Several countries around the world, most notably Switzerland, had adopted secrecy laws in their financial services sector as a means to attract foreign capital. According to the Boston Consulting Group, Switzerland’s banks housed a staggering $2.1 trillion, or 27% of offshore wealth. Under these laws, anonymity was secured; that is, jurisdictions with secrecy laws prohibit banks from providing personal or account client information to authorities, except under certain conditions such as criminal activities. Needless to say, these same laws are one of the main instruments used in organized crime and the black-market economy.
In the past, US citizens were able to rely on such secrecy laws as a protection against the IRS. Mere failure to report foreign assets and bank accounts was not reason enough to breach secrecy. Thus, Americans with accounts in ‘secrecy jurisdictions’ such as Switzerland, Singapore, Lebanon could hide from the IRS as long as they were not suspects in ongoing criminal investigations.
These activities were not in the best interest of the United States government; so, over the years, the IRS has taken steps to discourage foreign account usage, mostly due to concerns over lack of revenue from such accounts. The most impactful of these steps came when the IRS mandated all U.S. taxpayers with offshore accounts totaling more than $10,000 to file a new Financial Crimes Enforcement Network (FinCEN) Form 114, also known as the FBAR, and in 2004 when the penalties for willful failure to file an FBAR were increased to 50% of the accounts’ high balance.
While these new measures have been effective in bringing forth assets that have been stashed abroad to evade IRS taxation, they have also required regular law-abiding U.S. expatriates to report their income and assets to the IRS. Unlike almost any other country in the world, U.S. government taxes U.S. citizens living overseas, even if their income is generated in a foreign country. This can lead to double taxation to many U.S. expats. For example, let’s say Joe lives and works in Portugal, and he has a U.S. passport. Joe has to pay income taxes to both the Portuguese and the U.S. federal government. Though there exist some relief provisions to include foreign tax credits on overseas income, they are often insufficient.
Since foreign accounts are taxable (U.S. persons are taxed on worldwide income), the IRS and the Treasury Department have put in place strict measures to declare foreign assets. After Congress passed the Foreign Account Tax Compliance Act (FATCA) in 2010, it forced compliance standards on foreign banks across the globe, which require non-U.S. banks to report accounts held by U.S. persons worth over $50,000.
At the same time, under the Bank Secrecy Act (BSA), U.S. persons are required to electronically file the FinCEN 114 Form annually to the Department of Treasury through FinCEN’s BSA E-Filing System. This form is more commonly known as the FBAR.
An FBAR (Report of Foreign Bank and Financial Accounts) is a form used by any U.S. person to report a financial interest in, or signature authority over, a foreign financial account.
Before going any further, it is important to clarify a couple of terms as defined in the FBAR filing instructions:
You must file an FBAR if you meet the following requirements:
Must be filed on or before June 30th of the year following the calendar year reported. NO extension of time available for filing FBAR.
Sarah is a U.S. citizen. She currently lives in Germany, where she works as a college biology professor. She has a checking account at her local bank where she deposits her checks. Tax season is just around the corner, what steps should she take?
Does she have income from foreign sources? Yes. Therefore, she must declare her income to the IRS, whether or not the income is reportable or taxed in the country where she currently resides. Remember, U.S. government taxes on worldwide income. Her foreign earned income will be excluded, however, from U.S. tax up to a certain threshold. If she does have foreign tax obligations, she may be entitled to foreign tax credits as well.
Since she has a checking account at a bank in Germany, she should also answer the questions on the IRS Form 1040, Schedule B, Part III pertaining to Foreign Accounts and Trusts. In other words, she should check the box “yes” to having a foreign bank account. Also, if the value of her German bank account was more than $10,000 at any time during the year, then she should also file the FinCEN Form 114 (FBAR) due by June 30th.
In addition, if Sarah’s foreign financial assets exceed $50,000, then she must also file IRS Form 8938, Statement of Specified Foreign Financial Assets, which is due with her tax returns by April 15. Even though the information provided on the 1040, FBAR, and 8938 Forms are more often than not highly redundant, they must all be submitted on their respective deadlines.
There are two potential issues when failing to disclose offshore bank accounts. First, not reporting the existence of those accounts to the government, through FBAR and Form 1040 Schedule B, can result in hefty fines and penalties. Second, not paying taxes on foreign income deposited into foreign accounts can lead to civil and/or criminal investigations. Usually, an undeclared foreign account will involve both issues.
FBAR penalties include:
In some cases, especially non-willful violations with a reasonable cause and those residing abroad for at least 330 days, FBAR non-filings can be corrected without penalties. In other cases, a taxpayer can come into compliance through pre-emptive disclosures such as the “Offshore Voluntary Disclosure Program” (OVDP) or the “Streamlined Filing Compliance Procedure”. However, if the IRS already has information about the offshore assets, or if the taxpayer is already under investigation or audit, then it may be too late for a voluntary disclosure. Therefore, proper timing is important.