Corrective U.S. Tax Compliance for Dual Status and Foreign Taxpayers Andrew Bernknopf, Esq., Member:

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1 Corrective U.S. Tax Compliance for Dual Status and Foreign Taxpayers Andrew Bernknopf, Esq., Member: This article provides an overview of corrective United States tax compliance measures for individuals and companies who have failed to file required U.S. tax returns or foreign bank account reports ("FBARs") in prior years ("delinquent filers") or whose prior filings have contained errors or omissions ("errant filers"). Corrective compliance involves filing the late or amended return or participating in a special program for delinquent or errant filers before U.S. tax authorities become aware of the delinquency, error or omission. The focus here is on taxpayers with dual citizenship or dual residency ("dual status" taxpayers) and non-residents of the U.S. who have U.S. filing obligations because of contacts with the U.S., such as, conduct of business in the U.S., ownership of interests in U.S. business entities, ownership of real property in the U.S., or wealth transfer planning for family in the U.S. There is greater urgency than ever for corrective compliance with the impending enforcement of "FATCA" (Foreign Account Tax Compliance Act) provisions that will cause foreign financial institutions and other foreign entities to identify "U.S. owners" of foreign financial accounts to the U.S. Internal Revenue Service ("IRS"). The U.S. tax whistleblower reward program is another reason for some to be concerned about corrective compliance. June 2014 changes to the IRS Offshore Voluntary Disclosure Program ("OVDP") and the Streamlined Filing Compliance Procedures affect the analysis as to the appropriate course of action. I. Categories of Dual Status and Foreign Filers in the U.S. These are common examples of dual status and non-u.s. taxpayers who have U.S. filing obligations: A. Dual Status U.S. Income Tax Resident: A foreign citizen (i) is considered to be a U.S. federal income tax resident; (ii) has U.S. federal income tax and FBAR filing obligations; and (iii) is subject to U.S. federal income tax on worldwide income (after any available foreign tax credits or exemptions), if he/she: (1) has dual U.S. citizenship; (310) Website: Direct (310)

2 (2) has U.S. permanent residence (a "green card"); or (3) is a U.S. income tax resident because deemed to have "substantial presence" in the U.S. under a rolling three-year "day-counting" test (i.e., if in any year his/her total days of presence in the U.S. (a) in that year + (b) 1/3 of days in the prior year + (c) 1/6 of days in the second prior year = 183 or more), unless an exception applies. 1 B. Non-U.S. Individual or Entity with U.S. Contacts: A non-citizen, non-resident of the U.S. ("non-resident alien" or "NRA") may have U.S. reporting and tax payment obligations in many circumstances, such as: (1) Statutory or Treaty Claim of U.S. Income Tax Non-Residency. A non- U.S. national whose 3-year day-count exceeds 183 under the substantial presence test, but who can claim U.S. income tax non-residency (i) because the current year day-count is less than 183 and he/she maintains "closer connections" to a foreign country or (ii) qualifies for U.S. nonresidency under an income tax treaty residency "tiebreaker" provision. To claim an exemption, the taxpayer must file a U.S. tax return with the appropriate exemption form. (2) Non-Resident with U.S. Source Business Income. A non-resident of the U.S. who conducts business (including rental business) or performs services in the U.S. or who has an interest in a U.S. "pass-through" entity (such as, a limited liability company (LLC) or partnership) that conducts business in the U.S. or who sells a U.S. real property interest and is subject to "FIRPTA" (Foreign Investment in Real Property Tax Act) obligations. (3) Foreign Owner of U.S. Corporate Subsidiary or Foreign Settlor of U.S. Trust. The U.S. entity has U.S. tax obligations and the foreign ownership must be reported. 1 U.S. state income tax residency (and consequent filing requirements and state income taxation on worldwide income) also may arise under state rules. This is typically a question of whether the facts and circumstances support a finding of "domicile" (permanent home) in the state or is based on days of presence in the state. Income tax treaties do not apply to state issues and do not provide exemption. This article does not otherwise address U.S. state rules. -2

