S. person who has a "present beneficial interest" in more than 50% of the assets of a trust or receives more than 50% of a trust's current income is deemed to have a financial interest in the financial accounts of that trust (31 CFR section 1010.350[e][iv]); however, a present beneficial interest does not include a remainder interest or the interest of a beneficiary with purely discretionary benefits (Federal Register, vol. 76, no. 37,1, section 10324[e], Feb. 24,2011).
A U.S. person does not need to be the legal owner of record or the holder of legal title in order to have a financial interest in the account. Such a financial interest includes accounts owned by an agent, nominee, or an attorney. In addition, for FBAR purposes, ownership of more than a 50% interest in a corporation, partnership, or trust is treated as the equivalent of direct ownership of any accounts owned by the entities themselves (31 CFR section 1010.350[e]).
Signature or other authority. Mere signature or other authority over a foreign financial account-that is, the authority "to control the disposition of money, funds or other assets held in a financial account by direct communication (whether in writing or otherwise) to the person with whom the financial account is maintained" (31 CFR section 1010.350[f][l])-is sufficient to require filing of an FBAR (31 CFR section 1010.350[a]).
FBAR penalties. Failure to make a required FBAR disclosure can result in both civil and criminal penalties. Criminal penalties include fines and imprisonment, and they are subject to a five-year statute of limitations beginning on the due date of the FBAR (18 USC section 3282). Criminal liability requires proof that a taxpayer knew of the reporting requirement but did not file (U.S. v. $359,500 in U.S. Currency, 828 F.2d 930 [2d Cir. N.Y. 1987]).
The civil penalty for failing to file an FBAR is the greater of $100,000 or 50% of the balance in the account at the time of willful violation (31 USC section 5321 [a][C],[D]). A nonwillful failure to file subjects an individual to a civil penalty of up to $10,000 per failure, unless the failure is abated as a result of the reasonable cause exception (31 USC section 5321 [a]  [B] [ii] [I]-[II]); however, this requires that "the amount of the transaction or the balance in the account at the time of the transaction was properly reported" by the taxpayer (31 USC section 5321 [a][B][ii][D]).
The Foreign Account Tax Compliance Act (FATCA), under section 511 of the Hiring Incentives to Restore Employment (HIRE) Act of 2010, requires a U.S. person holding an interest in a specified foreign financial asset to attach Form 8938, Statement of Specified Foreign Assets, to each current income tax return for any year in which the aggregate value of all such specified foreign financial assets exceeds $50,000 (IRC section 6038[D][a]). Although the required information is similar to that disclosed in an FBAR, reporting under FATCA is a separate and distinct obligation; FBAR and FATCA reports must be filed when the statutory prerequisites are met. Form 8938 is filed with the applicable "annual return"-including Form 1040, U.S. Individual Income Tax Return; Form 1120, U.S. Corporation Income Tax Return; Form 1065, U.S. Return of Partnership Income; Form 1041, U.S. Income Tax Return for Estates and Trusts; Form 1120-S, U.S. Income Tax Return for an S Corporation; and Form 1040NR, U.S. Nonresident Alien Income Tax Return-by its due date.
Specified foreign financial assets. These are typically any depository or custodial accounts at a foreign financial institution (IRC section 6038D[b][l]). Specified foreign financial assets can also be stocks or securities issued by foreign persons, any other financial instrument or contract held for investment that is not issued by a U.S. person or has a counterparty that is not a U.S. person, and any interest in a foreign entity (IRC section 6038D[b][A]-[C]).
Filing Form 8938. In general, FATCA reporting is required only if the value of a U.S. person's specified foreign financial assets exceeds $50,000 at any point during the year (IRC section 6038D[a]). The assets are presumed to be worth more than $50,000 if 1) the 1RS determines that an individual has an interest in one or more specified foreign financial assets, and 2) the individual does not provide sufficient information to demonstrate the aggregate value of the assets (IRC section 6038D[e][l]-).
This reporting threshold varies, depending upon whether the individual lives in the United States or files a joint income tax return with a spouse. If the taxpayer is single or married filing separately and is not living abroad, the reporting threshold is satisfied only if the total value of the taxpayer's foreign financial assets is more than $50,000 on the last day of the tax year, or more than $75,000 at any time during the tax year. If the taxpayer is married filing jointly and not living abroad, the reporting threshold is satisfied if the total value of foreign financial assets is more than $100,000 on the last day of the tax year or more than $150,000 at any time during the tax year (Instructions to Form 8938).
