An Overview of Citizenship-Based Taxation, Filing Examples

Citizenship Based Taxation 

The United States is one of the only countries across the globe that follows a citizenship-based taxation model instead of a residence-based taxation model. That means that the United States taxes individuals based on what their U.S. person status is for tax purposes and not necessarily where they reside or where the income is sourced from. One important thing to keep in mind is that citizenship-based taxation is not limited to just citizens, rather it includes:

• • • U.S. Citizens

    • Lawful Permanent Residents

    • Foreign Nationals who Meet the Substantial Presence Test

If a taxpayer falls into one of these three categories above, they are typically required to pay U.S. taxes on their worldwide income along with reporting their foreign assets, accounts, and investments on various international information reporting forms. This is extremely unfair, especially for taxpayers who may only be residing in the United States temporarily but are still held to the same reporting standard as a U.S. citizen who may have been born a U.S. citizen and more familiar with the U.S. tax system. It is not as if the U.S. government provides new U.S. persons with instructions about what to report and how to report it properly.

Adding insult to injury is the fact that many taxpayers who are out of compliance end up getting penalized significantly by the IRS for failing to file the proper forms. Noting, that the IRS does offer various amnesty programs for taxpayers who qualify so that they may be able to avoid the fines and penalties, but some taxpayers only learn about these programs after they have been assessed penalties by the IRS – which it is too late to submit to programs such as the Streamlined Procedures.  Let’s walk through the basics of the citizenship-based taxation system along with some examples and tips.

First, Who Has to Report Worldwide Income

First, it is important to identify who is required to file taxes to include their worldwide income along with reporting their foreign accounts, assets, and investments. As indicated above, the three primary categories of individuals subject to U.S. taxes on their worldwide income are U.S. Citizens, Lawful Permanent Residents, and foreign nationals who meet the Substantial Presence Test. Let’s take a look at three examples of individuals who must report their worldwide income and assets.

• • • Michelle is a U.S. citizen that lives overseas and earns all her income from a foreign employer. She also has three foreign bank accounts and none of the money is repatriated back to the United States.

    • Scott is a lawful permanent resident who lives and works in the United States but has investment income from foreign sources.

    • Dana is in the United States on an L-1 work transfer. She does not intend on becoming a lawful permanent resident, but she remains in the united states for almost 300 days a year. She has several investments overseas that generate significant amounts of income.

In each one of the circumstances identified above taxpayers must file annual tax returns to report their worldwide income along with various international information reporting forms such as the FBAR and Form 8938.

What if the Income is Earned Overseas?

Just because income is earned overseas does not mean that it is exempt from U.S. tax liability. Since the United States follows a worldwide income tax model, income earned overseas or in the United States is included on a U.S. tax return. In addition, even if the income receives tax-deferred or tax-exempt treatment in the foreign country does not mean that it will also receive the same treatment in the United States. If there is a tax treaty between the United States and the country where the income is being generated have been — or where the taxpayer lives — that may impact the overall net effect of tax liability, but from a baseline perspective, just because income is earned overseas does not mean it is exempt from U.S. taxation.

What if I Paid Taxes Overseas? (Examples)

Just because the taxpayer may live overseas and/or pay taxes does not mean that they can avoid reporting their worldwide income or foreign accounts/assets. However, if the taxpayer goes overseas they may have various options available to them to reduce or eliminate U.S. tax liability.  Let’s look at some examples:

• • • Michelle lives overseas for 350 days throughout the year. She only travles to the United States twice a year for about a week at each time. Michelle can use the foreign earned income exclusion to exclude upwards $120,000 of her income along with foreign tax credits to reduce her U.S. tax liability on her foreign investments.

    • Scott earns a significant amount of passive income from foreign sources, but he also pays a significant amount of tax. When Scott files his U.S. tax return, he will report the gross amount of his foreign income along with the taxes he paid overseas which may reduce or possibly even eliminate his net effective U.S. tax liability on the foreign income.

    • Dana earned a significant amount of passive income as well, but she does not have to pay foreign taxes on the income because the income is exempt in that foreign country. As a result, Dana does not have any foreign tax credits to apply.

    • Brian is a U.S. Lawful Permanent Resident that lives in a foreign country. Brian lives there for almost the full 12 months each year and it is a treaty country. Since Brian lives in a treaty country and has significant contacts with that country, Brian may qualify for a treaty election to be treated as a foreign person for tax purposes and therefore would only be taxed by the United states on his U.S. sourced income and not his worldwide income.