3 (4) Gift/Estate Tax Resident makes any taxable gift or has U.S. taxable estate or Non-Resident who makes "U.S. situs" gifts or bequests. A U.S. citizen or person deemed to be U.S. resident for estate and gift tax purposes, is subject to gift tax (after applicable exemptions and credits) on worldwide gifts and is subject to U.S. estate tax at death (after applicable exemptions and credits) on worldwide assets. The estate of a non-citizen and non-resident of the U.S. is subject to U.S. estate tax (after applicable exemptions and credits) on the decedent's U.S. situs assets, an a non-citizen/non-resident of the U.S. is subject to U.S. gift tax (subject to certain exceptions) on gifts of U.S. situs assets. U.S. estate and gift tax residency is based on domicile, which is a facts and circumstances test of what constitutes the person's permanent home. There are not uncommon circumstances where a person may be deemed to be a U.S. income tax resident but not an estate or gift tax resident, such as, where the person has "substantial presence" in the U.S. but not a permanent home in the U.S. The converse -- domicile without U.S. income tax residency -- may be true in other less common circumstances. If an estate and gift treaty applies, this also affects the analysis. A taxable gift by, or taxable estate of, a dual citizen or a non-citizen U.S. domiciliary gives rise to U.S. gift or estate tax filing requirements and may give rise to tax liability to the donor or decedent's estate, after applicable exemptions and credits. If the gift or bequest is from a non-resident/non-citizen this also gives rise to reporting obligations to a U.S. person who is a recipient of the gift or bequest. II. U.S. Federal Tax and Informational Reporting By Category: A. U.S. Citizens / U.S. Income Tax Residents: If a person is a U.S. citizen or is deemed to be U.S. income tax resident, the full complement of U.S. filings is required, and filing is typically more complicated than for sole -3

4 U.S. status filers because of cross-border transactional, foreign tax credit and reporting issues. Examples of required filings include: IRS Form 1040 (Individual U.S. Income Tax Return) and all required schedules. FBAR (Foreign Bank Account Report). This must be filed electronically on FinCen Form 114 (formerly filed on Treasury Form TD F ) to report foreign bank and brokerage accounts held directly or through controlled entities. IRS Form 8938 (Report of Specified Foreign Financial Interests). Since 2011, this is filed in addition to the FBAR, as an attachment to Form 1040, if reporting thresholds are met. IRS Form 3520 (Report of Foreign Trust Transactions and Foreign Gifts and Bequests). This is filed by a U.S. recipient of a gift or bequest in excess of $100,000 from a non- U.S. donor or U.S. recipient of a distribution of any size from a foreign trust. It is filed separately from IRS Form IRS Form 3520-A (Report of Foreign Grantor Trust). This may apply in the very common situation where there is a revocable "living trust" that is governed by foreign law. This form is filed by the trustee of the trust. The U.S. owner also files Form 3520 when this applies. IRS Form 5471 (Report of U.S. Shareholder of Foreign Corporation). This is filed as an attachment to the U.S. federal income tax return of the "CFC" U.S. shareholder (Form 1040, if an individual shareholder). In general, there is a CFC if U.S. shareholders directly or indirectly own shares constituting more than 50% of the value or vote in a foreign corporation. IRS Form 8621 (Report of U.S. Shareholder of Passive Foreign Investment Company). This is filed as an attachment to the U.S. federal income tax return of the "PFIC" U.S. shareholder (Form 1040, if an individual shareholder). In general, there is a PFIC if a U.S. shareholder owns a minority interest in a foreign corporation that is not predominantly engaged -4

