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Foreign Life Insurance Taxation

Houston Tax Attorney

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Foreign Life Insurance Taxation

Life insurance can be good way to ensure that loved ones are taken care of in the event of an unfortunate situation. However, owning a foreign life insurance policy with cash value can prove to be more of a headache than it’s worth. We’ve come across such types of investments regularly in our offshore compliance cases; the reporting and tax obligations can be burdensome. Hopefully, this article will help foreign insurance policy owners understand their U.S. tax obligations.

How U.S. Life Insurance Policies are Taxed

A whole life insurance policy is part investment and part life insurance. Such policies have two basic financial components – cash value and death benefit. Insurance companies take policy premiums and invest them. The investments in turn are used to pay death benefits and “cashed out” policies. The cash value of the policy increases as premiums are paid and as the investment grows. This investment portion of it is tax-deferred – no tax will be paid on the cash value unless the policy holder cashes out the policy. The policy holder will pay a tax on the investment gain. The death benefit, or face value of the policy, is paid to the beneficiaries tax-free.

Insurance companies in the U.S. are heavily regulated as stock or mutual companies. Additionally, they pay taxes on the investment income they earn from investing policyholders’ premiums. A foreign life insurance company, on the other hand, cannot be regulated by the U.S. nor taxed by the U.S. unless they happen to have U.S. source income. They may have few regulations and possibly pay little or no foreign taxes. Many foreign life insurance policies are more investment oriented than actually life insurance policies and potentially have a huge advantage over U.S. life insurance companies. In order to level the playing field and close this loophole, Congress enacted the Tax Reform Act of 1986 and passed subsequent legislation to even the playing field.

Since the U.S. has no authority to tax the foreign life insurance companies directly, they imposed onerous reporting requirements for U.S. policy holders of such investments.

Tax and Reporting Requirements of Foreign Life Insurance Policies

As indicated above, a whole life insurance policy is part investment and part insurance product. Taxation of such policies is determined based on the primary function of the policy.

Is it a Life Insurance Policy or an Investment?

IRC Code §7702 contains a two-pronged test.  An insurance policy is non-taxable if it meets either (i) the cash value accumulation test or (ii) the guideline premium requirement and the specified cash value corridor.

Cash Value Accumulation Test (CVAT)

The CVAT requires a fairly straightforward determination: does the cash value of the insurance policy exceed the present value of all future premium payments on the policy?

Guideline premium requirement

A contract meets the guideline premium requirements of section 7702(c) if the sum of the premiums paid under the contract does not at any time exceed the greater of the guideline single premium or the sum of the guideline level premiums as of such time.

The guideline single premium is the premium that is needed at the time the policy is issued to fund the future benefits under the contract based on the following three elements:

  1. Reasonable mortality charges that meet the requirements (if any) prescribed in regulations and that (except as provided in regulations) do not exceed the mortality charges specified in the prevailing commissioners’ standard tables (as defined in section 807(d)(5)) as of the time the contract is issued;
  2. Any reasonable charges (other than mortality charges) that (on the basis of the company’s experience, if any, with respect to similar contracts) are reasonably expected to be actually paid; and
  3. Interest at the greater of an annual effective rate of six percent or the rate or rates guaranteed on issuance of the contract.

Specified Cash Value Corridor

A policy falls within the cash value corridor if the death benefit of the contract at any time is not less than the applicable percentage of the cash surrender value. The applicable percentage is determined based on the attained age of the insured as of the beginning of the contract year, as follows:

APPLICABLE PERCENTAGE   
In the case of an insured with an attained age as of the beginning of the contract year of:The applicable percentage shall decrease by a ratable portion for each full year:
More than:But not more than:From:To:
040250250
4045250215
4550215185
5055185150
5560150130
6065130120
6570120115
7075115105
7590105105
9095105100

Tax on the Inside Buildup

If the policy does not meet either of the above tests, IRC Code §7702(g)(1)(A) becomes applicable: “If at any time any contract which is a life insurance contract under the applicable law does not meet the definition of life insurance contract, the income on the contract for any taxable year of the policyholder shall be treated as ordinary income received or accrued by the policyholder during such year.” In other words, the policy holder is subject to a tax on the increase in cash value of the policy each year, even if the policy isn’t actually cashed out.