If a U.S. citizen is a bona fide resident of a foreign country or countries for the entire tax year, or at least is present in a foreign country for 330 full days as of the last day of the tax year being reported, then the reporting threshold increases to more than $200,000 on the last day of the tax year, or more than $300,000 at any time during the tax year. If such a taxpayer is married filing jointly, the reporting threshold increases to $400,000 on the last day of the tax year and $600,000 at any time during the tax year (Instructions to Form 8938).
FATCA penalties. Failure to file Form 8938 subjects the holder of the foreign asset to a $10,000 civil penalty under IRC section 6038D(d)(l); this penalty increases by $10,000 for each 30-day period (or fraction thereof) during which the form remains unfiled after 90 days from the date that the 1RS mails a notice of the failure (IRC section 6038D[d]). A failure under IRC section 6038D might result in a separate underpayment penalty under IRC section 6662(b)(7) and (j); the maximum penalty for each taxable year is $50,000. Any underpayments of tax attributable to undisclosed foreign financial assets are subject to a substantial additional understatement penalty of 40% under IRC section 66620(3), unless the taxpayer can demonstrate reasonable cause for the failure (IRC section 6038D[g]). Taxpayers and their advisors should keep in mind that prohibitions against disclosure of the required information under foreign law cannot be relied upon to establish reasonable cause.
Additional foreign account filing requirements. Taxpayers with signature authority over a foreign financial account must report its existence on Schedule B, Part III of their federal income tax returns (Form 1040), regardless of the account's value. Taxpayers are required to report this information, regardless of whether an FBAR is filed; failure to report the existence of such accounts might keep the statute of limitations open as an incomplete return.
Information Returns for Foreign Business Entities
The following sections describe the information returns required for foreign business entities.
Interests in Foreign Corporations
Four categories of U.S. persons with specific interests in or connections to foreign corporations must file Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations. (Although five categories are referenced in the Instructions to Form 5471, the first category of filer is no longer required to file, following the repeal of IRC section 6035 in 2004.) Depending upon the specific filer and circumstances, the report may include the corporation's business structure, transactions, and undistributed earnings (IRC sections 603 8[a] and 6046A; Treasury Regulations section 1.6038-3 details the information reporting requirements).
For each foreign corporation, a filer must attach a separate Form 5471 to a timely filed income tax return (Treasury Regulations sections 1.603 8-2 [a]  and 1.6046-1 [e]; Instructions to Form 5471). If two or more individuals are required to furnish information with respect to the same foreign corporation for the same period, they can make one joint return instead of separate returns (IRC section 603 8 [d]; Treasury Regulations sections 1.60382[j][l] and 1.6046-1 [e][l]). There are significant penalties for failing to file Form 5471, depending upon the taxpayer's status, such as monetary penalties, extensions of the statute of limitations, and the loss of foreign tax credits (IRC section 6038).
The following U.S. persons with specific interests in or connections to foreign corporations are required to file Form 5471:
* A U.S. person who is an officer or director of a foreign corporation in which another U.S. person owns or acquires either 10% or more of the voting or value of the foreign corporation's stock (IRC section 6046[a][l][A]; Instructions to Form 5471, category 2 filer)
* A U.S. person who acquires or disposes of 10% or more of the voting or value of the foreign corporation's stock or becomes a U.S. person who owns 10% or more of the voting or value of the foreign corporation stock (IRC section 6046[a][l][B]; Instructions to Form 5471, categoiy 3 filer)
* A U.S. person who "controls" the foreign corporation for 30 or more continuous days during the foreign corporation's taxable year that ends with or within the U.S. person's tax year (IRC section 6038[a][l]-; Treasury Regulations section 1.6038-2[a]); for purposes of this filing requirement, a person controls a foreign corporation by owning stocks that provide more than 50% of the total combined voting power of all classes of stock entitled to vote or that provide more than 50% of the total value of shares of all classes of stock of the foreign corporation (IRC section 6038[e][l]). Constructive ownership of stock in the foreign entity is considered, with certain modifications, in determining whether the control requirement is satisfied (Treasury Regulations section 1.6038-2[c]; Instructions to Form 5471, category 4 filer)
* A U.S. person who is treated as a U.S. shareholder of a controlled foreign corporation under Subpart F (IRC section 6038[a]; Instructions to Form 5471, category 5 filer).
The transfer of tangible or intangible property to a foreign corporation, or the transfer of cash in excess of $100,000 by a 10% or greater stockholder, triggers an obligation to file Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation. The form is due with the income tax return for the year of the transfer.
