Talking Expatriation (And A Little Latin)

A friend contacted me recently. He was calling to discuss the tax issues of expatriating. As background, there are two types of expatriation. The first is renouncing citizenship, which he is not considering. The second is simply living outside the United States. One remains an American, but one lives elsewhere.

It is not as easy as it used to be. 

I have, for example, been quite critical of Treasury and IRS behavior when it comes to Americans with foreign bank accounts. If you or I moved overseas, one of the first things we would do is open a bank account. As soon as we did, we would immediately be subject to the same regime as the U.S. government applies to the uber-wealthy suspected of stashing money overseas.  

Some aspects of the regime include:

(1) Having to answer questions on your tax return about the existence of foreign accounts. By the way, lying is a criminal offense, although filing taxes is generally a civic matter.

(2) Having to complete a schedule to your tax return listing your foreign financial and other assets. Move here from a society that has communal family ownership of assets and you have a nightmare on your hands. What constitutes wealthy for purposes of this schedule? Let’s start at $50,000, the price of a (very) nice pickup truck.

(3) Having to file a separate report with the Department of Treasury should you have a foreign bank account with funds in excess of $10,000. The reporting also applies if it is not your account but you nonetheless have authority to sign: think about a foreign employer bank account. It should be fun when you explain to your foreign employer that you are required to provide information on their account to the IRS.

(4) Requiring foreign banks to both obtain and forward to the IRS information about your accounts. Technically the foreign banks have a choice, but fail to make the “correct” decision and the IRS will simply keep 30% of monies otherwise going to them.

To add further insult, all this reporting has some of the harshest penalties in the tax Code. Fail to file a given tax form, for example, and take a $10,000 automatic penalty. Fail to file that report with the Treasury Department and forfeit half of your account to the government.

Now, some of this might be palatable if the government limited its application solely to the bigwigs. You know the kind: owners of companies and hedge fund managers and inherited wealth. But they don’t. There cannot be ten thousand people in the country who have enough money overseas to justify this behavior, so one is left wondering why the need for overreach. It would be less intrusive (at least, to the rest of us 320 million Americans) to just audit these ten thousand people every year. There is precedence: the IRS already does this with the largest of the corporations.

Did you know that – if you fail to provide the above information – the IRS will deem your tax return to be “frivolous?” You will be lumped in there with tax protestors who believe that income tax is voluntary and, if not, it only applies to residents of the District of Columbia.

There is yet another penalty for filing a frivolous return: $5,000. That would be on top of all the other penalties, of course. It’s like a party.

Many practitioners, including me, believe this is one of the reasons why record numbers of Americans overseas are turning-in their citizenship. There are millions of American expats. Perhaps they were in the military or foreign service. Perhaps they travelled, studied, married a foreign national and remained overseas. Perhaps they are “accidental” Americans – born to an American parent but have never themselves been to the United States. Can you imagine them having a bank close their account, or perhaps having a bank refuse to open an account, because it would be too burdensome to provide endless reams of information to a never-sated IRS? Why wouldn’t the banks just ban Americans from opening an account? Unfortunately, that is what is happening.

So I am glad to see the IRS lose a case in this area.

The taxpayer timely filed his 2011 tax return. All parties agreed that he correctly reported his interest and dividend income. What he did not do was list every interest and dividend account in detail and answer the questions on Schedule B (that is, Interest and Dividends) Part III. He invoked his Fifth Amendment privilege against self-incrimination, and he wrote that answering those questions might lead to incriminating evidence against him.

Not good enough. The IRS assessed the penalty. The taxpayer in response requested a Collections Due Process Hearing.

Taxpayer said he had an issue: a valid Fifth Amendment claim. The IRS Appeals officer did not care and upheld the penalty.

Off to Tax Court they went.

And the Court reviewed what constitutes “frivolous” for purpose of the Section 6702 penalty:

(1) The document must purport to be a tax return.

(2) The return must either (i) omit enough information to prevent the IRS from judging it as substantially correct or (ii) it must clearly appear to be substantially incorrect.

(3) Taxpayer’s position must demonstrate a desire to impede IRS administration of the tax Code.

The first test is easy: taxpayer filed a return and intended it to be construed as a tax return.

On to the second.