Reporting Requirements

U.S. Excise Tax: This may be one of the more ridiculous parts of the Internal Revenue Code. IRC §4371 requires policy holders to file a quarterly excise tax form (Form 720) to report and pay a 1% excise tax on insurance premiums paid to foreign life insurers.

Form 720 was meant for businesses to fill out for miscellaneous taxes such as transportation of persons by air, kerosene use, aviation gasoline, liquefied hydrogen, and other arcane items. IRS sneaked in “foreign insurance taxes” near the top of the 2nd page of the form. Because the form was designed for businesses to fill out, it cannot be filed using an SSN. Policy holders must apply online for an EIN, solely for purposes of filling out this form and paying the excise tax!

Form 720 Foreign Life Insurance Excise Tax

 

 

 

 

 

 

 

 

 

 

FinCEN 114 “FBAR” and Form 8938 “FATCA”

U.S. persons owning foreign financial accounts with values in excess of $10,000 at any point during the year are require to file FinCEN 114, commonly known as FBAR with the Financial Crimes Enforcement Network (“FinCEN”) on a yearly basis. “Foreign financial account” includes an account that is an insurance or annuity policy with a cash surrender value.

Foreign life policies are also considered “specified foreign financial assets” for Form 8938 purposes and must be reported annually if the value exceeds the applicable threshold.

Form 8621 “PFIC”

If there’s any good news coming from this, it’s that foreign life insurance policies are usually not considered to be passive foreign investment companies. There is no Form 8621 filing requirement if the holder of a life insurance contract does not have control over the available investment accounts. IRC §1297(b)(2)(B)(3), Treas. Reg. §1.367(a)-2T.

Conclusion

Foreign life insurance policies can be tricky for tax and reporting purposes, and those that are not compliant can face numerous penalties. For instance, a non-willful failure to file Form 114 and 8938 carry maximum penalties of $10,000 per form, per year. Where a person willfully fails to file an FBAR, the IRS may impose a penalty equal to the greater of $100,000 or 50 percent of the account’s highest balance. While these can be poor investment choices due to the burdensome reporting requirements and should probably be avoided, for those who do own such policies, it is important to fully disclose them and pay all applicable taxes.

IRS Tax Amnesty & Voluntary Disclosure Practice

Houston Tax Attorney

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IRS Tax Amnesty & Voluntary Disclosure Practice

What do you do if you have committed a serious tax crime but the IRS has not yet discovered it? Tax amnesty has been a longstanding practice of the IRS Criminal Investigation division whereby taxpayers are allowed to make timely, accurate, and complete voluntary disclosures to avoid criminal prosecution.

Taxpayers are given tax amnesty for “coming clean” regarding their tax crimes. There are two such programs depending on whether the tax evasion involves domestic or foreign income:

  1. Domestic Voluntary Disclosure Program (not to be confused with streamlined domestic offshore procedures which is a completely unrelated program)
  2. Offshore Voluntary Disclosure Program (OVDP)

Domestic Voluntary Disclosure

The domestic voluntary disclosure program has been around since the 1950s. It is used by persons who have two specific types of tax issues – those who have seriously delinquent (unfiled) tax returns and those with significant unreported income. Read more about how the IRS discovers unreported income.

Delinquent Returns

Taxpayers who have many years of delinquent tax returns can be subject to criminal prosecution. A well-known example is actor, Wesley Snipes, who was sentenced to federal prison for 3 years for willfully failing to file his tax returns.

It is important to note that not all cases involving delinquent returns require making a voluntary disclosure. The other option is to simply file up to 6 years of previously unfiled tax returns. 6 years (and not further) is recommended because the IRS’ Policy Statement 5-133 requires the filing of returns for the last 6 years, with prior managerial approval required to pick up more or less than six years of returns. The IRS recognizes that records tend to become unavailable or unreliable further back than 6 years. Also there is a 6 years federal statute of limitations period for prosecuting persons for failure to file a tax return.

