IRS Reminds Taxpayers of OVDP Ending and Hints at Updated Procedures

Earlier this year the IRS announced that the OVDP would end on September 28th and the IRS issued a reminder to taxpayers last week of the program ending.

More importantly the IRS states that it will maintain a pathway for such taxpayers to come into compliance after the OVDP ends. The IRS will be announcing updated procedures soon. The full text of the IRS news release appears below.

IR-2018-176, Sept. 4, 2018

WASHINGTON – The Internal Revenue Service today reminded taxpayers they have until Sept. 28 to apply for the Offshore Voluntary Disclosure Program (OVDP).

Since the OVDP’s initial launch in 2009, more than 56,000 taxpayers have used the various terms of the program to comply voluntarily with U.S. tax laws. These taxpayers with undisclosed offshore accounts have paid a total of $11.1 billion in back taxes, interest and penalties. The planned end of the current OVDP also reflects advances in third-party reporting and increased awareness of U.S. taxpayers of their offshore tax and reporting obligations.

In March, the IRS announced the program would end on Sept. 28, 2018. The IRS will continue to hold taxpayers with undisclosed offshore accounts accountable after the program closes.

The number of taxpayer disclosures under the OVDP peaked in 2011, when about 18,000 people came forward. The number steadily declined through the years, falling to only 600 disclosures in 2017.

Since the announcement, the IRS has not received any public comments addressing a continued need for the OVDP. The IRS will maintain a pathway for taxpayers who may have committed criminal acts to voluntarily disclose their past actions and come into compliance with the tax system. Updated procedures will be announced soon.

Separately, the IRS continues to combat offshore tax avoidance and evasion using whistleblower leads, civil examination and criminal prosecution. Since 2009, 1,545 taxpayers have been indicted related to international activities through the work of IRS Criminal Investigation.

A separate program, the Streamlined Filing Compliance Procedures, for taxpayers who may have been unaware of their filing obligations, has helped about 65,000 additional taxpayers come into compliance. These streamlined procedures will continue to be available for now, but as with OVDP, the IRS has said it may end this program too at some point.

The implementation of the Foreign Account Tax Compliance Act (FATCA) and the ongoing efforts of the IRS and the Department of Justice to ensure compliance by those with U.S. tax obligations have raised awareness of U.S. tax and information reporting obligations related to undisclosed foreign financial assets.  Taxpayers who made non-willful mistakes or omissions on their tax returns should file amended returns or delinquent returns as soon as possible.

Full details of the options available for U.S. taxpayers with undisclosed foreign financial assets can be found on IRS.gov.

What should non-compliant taxpayers do?

If taxpayers are non-compliant with the foreign asset and income reporting requirements, they should consider applying to one of IRS’ voluntary disclosure programs:

• Offshore voluntary disclosure program
• Streamlined domestic offshore program
• Streamlined foreign offshore program
• Delinquent international information return submission procedures

We assist taxpayers who have undisclosed foreign financial assets. Schedule an appointment to see how we can help.

Foreign Earned Income Exclusion – Late Elections

Can the foreign earned income exclusion be elected on a late-filed return? Redfield v. Comm’r, T.C. Memo 2017-71 (T.C. April 26, 2017) answers this question.

Facts

Below are the facts in the case:

• Taxpayer worked in a civilian position at Kandahar Air Field in Kandahar Province, Afghanistan in 2010
• Taxpayer received an extension of time until October 15, 2011, to file his 2010 Federal income tax return
• Since taxpayer did not file his 2010 tax return, in 2014 the IRS prepared a substitute for return (SFR)
• Subsequently, the taxpayer submitted to the IRS a delinquent return for 2010 on which he included with this return Form 2555, Foreign Earned Income Exclusion to exclude his foreign income
• The IRS disallowed petitioner’s claim for a foreign earned income exclusion (FEIE) because he had not elected to exclude foreign earned income on a prior Federal income tax return and had failed to make a valid election for 2010.

