Taxation of U.S. Citizens Abroad

Did you know that there are over 9 million citizens living outside the United States in over 160 countries throughout the world?  And did you also know that these U.S. citizens are required to file U.S.  income tax returns every year?  But only a small portion of these Americans abroad are filing returns.  Many of these citizens choose not to file because they owe no taxes, but this decision may result in serious consequences.

One common myth is that many of these taxpayers believe that if their income is under the Foreign Earned Income Exclusion threshold they are not required to file. In reality, a taxpayer must file a return to ELECT the Foreign Earned Income Exclusion.  If you have not filed a return, you have not made an election and you cannot exclude the income. Another misinterpretation about this exclusion is that it applies to ALL foreign income. This is not the case. The exclusion applies only to “earned” income such as wages or business income. The exclusion does not apply to investment income. Finally, the taxpayer must meet either the bonafide residence or physical presence test to be able to claim the exclusion.

But more importantly, in addition to filing US tax returns, there are a numerous additional forms that may be required to be filed. These annual foreign reporting requirements carry very onerous penalties if they are not timely filed.  It is important to note that U.S. persons living within the United States are also required to file these forms.

What forms are U.S. citizens abroad required to file?

FOREIGN BANK and FINANCIAL ACCOUNT REPORT (FinCEN -Form 114)

U.S. citizens or residents who had authority over or financial interest in financial accounts outside the U.S. that exceeded a $10,000 balance in aggregate during the year must file an information report with the U.S. Treasury Department on or before April 15 each year. Extension is available to October 15. Foreign financial accounts include bank accounts of any type, securities accounts (accounts maintained to buy, sell, hold, or trade stocks or other securities), and any other type of financial account.  

The penalties for failure to file are hefty. Multiple years of non-reporting may result in penalties that exceed the cash in the account. This form is filed separate from tax return by using the Treasury Department electronic reporting system.

FOREIGN FINANCIAL ASSETS (Form 8938)

In addition to filing the FBAR reports, U.S. citizens or residents who have foreign financial assets exceeding $50,000 ($100,000 joint) at the end of the year or $100,000 ($200,000 joint) at any time during the year must file Form 8938 with their income tax return for the year. Specified assets include any foreign financial accounts as well as stocks, financial instruments or interests in other foreign entities not held in foreign accounts. The filing threshold is increased for taxpayers living outside the United States to $200,000 on December 31 ($400,000 if joint) or $300,000 at any time during the year ($600,000) if joint.

Form 8938 forms part of the tax return as is separate from the FBAR rules.  The minimum non-compliance penalty is US$10,000, however, an additional penalty equivalent to 40 percent of the asset value may be imposed for undisclosed or undervalued foreign financial assets.

INTEREST IN FOREIGN CORPORATION (Form 5471)

If an individual is (1) a 10% shareholder, director, or officer in a foreign corporation; (2) the grantor of a trust that has formed a foreign corporation; or (3) an individual whose U.S. corporation or partnership owns shares in a foreign corporation, then you must determine whether the taxpayer is required to file IRS Form 5471. 

There are four circumstances in which the form is required to be filed.  A practitioner would need to know details on the individual’s involvement to determine if the form is required and request additional information from the client to complete these forms if they are required.   The form is filed with the individual’s income tax return. The penalty for not filing this form when required starts at $10,000.

If more than 50% of the total combined voting power or the total value of the stock is owned directly, indirectly, or constructively by U.S. shareholders on any day during the foreign corporation’s tax year, the individual may also be required to include the income from the foreign corporation on his/her tax return[vi].  The income must be included regardless of whether that income is distributed. This treatment can result in mismatches between the timing of income tax in the U.S. and the timing of income tax in the foreign country and could result in double taxation.

The reporting and disclosure requirements for U.S. tax purposes can be complex, and the U.S. taxation of income from these investments may be subject to a different U.S. tax regime.

INTEREST IN FOREIGN PARTNERSHIP (Form 8865)

If a U.S. person invests in a non-U.S. partnership, he/she may be required to file Form 8865 – Return of U.S. Persons with Respect to Certain Foreign Partnerships. An individual will generally be required to file this form if they own 10% or more of a partnership that is controlled by U.S. persons, each of whom owns at least a 10% interest. In addition, the individual will be required to file the form in any year that the invest more than $100,000 USD in any foreign partnership.

This form is also due when the U.S. person’s income tax return is due, including extensions. If the form is not filed on time, the IRS may impose a $10,000USD penalty.

INTEREST IN FOREIGN TRUST (Form 3520)

U.S. persons who are treated as the owner of any part of the assets of a foreign trust are required to file this additional report.   Annual reporting requirements apply to both contributors and beneficiaries of foreign trusts.