Taxpayer failed to provide the name of only one payer. All parties agreed that the total was correct, however. The IRS argued that it needed this information so that it may defend the homeland, repair roads and bridges and present an entertaining Super Bowl halftime show. The Court asked one question: why? The IRS was unable to give a cogent reply, so the Court considered the return as filed to be substantially correct.

The IRS was feeling froggy on the third test. You see, the IRS had previously issued a Notice declaring that even mentioning the Fifth Amendment on a tax return was de facto evidence of frivolousness. Faciemus quod volumus [*], thundered the IRS. The return was frivolous.

The Court however went back and read that IRS notice. It brought to the IRS’ attention that it had not said that omitting some information for fear of self-incrimination was frivolous. Rather it had said that omitting “all” financial information was frivolous. You cannot file a return with zeros on every line, for example, and be taken seriously. That however is not what happened here.

The IRS could not make a blanket declaration about mentioning the Fifth Amendment because there was judicial precedence it had to observe.  Previous Courts had determined that a return was non-frivolous if the taxpayer had disclosed enough information (while simultaneously not disclosing so much as to incriminate himself/herself) to allow a Court to conclude that there was a reasonable risk of self-incrimination.

The Court pointed out the following:

(1) The taxpayer provided enough information to constitute an accurate return; and

(2) The taxpayer provided enough information (while holding back enough information) that the Court was able to conclude that he was concerned about filing an FBAR. The questions on Schedule B Part III could easily be cross-checked to an FBAR. Given that willful failure to file a complete and accurate FBAR is a crime, the Court concluded that the taxpayer had a reasonable risk of self-incrimination.

The Court dismissed the penalty.

The case is Youssefzadeh v Commissioner, for the at-home players.

I am of course curious why the taxpayer felt that disclosure would be self-incrimination. Why not just file a complete and accurate FBAR and be done with it? Fair enough, but that is not the issue. One would expect that an agency named the Internal “Revenue” Service would task itself with collecting revenue. In this instance, all revenue was correctly reported and collected. With that backdrop, why did the IRS pursue the matter? That is the issue that concerns me. 

[*] Latin for “we do what we want”

Is Zwerner's 200% Penalty Excessive?

Let me ask you a hypothetical question.

Say you made a million dollars in 2013. Even in a worst-case, salt-the-fields scenario, what would be the most the government could take from you in taxes? 

I am thinking a million dollars. 

His facts are not attractive. There is a saying that “bad facts make bad law.” We have both in this case. 

His name is Carl Zwerner, is 86 years old and lives in the Miami area. For years 2004 through 2007, Zwerner maintained an account at ABN AMRO Bank in Switzerland. It is not (yet) illegal for an American to have a foreign bank account, but it is illegal not to report it. 

Somewhere in 2008 he had a change of heart. He filed a delinquent FBAR and amended his 2007 tax return to include the earnings from the account. In 2009 he decided to come clean on years 2004, 2005 and 2006 also.

There was a twist: Zwerner did not hold the bank account in his own name. The account was in the name of the “Bond Foundation” for a while, then in the name the “Livella Foundation.” At all times, though, Zwerner had control and was the beneficial owner of the funds. Those account names were just speed bumps.

Then he does the unbelievable. In a letter dated August 2010, he admitted to the IRS that he was aware that he should have reported both the existence of the account and the earnings from it.

Why, Carl, oh why?

The IRS, in yet another example of why people hate the IRS, decided that he “willfully” evaded his taxes, used regular gasoline in a high-octane-only car and failed to hold the door for an elderly woman at the grocery store. The IRS determined that the balances at the Swiss account were as follows over the years:

           

2004	$1,447,000
2005	$1,490,000
2006	$1,545,000
2007	$1,691,000

This did not take Sherlock-type powers by the IRS, by the way, as Zwerner had already reported the account.

The IRS then remembered that the penalty for willful failure to file an FBAR is 50% of the highest balance for each year.

NOTE: Did you pick-up on what the fifth-amendment-pleading crowd has done here? Two years worth of penalties and the account is depleted – essentially seized by the government. 

Well, Zwerner was facing 4 years. His penalty was almost $3.5 million, whereas his account had never exceeded $1.7 million.

Good thing he voluntarily filed amended returns! What would they have done to him had he not come clean? 