5 in active business (for example, foreign mutual fund, hedge fund and other investment fund interests, including non-actively managed real estate.). IRS Form 8858 (Report of Controlled Foreign Partnership). This is filed as an attachment to the U.S. federal income tax return of the U.S. partner of the "CFP" (Form 1040, if an individual partner). The foreign partnership does not necessarily have to be U.S.-controlled to give rise to CFP filing requirements. B. U.S. Non-Residents: (1) U.S. Non-Residency Exemption Claim: If an individual is treated as a U.S. income tax resident, under U.S. Internal Revenue Code (the "Code") and Treasury Regulations (the "Regs."), such as, due to "substantial presence", he/she may qualify for an exemption from U.S. income tax residency based on having closer connections to a foreign country. The claim of exemption requires filing of U.S. tax returns. IRS Form 1040NR (Individual U.S. Non-Resident Income Tax Return) is filed in this case. IRS Form 8840 (Closer Connection Statement) is filed if the exemption from the substantial presence test is claimed under the Code and is based on less than 183 days of U.S. presence in the current year and closer connections to a foreign country. IRS Form 8833 (Claim of Treaty Benefits) is filed to claim benefits under a bilateral income tax treaty between another country and the United States, such as, a claim of a non-residence for U.S. income tax purposes under a treaty residency "tiebreaker" provision (if the closer connections exception under the Code does not apply or as a backstop to a closer connections claim). This form is also used to claim reduced rates of withholding or exemption from U.S. tax on business profits if there is no U.S. "permanent establishment" or "fixed base". -5

6 Note 1: If exemption occurs under the Code, then the person is not a U.S. tax resident for all purposes, including FBAR and any other form requirements that may apply, such as those noted in Section II.A above. However, if exemption is claimed under a treaty residency tiebreaker, the person files Form 1040NR and has U.S. tax computed as a non-resident (i.e., is subject to U.S. tax on U.S. source income only), but is treated as a U.S. tax resident (a "U.S. person") for special reporting purposes including FBAR and special tax form requirements, such as, filing of Form 5471 with respect to any CFCs, etc. Note 2: U.S. income tax treaties have a "saving clause" that prevents U.S. citizens from claiming most treaty benefits against the U.S., including a claim of non-residency under treaty tiebreaker provisions. (2) Non-Resident with U.S. Source Business Income. In this category, there is often withholding paid by the payor of the U.S. source business income or by the U.S. partnership. If there is under-withholding (withholding of tax that is not sufficient to cover the taxpayer's U.S. tax liability after any allocable deductions), tax is paid with the U.S. return; if there is over-withholding (withholding of tax that exceeds the taxpayer's U.S. tax liability after any allocable deductions), U.S. filing is the means of obtaining a refund or carryover crediting of the excess. Examples of required filings include: IRS Form 1040NR (Individual Non-Resident Income Tax Return) and all required schedules. IRS Form 1120F (Foreign Corporation Income Tax Return). (3) Foreign Owner of U.S. Corporate Subsidiary or Foreign Settlor of U.S. Trust. The U.S. entity has U.S. tax obligations and the foreign ownership must be reported. For example: IRS Form 1120 (Domestic Corporation Income Tax Return). -6

7 IRS Form 1041 (Domestic Trust Income Tax Return). IRS Form 5472 (Report of Foreign 25% Ownership of U.S. Corporation). This is filed as an attachment to IRS Form Transactions with the foreign owner are reported on this form. (4) U.S. Estate/Gift Tax Resident who makes any gift or Non-Resident who makes "U.S. Situs" gifts or bequests. Forms for this reporting are: IRS Form 709 (Gift and Generation-Skipping Tax Return). IRS Form 706 (Estate Tax Return). In addition, the U.S. recipient of a gift with value in excess of $100,000 or any bequest from a foreign person must file IRS Form 3520 to report receipt. This is filed whether the gift or bequest from the foreign donor was a U.S. III. Four Basic Options for U.S. Corrective Tax Compliance. The delinquent or errant filer should consult with a knowledgeable U.S. tax advisor about possible means of corrective U.S. tax compliance, the costs, benefits and risks involved in each approach, and the suitability for the particular person's circumstance. These are several key options: A. Offshore Voluntary Disclosure Program (OVDP). If a delinquent or errant filer is not currently under audit or investigation, he can participate in OVDP. If OVDP is chosen as the corrective measure, it is imperative that "preclearance" be obtained from IRS criminal investigations to ensure that the taxpayer is not the subject of an investigation. Absent pre-clearance, submissions made in an attempt to participate in OVDP can be used against the taxpayer in pursuing a criminal case. Starting in July 2014, the request for pre-clearance must include the name of any foreign financial institutions at which the taxpayer has an account and any foreign entities in which the taxpayer has an interest. -7