Foreign earned income exclusion – timely filing requirement

In addition to satisfying the tests for foreign earned income exclusion the taxpayer must also make a timely “election” to exclude foreign earned income.

Treasury Reg. 1.911-7(a)(2), establishes the timing requirements under which a valid election can be made.

In general, an election to claim foreign earned income exclusion must be made on an income tax return that is timely filed (including any extensions of time to file). The IRS allows a grace period – the exclusion may be claimed on an income tax return that is filed within one year after the due date of the return.

For taxpayers that are claiming the exclusion on a tax return that is more than 1 year late, the foreign earned exclusion may be elected if:

1. The taxpayer owes no federal income tax after taking into account the exclusion and files Form 1040 with Form 2555 or a comparable form attached either before or after the Internal Revenue Service discovers that the taxpayer failed to elect the exclusion; or
2. The taxpayer owes federal income tax after taking into account the exclusion and files Form 1040 with Form 2555 or a comparable form attached before the Internal Revenue Service discovers that the taxpayer failed to elect the exclusion.

A taxpayer filing an income tax return pursuant to either of these sections must type or legibly print the following statement at the top of the first page of the Form 1040: “Filed Pursuant to Section 1.911-7(a)(2)(i)(D).”

Analysis

In Redfield, taxpayer conceded that the foreign earned income was not timely elected. The issue was whether the taxpayer qualified under one of the alternative timing methods. Since taxpayer did owe taxes after the foreign earned income exclusion, the question was whether taxpayer filed the Form 1040 with Form 2555 before the IRS discovered that the taxpayer filed to elect the exclusion.

The court reasons that because the IRS filed a substitute return, it effectively discovered the taxpayer’s failure to make a timely election. Therefore no relief is available under the alternative timing methods, and taxpayer is not allowed to now claim the foreign earned income exclusion.

By preparing for petitioner on May 27, 2014, an SFR that treated all of his wages for 2010 as gross income, the IRS evidenced its “discovery” that he had failed to elect the FEIE for that year by filing a Form 1040 accompanied by a properly completed Form 2555. Petitioner did not file his delinquent 2010 return accompanied by a Form 2555 until October 7, 2014, more than four months later.

As to whether a taxpayer who does qualify for the exclusion under one of the alternative timing methods but fails to type or legibly print “Filed Pursuant to Section 1.911-7(a)(2)(i)(D)’”, the court does not decide whether that would invalidate an FEIE election. Likely it should not invalidate an election based on a technicality alone. Moreover, a taxpayer could simply file an amended return to include the language, for example, if the FEIE return is filed late but owes no taxes after the election, regardless of whether it’s filed before or after the IRS discovers the failure to make the election.

Estate Tax Planning for Non-Residents Owning U.S. Real Estate

IRC § 2101 imposes a tax on the transfer of the taxable estate of a person who was not a U.S. nonresident alien (NRA) at the time of death.

The 2017 Tax Cuts and Jobs Act increased the basic exclusion amount for estates of U.S. residents and citizens, doubling it from $5.5 million to $11.2 million. However, the IRC sections relating to the taxation of estates of non-U.S. residents remained the same – the excluded amount remains at a paltry $60,000.

A common situation is where a foreign investor has purchased U.S. real property and owns the property directly. Upon death, the value of that real property would be included in the estate and subject to tax on its gross estate exceeding $60,000.

While there are planning opportunities for NRAs to purchase U.S. real estate to avoid estate tax (such as owning U.S. real estate through a foreign corporation), opportunities are limited when an NRA already owns real property that is held directly.

Estate tax for non-residents – generally

The U.S. estate tax filing requirements of a decedent’s estate are determined by whether, at death, the decedent was a U.S. citizen or resident for estate tax purposes. And if the decedent was not a U.S. citizen nor a U.S. resident, whether the decedent had U.S. situs property.

A non-citizen non-resident decedent will be subject to U.S. estate tax on U.S. situs assets.  The executor of an estate of a non-citizen, non-resident decedent is required to file a Form 706-NA to report property located within the United States worth more than $60,000.

