As the world has become more global, more clients of all types hold assets outside of the United States. The following summarizes some important tax-reporting and disclosure requirements and where to find those assets in the new documentation.
Foreign Assets: Taxation of Individuals
U.S. citizens and green card holders are subject to tax on worldwide income. That means any income, whether earned overseas or in the United States, is subject to U.S. taxation. Assets and their tax attributes should be reported annually; therefore, repatriation of those assets should not trigger any additional liability.
Ownership in foreign corporate stock creates a U.S. tax liability in the same way as ownership in U.S. corporate stock. If the foreign corporation pays dividends, the dividend income is included with all income of the individual. Gains on foreign stock sales are also treated with the same capital gain treatment as in the United States. Disclosure of that stock ownership is referenced below.
Individuals holding an interest in a foreign mutual fund or holding company may be subject to the rules of passive foreign investment companies (PFICs). PFIC taxation can include a mark-to-market component unless the taxpayer chooses to opt out and, thus, become subject to the taxation rules like those of owning a U.S. investment. This election is filed annually with the individual’s income tax returns on Form 8621.
Holding these assets overseas or bringing the funds back to the United States typically does not change the U.S. tax impact to the individual.
Foreign partnerships will report the U.S. partner’s respective income to the U.S. individual so the individual can include it on his or her U.S. income tax return. While the partnership may not have a direct U.S. filing obligation, the U.S. individual must disclose this information by filing Form 8865, Return of U.S. Persons with Respect to Certain Foreign Partnerships, with his or her individual income tax returns.
The assets held overseas or brought back to the United States are reported with the annual income tax returns. The location of the funds should not have a U.S. tax impact.
In general, a foreign corporation is only subject to U.S. tax on income when income is earned in the United States or when that income is distributed as a dividend or otherwise repatriated to a U.S. taxpayer. Foreign corporations controlled by U.S. entities (often referred to as controlled foreign corporations) are taxable under the rules of Subpart F of the tax code. The 2017 tax law change lowered the tax rate on some income that is taxable under Subpart F but also expanded the definition of what income would be subject to the tax under Subpart F.
Foreign Inheritance and Trusts
Recipients of a non-U.S. inheritance do not incur a U.S. income tax liability on the receipt of that non-U.S. inheritance. However, the inheritance and any financial interest in a non-U.S. estate or trust would be reported to the IRS via Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts.
Reporting and Noncompliance
The IRS has encouraged people to come forward in reporting foreign assets by use of both a voluntary disclosure program with discounted costs and one with extreme fines. For example, a nonwillful violation could carry a penalty of $10,000 per year for not filing a foreign bank account with a balance over $10,000. Willful violations can be penalized with $100,000 or 50% of the account value. There are reporting requirements for any non-U.S. financial assets on Form 8938, Statement of Specified Foreign Financial Asset. This includes, but is not limited to, non-U.S. stock holdings, life insurance, retirement plans, or partnerships. This form is very helpful in discovery, once the taxpayer is over the filing threshold, as it discloses all non-U.S. accounts.
Identifying all non-U.S. assets requires strong attention and thoroughness. Overseas asset statements may include different or limited information than what you might expect from U.S. asset statements. For instance, foreign assets often require more tax disclosure than their corresponding U.S. investments but only when the value in the account is above an IRS threshold. A U.S. taxpayer must be diligent in disclosing all foreign bank accounts, no matter the value in each individual account, if the aggregate foreign assets in non-U.S. bank accounts total over USD $10,000. Non-U.S. specified financial assets, including stock holdings, foreign partnerships, or life insurance policies over the value threshold, must be disclosed and filed on Form 8938.
Foreign companies or partnerships often involve a tiered ownership structure. For example, a U.S. partnership may own an underlying non-U.S. partnership. Practitioners should understand that passthrough foreign income on partnership K-1s may not be included with ordinary income. The income may be reported under the “other income” section, or “Subpart F income” that is only disclosed in the footnotes to the K-1. Full discovery includes review of the K-1 and all related footnotes. Reviewing the individual’s tax elections regarding their non-U.S. holdings will give an understanding of ownership.
In discovery, the following list of forms can be helpful to determine which assets are held by the parties and can help define where to spend additional time and effort.
- FINCEN 114, Foreign Bank Account Report (FBAR)—Reports bank accounts and highest balances held overseas if over the $10,000 reporting threshold.
- Form 8938, Statement of Specified Foreign Financial Asset—Reports foreign financial assets such as pensions, stock holdings, and mutual funds, among others, if total value is above the relatively high reporting threshold. The reporting threshold varies for taxpayers living overseas or those living in the United States.
- Form 8865, Return of U.S. Persons with Respect to Certain Foreign Partnerships—Reports foreign partnership income owned directly by the U.S. taxpayer if he or she meets the reporting requirements.
- Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Fund—Election statement of tax treatment on foreign investment companies including mutual funds. Indicates foreign investment company holdings and can include foreign mutual funds.
- Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts—Reports receipt of gifts or bequests received from overseas and foreign trust beneficiaries.
- Schedule E, Supplemental Income and Loss—Reports the Subpart F income that can indicate a foreign entity held by a U.S. passthrough entity.