Domestic Tax Evasion

When taxpayers have knowingly omitted income on their tax returns, they have committed tax evasion. Whether the IRS will discover the tax evasion or will refer it for prosecution is another matter. A large number of taxpayers probably underreport some income, accidentally or knowingly. Those that have significantly omitted income and do not have a valid reason for the under-reporting should consider entering into the domestic voluntary disclosure program.

How much is significant? It depends on various factors as well as the local criminal investigations group. Usually each local group has a threshold for deciding whether to refer a case to the DOJ for criminal prosecution. Cases referred for prosecution usually involve over $100,000 of total tax loss (not income).

For cases where the unreported amount is not as significant, the tax returns may simply be amended for a period of 3 or 6 years, depending on the situation.

Pros and Cons

Entering into the domestic voluntary disclosure program isn’t simply a matter of filing late taxes or amended returns for 6 years and calling it even with the IRS. The IRS may assess a 75% fraud related penalty on the balance due.

So if you file your tax return and owe $100,000 in taxes, a 75% fraud penalty would increase that total to $175,000. And you’ll still pay failure-to-file and failure-to-pay penalties, and interest on top of that.  If you have a low level risk of criminal prosecution, you might be well-served by simply filing the returns or correcting the omission, whatever the case may be.

On the other hand, almost all tax crimes can be cured through a voluntary disclosure, which means not having to face criminal prosecution and potential jail time.

Offshore Voluntary Disclosure Program

The Offshore Voluntary Disclosure Program (OVDP) has been available since 2009. It’s based on the same principles as the Domestic Voluntary Disclosure Program. It’s available for taxpayers who have unreported foreign income and assets.

The OVDP is a very structured program with specific requirements. Taxpayers are required to amend or file 8 years of the most recent tax returns and FBARs.

This program is for those who have criminal exposure for unreported foreign income. It should be used by individuals who have significant unreported foreign-sourced income and where there is evidence of willfulness.

Pros and Cons

A successful OVDP disclosure protects the taxpayer from criminal prosecution for failing to report their offshore income and assets. However, it comes at a very steep price. The taxpayer will be subject to a 27.5% miscellaneous Title 26 penalty on the highest aggregate value of their unreported financial assets during the 8 year look-back period. In addition, the taxpayer will be subject to a 20% accuracy-related penalty on the additional income tax.

Requirements for Tax Amnesty

In order to qualify for tax amnesty under the voluntary disclosure programs, the disclosure must be truthful, timely, and complete.

  • Truthful and complete: The taxpayer shows a willingness to cooperate (and does in fact cooperate) with the IRS in determining his or her correct tax liability.  The taxpayer makes good faith arrangements with the IRS to pay in full, the tax, interest, and any penalties determined by the IRS to be applicable.
  • Timely: A disclosure is timely if it is received before:
    • The IRS has initiated a civil examination or criminal investigation of the taxpayer, or has notified the taxpayer that it intends to commence such an examination or investigation.
    • The IRS has received information from a third party (e.g., informant, other governmental agency, or the media) alerting the IRS to the specific taxpayer’s noncompliance.
    • The IRS has initiated a civil examination or criminal investigation which is directly related to the specific liability of the taxpayer.
    • The IRS has acquired information directly related to the specific liability of the taxpayer from a criminal enforcement action (e.g., search warrant, grand jury subpoena).

How to make a Voluntary Disclosure

Domestic Voluntary Disclosure

Note that a voluntary disclosure will not automatically guarantee immunity from prosecution. However, it has been IRS’s practice to not refer voluntary disclosure cases for prosecution except where the income comes from illegal sources.