If the decedent owned property with a surviving spouse who is not a citizen of the United States, the value of that property must be reported in full on Form 706. Under IRC 2056(d)(1), the unlimited marital deduction is generally not available for property passing to a surviving spouse who is not a United States citizen. Under IRC 2056A, bequeathing property to a noncitizen surviving spouse through a qualified domestic trust (QDOT) allows an estate to receive a marital deduction. For the marital deduction to apply, property must be transferred to the QDOT prior to the death of the decedent. However, a QDOT merely defers the tax and upon the death of the surviving spouse, the U.S. situs assets will be subject to estate tax.

The rates applicable to estates of NRAs are the same as those that apply to U.S. citizens, at a maximum tax rate 40%.

U.S. situs property

The following are a non-exclusive list of assets treated as U.S. situs property:

1. Real estate located in the U.S.
2. Tangible personal property is deemed to be U.S. situs property if physically present in the United States on the date of death. There is an exception for works of art which are imported solely for public exhibition, on loan to a non-profit gallery or museum or on exhibition or en route to or from an exhibition.
3. Stock of U.S. corporations (those located in the United States or organized under U.S. law) is considered property in the United States.
4. Generally, debt obligations are property located in the United States if they are debts of a U.S. citizen or resident, a domestic partnership or corporation, a domestic estate or trust, the United States, a state or a political subdivision of a state or the District of Columbia.
5. Deposits with a U.S. branch of a foreign corporation that is engaged in the commercial banking business are treated as property located in the United States.

When an NRA investor has already acquired U.S. property

Once a NRA directly owns a U.S. real property interest, there aren’t many great options to avoid estate tax, but there are options.

The following options lead to unintended tax consequences:

1. Making a lifetime gift. There is no lifetime gift tax exemption for NRAs. An annual exclusion of $14,000 is available, which is never sufficient, subjecting the transfer to gift tax.
2. Exchanging the interest in the real property for stock in a foreign corporation. Transfers of USRPIs for foreign corporation stock generally do not qualify for nonrecognition treatment, subjecting the transfer to U.S. income tax.

The following approaches are worth looking into:

1. The NRA becomes a U.S. resident for estate tax purposes to take advantage of the $11.2 million exclusion ($22.4 million if married filing jointly). However, doing so will also expose the individual’s worldwide assets to U.S. estate tax and to tax on worldwide income.
2. The NRA transfers the U.S. real property interest for a U.S. partnership interest. The exchange of an interest in a U.S. real property for an interest in a partnership will receive non-recognition treatment for the transfer. Partnership situs rules come with uncertainty as the IRS has not provided much guidance on whether partnership interests are considered U.S. situs. It is unclear whether the IRS would apply a look-through test, or possibly a combination of factors including where the partnership was organized, the domicile of the decedent, or the partnership’s place of management. Depending on the circumstances, it can be a reasonable argument by the decedent’s executors that the partnership interest is not U.S. situs property. The risk is that the IRS may disagree with the position in the event of an audit.
3. A foreign corporation owned by the NRA encumbers the asset with nonrecourse debt, which would limit estate tax exposure to the net value above the amount of debt.
4. Purchasing life insurance to cover the estimated estate tax liability.

TIGTA Reports that IRS is not Prepared for FATCA Enforcement

In a recent report by the Treasury Inspector General for Tax Administration (TIGTA), the IRS has taken limited or no action on a majority of the planned activities outlined in the FATCA Compliance Roadmap.

What is FATCA?

The Foreign Account Tax Compliance Act (FATCA) is a law passed in 2010 requiring all non-U.S. financial institutions (FFIs) to report the identities of U.S. persons to the U.S. Department of Treasury.

The U.S. Congress intended the Foreign Account Tax Compliance Act (FATCA) to improve U.S. taxpayer compliance with reporting foreign financial assets and offshore accounts.

It was estimated that revenue from the FATCA’s offset provision would be $8.7 billion from Fiscal Years 2010 to 2020.

