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.

IRS Modifies Streamlined Installment Payment Program

The IRS issued a memorandum on January 20, 2012 liberalizing streamlined installment agreements. I am happy with this change.

As a refresher, the advantage of the “streamlined” is that one does not have to provide financial information to the IRS. If you have gone through this effort, you may remember IRS Form 433 – the financial information form. This is where you provide financial detail such as monthly deposits and expenses. You will also attach documentation, including copies of bank statements as well as copies of your mortgage or rent advice and certain other expenses. 

The IRS has standards for broad household expenses, such as mortgage and utilities, clothing and personal effects, medical expenses and vehicle payment and operating expenses. The IRS is inclined to use their numbers, although they will allow you to document higher or additional expenses. You then have to persuade them that your numbers are better than theirs and do not reflect a “lavish” lifestyle or incorporate”excessive” expenses. To give you an idea, the IRS does not allow for payments on your credit cards. I am not sure if they consider credit card payments to be “lavish” or “excessive.”

The “streamlined” allows you to fast-forward through this.

The liberalized streamlined rules apply only to an individual taxpayer. They do not apply to corporations and other types of businesses. You can now enter streamlined if your assessed balance (taxes, interest and penalties) is less than $50,000, an increase from the previous $25,000. In addition, you now have 72 months to pay, an increase of one year from the previous 60 months.

The IRS does charge a small fee (either $104 or $52, depending on whether you permit direct deposit) for the payment plan. Any streamlined over $25,000 must be on direct deposit.

To clarify, you do not have to enter streamlined, even if your assessed balance is less than $50,000. You can go the normal route, provide information and pursue a more favorable payment plan.  You would do that if you are pursuing a partial pay, for example. You would certainly have to go that route if you are pressing for an offer in compromise. For many people, however, the increase from $25,000 to $50,000 and an additional year to pay may make all the difference.

Why would someone hesitate to provide a 433? For one, it can be a pain to assemble and complete. Also, you have to disclose your bank accounts, including bank account numbers, on the 433. Some people believe this makes it easier for the IRS to levy your bank account. Whether correct or not, you have provided the IRS a roadmap to your finances.

The Anschutz Company v. Commissioner

So what do you do when you own a fortune in stock but do not want to pay the tax man?

Let’s look at Philip and Nancy Anschutz and The Anschutz Company (TAC). Philip Anschutz (PA) began acquiring oil and mineral companies during the 1960s. He expanded his activities to include railroad, real estate and entertainment companies. This meant he owned large blocks of various companies’ stock, and he housed them in TAC. TAC was an S corporation, a fact which is important and to which we will return later.

Well, if you keep buying companies, eventually you wind up having a lot of money invested in those companies. In the late 1990s and early 2000s, PA and TAC began looking for ways to free up some of that invested cash.

In 2000 and 2001 TAC received approximately $375 million from a series of variable prepaid forward contracts with Donaldson, Lufkin & Jenrette (DLJ). The contracts involved shares of Union Pacific and Andarko Petroleum. DLJ later became part of Credit Suisse.

Let’s get into eye-rolling territory and talk about a “forward contract.” Here is an example:

You want to unload $250 million worth of AJ stock but delay any tax consequence. Tony Soprano (TS) wants to help you. You hire a firm (BADA BING) who proposes a business deal involving TS. You loan the stock to TS. No, instead you loan the stock to BADA BING and you grant TS a security interest in the shares. TS then sells the stock. TS sells short, though.

QUESTION: By selling short, TS is saying that he does not own the stock. This is consistent with the story so far, as you lent the stock to TS. TS has a security interest in the stock, but that interest is not the same as owning the stock. Therefore TS has to sell short. He is protected however because – if ever called upon – he can deliver your shares to close-out the trade. Remember, your shares are in his possession.

                What do you get out of this? Nothing so far.

But let’s say that TS gives you 75% the money from the short sale. Ah, now you have something – you have cash in your pocket. The transaction as described is now a “prepaid” forward contract. The “prepaid” means that you got money.

There is more. You get a 5% prepaid lending fee because, by golly, you are lending the use of your shares to TS.