Taxpayers or their representatives initiate a voluntary disclosure by contacting IRS Criminal Investigations. Examples of voluntary disclosures include:

  • A letter from an attorney which encloses amended returns from a client which are complete and accurate (reporting legal source income omitted from the original returns), which offers to pay the tax, interest, and any penalties determined by the IRS to be applicable in full.
  • A disclosure made by a taxpayer of omitted income facilitated through a widely promoted scheme that is the subject of an IRS civil compliance project. Although the IRS already obtained information which might lead to an examination of the taxpayer, it not yet commenced any such examination or investigation or notified the taxpayer of its intent to do so. In addition, the taxpayer files complete and accurate returns and makes arrangements with the IRS to pay in full, the tax, interest, and any penalties determined by the IRS to be applicable. This is a voluntary disclosure because the civil compliance project involving the scheme does not yet directly relate to the specific liability of the taxpayer.
  • A disclosure made by an individual who has not filed tax returns after the individual has received a notice stating that the IRS has no record of receiving a return for a particular year and inquiring into whether the taxpayer filed a return for that year. The individual files complete and accurate returns and makes arrangements with the IRS to pay, in full, the tax, interest, and any penalties determined by the IRS to be applicable. This is a voluntary disclosure because the IRS has not yet commenced an examination or investigation of the taxpayer or notified the taxpayer of its intent to do so.

Offshore Voluntary Disclosure

A person desiring to enter the OVDP program must take the following steps:

  • Obtain a preclearance: Prior to making a disclosure, taxpayers may request a preclearance letter from the IRS Criminal Investigation Lead Development Center. If the IRS has already learned of the taxpayer’s noncompliance then the preclearance letter will be rejected. A decision can take up to 30 days. If a preclearance letter is granted, the taxpayer has 90 days to fully comply with all the provisions in the letter.
  • Submit an application: After the initial letters are submitted to the IRS, the IRS will respond back with a letter stating that if the taxpayer completely and truthfully submits documents required under the OVDP, the IRS will not recommend prosecution by the Department of Justice for noncompliance. Taxpayers have 90 days from the date of the IRS letter to submit the required documents. Additional time may be requested.

The OVDP submission will then be reviewed by the IRS and at the completion of the review, the IRS will propose a closing agreement (Form 906). The taxpayer must then sign the agreement or decide to opt out of the OVDP. If the taxpayer cannot full pay the additional tax, penalties, and interest, an installment agreement may be requested.


Sources:

IRS.gov, How to Make a Domestic Voluntary Disclosure

IRS.gov, 2012 Offshore Voluntary Disclosure Program

Internal Revenue Manual (IRM) 19.5.11.9

IRS Policy Statement 5-133, IRM 1.2.14.1.18

Casualty Loss Deductions

Houston Tax Attorney

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Hurricane Harvey & IRS Casualty Loss Deduction

As Houston recovers from what some consider to be a 1 in 1,000 year event, only 15% of Houston residents are protected by flood insurance. Undoubtedly, there will be massive personal and business losses. A casualty loss deduction on your tax return can help offset some the cost of repairs. The first few weeks after a natural disaster are very important in properly documenting a casualty loss claim and here are some important things you need to know for tax purposes.

Casualty Loss Deduction – an Overview

There are special casualty loss rules for those located in federally declared disaster areas. FEMA has declared Hurricane Harvey a federal disaster and designated the following counties as disaster areas: Aransas, Bee, Brazoria, Calhoun, Chambers, Fort Bend, Galveston, Goliad, Harris, Jackson, Kleberg, Liberty, Matagorda, Nueces, Refugio, San Patricio, Victoria, and Wharton.

Residents of these counties who have experienced a casualty loss may deduct the loss in either the tax period in which the loss occurred or the tax period immediately preceding the disaster year. In this case, casualty losses caused by Hurricane Harvey can be deducted on the 2017 return (filed next year) or on the 2016 return. If the 2016 return has already been filed, you have until October 15, 2018 to file an amended return to claim the casualty loss deduction. If you’ve already paid your 2016 taxes, you may be able to get a refund by amending it.

Figuring out the Amount of the Loss

Step 1: Determine the lower of (A) the adjusted basis in the property before the loss and (B) the decrease in Fair Market Value after the casualty loss. The adjusted basis is the cost of the property plus the cost of any improvements. The Fair Market Value can be proven through an appraisal or the cost of repairs.

Step 2: Subtract the lower of the two amounts in Step 1 and subtract any insurance proceeds received or expected to be received. The net is the amount of your casualty loss.

Business Property

The process is slightly different for casualty loss incurred to business property. The amount of loss is the adjusted basis minus salvage value minus insurance reimbursement.

