Tax Law Center Blog

There is an increased focus by the Internal Revenue Service (IRS) on offshore activities.  There are tax return and information return filing obligations that may be associated with foreign income, assets and transactions. Many taxpayers (including non-U.S. persons who might not otherwise consider themselves U.S. taxpayers) should resolve any reasonable doubt they might have in favor of filing.

Information Return Filing Obligations

U.S. citizens, U.S. green card holders and U.S. corporations are clearly required to file a U.S. income tax return each year if their income meets the filing threshold. Less clear is whether such U.S. persons must file “information returns” for activities in which they may be involved outside of the United States, and whether non-U.S. persons who have some U.S. business-related activity are required to file U.S. income tax returns. Some examples of these situations are as follows.

U.S. persons involved in funding a foreign arrangement (such as a will or a retirement plan) may not readily be able to determine whether the arrangement constitutes a trust for U.S. tax purposes. There may be a need to file  additional information returns (Forms 3520 and/or 3520A) to report a foreign trust?

A U.S. person with an ownership interest in a foreign corporation may need to file an information return, such as a Form 5471, to disclose that ownership.

A U.S. person with an ownership interest in a foreign account may need to file a FBAR Form FinCEN 114. This form is independent of the tax return and a separate filing requirement. The FBAR applies to any U.S. person who owns, has beneficial interest or signature authority over foreign financial accounts that exceed $10,000 in the aggregate in value at any time during the year. If you have any foreign bank accounts, this also has to be disclosed on Part III of Schedule B, whether the FBAR is required to be filed or not. FinCEN 114 must be e-filed and cannot be mailed, with the absolute filing deadline on June 30, with no extension possible.

A U.S. person with an ownership interest in foreign accounts may also need to file a Form 8938. This form, also known as the Fatca form, is used to report Specified Foreign Financial Assets and the income derived from them. There is some overlap with the FinCEN 114 Form (FBAR), but the filing thresholds are higher, and depend on the taxpayer’s residency and marriage status, with different thresholds for the highest value reached during the year and on the last day of the year. These thresholds range from a low of $50,000 to a high of $600,000.

It is advantageous to make a “protective” filing of tax returns or information returns. The primary reason is that if the IRS later concludes that such a return is required, then a protective filing of the return can preserve numerous benefits for the taxpayer which would not have been available had the taxpayer not made such a protective filing.

The first major benefit is to get the statute of limitations started.  The statute of limitations for assessing taxes generally determines the length of time that the IRS is allowed to propose adjustments to a filed tax return. If the statute of limitations has expired with respect to a particular tax year, then the IRS is precluded from making such adjustments for that year. Generally, the statute of limitations for tax returns is three years starting from the date of filing or the date it was due (if later). The statute can be extended to six years if there is a “substantial understatement” of income. If a taxpayer never files a tax return with respect to a given taxable year, then there is no statute of limitations on the IRS’s right to assess additional taxes for that year. Regardless of the length of the statute of limitations, therefore, it is imperative to get the statute of limitations running.

The statute of limitations does not begin to run until a tax return is filed. Moreover, if certain information returns reporting transfers or ownership of assets outside the United States are required parts of the tax returns, then the statute of limitations does not begin to run until the required information returns are filed, because the tax return otherwise is considered incomplete. Sometimes, it is not entirely clear whether an information return is required to be filed, especially when foreign arrangements are involved. For instance, a U.S. person who has an interest in or makes a contribution to a foreign trust is required to file Form 3520 (Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts) and/or Form 3520-A (Annual Information Return of Foreign Trust With a U.S. Owner). Unfortunately, it may not be easy to determine whether some of the foreign arrangements constitute a trust for U.S. tax purposes. A foreign estate planning arrangement or a foreign foundation may be deemed a trust for these purposes.

A taxpayer probably should take a conservative approach and make a protective filing of the IRS forms.  Likewise, if a U.S. person has certain involvement with or ownership interest in a foreign corporation, then that U.S. person may be required to disclose that involvement or ownership on a Form 5471 (Information Return of U.S. Persons With Respect to Certain Foreign Corporations). Again, if the facts are not entirely clear as to the requirement of filing such an information return, a protective filing should be considered to get the statute of limitations running.

Avoid Failure to File Penalties

Another advantage of making a protective filing is to avoid failure to file penalties. For example, if the IRS later determines that a foreign arrangement constitutes a trust, and Form 3520 and/or Form 3520-A should be filed, then failure to file the return can subject the taxpayer to severe penalties. If a required Form 3520 is not timely filed, then the initial penalty is $10,000 or 35 percent of the value of the trust assets in question, whichever is greater. If a required Form 3520-A is not timely filed, then the initial penalty is $10,000 or 5 percent of the gross value of the portion of the trust owned by the U.S. person, whichever is greater. Similarly, if a taxpayer is required to file Form 5471 and fails to do so, the failure to file penalty can be $10,000 for each year for each Form 5471 not filed.