Somewhere down the line this story has to end, however. Say that 8 or 10 years down the road you are obligated to deliver to TS either:

·         a (variable) number of AJ shares, or

·         cash, or

·         equivalent but not identical stock 

The variable number of shares permitted to settle the contract makes this a variable prepaid forward contract.

There is also a way to do this with puts and calls and is referred to as a collar. It is interesting in a train-wreck sort of way, but let’s spare ourselves that discussion.

Let’s give TS some incentive to do the deal. We can add the following:

·         If the stock appreciates over the term of the deal, you get the first 50% in appreciation but TS gets ALL the appreciation after that.

·         TS kept 25% of the cash. He could invest it over the term of the deal and keep the earnings.

·         TS did sell the stock short, so if the stock goes down, the short sale would earn TS additional profit.

·         Upon the occurrence of certain events (bankruptcy, material change in economic position), TS could accelerate the settlement date of the deal.

How could TS lose money? TS already sold all the stock and paid you 75% of the proceeds. TS kept the remaining 25% for a period of time. Granted, TS did sell the shares short, so TS would have the risk of the stock going up in price over the term of the deal. This is how one loses money on a short sale, as it would make it more expensive for TS to close out his short position. But wait, TS has physical possession of your stock. If you do not make TS whole, he will simply take your stock to cover the short sale. What if the stock goes down? Then TS has a profit on the short sale. TS dealt a pretty good hand for himself.

How could you lose money? You really can’t. If the stock goes down, you buy it at the lower price and deliver it to TS. If the stock goes up you participate in the gain. Not all the gain, but still a gain. You lose by not making as much money as you could have by holding on to the stock. I can live with that kind of loss.

What was the underlying tax law that drove this transaction? Under long-standing tax law, a taxpayer did not have a sale - for tax purposes – of securities until the taxpayer delivered shares from his/her long position. In a forward contract, the delivery is delayed for years, possibly many years. So a forward contract, even a prepaid forward contract, of securities was not considered a "sale.” The IRS changed this in 1997 with Section 1259, which provided tax rules for constructive sales of financial positions. You may remember that you used to be able to protect an appreciated stock position at year-end by something called a “short sale against the box.” Then one day your accountant told you that you could not do that anymore because the law had changed. Tax law now requires you to have some level of risk in the position. The question is: how much risk?

Since TAC entered into these transactions in 2000 and 2001, it at least had the warning of Section 1259. TAC did not however have clarification of how far it could push the “link” between a variable contract and a stock loan. Tax law takes time to evolve. This is an innovative tax area involving financial instruments and derivatives, and tax clarification takes time. In 2006 the IRS finally gave warning that it did not like this structure. Too late for TAC to close the barn door, of course.

The IRS went after TAC.

What was the IRS position? We can hear the IRS saying:

“TAC did not keep enough risk to avoid a constructive sale of the Union Pacific and Andarko stock.”

What was TAC’s position? We can almost hear them saying:

“What are you talking about? We entered into two transactions - a prepaid variable and a stock loan, not one. The prepaid variable did not rise to the level of a constructive sale. The loan was to Wilmington Trust Company as collateral agent and trustee. Last time we checked, Donaldson, Lufkin & Jenrette was not Wilmington Trust Co.

In addition, is it fair to make tax law retroactive?”

In 2010 the Tax Court agreed with the IRS. TAC immediately appealed. The Appeals Court handed down its decision on Tuesday, December 27, 2011.

The 10^th Circuit Appeals Court noted that TAC effectively exchanged its shares for …

(1)    Upfront monies of 75% and 5%

(2)    the  potential to benefit to a limited degree if the pledged stock increased in value, and

(3)    the elimination of any risk of loss of value in the pledged stock

NOTE: Think about this for a moment. TAC transferred its shares to DLJ and DLJ relieved TAC of any risk of loss. What does this sound like?

The 10^th Circuit Appeals Court further reasoned that DLJ…

(1)    obtained all incidents of ownership in the shares, including the right to transfer them

(2)    acquired an interest in the property that it could not prudently abandon

(3)    had a present obligation to pay monies to TAC

(4)    had the right to sell or rehypothecate the shares

NOTE: DLJ had an immediate obligation to pay TAC and also had the right to sell the shares. What does that sound like?