If there is loss in business inventory, the taxpayer can claim the loss through by either taking a casualty loss deduction or by an adjustment to the cost of goods sold.

Things you Should do Immediately after a Casualty for Tax Purposes

Obviously taxes are not a priority after a natural disaster. But sometime in the days following the incident you should take the following steps to ensure that your casualty loss claim is successful.

1. Begin Reconstructing your Records

Personal Residence/Real Property

  • Be sure to take photographs as quickly as possible after the casualty to establish the extent of the damage. Take photos of specific valuable items if possible, rather than just a general picture of the damage. This will help establish the extent of damage to your personal items.
  • Contact the Title Company, Escrow Company, or bank that handled the purchase to obtain copies of escrow papers. Your real estate broker may also be able to help.
  • Use the current property tax statement for land vs. building ratios, if available; if not available, get copies from the county assessor’s office.
  • Check with appraisal companies to locate a library of old multiple listing books. These can be used for “comps” to establish a basis or fair market value. “Comps” are comparable sales within the same neighborhood.
  • Check with your mortgage company for copies of any appraisals or other information they may have about cost or fair market value.
  • Tax records – Immediately after the casualty, file Form 4506, Request for Copy of Tax Return, to request copies of the previous four years of federal income tax returns. To obtain copies of the previous four years of transcripts you may file a Form 4506‐T, Request for Transcripts of a Tax Return. Write the appropriate disaster designation, such as “HURRICANE HARVEY,” in red letters across the top of the forms to expedite processing and to waive the normal user fee.
  • Improvements – Call the contractor(s) to see if records are available. If possible get statements from the contractors verifying their work and cost.
  • If a home improvement loan was obtained, obtain paperwork from the institution issuing the The amount of the loan may help establish the cost of the improvements.
  • Inherited Property – Check court records for probate values. If a trust or estate existed, contact the attorney who handled the estate or trust.
  • No other records are available – Check at the county assessor’s office for old records about the property. Look for assessed value and ask for the percentage of assessment to value at the time of purchase. This is a rough guess, but better than no records at all.

Vehicles

Kelly’s Blue Book, NADA, and Edmunds are available on‐line and at most libraries. They are good sources for the current fair market value of most vehicles on the road.

  • Call the dealer and ask for a copy of the contract. If not available, give the dealer all the facts and details and ask for a comparable price figure.
  • Use newspaper ads for the period in which the vehicle was purchased to determine cost basis. Use ads for the period when it was destroyed for fair market value. Be sure to keep copies of the ads.
  • If you are still making payments, check with your lien holder.

Personal Property

The number and types of personal property may make it difficult to reconstruct records. One of the best methods is to draw pictures of each room. Draw a floor plan showing where each piece of furniture was placed. Then show pictures of the room looking toward any shelves or tables. These do not have to be professionally drawn, just functional. Take time to draw shelves with memorabilia on them. Do the same with kitchens and bedrooms.

Reconstruct what was there, especially furniture that would have held items — drawers, dressers, and shelves. Be sure to include garages, attics, and basements. Here are some examples of ways that you can prove the value of your personal property:

  • Get old catalogs. These catalogs are a great way to establish cost basis and fair market value. Check the prices on similar items in your local thrift stores to establish fair market value. Walk through the stores and look at comparable items, especially items such as kitchen gadgets. Look for odds and ends you may have had but forgotten because of infrequent use.
  • Use your local “advertiser” as a source for fair market value. Keep copies of the issues handy and copy pages used for specific items to put with your tax records file on the disaster.
  • Check local newspaper want ads for similar items. Again keep a copy of any you use for comparison with the tax
  • If you bought items using a credit card, contact your credit card company.
  • Check with your local library for back issues of newspapers. Most libraries keep old issues on microfilm. The sale sections of these back issues may help establish original costs on items such as appliances.
  • Go to a used bookstore with a tape measure and the diagram of the destroyed property. Measure several rows of used books and count the number of books per shelf. Add up the prices of those books and determine an average cost per shelf. Then count the number of shelves you had in your home and multiply by the average cost per shelf. This will help determine the value of your books before the loss.

