Unreported Foreign Income: What Options do Taxpayers Have?

Unreported Foreign Income 

The United States has one of the most complicated tax systems in the world. Unlike almost every other country across the globe, the United States follows a worldwide tax model. Therefore, if you are considered a US person for income tax purposes, then you are required to report your worldwide income to the IRS. Even if you are a US person who resides overseas and earns all their money from foreign sources outside of the United States, you still have to report all the income on your US tax return. Making matters more confusing, is that although worldwide income is based on the United States’ Citizenship-Based Taxation rules, the term Citizenship-Based Taxation is a misnomer because it is not limited to just U.S. citizen. Rather it includes US Citizens, Lawful Permanent Residents and Foreign Nationals who meet the Substantial Presence Test. The focus of this article is on individuals — because matters involving corporations and other entities can get even more complicated. Let’s start with some of the different categories of unreported income and then summarize the different methods you can use to get it to compliance.

Foreign Employment Income

When a person earns foreign income through employment or independent contractor work, this income is taxable in the United States. Therefore, even if you work for a US or foreign company abroad and they do not issue a traditional W-2 or 1099, that income is still reportable on your US tax return. If you work overseas, you may be able to qualify for the Foreign Earned Income Exclusion on their earned income — as well as foreign housing exclusion. Not everyone qualifies and there are some exceptions, exclusions, and limitations to be aware of. A Taxpayer may also qualify for potential for tax credits (see below).

Foreign Investment Income

Another common source of unreported income from overseas is investment income. Some common examples include dividends, capital gains, interest, royalties, and rental income. Even if the investment income is generated from sources outside of United States — it is still included on your US tax return. Where some people get understandably misled is that this interest may be tax-exempt in the foreign country or might be generated in a jurisdiction that does not tax passive income, such as dividends and capital gains in many Asian countries. Nevertheless, from a baseline perspective, the foreign income is taxable in the United States. You may be able to try to claim treaty benefits to reduce or eliminate income taxes — but that may be a difficult hill to climb. Taxpayers may qualify for foreign tax credits though to try to reduce or eliminate the tax liability. We have a separate article summarizing how Foreign Tax Credits work, along with examples to assist you.

How to Disclose Unreported Foreign Income (and Accounts/Assets)

There are several different offshore compliance programs — and they vary based on the facts and circumstances of the Taxpayer. Not all Taxpayers will qualify for every program. Let’s review the basics of the different delinquent FBAR late-filing submission procedures:

Delinquent FBAR Submission Procedures (DFSP)

When a Taxpayer does not have to make any substantive changes to their tax return involving unreported income, they may qualify for the Delinquent FBAR Submission Procedures. This program is typically limited to Taxpayers who have no unreported income and are not required to file other delinquent forms in addition to the FBAR. For Taxpayers who qualify for these submission procedures, there is generally no penalty applied for prior-year noncompliance.

Delinquent International Information Return Submission Procedures (DIIRSP) 

Up until November of 2020, Taxpayers who had no unreported income (but missed filing international information reporting forms) could sidestep any offshore penalties by filing delinquent forms under DIIRSP. In November of 2020, the IRS rules changed and the IRS does not guarantee that filing delinquent forms will circumvent penalties — although with the right set of facts and circumstances, the Taxpayer may avoid penalties by showing reasonable cause (see further below).

Streamlined Domestic Offshore Procedures (SDOP)

The Streamlined Domestic Offshore Procedures are IRS procedures designed for Taxpayers who do not qualify as foreign residents, are non-willful, and filed their original tax returns timely. Under these procedures, a Taxpayer can opt to pay a 5% Title 26 Miscellaneous Offshore Penalty in lieu of all the other delinquent FBAR and FATCA penalties.

Streamlined Foreign Offshore Procedures (SFOP)

The Streamlined Foreign Offshore Procedures are probably the best of all the offshore tax programs for Taxpayers who qualify as eligible. This is because if a Taxpayer qualifies as a foreign person and is non-willful, they can avoid all offshore penalties under these procedures. In addition, Taxpayers can file original tax returns.

IRS Voluntary Disclosure Program (VDP) for Delinquent FBAR & FATCA

The IRS Voluntary Disclosure Program (VDP) has been in existence for many years. From 2009 to 2018, there was an offshoot of the VDP program — which was referred to as the Offshore Voluntary Disclosure Program (OVDP) — and was primarily for Taxpayers with undisclosed foreign income and assets.  In 2018, the IRS closed this program — but also expanded the traditional voluntary disclosure program on matters involving foreign and offshore income and asset disclosures.

Under the prior version of OVDP for delinquent FBAR, FATCA, etc. — even non-willful Taxpayers would submit to the program in order to both receive a closing letter and almost always avoid an audit (unless they opted-out). The new version of the VDP program is geared primarily for Taxpayers who are willful or are unable to certify under penalty of perjury that they are non-willful. It is still a great program in which Taxpayers can almost always avoid criminal prosecution — and it rarely if ever would have any impact on a person’s immigration status (unless the Taxpayer was also “criminally” willful and the government pursued that criminality against the Taxpayer, which is extremely rare).

Reasonable Cause for Delinquent FBAR and FATCA

In general, a Taxpayer cannot be subject to penalties for missing the filing of delinquent FBAR and other international information reporting forms if they can show reasonable cause and not willful neglect. This is not a program per se but rather an alternative submission package in which the Taxpayer seeks to avoid or minimize penalties without formally going through the programs listed above — while also avoiding making a quiet disclosure. If you are considering a reasonable cause submission, you should speak with a Board-Certified Tax Lawyer Specialist about your different options.

Current Year vs Prior Year Non-Compliance

Once a taxpayer has missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist that specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties. 

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure. 

Contact our firm today for assistance.