Reporting ofpassive foreign investment company interest U.S. shareholders of a foreign corporation that is a passive foreign investment company (PFIC) must file Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund (IRC section 1298[Q). For reporting purposes, a PFIC is a foreign corporation that has at least 75% passive income, or in which at least 50% of its assets either actually produce or are held to produce passive income (IRC section 1297[a][ 1 ]-).
In general, a U.S. shareholder will pay additional tax and interest on a distribution or disposition with respect to PFIC stock (i.e., "interest charge regime"; IRC section 1291 [c]); however, a U.S. shareholder of a PFIC may elect to treat the corporation as a qualified electing fond (QEF) and, thus, avoid paying additional tax and interest on deferred PFIC income. The QEF election allows U.S. shareholders to include their pro rata shares of the PFIC's earnings and profits as ordinary income and classify the PFIC's net capital gain as long-term capital gain, for each year the PFIC stock is held (IRC section 1293[a][l][A]-|B]). This election is valid only if the PFIC complies with the 1RS information disclosure requirements that enable the 1RS to determine the PFIC's ordinary earnings and capital gains. The U.S. shareholder must timely file Form 8621 by the due date (including extensions) of the federal return for the first year to which the election will be applied (IRC sections 1295[a] and 1295[b] ). Once made, the QEF election is effective for the current tax year and all subsequent tax years; it is revocable only with 1RS consent (IRC section 1295[b][l]).
As an alternative to the QEF election, if PFIC stock is marketable-that is, if it is regularly traded (i.e., other than in de minimis quantities, on at least 15 days of the calendar quarter) on a national securities exchange that is registered with the SEC, the Nasdaq, or any exchange designated to have rules adequate to carry out the PFIC provisions-U.S. persons owning the PFIC stock can instead make a mark-to-market election under IRC section 1296 in order to avoid the interest charge regime (IRC section 1291; Treasury Regulations section 1.1291-l[c]).
Under the mark-to-market election, the shareholder annually includes in income an amount equal to the excess, if any, of the fair market value of the PFIC stock as of the close of the tax year over the shareholder's adjusted basis in the stock (mark-to-market gain; IRC section 1296[a][l]; Treasury Regulations section 1.129-1 [c][l]). When stock in a PFIC that has made a mark-to-market election is sold, any gain is treated as ordinary income (IRC section 1296[c][l][A]; Treasury Regulations sections 1.1296-1 [c] and [c], Ex. 2). If the foreign corporation is not a PFIC at the time of the sale, the gain can be long-term capital.
The mark-to-market election is made on Form 8621, which should be attached to the shareholder's U.S. income tax return on or before the due date (including extensions) of the year for which the election is to be effective (Treasury Regulations section 1.1296-1 [h][l][i]). The election continues to be in effect unless the foreign corporation ceases to be a PFIC or the 1RS consents to a revocation. An election or obligation to mark-to-market the stock under another 1RS provision also terminates the PFIC mark-to-market election (IRC section 1296[k]; Treasury Regulations section 1.1296-1 [h] ).
Prior to the passage of the HIRE Act, oily taxpayers who directly or indirectly owned PFIC stock were required to file Form 8621 upon a disposition of PFIC stock or with respect to a QEF (1RS Notice 2010-34, Internal Revenue Bulletin (IRB) 2010-17; 1RS Notice 2011-55, IRB 201129). The HIRE Act, however, added IRC section 1298(f), which now requires all U.S. shareholders to file Form 8621 if they owned PFIC stock throughout the year (see 1RS Notices 2010-34 and 2011-55). The HIRE Act also extended the statute of limitations on assessment to six years if a taxpayer omitted reporting gross income in excess of $5,000 attributable to a foreign financial asset, including PFIC stock. In addition, the statute of limitations period for assessment is suspended if the taxpayer fails to timely file Form 8621.
On June 21, 2011, the 1RS issued Notice 2011-55, which limited the application of the new filing rules until a new Form 8621 is released. PFIC shareholders who would have been required to file Form 8621 before March 18, 2010, must still file Form 8621 upon a disposition of stock of a PFIC or with respect to a QEF (see IRC section 1298[f]; 1RS Notice 2010-34 and Notice 2011-55); however, other PFIC shareholders are not required to file prior to the release of a new Form 8621. Subsequent to the release of the revised form, PFIC shareholders will be required to attach Form 8621 to the return for each year during which the requirement was suspended (see IRC section 1298[f]; 1RS Notice 2010-34 and Notice 2011-55). In essence, the standards of the prior law remain in effect until the new form is issued.