Business Records

  • Inventories – Get copies of invoices from suppliers. Whenever possible, the invoices should date back at least one calendar year.
  • Income – Get copies of bank statements. The deposits should closely reflect what the sales were for any given time period.
  • Obtain copies of last year’s federal, state, and local tax returns including sales tax reports, payroll tax returns and business licenses (from city or county). These will reflect gross sales for a given time period.
  • Furniture and fixtures – Sketch an outline of the inside and outside of the business location. Then start to fill in the details of the sketches. (Inside the building — what equipment was where; if a store, where were the products/inventory located. Outside the building — shrubs, parking, signs, awnings, etc.)
  • If you purchased an existing business, go back to the broker for a copy of the purchase agreement. This should detail what was acquired.
  • If the building was constructed for you, contact the contractor for building plans or the county/city planning commissions for copies of any plans.

2. File an Insurance Claim

The IRS requires you to file a timely insurance claim first and then take a casualty loss deduction for any loss that is not covered. The IRS will disallow your casualty loss deduction if you fail to make a timely insurance claim.

3. Begin Documenting your Casualty Losses

If you try to compile all of this information during tax time next year, it will be extremely difficult. You should begin documenting your losses through a worksheet or other method as soon as possible after the loss.

Worksheet for Personal Use Property (courtesy of IRS)

Worksheet Business Property (courtesy of IRS)


Sources:

IRS Publication 547

IRS Publication 2194

IRS FAQs for Natural Disaster Victims

Gifts from Foreign Persons

Houston Tax Attorney

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IRS Form 3520 – What are the Reporting Requirements and Tax Consequences of Receiving a Gift from a Foreign Person?

It is a common scenario where a U.S. person receives a gift from a parent or relative who lives abroad. Such transactions usually trigger a Form 3520 filing requirement. There are two steps to determining the tax and reporting consequences of such transactions.

Is the Transfer Actually a Gift and not Disguised Compensation?

A true gift that is not compensation for past services is not taxable to the recipient. Any income generated from the gift is taxable. For instance, if you receive real estate from a parent and subsequently rent the property, the rental income as well as any gain from the sale of the property is taxable income.

Quick note about tax basis: a gift has the same tax basis for the recipient as it did in the hands of the donor. This is opposed to a transfer through inheritance, where the recipient’s basis in the property is the fair market value at the decedent’s death (AKA “stepped up” basis). For instance, Ann has 2,000 shares of Company A that were transferred from her father, Bob. The cost basis (the amount Bob purchased it for) is $100,000 and the fair market value at the time Bob passes away is $900,000. Assume that Ann wants to sell the stock which are now worth $1,000,000. If Bob had gifted the stock to Ann, the gain (taxable amount) would be $900,000 ($1,000,000 sale price – $100,000 cost basis). On the other hand, if the stocks had been transferred through inheritance, the gain would be $100,000 ($1,000,000 sale price – $900,000 stepped up basis).

There are situations where a “gift” is really disguised compensation for past services. Courts have defined a gift as “a detached and disinterested generosity out of affection, respect, admiration charity or like impulses.” For example, Bob works for Joe for several months and in exchange he receives a new car worth $20,000 as a “gift.” The IRS would scrutinize such a transaction – was this really a gift or is it compensation for past services? If the IRS determines it is compensation for services, the $20,000 would be taxable income to Bob. The relationship between the parties is an important factor. Gifts between family members would likely face less scrutiny.  For example, a father gifting stocks to his daughter for having graduated from college is a gift.

What is the Residency of the Donor?

Donor is not a U.S. Tax Resident

If the donor is not a U.S. tax resident (i.e., is not a U.S. Citizen or permanent resident and does not meet the substantial presence test), then the donor has no reporting requirement.  However, the recipient of the gift as a U.S. tax resident must report the gift from any foreign person or entity if:

(a) The value of the gifts and bequests received from a nonresident alien individual or foreign estate, which must also include gifts or bequests received from foreign persons related to the nonresident alien individual or foreign estate, exceeds $100,000, or

(b) The value of the gifts received from foreign corporations or foreign partnerships, which must also include gifts received from foreign persons related to the foreign corporations or partnerships, exceeds $15,358 in 2014, or $15,601 in 2015, or $15,671 in 2016 (this value is adjusted annually for inflation).