8 OVDP involves filing eight prior years of corrected (or newly filed) tax returns, FBARs, and all other applicable forms, such as those noted in Part II.A above. The prime benefits of OVDP are (1) amnesty from criminal tax and FBAR prosecution, and (2) quantification of monetary penalties, thus eliminating possible exposure to multiple 75% civil tax fraud penalties, 50%-of-account-balance penalties applicable to willful failures to file FBARs, and other high penalties, such as possible 35% penalties for failure to report foreign trust distributions on IRS Form OVDP does not provide amnesty from any non-tax criminal exposure (such as, any relating to the source of funds in foreign accounts). OVDP involves a high price for these benefits: (1) an "all-in-one" FBAR/failure to file penalty equal to 27.5% of the highest "foreign account balance" in the eight-year look-back period (including the value of interests any previously unreported foreign entities), (2) underpaid tax owed during the 8-year look-back period, (3) a civil tax penalty of 20% any underpaid tax, and (4) interest on the underpaid tax and 20% penalty. Under newly revised OVDP "FAQs", the FBAR penalty is raised to 50% for accounts at banks that have been publicly identified as the subject of an IRS investigation. The 50% penalty is presumably intended as an incentive for those with unreported foreign bank income to come into OVDP right away, rather than taking a wait and see approach. As an alternative to the quantified penalties above, a taxpayer who has been accepted into OVDP may "opt out" and have the eight years of past returns and FBARs subjected to IRS examination. Amnesty from criminal tax prosecution for these years is retained by those who opt out of the OVDP monetary penalty regime. In many circumstances, the IRS position in such an opt-out examination may be that the taxpayer owes more than under OVDP's quantified penalties. As with any examination, the taxpayer would have an opportunity to present his/her case, including any arguments as to why penalties should be reduced or eliminated due to "reasonable cause" (such as, reliance on prior bad professional tax advice). Negotiations are part of this process. -8

9 OVDP is the best approach for those who have committed egregious violations and for those who are otherwise averse to any risk of criminal prosecution or exposure to higher monetary penalties. The OVDP opt-out option generally is best suited to those who have arguments as to reasonable cause for their filing errors. B. Streamlined Filing Procedures. In June 2014, the IRS announced substantial changes to the so-called streamlined filing procedures that were first introduced by the IRS in 2012 (and which were anything but streamlined, in its original incarnation). Originally, the streamlined program was available only to non-residents who had not filed U.S. tax returns (delinquent filers). For those eligible, the original streamlined program involved a guessing game as to whether the returns would qualify as "low risk," in which case they would be processed normally or "high risk," in which case they would be subjected to audit. Previously, a delinquent non-resident could be deemed to be high risk from owing only $1,500 of U.S. tax, which could easily arise as a result of complications in the foreign tax credit rules. Now, as revised, the streamlined program is available to both U.S. residents and nonresidents, and is available to errant filers as well as delinquent filers with unreported foreign income. Non-residents who qualify for the program are subject to no penalties. U.S. residents who qualify for the program are subject to a 5% penalty, based on their highest aggregate foreign account balance for the last six years. The key issue for participation in the streamlined program is whether the prior failure to file or failure to report non-u.s. income was "willful". A taxpayer who participates in the streamlined program must certify that the errors or delinquency were not willful and explain why they were not. The streamlined program does not eliminate any exposure that may exist to criminal prosecution, so it is best suited to those who may owe little or no U.S. income tax after foreign tax credit and who have a solid basis for asserting non-willful failure to file or errors in previous filings (such as, faulty professional advice, or, perhaps, past ignorance or misunderstandings -9