The 1RS recently released a draft version of Form 8621; thus, it is likely that a final version will be released in the near future, which will trigger the new filing requirements.
Penalties. Failure to make a timely filing of the required foreign corporation or PFIC information returns can result in penalties and a reduced foreign tax credit (IRC section 6038[b]-[c]). A penalty of $10,000 applies to any person who does not timely file a foreign corporation or PFIC information return (IRC sections 6038[b][l] and 6679, which imposes the penalty for failing to file under IRC section 6046 or 6046[A]). The penalty increases by $10,000 for each 30-day period (or fraction thereof), up to a maximum $50,000 for each taxable period during which the return remains unfiled past 90 days after the 1RS mails a notice of the failure to file (IRC sections 6038[b]  and 6679[a]); however, if the failure is due to reasonable cause, the penalty will be waived (IRC section 6038[c]).
In addition to the above penalties, the taxpayer's foreign tax credit may be reduced by 10%; an additional 5% reduction is made, starting 90 days or more after notification of the failure to file by the 1RS, for each three-month nonfiling period (IRC section 603 8 [c]). The maximum reduction is the greater of $10,000 or the income of the foreign corporation during the annual accounting period in which the failure occurred (IRC section 6038[c]).
Interests in Foreign Partnerships
Any U.S. persons who 1) acquire an interest in a foreign partnership, 2) dispose of an interest in a foreign partnership, or 3) have an interest in a foreign partnership that changes substantially may be required to file Form 8865, Return of U.S. Persons with Respect to Certain Foreign Partnerships, with their timely filed (including extensions) income tax return for the year in which the reportable event occurred (IRC section 6046[a][l]-; Treasury Regulations section 1.6046A1[A]). The filing requirements will apply only to an acquisition or disposition of a foreign partnership interest if a U.S. person directly or indirectly holds at least a 10% interest in the partnership either before or after such acquisition or disposition (IRC section 6046A[a]). Such individuals will also be required to file Form 8865 if their direct proportional interest in a foreign partnership has increased or decreased by the equivalent of a 10% interest (IRC section 6046A[a], [d]). The instructions to Form 8865 refer to the following four distinct categories of U.S. persons who are required to complete Form 8865:
* A category 1 filer is defined as a U.S. person who owns more than a 50% interest in a foreign partnership under Treasury Regulations 1.6038-3(a) at any time during the taxable year.
* A category 2 filer is considered any U.S. person who was a "controlling 10% partner" in a foreign partnership during the taxable year (Treasury Regulations section 1.6038-3[b]). A person is a controlling 10% partner if, at any point during a foreign partnership's tax year, the individual owned a 10% or greater interest in the partnership while the partnership was controlled by U.S. persons owning 10% or greater interests (Treasury Regulations section 1.60383[a]). The individual is not a controlling 10% partner for the tax year if, at any point during that year, the partnership had a controlling 50% partner (Treasury Regulations section 1.6038[a]).
* A category 3 filer is any U.S. person who contributes property to a foreign partnership in IRC section 721 transactions if the total value of the property contributed for the year exceeds $100,000 or if the U.S. person directly or constructively owns 10% of the foreign partnership after the contribution (IRC section 6038B[a][l][B]; Treasury Regulations section 1.6038B-2 [a] [ 1 ] [i]-[ii] ; see also instructions to Form 8865). This includes indirect contributions by a U.S. person through a domestic partnership (Treasury Regulations section 1.6038B-2[a]); the regulations do not require reporting of indirect contributions through a trust.
* If U.S. persons experience an IRC section 6046A reportable event during the tax year, they are considered category 4 filers; such reportable events under IRC section 6046A are acquisitions, dispositions, or changes in proportional interests, discussed in the sections below.
Acquisitions. A U.S. person who acquires a foreign partnership interest has a reportable event if his interest in the partnership was less than 10% prior to an acquisition and 10% or more thereafter. Similarly, if a U.S. person who had a reportable event acquires an additional interest in a subsequent tax year that increases his existing interest by at least another 10%, he must file once again.
Dispositions. A U.S. person who disposes of a foreign partnership interest has a reportable event if she had a 10% or greater interest prior to a disposition and less than 10% thereafter. Similarly, if a U.S. person who had a prior reportable event makes a disposition in a subsequent tax year, which decreases her existing interest by at least 10%, she must file once again.