In the area of foreign accounts, Treasury and the IRS have decided that we are all guilty, and that the only way to salvation is through their disclosure program du jour. The fact that these programs may not be a fit for many (or most, in my opinion) is beside the point. Many tax practitioners, me included, have represented clients with foreign non-reporting issues. My clients have been “ordinary” – an expat who started a business in Scotland, another who had no idea what an “FBAR” was, much less that she had to file tax returns even though she had lived out of the U.S. for two decades. These are not tax desperados, and to lump them in with IRS programs designed to avoid criminal prosecution is bonkers.

And there is the rub. The IRS took Zwerner’s letter as an admission of “willfulness,” meaning that he is charged with tax fraud. This is a criminal charge, and Zwerner should have entered the Offshore Voluntary Disclosure Program if he wanted protection from criminal charges. The IRS would say this is not the same as my Aberdeen restaurateur. I in turn would ask the IRS: why don’t you have a program for people like my restaurateur? Do you think I enjoyed that phone call with an expat who is afraid to return to the United States to visit her mother? Why are you terrorizing ordinary people? We could probably put all the people with significant money hidden overseas into one hotel conference room. Why is it that attorneys and tax CPAs in 50 states have horror stories to tell? There cannot be that many overseas-money-hiding uber-wealthies to go around.

Zwerner amended his returns. He did not enter the disclosure program. The IRS calls this a “quiet disclosure,” and they do not like it. They assessed 200% penalties.

What choice did the IRS leave him? He filed a lawsuit against the government.  He has an interesting argument, as the Eighth Amendment prohibits “excessive fines.” 

What do you think? Is a penalty of more than 100% an “excessive fine?”

There is precedent. There is a 1998 case where someone tried to take $357 thousand overseas and got caught with the money in his luggage. The U.S. sought forfeiture of the entire amount. The Supreme Court ruled against the government, stating that forfeiture of all the money was “grossly disproportional to the gravity of the offense.” The Supreme Court ordered him to pay $20,000 instead.

We’ll be paying attention to Zwerner’s case as it goes through the courts.

The IRS Is Looking For Hundreds of Thousands of Canadian Trust Returns

The IRS wants us to believe that there are hundreds of thousands of Americans who have failed to file required U.S. tax returns for their Canadian trusts.

Nonsense.

Let’s go over this, as it reflects a relentless demand by Treasury and the IRS for ever-more information on any financial transaction that may have –even remotely - an American connection. 

If an American funds or receives a distribution from a foreign trust, he or she is supposed to file tax Form 3520 with his/her Form 1040. If an American has a continuing interest in the trust (the likely reason is that he/she is a beneficiary), then he/she also has to file Form 3520-A annually. 

If one is so obstinate as to not file the 3520 or 3520-A, the IRS has a penalty of $10,000 they will gladly drop on you. You can get out of the penalty by showing “reasonable cause” for not filing, but the IRS reserves the right to define reasonable cause. 

  

The issue with reasonable cause is that it presumes both parties are reasonable, a presumption the IRS is near to abrogating. For example, whose brilliant idea was it to impose an automatic $10,000 penalty? The penalty for late filing of your personal tax return is 5% of the tax due per month – not $10,000. Late file a partnership return and the penalty is $195 per K-1 per month – not $10,000.  Why is this penalty different? Does the Treasury suspect that we are all hiding hundreds of thousands if not millions of dollars overseas? If so, where is mine?

Am I being heavy-handed? Let me give you three examples of what the IRS considers to be Canadian trusts:

• registered education savings plans (RESPs)
• tax free savings accounts (TFSAs)
• registered disability savings plans (RDSPs)

A RESP is a Canadian Section 529 plan, but with a twist. Like the American 529 plan, you open the account at a bank, broker or other financial institution. You or other family members can contribute. Unlike a 529, however, Canada will match your contribution, up to a certain percentage. Like a 529, there will be taxes when the child withdraws money to attend college.

There is no U.S. equivalent to a tax-free savings account. There is no deduction for the contribution, but there is no tax on withdrawals either. This aspect resembles an American Roth, but the Canadian TFSA is not limited to retirement savings. There are limits on how much one can contribute, of course, and for low-income taxpayers the government will contribute 500 hundred dollars Canadian.

Once again, there is no U.S. equivalent to a registered disability savings plan. The government will match one’s contribution, and for low-income taxpayers it will contribute up to 2 thousand dollars Canadian. Its purpose is self-descriptive.

