Offshore reporting is filled with sinkholes that can entrap the unwary taxpayer. With some of the largest civil penalties found anywhere, it’s an area where even the smallest mistake can be costly.
The Report of Foreign Bank and Financial Accounts, or FBAR, is one of the most common offshore reporting forms (Form TD F 90-22.1). But it’s often overlooked.
Schedule B of the U.S. Individual Income Tax Return, Form 1040, requires taxpayers to disclose whether they own or have signatory authority in foreign accounts. If the answer is “yes,” a taxpayer may be required to file an FBAR.
Many taxpayers incorrectly fail to check the appropriate box on Schedule B. That’s critical because the IRS views a box that is checked “no” as an affirmative or “willful” misstatement.
A willful misstatement can subject a taxpayer to enhanced civil penalties. Those penalties can include prison, a $500,000 fine and civil penalties of 50 percent of the highest account balance for each year the taxpayer did not report the account properly.
It’s important for taxpayers to tell their accountants whether they have offshore accounts. Often a CPA will have an affirmative representation in the engagement letter stating that a client doesn’t have any interests in foreign accounts.
Many taxpayers think that the offshore reporting requirements affect only foreign bank accounts. But FBAR may also require the following to be reported:
- Foreign brokerage accounts
- Custodial precious metal accounts
- Foreign hedge funds
- Real estate investments
- Life insurance policies with some type of annuity or savings component
If taxpayers have ownership or signature authority in a foreign investment or account, they should share answers to the following questions with their CPA:
- When was the account opened?
- What is the approximate value of the account?
- What is the source of funds?
- What is the account used for?
- Does the account generate income?
- Is the account related to any business activity?
- Is anyone else related to the account?
Answers to these questions will determine whether a taxpayer has an FBAR reporting requirement.
The instructions give the following guidance: “A United States person that has a financial interest in or signature authority over foreign financial accounts must file an FBAR if the aggregate value of the foreign financial accounts exceeds $10,000 at any time during the calendar year.”
That may be a good starting point. But a few important clarifications may affect a CPA’s final decision.
First, some taxpayers have the false impression that, as long as no individual account exceeds the threshold of $10,000, they aren’t required to file an FBAR report for any of their accounts. This is a common error. Actually, the aggregate of the accounts is determinative. If two accounts hold $8,000 each, both accounts must be reported.
Another big hurdle in FBAR reporting is the definition of “U.S. person.” It is not uncommon for taxpayers to be dual nationals, foreign-born naturalized citizens, ex-pats living overseas and resident aliens (green card holders).
Are green card holders who never lived here residents? What if they moved here late in the calendar year? If taxpayers are unsure of how the answers apply to them, they should consult with an immigration attorney or ask their CPA to review the residency tests.
A taxpayer’s CPA should carefully note the definition of “resident alien” and the Substantial Presence Test. First- and last-year residency may complicate things but can be important for tax purposes.
Another issue is whether a taxpayer has a financial interest or signature authority over a foreign account. Estate planning maneuvers and cultural norms can play havoc. The Tax Code often says that interests are reportable even though taxpayers do not consider the accounts to be “theirs.”
Common reporting scenarios include elderly parents who add their children to accounts to help with money management and children who open accounts “back home” to provide for elderly parents or siblings who have not emigrated. As a general rule, a taxpayer should report the account if the taxpayer’s name is on it.
Indirect interest through more than 50 percent ownership of an entity is another area of complication. Many countries do not allow foreigners to own land directly, so Americans wishing to own property must set up LLCs or trusts to buy property. Then they own 100 percent of that LLC.
Other similar situations are comparable to condominium ownership or timeshares but through a foreign entity. Depending on the ownership and entity, this type of ownership may be reportable.
The definition of “foreign financial account” is not as black and white as one might think. For the average taxpayer, only checking, savings, investment and retirement accounts come to mind. As noted above, the definition encompasses many other financial instruments, such as:
- Certificates of deposit
- Foreign stock and securities
- Hedge funds
- Mutual funds
- Commodities and precious metals accounts
- Indirect interests in foreign financial assets through an entity if ownership exceeds 50 percent
- Life insurance and annuities with cash value
With so many financial products and derivatives invented every year, it’s important to remember that the definition of “account” is quite broad.
The definition of “foreign financial institution” is also important. An account at the local UBS branch is not a foreign financial account. However, an account at the London branch of the Bank of America is.
For people who hold gold bullion or silver bars, the definitions of these accounts are also important. Reporting may be required, depending on what type of institution holds the metal and whether the taxpayer can purchase and sell through that account.
The purpose of this information isn’t to frighten people away from having offshore accounts. The number of taxpayers who do is growing. They need to know when to seek outside help and be aware of the potential pitfalls. Addressing these issues with their CPAs is wise.
Simply hoping that they won’t need to disclose offshore accounts or even to understand what the IRS considers reportable is a recipe for disaster for taxpayers.