Changes in proportional interests. A reportable event also occurs if a U.S. person's direct proportional interest has increased or decreased by at least the equivalent of a 10% interest in the partnership from the time of the last reportable event.
Foreign Disregarded Entities
A foreign disregarded entity (FDE) is an entity that is created or organized in a foreign jurisdiction and is disregarded as separate from its owner for U.S. income tax purposes (Treasury Regulations section 301.7701-3). All U.S. persons with direct ownership in an FDE must file an information return on Form 8858, Information Return of U.S. Person with Respect to Foreign Disregarded Entities. In addition, certain U.S. persons who indirectly own at least 10% of an FDE through a controlled foreign corporation (CFC) or a controlled foreign partnership (CFP) are required to file Form 8858 for each FDE, according to the instructions for Form 8858. Direct owners of an FDE should attach the Form 8858 to their federal income tax returns; indirect owners of an FDE should attach the form to any other required form pertaining to the foreign entity that owns the FDE (e.g., Form 5471, if the FDE is owned by a CFC).
In addition, category 4 and category 5 filers of Form 5471 must also file Form 8858; the associated schedules depend upon their specific status relative to the FDE (see instructions to Form 8858).
biformation Returns for Gifts and Trusts
The following sections describe the information returns required with respect to gifts from foreign individuals and estates and foreign trusts.
Requirement to File a Foreign Gift Return
A U.S. person receiving foreign gifts valued at more than $100,000 (not adjusted for inflation) from a nonresident alien individual or a foreign estate, or gifts valued at more than $10,000 (adjusted annually for inflation, set at $14,723 for 2012; see Revenue Procedure 2011-52, section 3.35) from foreign corporations or foreign partnerships, is required to file Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts, and report each such foreign gift (IRC section 6039F[a]). Once the $100,000 threshold has been met, Form 3520 requires a donee to separately identify each gift in excess of $5,000, but does not require the identification of the donor (see Notice 97-34, section VI(B)(1), 19971 1 422). Form 3520 requires a donee to separately identify all gifts from a foreign corporation or foreign partnership, including the identity of the donor entity. A foreign gift is "any amount received from a non-U.S. person which the recipient treats as a gift or bequest" (IRC section 6039F[b]). Form 3520 must be filed by the U.S. donee on the due date, including extensions, of that U.S. person's income tax return following the year the gift was made.
Penalties. If the U.S. donee fails to report any foreign gifts, the donee will be subject to a penalty of 5% of the value of the aggregate unreported foreign gifts for each month in which the foreign gifts were not reported, up to a maximum of 25% of the value of the foreign gifts (IRC section 6039F[c][l][B]). Penalties can be abated, if the failure to report is due to reasonable cause and not to willful neglect (IRC section 603 9F).
Foreign Trust Reporting
A U.S. person who creates, transfers, or receives a distribution from a foreign trust is required to file Form 3520, as well as Form 3520-A, on or before the income tax return's due date, including extensions (IRC section 6048[a], [c]; 1RS Notice 97-34; Instructions to Form 3520). Form 3520 must also be filed following the death of a U.S. person who is treated as the owner of any portion of a foreign trust, or if any portion of such trust was included in the decedent's gross estate (IRC section 6048[a][A][iii][I]-[II]). A U.S. person who is the owner of a foreign trust under the grantor trust rules is also responsible for the filing of an annual return by the trust on Form 3520-A, which is due by the 15th day of the third month following the close of the trust's taxable year (1RS Notice 97-35; Instructions to Form 3520-A).
Penalties. The typical deficiency procedures relating to income, estate, and gift taxes do not apply to the assessment or collection of the penalties with respect to foreign trusts (IRC section 6677[e]). The 1RS holds that the IRC section 6677 penalty is not a "divisible tax," meaning that a taxpayer who seeks to challenge the entire assessment must pay the entire penalty before bringing a refund suit; however, because the penalty may be imposed for a variety of failures, the IRS's position is that a taxpayer who contests only a portion of the penalty relating to one or more particular failures may pay that portion and sue for a review (see Chief Counsel Advice [CCA] 201150029).