The recipient must file Form 3520 which is due on the date of the income tax return, including extensions.

Donor is a U.S. Tax Resident

However, if the donor is a U.S. tax resident, they may have a gift tax return filing requirement if the total value of all gifts made to the same person within the same calendar year exceeds $14,000 (or $28,000 for married individuals).

If a gift tax return is required, the donor must file Form 709 on or before April 15th of the year following the calendar year in which the gift(s) were made. Although there is a reporting requirement for gifts above $14,000 (or $28,000), the donor will not pay taxes on the gift unless it exceeds the maximum lifetime exclusion amount of $5.45 million (as of 2016).

Penalties for Failing to File Form 3520

Under IRC 6677, a penalty applies if Form 3520 is not timely filed or if the information is incomplete or incorrect (see below for an exception if there is reasonable cause). Generally, the initial penalty is equal to the greater of $10,000 or the following (as applicable):

  • 35% of the gross value of any property transferred to a foreign trust for failure by a U.S. transferor to report the creation of or transfer to a foreign trust.
  • 35% of the gross value of the distributions received from a foreign trust for failure by a U.S. person to report receipt of the distribution.
  • 5% of the gross value of the portion of the foreign trust’s assets treated as owned by a U.S. person under the grantor trust rules (sections 671 through 679) for failure by the U.S. person to report the U.S. owner information. Such U.S. person is subject to an additional separate 5% penalty (or $10,000 if greater), if the foreign trust (a) fails to file a timely Form 3520-A or (b) does not furnish all of the information required by section 6048(b) or includes incorrect information. See section 6677(a) through (c) and the Instructions for Form 3520-A.

Additional penalties will be imposed if the noncompliance continues for more than 90 days after the IRS mails a notice of failure to comply with the required reporting. For more information, see section 6677.

Reasonable cause. No penalties will be imposed for failing to file a Form 3520 if the taxpayer can demonstrate that the failure to comply was due to reasonable cause and not willful neglect.

Community Property and Tax Liabilities

Houston Tax Attorney

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Community Property and IRS Tax Liabilities

What is Community Property?

Texas is a community property state, which means that all “community property” is owned jointly and equally by both spouses.  In Texas, all property accumulated during marriage is community property unless it is received by gift, devise, or inheritance.  Tex. Fam. Code Ann. § 5.01.  Even income derived from separate property—including interest and dividends from separately owned securities—is considered community property.  Commissioner of Internal Revenue v. Chase Manhattan Bank, 259 F.2d 231, 239 (5th Cir. 1958), cert. den., 359 U.S. 913 (1959).  Texas’s community property laws can have unusual implications for married couples’ federal income tax liabilities.

What is Each Spouse’s Liability on a Tax Return?

Sometimes, sorting out tax liability for spouses in community property states is simple and straightforward.  For instance, when spouses are jointly and severally liable for federal taxes—spouses who file joint tax returns, for instance—the IRS can collect these taxes from any community or separate property.  However, most community property collection issues come from more complicated circumstances.

Community property collection issues typically arise where only one spouse owes a tax liability.  This can happen in a variety of contexts, but most commonly occurs when:

The chief issues in these contexts are: (1) identifying which assets are available to satisfy the obligations; and (2) navigating how community property laws affect these obligations.

Section 6321 of the Internal Revenue Code imposes a federal tax lien on “all property and rights to property” of a taxpayer who neglects or refuses to pay assessed taxes after notice and demand. State laws determine the extent to which a taxpayer has an interest in property for federal tax purposes, while federal law determines the consequences of that interest.  National Bank of Commerce, 472 U.S. at 722.

Navigating the second issue is slightly more complicated.  The Texas Family Code characterizes a spouse’s earnings as the “sole management community property” of that spouse and makes them exempt from the other spouse’s creditors.  Tex. Fam. Code Ann. §§ 5.22(a)(1), 5.61(b)(2).  However, the Supreme Court has held that state law exemptions are not effective against the United States for federal tax purposes.  United States v. Mitchell, 403 U.S. 190, 205 (1971).  Applying this ruling, the Fifth Circuit has held that, in community property states, the tax debts of one spouse (but not the other) may be satisfied with 100% of that spouse’s “sole management” community property and 50% of the other spouse’s “sole management” property. See, e.g., Medaris v. United States, 884 F.2d 832 (5th Cir. 1989); Broday v. United States, 455 F.2d 1097, 1100 – 01 (5th Cir. 1972).