Reporting is required for foreign grantor trusts and foreign non-grantor trusts. If a foreign trust is considered a grantor trust, it is disregarded for U.S. income tax purposes, and the trust’s income is taxable in the hands of the person considered the trust’s owner (the grantor).

The U.S. person may be required to file the following two foreign reporting forms annually:

• Form 3520-A – Annual Information Return of Foreign Trust with a U.S. Owner, and

• Form 3520 – Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts.

These forms are filed separately from the taxpayer’s individual income tax return. Form 3520-A is due March 15th (a 6-month extension is available by filing an extension request by the due date). Form 3520 is due the same day as the individual’s individual income tax return, including extensions.

Non-reporting may trigger penalties as follows:

  • A penalty equal to the greater of $10,000 USD or 35 percent of the value of property trans­ferred to a trust or 35 percent of distributions they received from the trusts or 5% of the gross value of the portion of the plan that the person is deemed to own for failure to file, or for late filing Form 3520
  • If the individual does not file, or late files, Form 3520-A a penalty equal to the greater of $10,000 USD or 5% of the gross value of the portion of the plan the U.S. person is deemed to own.

INTEREST IN PASSIVE FOREIGN INVESTMENT CORPORATION (Form 8621)

Perhaps the most complex additional reporting faced by US citizens or residents apply to any person that owns an interest in passive foreign investment corporation (PFIC). Generally, a non-U.S. corporation is considered to be a PFIC if more than 75% of its income is “passive” income, or 50% or more of the corporation assets generate “passive” income. Passive income generally includes interest, dividends, capital gains and rents. For U.S. tax purposes, some foreign mutual fund trusts may be considered corporations. Therefore, if your client owns an interest in a mutual fund trust, they may be subject to the PFIC rules.

Distributions received from the PFIC, and any gain realized on sale of the PFIC could be subject to a very punitive deferred tax regime. There are detailed reporting rules that require an annual analysis of the current year distributions from the PFIC to determine if there is an excess distribution from the fund in the current year (these rules apply to each mutual fund separately). This could result in US persons being subject to an additional excess distribution tax as well as an imputed interest rate applied to the to this tax.

There are certain elections available which would allow U.S. persons to avoid the default PFIC deferred tax regime. Due to the advanced nature of this regime, we strongly recommend that practitioners become familiar with the details or refer the return to a professional that is knowledgeable with this subject.

If a U.S. person has an interest in a PFIC, you are required to include Form 8621 – Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund with the U.S.income tax return regardless of whether distributions are made.  

There is actually no penalty for failure to file this form, however, the Form 8938 penalty provisions could impose a US$10,000 per year, per PFIC non-filing penalty.

INTEREST IN FOREIGN DISREGARDED ENTITY (Form 8858)

US persons are required to file Form 8858: Information Return of US Persons with Respect to Foreign Disregarded Entities and Foreign Branches for any interests they hold in foreign disregarded entities or the operations of true foreign branch. 

A foreign disregarded entity is an entity that is not organized in the United States and is disregarded as an entity separate from its owner for US income tax purposes. A Foreign Branch exists when business operations are carried out by a US person or a controlled foreign corporation outside the United States, but no separate foreign legal entity has been created to hold the business operation.

This reporting would be required by US persons who have created foreign entities that are similar to U.S. LLC’s or who operate a business as a sole proprietor.  It may also include rental of foreign property if they are operated as a “business” rather than a passive activity.

IN SUMMARY

Many U.S. Citizens located in a foreign country will consider investments or incorporate business entities in their home country.  It is important to know that there are United States reporting requirements relating to these investments.  Very large penalties are imposed for failure to file these annual reporting forms.

As the reporting and disclosure requirements for U.S. tax purposes in respect of all these reports can be complex, it is strongly recommended that practitioners seek assistance from an international tax specialist if they are uncertain about filing these reports. 


LEARN MORE ABOUT THE TAXATION OF U.S. CITIZENS ABROAD

PTIN Courses International has developed a course that discusses the taxation of U.S. citizens abroad as well as a number of other courses relating to international taxation issues.

Upon completion of the U.S. Citizens Abroad course, participants will be able to:

  • Realize the U.S. tax obligations that U.S. Citizens and green-card holders are subject to
  • Identify the two mechanisms used to avoid double taxation and decide which of these to apply to individual situations.
  • Describe the various foreign reporting requirements that are required of U.S. persons holding interests in various assets or entities.
  • Discuss with their clients the consequences of not filing these returns and reports.
  • Know which programs are available that may provide relief from penalties to certain taxpayers
  • Advise clients on the U.S. estate and gift tax consequences when living overseas.

PTIN Courses International is an IRS-approved CE Provider.

We offer a quality continuing education experience for a reasonable price of $10.00 per credit hour!! Please take a look at the courses we currently have to offer by visiting our “All Courses” page. We are so excited to become a part of your professional journey.


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