10 about U.S. filing obligations). The IRS has warned that it will examine participants' claims of non-willfulness. If willfulness is found, the taxpayer may face civil penalties and perhaps could face criminal prosecution. Therefore, the facts and circumstances of the past failure and whether it was willful or not should be addressed carefully in consultation with a tax advisor. The streamlined program involves filing (1) three prior years of delinquent or amended returns and payment of any tax and interest due; (2) six prior years of FBARs, with an explanatory statement as to reason for non-filing or past errors; and (3) completion and submission of a statement as to non-willfulness. (This essentially replaces a questionnaire that had been required under the former version of the streamlined program). Note: For those taxpayers who have no unreported income but who merely failed to file FBARs or tax information forms (such as, Form 5471, relating to U.S. shareholders of foreign corporations or Form 8938, relating to foreign financial assets or Form 3520, as it relates to reports of foreign gifts), these errors can now be corrected by filing these forms in accordance with program guidelines. Careful analysis should be conducted as to whether participation in the full-scale streamlined program is appropriate. C. "Quiet filing" of delinquent returns or amended returns to correct errors. It has been IRS historic practice, as expressed in the Internal Revenue Manual, not to pursue criminal prosecution and not to seek tax or civil penalties for earlier years if six years of amended returns (and FBARs) are filed to correct prior errant filings or six years of delinquent returns (and FBARs) are filed to correct delinquent filings. Such "voluntary disclosure" outside of OVDP may (but is not certain to) eliminate exposure to criminal tax prosecution, and does not quantify penalty risk (such as, possible assertion of multiple 50% FBAR willful failure penalties) if the returns are audited, nor does it necessarily eliminate exposure to civil penalties for years prior to the six years of returns for which the statute of limitations is open for tax and civil penalties. (In general, the civil statute remains open indefinitely for years for which no return was filed or for which fraud was involved). It is also possible that quiet corrective filing could -10

11 result in a better monetary result than the 27.5% penalty regime under OVDP, such as, acceptance of the returns as "qualified amended returns" that do not give rise to underpayment penalties. IRS has warned that it is on the lookout for quiet disclosure so that it can subject such returns to the audit process. The streamlined program now offers taxpayers who had previously made quiet filings the opportunity to file again under the streamlined program. In that case, as long as there are grounds for lack of willful error, penalty exposure would be removed for nonresidents and would be quantified at 5% of the highest account balance for U.S. residents. D. "Going Forward" compliance. Some taxpayers may choose to come into U.S. tax compliance on a going forward only basis (and not correct past year errant or delinquent filing). This route involves full exposure to criminal penalties until applicable statutes of limitations burn off and full exposure for tax and civil penalties for all prior years. The IRS has also warned that it is giving close scrutiny to firsttime filers in this context. In view of new FATCA requirements for foreign financial institutions to identify U.S. accountholders (and U.S. owners of entity accountholders) to the IRS, going forward compliance involves greater risk than ever with respect to past years of non-compliance. IV. "Coming in" to get out: Exit tax / Coming in to stay: Green card renewal or citizenship application. The United States now has an "exit tax" regime (a deemed sale or "mark to market" of worldwide assets) that is applicable to those who renounce U.S. citizenship and is also applicable to green card holders who relinquish their green cards after having had permanent residency status for eight years or more. The exit tax only applies to "covered expatriates," which generally means those with at least $2 million net worth at the time of expatriation or those who owed a high U.S. income tax liability in the prior five years. However, the exit tax (and continuing U.S. estate and gift tax consequences and U.S. withholding tax obligations on distributions from foreign trusts) applies -11

12 in all events if the expatriate cannot certify that he has been in compliance with all U.S. tax obligations for past 5 years. Some dual status taxpayers who wish to give up their U.S. status may have to come into the U.S. tax system with corrective compliance for the prior five years in order to get out of the system without owing an exit tax. Others may need corrective compliance in connection with green card renewal applications or conversion of permanent residency to citizenship, or simply to maintain the privilege of residing in the U.S. A conviction for criminal tax evasion will subject a non-citizen to deportation, in addition to the criminal penalties. V. Attorney-Client Privilege. Any taxpayer facing corrective compliance issues should consult with an attorney about his/her options, preferably before discussing the matter with the taxpayer's accountant or any other advisor. The communications and development of the case prior to filing of returns should be subject to attorney-client privilege. Every corrective compliance case has particular details that will affect the risks, costs and benefits involved in one alternative versus another, as does the client's own tolerance for, or aversion to, risk. This article is intended for general informational purposes only and is not legal advice. This article is not provided or intended by this firm to be used for (i) the purpose of avoiding federal tax penalties that may be imposed, or (ii) promoting, marketing or recommending any entity, investment, plan or arrangement to any person. -12 M:\FirmDocs\AB\Blog\Corrective U.S. tax compliance.july docx