Property that is the sole management property of one spouse is subject to that spouse’s control despite the other spouse’s half interest in it.  In essence, it is the property the spouse would have if he or she were single.

What Happens to Tax Debt When the Liable Spouse Passes Away?

Things can become a bit complicated when only one spouse is liable for back taxes and then passes away before the non-liable spouse. A decedent’s estate is responsible for paying his or her tax debts. Tex. Fam. Code Ann. § 5.01.  This includes any income derived from separate property.  Chase Manhattan Bank, 259 F.2d 231, 239 (5th Cir. 1958).  Although Texas state law exempts certain property from creditors, the Supreme Court and Fifth Circuit have held that state law exemptions are not effective against the United States for the purpose of tax liens.  Mitchell, 403 U.S. at 205; Medaris, 884 F.2d 832; Broday, 455 F.2d at 1100 – 01.

Further, in Medaris and Broday, the Fifth Circuit has held that, in community property states, the federal tax debts of one spouse (but not the other) may be satisfied with 100% of that spouse’s “sole management” community property and 50% of the other spouse’s “sole management” property.  Thus, the IRS is allowed to attach 100% of the deceased (liable) spouse’s interest in the community property, as well as half of the surviving spouse’s interest.  Moreover, the IRS was not required to provide notice to the surviving spouse when attaching the property.

What Happens After an IRS Audit?

Houston Tax Attorney

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What Happens After an IRS Audit?

Clients often come to us after going through an IRS audit and receiving a large tax bill. They either represented themselves or hired someone who did not represent them effectively. This article is not about audit representation, but rather the steps that occur after an audit has concluded, and what taxpayers can do to challenge an audit determination. Read more

IRS Form 8938 Filing Requirements

Houston Tax Attorney

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IRS Form 8938 (FATCA) Filing Requirements

The “FATCA” (Foreign Account Tax Compliance Act) provisions require specified individuals to report ownership of specified foreign financial assets if the total value exceeds the applicable reporting threshold. The IRS created Form 8938, Statement of Specified Foreign Financial Assets, for this purpose. Form 8938 must be included with the individual’s tax return. Failure to include the Form 8938, if required, could lead to significant penalties. Note that the Form 8938 is also referred to as “FATCA” which can cause confusion since that term also refers to the regulations themselves. Read more

Innocent Spouse Relief

Houston Tax Attorney

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Innocent Spouse Relief

When a husband and wife sign a joint tax return, each spouse is jointly and severally liable for all taxes relating to that year. Where one spouse does not believe he or she should be liable for the  full amount of the tax liability, that spouse may seek innocent spouse relief under IRC 6015. Read more

How the IRS Investigates FBAR Violations

Houston Tax Attorney

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How the IRS Investigates FBAR Violations

In this article are the IRS’ internal procedures for investigations of FBAR violations. After the foreign bank reports the non-compliant taxpayer’s account information to the foreign taxing authority, the information is then provided to the IRS. For those countries without intergovernmental agreements (IGAs), the account holder’s information will be sent directly to the IRS. Or the IRS has discovered the non-compliance based on stated or implied sources of foreign income on filed tax returns or information forms. Regardless of how the IRS obtains the information, what follows next is an investigation by an IRS examiner of the potential FBAR violation(s). Read more

Foreign Bank Account Reporting under the Bank Secrecy Act (FBARs)

Houston Tax Attorney

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Foreign Bank Account Reporting under the Bank Secrecy Act (FBARs)

If you are a US citizen or tax resident, you may have a foreign bank account reporting obligation. There are individuals who don’t report their foreign financial accounts to evade taxes, but that is an exception and not the norm. For the vast majority of those who fail to report, the reason is that they were simply unaware of their reporting requirements. Read more