IRS foreign information reporting returns
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The IRS has an interest in U.S. taxpayer transactions overseas. Therefore, it is no surprise that Congress has enacted numerous federal tax reporting laws that require individuals to prepare and file foreign information returns with the agency. The IRS closely monitors these filings and routinely assesses civil penalties for late or improper submissions. And these penalties can apply to more than one tax year and more than one information return filing obligation.
Most foreign information returns result from a taxpayer’s classification as a “U.S. person.” Although these persons include U.S. citizens and lawful permanent residents (e.g., “green-card holders”), the definition of a “U.S. person” also encompasses those with substantial physical presence in the U.S. As discussed more below, the substantial presence test often serves as a trap for the unwary foreign citizen who travels and resides for some time in the U.S.
Substantial Presence Test
The substantial presence test measures and analyzes the number of days that a person is physically present in the U.S. Current year days are given more significance than days in prior years.
As a threshold requirement, the individual must be physically present in the U.S. at least 31 days in the calendar year. Once this threshold is met, the person must determine the actual number of days physically present in the current year and the two preceding tax years. If the person’s physical presence in the U.S. equals or exceeds 183 days, based on the discount factor for the preceding two tax years, then the individual is a U.S. person for federal tax purposes. The formula requires the person to multiply the number of days physically present in the U.S. in the current calendar year by one, the preceding year by 1/3, and the second preceding year by 1/6. More details on the substantial presence test can be found here.
There are numerous exceptions to the substantial presence test (and even exceptions to those exceptions). For example, individuals physically present in the U.S. for less than one-half of the calendar year who can establish a “closer connection” to a foreign country do not fall within the substantial presence test unless the individual falls within another inclusionary exception to this exception (e.g., the individual took steps in the calendar year to become a lawful permanent U.S. resident).
Another exception to the substantial presence test relates to “exempt individuals.” Exempt individuals are not required to count their physical presence in the U.S. for purposes of the substantial presence test. Common examples here include teachers and students in the U.S. on visas. Significantly, the exempt individual characterization does not last forever—e.g., students may generally only use it for five calendar years unless they can demonstrate they don’t intent to permanently reside in the U.S. and meet other requirements.
U.S. persons are usually subject to the foreign information return requirements. Conversely, individuals who are non-resident aliens generally don’t have the same filing requirements.
IRS Information Return Filing Requirements
U.S. persons are generally subject to the foreign information return requirements. Conversely, individuals who are non-resident aliens are not subject to these return requirements. As seen above, it can be easy for individuals to mischaracterize themselves for U.S. tax purposes, either due to an unawareness of the substantial presence test, errors in computations related to the number of days physically present, or the inherent complexities in the exceptions to the substantial presence test rules.
Taxpayers who are characterized as U.S. persons, even under the substantial presence test, are required to file the following foreign information returns.
Form 3520 And Form 3520-A
U.S. persons with interests or transactions with foreign trusts must file Form 3520 and often Form 3520-A. In addition, U.S. persons who receive foreign gifts over a threshold amount in the tax year must file Form 3520. Common transactions that require Form 3520 and Form 3520-A filing requirements include:
- Creation of a foreign trust or transfer of funds or property to a foreign trust (Part I of Form 3520);
- U.S. person treated as a grantor or owner of the foreign trust under the grantor trust rules (Part II of Form 3520 and requirement to file Form 3520-A if the foreign trust fails to file the information return);
- Receipt of a distribution from a foreign trust (Part III of Form 3520);
- Receipt of a gift from a non-resident alien that exceeds $100,000 if the donor is a foreign individual (Part IV of Form 3520).
The failure to file Form 3520 and Form 3520-A can result in significant civil penalties. For the Form 3520, the foreign-trust penalty is computed as the greater of $10,000 or 35% of the “gross reportable amount,” which in turn, means the value of the transfer to or distribution from the foreign trust. Concerning the foreign gift Form 3520 filing obligation, the penalty is 5% of the value of the foreign gift each month the information return is filed late (not to exceed 25%). With respect to the Form 3520-A foreign grantor trust filing requirement, the penalty is the greater of $10,000 or 5% of the “gross reportable amount,” which here usually means the value of the foreign trust’s assets at the close of the tax year.
Form 8938
U.S. persons with interests in “specified foreign financial assets” must file an annual Form 8938. For these purposes, a specified foreign financial asset includes: (i) foreign bank and investment accounts; (ii) interests in foreign entities; and (iii) notes or other debt from foreign persons. Failure to file a timely and proper Form 8938 can result in penalties of $10,000 per year.
FBAR
U.S. persons must also file an annual FBAR if the individual has a financial interest or other reportable interest in a foreign financial account and the account or accounts exceed $10,000 in the aggregate at any time during the calendar year. Of all the foreign information return requirements, the FBAR penalty can be the most expensive: penalties are equal to the greater of $100,000 (indexed for inflation) or 50% of the foreign account balance at the time of the filing violation.
Although the Forms 3520, 3520-A, 8938, and FBAR are the most common foreign information returns, taxpayers should be mindful that there are many others. See here.
IRS Compliance Options
There are options to remedy non-compliance related to the failure to file the above foreign information returns. First, many penalties have an escape hatch known as “reasonable cause.” To put the reasonable cause defense front and center with the IRS, it is often important to assert the defense early, such as with the filing of the late information returns. Under newer guidance, the IRS has indicated that it will review reasonable cause statements with the late filings (previously, the IRS would automatically assess the penalties and make the taxpayer go to IRS Appeals to fight it).
Second, the IRS offers compliance programs that can be extremely useful in resolving late-filing penalties. Under the IRS’ Streamlined Filing Compliance Procedures (SFCP), taxpayers who are “non-willful” may file the information returns late, pay any applicable taxes and interest on the foreign income, and pay a potentially reduced civil penalty (or no penalty at all if the taxpayer meets certain other SFCP offshore requirements).
There are other IRS compliance initiatives outside the SFCP, including the Delinquent FBAR Submission Procedures and the Voluntary Disclosure Program (VDP). Taxpayers who have missed filing a timely foreign information return should determine which program best fits their particular facts and circumstances as each compliance program has its own requirements and pros and cons.
Conclusion
Foreign individuals who relocate to the U.S. often find themselves as unknowing violators of U.S. foreign information return rules. These taxpayers have options to regain compliance, including through IRS compliance programs or reasonable cause contentions. Prior to filing a foreign information return late, taxpayers should consult these options to determine the best fit for their individual facts and circumstances.