Failure to timely or accurately file any notice or return required by the foreign trust reporting rules can result in a penalty equal to the greater of $10,000 or 35% of the gross reportable amount (see IRC section 6677[a], as amended by the HIRE Act). For these purposes, the gross reportable amount is defined as the gross value of the property transferred or received, as of the date of the transfer or receipt (IRC section 6677[c]). In the case of a failure to file an annual return by a U.S. person treated as the owner of any portion of a foreign trust under the grantor trust rules, the penalty is 5%, rather than 35%, of the gross reportable amount (IRC section 6677 [b]). The penalty increases by $10,000 for each 30-day period (or fraction thereof) during which such failure continues beyond 90 days after the 1RS mails a notice of the failure (IRC section 6677[a]).
A U.S. person's failure to report activities with a foreign trust can expose the individual to both the penalty for failing to report a foreign gift and the penalty for failing to comply with foreign trust reporting requirements. If both penalties apply, the trust reporting penalty is assessed first and reduces any penalty for failing to report a large foreign gift (1RS Notice 97-34). An additional 40% accuracy-related penalty will also apply to any understatement attributable to any transaction involving a foreign trust with respect to which an information return is required (IRC section 6662[b]).
An estate is liable for the initial penalty for a decedent's failure to file Form 3520A; the estate assumes the decedent's liabilities, including a liability for failing to file the required return (CCA 2012208028). The estate may be liable for additional penalties if the failure to file continues after notification from the 1RS (CCA 2012208028).
Offshore Voluntaiy Disclosure Program
Taxpayers who have failed to properly report the existence of, or income from, foreign financial accounts may now be able to achieve compliance without placing themselves in jeopardy by taking advantage of the IRS's offshore voluntary disclosure program (OVDP). The most recent iteration of this program's requirements is presented in an updated set of frequently asked questions (FAQ), issued on June 26, 2012, in IR2012-64 and IR-2012-65. (The initial terms of the 2012 OVDP were set forth in IR-20125, released on Januaiy 9,2012.)
The OVDP is a counterpart to the longstanding 1RS Criminal Investigation voluntary disclosure practice. When a qualifying taxpayer truthfully, timely, and completely complies with all provisions, the 1RS will not recommend criminal prosecution to the Department of Justice. The OVDP addresses the civil side of a taxpayer's voluntary disclosure of foreign accounts and assets by defining the number of tax years covered and setting the civil penalties that will be applied (FAQ 3).
The OVDP is available to individuals and entities (i.e., corporations, partnerships, and trusts, according to FAQ 13) that have undisclosed offshore accounts or assets and are not currently under examination by the 1RS, including those that made disclosures after the deadline for the earlier offshore voluntary disclosure initiative (OVDI) in 2011 (FAQ 12).
One significant difference between the current OVDP and its predecessors is the lack of a specified application deadline. The 1RS has, however, reserved the right to change-or even eliminate-this program at any time (FAQ 12).
The OVDP applies a single penalty in lieu of the numerous penalties that could otherwise be imposed, such as the FBAR and fraud penalties (FAQ 5). The current OVDP imposes an "in lieu of' penalty equal to 27.5% of the highest aggregate balance in foreign bank accounts or entities, or the value of foreign assets at any time during the eight tax years prior to the disclosure (FAQ 7). In the 2011 OVDI, the penalty rate was 25%. As in that program, some taxpayers in the current OVDP may qualify for reduced 5% or 12.5% penalties; however, the standard accuracy-related or delinquency penalties continue to apply, in addition to the in lieu of OVDP penalty (FAQ 7).
Taxpayers can still choose to opt out of the OVDP program. When a taxpayer opts out, the individual irrevocably elects to have liability determined under the standard audit process. Generally, a taxpayer will opt out when the circumstances clearly mandate limited or lower-level penalties, or possibly even warrant a complete abatement for reasonable cause. The FAQs provide several examples of circumstances in which taxpayers might consider opting out of the OVDP. Although opting out requires a very thorough consideration of risks and benefits, it has no effect on the protection from criminal prosecution provided by the OVDP disclosure (FAQ 51).
Nowhere is the axiom "forewarned is forearmed" more appropriate than when dealing with the myriad reporting responsibilities that arise from cross-border business activities. CPAs and their advisors must remain abreast of this complex arena, from various foreign reporting requirements (i.e., FBAR, FATCA, PFIC, CFC) to the responsibility to file reports related to interests in foreign partnerships, corporations, trusts, and even foreign gifts. Moreover, they must enhance their understanding of related conditions and penalties in order to successfully navigate these obligations. ?
Barry Leibowicz, JD, LLM (Tax), is an attorney in the law offices of Barry Leibowicz, Great Neck, N.Y., and an associate professor in the department of accounting and information systems at Queens College of the City University of New York, Flushing, N.Y.