Paying taxes on investments often seems to steal the icing on the cake, gobbling up the best part of an investment’s return. With foreign investments, it is not just the taxes themselves, but the fees associated with filing tax forms that can reduce returns to a marginal level.
Uncle Sam taxes US citizens on their worldwide income, but the complexities of reporting income correctly are often more difficult than the tax is costly – and the penalties for misreporting can be astronomical. For example, the minimum penalty for not filing the FBAR to report foreign bank accounts is over $10,000, or 10% of the account value; however, no tax has ever been paid with an FBAR report.
Many of my clients have renounced US citizenship to prevent the prying eyes of the US Treasury from gaining insight into the intimate details of their financial lives. But in our digitalized world, that’s a weak argument, as few places in the world hold bank details privately.
In our rapidly globalizing world, the doors to hiding money will continue to close. Unfortunately, understanding How? ‘Or’ What meeting ever-increasing reporting requirements is not so easy to manage.
The Layer Cake Analogy
Foreign investments are like a layer cake, with several areas that potentially need to be reported, depending on the type of account and assets. The base layer is the foreign bank account reporting rules that require the FBAR report to be filed annually with the Treasury Department. The FBAR reporting threshold is to have balances greater than $10,000 combined in all non-US financial accounts at any given time during the tax year. This means that if you are selling a home inherited from an Italian relative and the funds from the sale arrive in your Italian bank account for a minute before transferring them to the United States, you must file an FBAR report.
A common mistake is not realizing that foreign pension accounts must also be reported. Often, pension accounts are large sums that will trigger not only FBAR, but also Form 8938 attached to the individual’s tax return. Thresholds for 8938 range from $50,000 to $600,000 in balances, depending on residency and filing status.
The dreaded PFIC
The next layer is the investment accounts. If you directly hold foreign securities, your reporting obligations are generally limited to the FBAR/8938 rules. But foreign mutual funds are treated quite differently: a few decades ago, someone figured out that they could keep money in foreign mutual funds and not pay US taxes while the accounts were growing, only having to pay once the money was withdrawn – much like how a traditional IRA generates income. As the saying goes, you can’t have your cake and eat it too.
The US government did not appreciate this strategy too much. This was the genesis of the Passive Foreign Investment Company (PFIC) Section 1291 rules, which when taking a distribution can result in a large tax penalty. The way around this is to choose the “Mark to Market” treatment. With this, you are taxed each year on your account growth at your normal tax rate, and you can take losses on income, up to the previously reported gains. This seems to me to be a very fair way to remove the complexity of penalties applied under Section 1291. PFIC income requires an annual report on Form 8621, if the total amounts held are greater than $25,000, and does not do not apply to retirement accounts.
Since corporate reversals are the “pineapple upside-down cake” of tax topics, many people think foreign corporations are equal to tax-exempt status, but it’s not that simple. If the company meets certain requirements, it can retain undistributed earnings without incurring US tax. Foreign corporations make the most tax sense when operated by owners living outside the United States: without majority ownership by U.S. persons, and if the services are provided in the United States or if the money is contributed, US tax will be due. This is why many companies complain about their profits abroad. My opinion is that lowering the tax rate for income repatriation is foolish and invites abuse, but I am sure that all the rules promulgated will help some of my clients. And it’s my job to help customers at the end of the day.
I could fill another article, or five, with the complexities of foreign flow-through entities, but for now some basics:
1. Most of what people think are ignored foreign entities are actually US corporations. This includes entities with suffixes such as: “LP”, “LTD” and “LLC”, and although it may look like a domestic LLC, it is not treated that way.
2. Generally, choosing to be treated as an ignored entity under US law is not to the benefit of the taxpayer. The rules in this area are very complex and require the costly annual filing of the two information declarations and tax forms required as if a US corporation.
3. Foreign trusts generally require two separate reporting forms each year: 3520 and 3520-A. One is to report the distributions the US taxpayer receives, and the other is the information statement to report the activities of the trust. This creates a heavy filing burden, although the benefits can be attractive in certain situations.
take the cake
By now, you should at least have an idea of where to start when looking at what to file to avoid trouble with foreign investments, as well as how the different layers of information reporting fit together. Fortunately, there are a few programs to become compliant if you have inadvertently failed to meet these requirements over the years, such as the Simplified Procedure and the Delinquent Feedback Submission Procedures. These are relatively painless (and mostly penalty-free) ways to avoid any problems.