ELITE ADVISOR BEST PRACTICES
Don’t Let Well-Traveled Clients Get Tripped Up on Tax Day - Part Two
More cross-border issues to keep top of mind when filing U.S. taxes (second in a series)
By Deepa Venkatraghvan
- While total global income must be reported on the relevant lines of the 1040, some forms are specific to global tax reporting.
- Form 8938 relating to foreign asset reporting is now in its second year.
- PFIC reporting—Form 8621 for all foreign mutual funds and private equities held by U.S. residents and citizens—is slowly becoming important.
- Your clients must also declare their financial interest in foreign entities via Form 5471.
As we discussed in Part 1 of this article series, 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. Here we’ll look closer at the important forms that will kick in for such persons.
Foreign assets reporting—Form 8938
Last year, the U.S. Internal Revenue Service (IRS) added one more form to collect information from U.S. citizens and residents on their foreign financial assets. Form 8938, Statement of Specified Foreign Financial Assets, must be filed along with the income tax return.
Experts agree that Form 8938 will become a significant tool for the IRS to identify the scope of international tax noncompliance of a given U.S. taxpayer. This form requires a taxpayer to disclose more information that connects various parts of a taxpayer’s international tax compliance, including the information that escaped disclosure on other forms earlier. Schedule B is a typical example where a client may have failed to report foreign financial accounts. Moreover, Form 8938 is far more detailed and asks the opening date of a certain financial account. This can become a tricky situation if the client has held a foreign account for a significantly long period of time but has never disclosed it in earlier returns.
Foreign financial assets that must be declared in Form 8938 include shareholdings, mutual fund holdings, insurance policy holdings, pension plans and bank balances abroad.
Specified foreign financial assets do not include physical assets such as gold and real estate. However, if gold is held in the form of ETFs, it should be included as a specified foreign financial asset.
Tip: Form 8938 is exhaustive and requires your clients to enter detailed values of financial assets. Ask your clients to get in touch with their overseas bankers or financial companies to gather this information right now.
PFIC reporting—Form 8621
The U.S. has a peculiar reporting requirement for all foreign mutual funds and private equities held by its residents and citizens. In the U.S., these funds are considered passive foreign investment companies (PFICs). In a nutshell, according to the PFIC rules, any notional gains from a mutual fund or private equity fund holding must be declared every year, and tax must be paid on such notional gains.
If your clients do not comply, their gains on sales will be treated under the “excessive distribution” option, which is also the default method. Suppose a client did not make any election on PFICs and, throughout the holding period, did not complete Form 8621 for PFIC holdings. The client held the PFIC units for, say, 10 years and did not receive any distributions during those 10 years. In the year of sale, the client made a gain of $100. In the year of sale, gains will be distributed over the past 10 years, that is, $10 per year. It will be treated as though the client did not pay tax on $10 per year, and hence in Year 10, must pay tax for each of these years plus interest on the delay. Essentially, this default method kicks in at the year of sale.
Tip: If your clients have foreign mutual funds, collect information such as opening and closing values. If dividends were paid, gather that information as well. It can be a long, drawn-out exercise so the sooner you begin, the better.
Declaration of financial interest in Indian entities
Forms 5471 and 8865 are triggered when a U.S. resident, citizen or green card holder has financial interest in foreign corporations or foreign partnerships. So if your clients have a stake in an overseas company, or are directors or officers of an Indian company, they may need to file Form 5471 (for companies) or 8865 (for partnerships) and declare their interest. There are certain conditions that apply to both forms. What is important is that the penalties are very high. There is a penalty of $10,000 for each year for failing to file the form.
Another form, the 926, was also introduced recently. This form captures information on any transfers of property or funds by a U.S. taxpayer to a foreign corporation.
As I mentioned at the beginning of this article series, 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 facing harsh penalties will start to diminish. So the sooner your clients act, the better.