Editor: Mark Heroux, J.D.
U.S. persons (citizens and permanent residents) whose financial matters extend overseas may face a tax situation that virtually no other country’s nationals do. The United States imposes federal income tax reporting and payment obligations based on citizenship status rather than — as is common in the rest of the world — physical residency. Because of this, serving a U.S. client with international income, assets, and disclosures can be complex, even apart from the onerous regulations around the reporting of foreign assets and entities. Below are five tips for managing the compliance and taxation of these clients.
1. Not all due dates follow the ‘traditional’ deadlines
U.S. persons with foreign disclosures and resident aliens who live outside the United States will find themselves with some additional dates to contend with beyond the “traditional” federal due dates.
First, an automatic two-month extension is permitted to file and pay federal income tax for a U.S. citizen or resident alien who lives outside the United States and Puerto Rico and has a main place of business outside the United States/ Puerto Rico. This extension applies for taxpayers filing married filing jointly if either spouse qualifies (if filing separately, only the qualified spouse receives the automatic extension). No late-payment penalty is assessed on tax paid by June 15; however, interest does accrue in this two-month period.
A U.S. citizen or resident alien living outside the United States who has properly extended his or her return to Oct. 15 may also be granted an additional extension for filing the federal tax return to Dec. 15. A written request must be made with the IRS.
FinCEN Form 114 (formerly Form TD F 90-22.1), Report of Foreign Bank and Financial Accounts (FBAR), is extended automatically from April 15 to Oct. 15 (or Oct. 17, 2022, for 2021 filings), regardless of the status of the personal income tax return. There is no form to file or request to make with the IRS or the Financial Crimes Enforcement Network (FinCEN).
Finally, U.S. owners of foreign trusts who are obligated to file Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner, must file the form or an extension (via Form 7004) annually by March 15 for a calendar-year trust. This is one month before the deadline for filing Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, which uses the due dates of an individual’s personal income tax return and accepts extensions via Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return. Missing the March 15 deadline can result in substantial penalties for late filing. Advisers and taxpayers can be caught by surprise since this is a month earlier than the expected April 15 due date.
2. Beware the savings clause
Income tax treaties are in place to eliminate double taxation of individuals with income tax obligations in two countries. As noted above, a U.S. person residing outside the United States will often have income tax residency in two (or more) countries.
Each tax treaty contains language addressing which country has the primary or exclusive right to tax different types of income (such as dividends, gains, director’s fees, and so on). When determining if a treaty provision applies to your client, after evaluating whether he or she is a qualified taxpayer covered by the treaty and the taxes in question are qualified under the treaty, the specific income provision should be reviewed.
Importantly, one must also take care to review the “savings clause,” which can generally be found within the first articles or general scope article. Essentially, the savings clause gives the right to the United States to tax its citizens and resident aliens as if the treaty had not been in force. Other provisions of the tax treaty will identify those specific sections of the treaty containing benefits that are exempted from modification under the savings clause.
3. A treaty tie-break claim for income tax residency does not relieve FBAR filing obligation
Due to the unique approach of the United States in taxing citizenship status rather than physical residency, U.S. citizens and permanent residents who live outside the United States find themselves in an uncommon situation: They may be income tax residents in more than one country at the same time. A U.S. taxpayer who is a dual income tax resident might avail himself or herself of a treaty tie-break claim in the income tax treaty between the United States and the other home country. The tests set forth in the tie-break provision will be applied to determine, for instance, that the individual is considered resident in the other country and not the United States for income tax purposes. Generally, that individual would then file as a nonresident in the United States.
However, the above treaty claim of nonresidence would not exempt the taxpayer from the obligation to file an FBAR. The individual’s FBAR is governed by Title 31 of the U.S. Code, not Title 26 of the U.S. Code.
Penalties for noncompliance with FBAR obligations can be substantial. However, there is a difference of opinion among the U.S. courts of appeal as to whether the nonwillful civil penalty amount is assessed per form or per account. In June, the Supreme Court announced that it will rule on the issue (Bittner, No. 21-1195 (U.S. 6/21/22) (cert. granted)).
4. Gifts received from non-US persons may be penalized if not disclosed to the IRS
While the United States will generally not impose federal income tax on receipt of foreign gifts, the Internal Revenue Code requires that taxpayers notify the IRS about the receipt of certain gifts. Any amount from a non-U.S. person that is treated as a gift or bequest exceeding $100,000 must be reported on Form 3520, Part IV, relating to the tax year in which the gift was received. A gift from a non-U.S. person can include transfers from a non-U.S. spouse to a U.S. citizen spouse. (It is also important to be mindful of gifts from a U.S. spouse to a non-U.S. spouse, which would be reportable on a gift tax return if the value exceeds $164,000 (the 2022 exclusion amount).)
The information reported about a foreign gift is not very detailed: date of receipt, description of the property received, and the fair market value of the property. Required reporting also includes amounts received from foreign corporations or partnerships that are treated as gifts.
The IRS can impose civil penalties of up to 25% for failure to disclose receipt of a gift or inheritance from a foreign person. The penalty is initially imposed at 5% of the gift for each month the failure to disclose continues.
As noted above, Form 3520 follows the due dates of an individual’s personal income tax return and can be extended by a timely filed Form 4868.
5. Totalization agreements may relieve US citizens of double social security obligations
Since the 1970s, the United States has entered into agreements with other countries around the world to limit the imposition of double social security taxes. Currently, 31 international social security agreements, often referred to as “totalization agreements,” are in place to address employment and self-employment arrangements for social security taxation. These agreements are separate from the income tax treaties.
U.S. Social Security applies to all U.S. citizens and residents, whether their work is performed inside or outside the United States. By virtue of being a U.S. resident and resident of another country while living and working there, an individual may find that he or she has paid social security taxes to both countries.
In the case of self-employed individuals, the applicable totalization agreement between the United States and the other country should be reviewed to determine which country is entitled to assess social security taxes on self-employed earnings. Though the details of each client situation must be confirmed by reviewing the agreement, often the United States will permit an exemption from self-employment taxes where a taxpayer is resident in the other country and subject to the other country’s self-employment tax system. In this instance, no self-employment taxes would be assessed on the individual’s federal income tax return.
Mistakes can be expensive
The U.S. worldwide system of taxing its citizens and resident aliens creates problems for those who live outside of the United States. The rules are complex, and foot faults can be expensive. The better you know the rules, the better you can serve your clients.
Mark Heroux, J.D., is a tax principal in the Tax Advocacy and Controversy Services practice at Baker Tilly US, LLP in Chicago. Contributors are members of or associated with Baker Tilly US, LLP. For additional information about these items, contact Mr. Heroux at firstname.lastname@example.org.