ELITE ADVISOR BEST PRACTICES
Don’t Let Well-Traveled Clients Get Tripped Up on Tax Day - Part One
Cross-border issues to remember while filing U.S. taxes (first in a series)
By Deepa Venkatraghvan
- The IRS takes the definition of “global” seriously. All global income, including employee stock option plans, must be reported.
- There is an increased focus on offshore income tax compliance.
- The IRS also expects to hear from all U.S. citizens and green card holders living overseas.
- Taxpayers might be failing this compliance simply because they are not aware of the rules.
- As advisors, it’s imperative to be updated about offshore income rules and to keep clients abreast of the latest developments.
As your clients get ready to put the final touches on their tax returns, here are some important things you should remember with respect to global income compliance.
All global income must be reported
If your clients are U.S. residents or U.S. citizens (whether NRI, PIO or OCI), they must pay taxes in the U.S. on all global income. A U.S. resident is a green card holder and/or someone who has been physically present in the United States for at least 31 days during 2012 and for at least 183 days during the three-year period that includes 2012 and the two years immediately before. To satisfy the 183-day requirement, count all the days that your clients were present in the current year, add one-third of the days they were present in the first year before the current year, and then add one-sixth of the days they were present in the second year before the current year.
Global income will include:
- Any salary partly received in another country
- Any income received overseas for freelance or consulting work
- Interest on bank deposits and other securities held overseas
- Dividends from shares and mutual funds
- Capital gains from sale of assets
- Rent from property
Remember, your clients’ global income will be taxed in the U.S. as per rules that apply to similar income in the U.S. For instance, while dividends may be tax-free in India, they are taxed in the U.S., and hence your clients’ dividends from India will be taxed in the U.S. The same goes for capital gains. According to U.S. law, the definition of “long term” is one year for all assets, but it may be different in other countries. When your clients file tax returns in the U.S., they must take into account this difference and treat overseas capital gains as per the time period specified in U.S. law.
If your clients have paid tax in the overseas country from which the income described above is derived, you must check the Double Taxation Avoidance Agreement to see if they are eligible to claim a foreign tax credit.
Tip: When you fill in Schedule B of your clients’ tax return Form 1040, pay close attention to line 7. Line 7 asks if the taxpayer had, during the tax year, held any financial interest in or signature authority over a foreign financial account (such as a bank account, securities account or brokerage account). Make sure you confirm that your clients indeed had overseas investments.
If your clients exercised an employee stock option plan (ESOP) in 2012, that’s one more thing they must declare in their U.S. tax returns. In the U.S., the value of ESOPs granted is taxed at the time when the employee exercises the option.
Your clients must add the total value of their ESOP compensation to their total income in the U.S. Since they may have also paid tax in the country where the ESOP originated, they will be eligible to claim a tax credit in their U.S. tax returns. You must refer to the Double Taxation Avoidance Agreement.
Tip: Your clients can disclose this as other income in Form 1040. They can claim foreign tax credit using Form 1116.
U.S. citizens and green card holders living overseas
In this connected world, you may have clients who are constantly on the move. This red flag is for them.
Regardless of where they live, all U.S. citizens and green card holders must file tax returns in the U.S. based on their total global income. They must pay taxes on such foreign income unless a treaty or statutory exclusion or foreign tax credit applies to reduce their U.S. tax liability to zero.
In such cases, if your clients are U.S. citizens or green card holders residing overseas, on the regular due date of their return, they are allowed an automatic two-month extension to file their return and to pay any amount due without requesting an extension. So this year, the automatic two-month extension goes to June 15. But remember, while no penalty is charged, interest is still charged on the balance due between April 15 and June 15.
If your clients are unable to file a return by the automatic two-month extension date, they can request an additional extension to October 15 by filing Form 4868 before the automatic two-month extension date. However, any tax due payments made after June 15 will be subject to both interest charges and failure-to-pay penalties.
Tip: Filing U.S. tax returns from overseas can be quite a challenge. Not all software is equipped to handle foreign tax issues such as earned income exclusions—Form 2555, foreign tax credit—Form 1116, Form 8938, Form 8833 and so on. In such cases, your clients will need to file a paper return. So, make sure you and your clients get started well in advance of the deadline.
Foreign income compliance is becoming increasingly important to the IRS. As the Foreign Account Tax Compliance Act (FATCA) gathers steam, opportunities to come into compliance without harsh penalties will diminish. The sooner your clients act, the better.
In the next installment of this article series, we’ll look at the various additional forms that must be included with the 1040 to be compliant with global income reporting.