Be Careful With Foreign Tax Information Returns

Today we filed an extension for a client company with a foreign subsidiary. I was recently reading a Chief Counsel’s Advice concerning the same type of tax return that our client will be filing in a few months.

There is an additional form to file when one owns a foreign corporation. That is Form 5471 “Information Return of U.S Persons with Respect to Certain Foreign Corporations.” The common ownership threshold for filing is 10 percent. There is a twist in which an officer or director has a responsibility to file, even if the officer or director owns no shares directly, as long as a US citizen owns at least 10 percent.

Frankly, this is a confusing return. There are four types of “filers,” and each has to fill-out – or not fill-out- certain sections of the return. One may have to provide an income statement for the foreign company, for example, or track its earnings and profits.

The 2010 HIRE Act amended the tax Code (Section 6501(c )(8)) so that the statute of limitations for an income tax return to which an international “information return“ relates does not start until the information return is filed.

What does this mean? Well, Form 5471 is considered an “information return.” This means that it has numbers on it, but there is no line that says “tax due.” There is a similar form (Form 8865) for foreign partnerships and another (Form 3520) for foreign trusts.

So you own (enough of) a foreign corporation to file Form 5471. The accountant doesn’t think about it and files the corporate return without it.  The IRS in CCA 201104041 clarified that the statute of limitations on the corporate return does not begin to run until the Form 5471 is filed.

The client referred to above is new to the firm. One of the reasons that they switched firms? Their former CPA had not been filing Forms 5471.

If you remember, there are also penalties for not filing foreign information returns, including Form 5471. That however is for another blog post.

An Expat Tax Horror Story

I acquired a client last week. He was an expat living in Scotland for more than a decade. He recently returned to the US and is now working the in the oil industry.  Yep, based in Cincinnati and working the oil fields of west Texas. While in the UK he worked in the North Sea, went to college, met his wife and started and closed a restaurant, losing quite a bit of money along the way.  He is in the process of immigrating his wife into the US. He has not filed US tax returns since he left the US way back when.

What does a tax guy see here?

(1)    The first is obvious: he hasn’t filed individual tax returns.

There are two saving graces: he will receive foreign income exclusion while working in the UK. That should remove all or almost all his income from taxation. As the UK tax rates are higher, he may also receive a foreign tax credit for tax paid on income in excess of the exclusion.

(2)    He hasn’t filed FBARs.

This is the annual report one sends to Treasury if one has more than $10,000 in an overseas bank account. He made pretty good money while in the North Sea, so he would have exceeded the $10,000 threshold.

This is where it becomes unfair. After the UBS episode, the IRS has taken a very tough stance with overseas accounts.  Some of this is understandable, as the IRS is pursuing the “fat cats.”  This fellow is not a fat cat. He is an ordinary guy who lived in Scotland, and while there he made a couple of dollars. If you have previously read my blog, you may know that I have in-laws overseas. His situation is not disparate to my brother-in-law.

The IRS has an initiative (the Overseas Volunteer Disclosure Initiative) which was to close yesterday (August 31) but was extended to September 9^th because of Hurricane Irene. We considered the OVDI.

Here is the IRS:

A penalty for failing to file the Form TD F 90-22.1 (Report of Foreign Bank and Financial Accounts, commonly known as an “FBAR”).United States citizens, residents and certain other persons must annually report their direct or indirect financial interest in, or signature authority (or other authority that is comparable to signature authority) over, a financial account that is maintained with a financial institution located in a foreign country if, for any calendar year, the aggregate value of all foreign accounts exceeded $10,000 at any time during the year. Generally, the civil penalty for willfully failing to file an FBAR can be as high as the greater of $100,000 or 50 percent of the total balance of the foreign account. See 31 U.S.C. § 5321(a)(5).  Nonwillful violations are subject to a civil penalty of not more than $10,000.

I spoke with an attorney in the IRS unit yesterday afternoon, and he informed me that – because of the favorable facts – the IRS would not penalize my client more than 12.5% for not filing his FBARs timely. The penalty might even be reduced to 5%. So if my client had $50,000 in a Scotland bank, he could be facing a fine of $6,250.

(3)    He owned a business in Scotland.

This business was organized as a private limited company. Had he made a timely US election, we would have treated this entity as an LLC and folded the numbers into his personal return. As the returns are late, that avenue is not available. The entity is therefore treated as a foreign corporation. Since the corporation is controlled by a US citizen, it has to file Form 5471 with the IRS.

Take a look at these penalties from the IRS Voluntary Disclosure website:

A penalty for failing to file Form 5471, Information Return of U.S. Person with Respect to Certain Foreign Corporations. Certain United States persons who are officers, directors or shareholders in certain foreign corporations (including International Business Corporations) are required to report information under sections 6035, 6038 and 6046.The penalty for failing to file each one of these information returns is $10,000, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return.

(4)    He funded a business in Scotland.

There is additional reporting here. He is required to file Form 926 disclosing his outbound investment into the restaurant. Now, it wasn’t really “outbound” as he lived in Scotland at the time, but because he is a US citizen it is considered “outbound.”

Let’s look again at the IRS:

A penalty for failing to file Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation. Taxpayers are required to report transfers of property to foreign corporations and other information under section 6038B.The penalty for failing to file each one of these information returns is ten percent of the value of the property transferred, up to a maximum of $100,000 per return, with no limit if the failure to report the transfer was intentional.

Now, does this appear reasonable to you?

As a long-standing tax practitioner I have very firm opinions on desirable attributes of a fair and efficient tax system. One is that a citizen should be able (in most cases) to prepare his/her tax return without the need of someone like me.  Second is that the system should not be random and arbitrary, either in its laws or regulations or in its enforcement of the same. Third is that the system should not mete out draconian punishment for matters representing less-than- extreme abuse or disregard of the system. I cannot help but feel that the Treasury has violated the third precept. This fellow is a driller, not a hedge fund manager. To me his noncompliance is roughly equivalent to me not knowing the holidays in Peru.

If you wonder how my client turned out, there was another way to file. He loses the certainty of the OVDI penalty structure, but when the penalty is that severe can you blame a taxpayer for preferring an unknown to the known?