Under the FATCA, individual taxpayers with specified foreign financial assets that meet a certain dollar threshold should report this information to the IRS, beginning with Tax Year 2011, by filing Form 8938, Statement of Specified Foreign Financial Assets, with their income tax return. This requirement is established under IRC § 6038D. Individuals are required to file Form 8938 with their income tax returns if the aggregate value of their foreign financial assets exceed certain dollar thresholds.5

To avoid being subject to a 30 percent withholding rate on U.S. source payments, the FATCA also requires foreign financial institutions (FFI) to register and agree to report to the IRS certain information about financial accounts held by U.S. taxpayers or held by foreign entities in which U.S. taxpayers hold a substantial ownership interest. The intent was for the IRS to use this information to verify that U.S. persons have reported such financial accounts on Form 8938.

TIGTA’s Findings and Recommendations

TIGTA determined that, despite spending nearly $380 million, the IRS has taken limited or no action on a majority of the planned activities outlined in the FATCA Compliance Roadmap.

Of the 31 activities, the IRS indicated that it has taken action on 24 activities. However, TIGTA found that for 16 of those 24 activities, action was either limited or in the early stages of
development.

A large number of reports filed by the FFIs did not include (or included invalid) Taxpayer Identification Numbers (TIN). Consequently, the IRS has not been able to successfully identify and enforce FATCA requirements for individual taxpayers.

TIGTA recommends that the IRS:

1. Establish follow-up procedures and initiate action to address error notices related to file submissions rejected by the  International Compliance Management Model (ICMM);
2. Initiate compliance efforts to address taxpayers who did not file a Form 8938 but who were reported on a Form 8966 filed by an FFI;
3. Add guidance to the Form 8938 instructions to inform taxpayers on how to use the FFI List Search and Download Tool on the IRS’s website;
4. Initiate compliance efforts to address and correct missing or invalid TINs on Form 8966 filings by non-IGA FFIs and Model 2 IGA FFIs;

Moreover, it does not appear the IRS is using standardized procedures for working a Form 8938 (§ 6038D) penalty case.  Revenue agents use judgment in selecting the techniques that apply to each taxpayer. The IRS noted that a lead sheet is available to revenue agents when conducting an examination. The lead sheet was finalized and placed on the IRS website in July 2016. However, there is currently no requirement to use the lead sheet for selecting and reviewing cases under the FATCA.

The IRS responded that it will continue its efforts to systemically match FFI information and Form 8938 data to identify nonfilers and underreporting related to U.S. holders of foreign accounts and to the FFIs. The IRS has initiated development of a data product to automate risk assessments across the FATCA filing population.

Based on the recommendations in this TIGTA audit, we should expect that the IRS will soon begin identifying and acting on Form 8938 non-compliance based on financial information provided by foreign financial institutions.

What should non-compliant taxpayers do?

If taxpayers are non-compliant with the foreign asset and income reporting requirements, they should consider applying to one of IRS’ voluntary disclosure programs:

• Offshore voluntary disclosure program
• Streamlined domestic offshore program
• Streamlined foreign offshore program
• Delinquent international information return submission procedures

We assist taxpayers who have undisclosed foreign financial assets. Schedule an appointment to see how we can help.

U.S. Tax on Australian Superannuation Funds

An Australian superannuation fund is a partly compulsory pension program put in place by the Government of Australia. The employer contribution rate has been 9.5% since 1 July 2014, and as of 2015, was planned to increase gradually from 2021 to 12% in 2025.

An individual can withdraw funds out of a superannuation fund when the person meets one of the conditions of release, such as retirement, terminal medical condition, or permanent incapacity.

U.S. taxation of these plans can be confusing.

Classification of Australian supers for U.S. tax purposes

An Australian superannuation is a hybrid plan that the U.S. doesn’t have a parallel. It has characteristics of both a social security program and a private pension.

Contributions to Australian superannuation funds are treated as social security contributions in the U.S-Australia totalization agreement.

However, unlike a government social security program, an Australian super is not mandatory upon the employee to contribute.  Moreover, it’s not a public fund; it’s privatized.