The issue with the above three is that most people – even financially astute people – would not consider these vehicles to be trusts. We see savings vehicles, perhaps government-subsidized, but we do not see trusts. The problem however is that the IRS sees them as trusts. The IRS has defined a dog as a four-legged animal, and it now doesn’t know how to undefine any four-legged animal from being a dog. We are sitting ducks for that $10,000 penalty. 

What if you decide not to file prior IRS returns and just begin filing for the current year? One could easily come to this decision if there isn’t much money involved. This technique is known as “quiet disclosure.” Many practitioners, including me, have used it. The IRS does not care for it. The IRS has three reservations about quiet disclosures:

(1) Using quiet disclosures undermines the incentive to use government-approved disclosure programs, such as the most recent OVDP with its 27.5% penalty on the account’s highest balance over the last eight years. That is on top of any other applicable IRS penalties.

(2) Taxpayers using quiet disclosures may pay fewer penalties than those using the government-approved programs.

(3) Quiet disclosure is antithetical to general fairness, meaning that some taxpayers receive more favorable treatment than others do.

OBSERVATION: After the 501(c)(4) scandal, one will forgive my extreme cynicism on argument (3). Perhaps I will relent some when IRS bigwigs go to jail. It's only fair.

Reread (1) and (2) and you can see the real reason the IRS does not like quiet disclosures. It is not sufficient merely to bring someone back into compliance.

How is a reasonable person supposed to comply with the tax law, when the law is capricious? Consider that ignorance of the tax law is not defined as “reasonable cause” and you begin to see the box that the IRS is placing you in. They can pass any ludicrous demand – perhaps they want the napkin from your third lunch in the fifth week of alternating quarters – and then, with a straight face, say that your ignorance of their requirements is not an excuse.

It is also how they can say that hundreds of thousands of American citizens have failed to file for their Canadian trusts.

New Plan for U.S. Expats to Comply With The IRS

There is good tax news for many U.S. expats and dual citizens. Beginning September 1^st, the IRS is starting a new program allowing many expats to catch-up on late tax returns and late FBARs without penalties.

This new program is different from the “Offshore Voluntary Disclosure” programs of the last few years. For one thing, this program is more geared to an average expat. Secondly, and more important to the target audience of the OVD programs, this program does not offer protection from criminal prosecution. That is likely a nonissue to an average expat who has been living and working in a foreign country for several years and has not been trying to hide income or assets from the U.S.

Under this new program, an expat will file 3 years of income tax returns and 6 years of FBARs. This is much better than the 8 years of income tax returns and 8 years of FBARs for OVD program participants.

All returns filed under this program will be reviewed by the IRS, but the IRS will divide the returns into two categories:

Low Risk – These will be simple tax returns, defined as expats living and working in foreign countries, paying foreign taxes, having a limited number of investments and owing U.S. tax of less than $1,500 for each year. Low risk taxpayers will get a pass – they will pay taxes and interest but no penalties.

NOTE: When you consider that the expat will receive a foreign tax credit for taxes paid the resident country, it is very possible that there will be NO U.S. tax.

 Higher Risk – These will be more complicated returns with higher incomes, significant economic activity in the U.S., or returns otherwise evidencing sophisticated tax planning. These returns will not qualify for the program and (likely) will be audited by the IRS. This is NOT the way to go if there is any concern about criminal prosecution. However, it MAY BE the way to go if concern over criminal prosecution is minimal. Why? The wildcard is the penalties. Under OVDP a 27.5% penalty is (virtually) automatic. Under this new program the IRS may waive penalties if one presents reasonable cause for noncompliance.

NOTE: This is one of the biggest complaints about the OVD program and its predecessors: the concept of “reasonable cause” does not apply. The IRS consequently will not mitigate OVD penalties. This may have made sense for multimillionaires at UBS, but it does not make sense for many of the expats swept-up by an outsized IRS dragnet.

The IRS has also announced that the new program will allow resolution of certain tax issues with foreign retirement plans. The IRS got itself into a trap by not recognizing certain foreign plans as the equivalent of a U.S. IRA. This created nasty tax problems, since contributions to such plans would not be deductible (under U.S. tax law) and earnings in such plans would not be tax-deferred (under U.S. tax law). You had the bizarre result of a Canadian IRA that was taxable in the U.S.

QUESTION: If your tax preparer had told you that this was the tax result of your Canadian RSSP, would you have believed him/her? Would you have questioned their competency? Sadly, they would have been right.