Welcome to the new tax shelters. There was a time that shelters involved real estate or oil and gas and relied on nonrecourse loans or accelerated depreciation. Contemporary shelters use financial derivatives.

At the heart of this case is a metaphysical tax question: when is a sale a sale? The IRS did not challenge the substance of the deal. What it did challenge was this important detail: TAC lent its shares to DLJ to make the deal work. TAC argued that the stock loan and variable forwards were separate deals and that the stock was loaned to Wilmington Trust, not DLJ. The Tax Court in 2010 could not overcome the fact that, when TAC lent its shares, the shares were effectively gone and could not be recovered. A common factor of a sale is that the seller no longer has possession of the property sold.  

Why did TAC do this? TAC is an S corporation. S corporations can pay tax if they have a unique fact pattern called “built-in gains.” Sure enough, TAC had built-in gains in the Union Pacific and Andarko stock. The built-in gain had a clawback period of ten years. Sale of property with built-in gains within this period triggers the built-in gains tax. TAC was trying to avoid the double-taxation of built-in gains and then capital gains.

TAC lost big. The taxes were about $110 million. Oh, add on about another $30 million for penalties and taxes. Since TAC was an S corporation, all its income, deductions and credits flowed-through to PA and were reported on his individual income tax return. This means that PA lost big too.

New Reporting For Foreign Bank And Other Financial Accounts

I have mentioned on this blog that I have in-laws overseas (England). My wife and I have discussed buying property and retiring (some day!) overseas. She e-mailed me something recently on property in Ecuador that caught her eye. I only recall that the average temperature was not equal to the surface of the sun, which surprised me. (It’s called Ecuador because it is on the equator.)

Let’s say that my wife and I retire overseas. We would be expatriates. Nope, this is not a bad word. It means a person who lives outside his/her country of citizenship.

What tax issues should an expatriate know about? There are many, but today I want to talk about the HIRE Act, FATCA and the brand-new IRS Form 8938 Statement of Specified Foreign Financial Assets.

Congress passed the Foreign Account Tax Compliance Act ("FATCA") as part of the HIRE Act in 2010. The intent was to make it difficult for US taxpayers to evade tax by hiding assets overseas. FATCA requires US persons to file yet another form (Form 8938) to report foreign financial assets.

Form 8938 is out in draft. Interestingly, its instructions are NOT out. Form 8938 will be attached for the first time to your 2011 tax return.

Please note that this form is IN ADDITION to Form TD 90-22.1 (the "FBAR") you may already be filing with Treasury by June 30th of every year. The FBAR is required when you have more than $10,000 in foreign financial accounts.

Form 8938 is primarily geared but not necessarily limited to financial accounts.  You have to report (as I read it) foreign rental property, for example, as long as it is income-generating.  This is an issue for a couple of our clients, so I intend to go back and verify this point.

Form 8938 does have a higher reporting threshold - $50,000 – than the FBAR.

Form 8938 may require substantial time to prepare. Part I is relatively straightforward and asks you to disclose your overseas bank accounts. Part II asks you to disclose foreign financial interests (other than bank accounts) and their maximum value during the year. Depending on the financial interest, you may also have to disclose mailing addresses and other information. Part III requires the disclosure of “tax items” attributable to foreign interests previously disclosed. “Tax items” are interest, dividends, royalties and such other income, so you will (effectively) be tracing the income from the disclosed assets to a specified line on your individual income tax return.

The IRS did realize that some of this information is being disclosed on other tax filings already in their possession. Foreign corporations, for example, file Form 5471.  Foreign partnerships file Form 8865. Foreign trusts file Forms 3520 and 3520A. Part IV allows you exclude these financial interests from 8938 reporting. You do however have to provide some information on how many and what type of filings the IRS will receive on your behalf. Presumably there will be computer matching for the IRS to double-check that it has all these filings.

My take on all this? Does it seem reasonable to you that this level of reporting kicks-in at $50,000? Why not $10 or $15 million – a more reasonable threshold if in fact it is the “fat cats” that FATCA is going after?