Unfortunately, the IRS has not provided much guidance on this hybrid plan. Most practitioners treat them as private pensions.

We’ve heard about practitioners who take the position that they’re social security funds and completely exclude super earnings and distributions from U.S. taxation relying on Article 18 the U.S.-Australian income tax treaty:

Social Security payments and other public pensions paid by one of the Contracting States to an individual who is a resident of the other Contracting State or a citizen of the United States shall be taxable only in the first-mentioned State.

And Article 1 section 3 excepts the Savings Clause from Article 18, which otherwise would’ve subjected social security plans to U.S. tax.

To take this treaty position on Australian supers is almost certainly incorrect because Australian superannuation funds are not social security or public pensions:

• Australia has a system of social welfare payments provided by the Government of Australia. Superannuation funds are privately managed and are not paid directly by the Government of Australia, although it could be argued that Australian employers are acting as agents of the Government of Australia. Note that in Article 18 it specifically states that the payment must be “paid by one of the Contracting States.”
• The IRS has provided guidance on the tax treatment of similar funds such as the Singapore Central Provident Fund, which the IRS treats as a nonexempt employees’ trust.

[W]e have concluded that the Fund is a nonexempt employees’ trust described in § 402(b). It appears that contributions to the Fund generally are made as a uniform percentage of salary for the vast majority of each employer’s employees.

• In a 2005 private letter ruling, the IRS concluded that “Under the Treaty, the payment to Taxpayer from an Australian superannuation fund is subject to U.S. tax.”

Is the growth in a superannuation taxable in the U.S.?

It depends on the plan and whether it’s considered a foreign grantor trust or an employees trust.

(1) Foreign grantor trust

A foreign grantor trust arises when more than 50% of the contributions to the fund were made by the individual. And if so, a portion attributable to the after-tax contributions would be reported on Form 3520 as a grantor trust. The earnings inside the funds would be taxed concurrently. Self-managed super funds are usually considered grantor trusts.

(2) Employees trust

If employer contributions are greater than 50%, the employer is the owner of the entire trust and the plan is considered a non-qualified employee’s trust.

In that case, it must be then determined whether the participant is highly compensated under IRC 410(B). If the participant is not highly compensated, then fund earnings are not subject to tax until distribution under IRC 402(b)(2). For highly compensated employees, the increase in the value of the plan is included as taxable income annually.

Section 414(q) defines highly compensated employees as one who:

(A) was a 5-percent owner at any time during the year or the preceding year, or

How are Australian supers taxed on distributions in the U.S.?

Upon distribution, the funds are taxable in the U.S. to the extent that the distributions exceed basis.

The basis in a super are amounts that were previously included in taxable income. This would include funds contributed by the employee but would not include fund-level taxes paid.

Required international information reporting forms

If the fund is a grantor trust, it’ll require Form 3520, 3520-A, Form 8621, FBAR, and Form 8938. As a non-grantor trust, only Form 8938 and FBAR are required.

Court Says FBAR Willful Penalty not Limited to $100,000

Breaking from Wadhan and Colliot, the court in Norman v. United States, No. 15-872T (Ct. Cl. 2018) recently held that FBAR willful penalties are not limited to $100,000 despite the regulation which sets a $100,000 maximum cap.

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FBAR Instruction Guide for U.S. Entities

U.S. Person

For FBAR compliance purposes, a “U.S. person” includes U.S. citizens, U.S. residents, and entities which include corporations, partnerships, limited liability companies, trusts, and estate formed under the laws of the United States. Such entities must file FBARs if they have financial interest in a bank, securities or other financial account located in a foreign country.

Financial Interest: Owner of record or holder of legal title

A domestic entity has a financial interest in a foreign financial account for which the entity is the owner of record or has legal title, regardless of whether that account is maintained for its benefit or the benefit of another.

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FBAR willful penalty capped at $100,000

In the wake of U.S. v. Colliot FBAR civil penalty case discussed previously, another district court in U.S. v. Wadhan has held that 31 CFR §1030.820 limits the maximum willful penalty to $100,000.

Case background

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