Understanding FEIE (Foreign Earned Income Exclusion)

For some taxpayers who live and work in a foreign country, they may qualify for the foreign earned income exclusion (FEIE). The foreign earned income exclusion is a way that taxpayers can exclude upwards of $120,000 a year (adjust for inflation) from their U.S. taxes. A few important concepts to note are that it only applies to earned income and not passive income such as dividends, capital gain, or interest. In addition, taxpayers must include the income as part of their tax return and then file a Form 2555 along with their tax return to exclude the income.

In other words, taxpayers who qualify for FEIE still have to file tax returns even if the income is going to ultimately be excluded for the foreign earned income exclusion to work. In addition, taxpayers may also qualify for certain housing deductions which are also included on Form 2555.

What Type of Accounts/Assets do I report?

Let’s walk through the basis of foreign account reporting, and specifically what types of accounts are reportable (and which international reporting forms are used to report the accounts).

Foreign Bank Accounts

Bob is a US person who has foreign bank accounts in several foreign countries, with the total value of the foreign bank accounts at around $300,000. Several of the accounts have less than $10,000 and are dormant and/or inactive. In this type of situation, since the total value of foreign accounts exceeds $10,000 for the year, all the accounts are reportable on the FBAR — even if they are below $10,000 and even if they are dormant.

Foreign Investment Accounts

Linda is a permanent resident who previously lived in a foreign country and still maintains many of her overseas accounts. The accounts are not bank accounts but rather investment accounts similar to a Vanguard or E*TRADE account in the United States. The assets are not taxable in the foreign country, and the accounts are comprised primarily of stock and mutual funds. In this type of situation, Linda must report the foreign investment accounts on her annual FBAR. Since the stock and mutual funds are in accounts, she does not typically have to parse out each stock/fund but instead, she can gross up the value of the accounts for FBAR purposes. She may have a separate requirement for reporting the individual foreign funds as well.

Foreign Stock Certificates

Louise has ownership of various foreign stock certificates. The stock certificates are not located in foreign accounts. Instead, she inherited them several years ago and in total, she has ownership of nine different stocks worth $2 million. Louise does not have to report the foreign stock certificates on the FBAR, because she owns the stock certificates individually and they are not located in a foreign account. Louise would still have to report the certificates for FATCA on Form 8938.

Foreign Pension Plans

Tina is a US citizen who worked in various countries in her lifetime. She has retirement plans in the United Kingdom (SIPP), Singapore (CPF), and Australia (Superannuation). Since the foreign pension plans are considered accounts, they are included in the annual FBAR. This is distinct from the rule that if a person has an IRA or 401(k) in the United States that holds foreign accounts in it, those foreign accounts are generally not parsed out and reported on the FBAR. But, foreign pension plans are generally included on the annual FBAR. The US Tax treatment of these accounts will vary.

Foreign Mutual Funds

Gene is an astute investor. When the market was down, he acquired various foreign ETFs and foreign mutual funds in different countries and those funds have increased in value significantly. Gene holds the funds in a single investment account. For FBAR purposes, Gene will report the account with the total different funds. But, since the total value of the funds exceeds $25,000 (Gene is still single), he will most likely have to parse out the different funds on individual form 8621s when filing his tax returns. Remember, the FBAR is a separate form from your tax return. And, since some of these funds issued large dividends for the first time this year (and he was not properly advised to make an MTM or QEF election in prior years), he may have a very complicated tax return in the coming year.

What Forms do I report them on?

While there are many different international information reporting forms, here are five (5) of the most common:

FBAR 

The FBAR is used to report foreign bank and financial accounts to the US Government. The Form is due on April 15, but is currently on automatic extension. Therefore, if you did not file the FBAR (FinCEN Form 114) by April 15, you still have until October to file it. And, you do not have to file an extension form such as Form 4868 or 7004 to obtain the FBAR extension — because the extension is automatically granted.

Form 8938 

Form 8938 is used to report foreign assets to the IRS in accordance with FATCA (Foreign Account Tax Compliance Act). It is similar (but not identical) to the FBAR. Form 8938 is filed with your tax return and is due when your tax return is due. If you are an individual filing a Form 1040, then the Form 8938 would be due in April along with your 1040 tax return — but if you extend the time to file your tax return, then your Form 8938 will go on extension as well.

Form 3520 

Form 3520 is used to report foreign gifts and foreign trust information. The due date for Form 3520 is generally April 15, but taxpayers can obtain an extension to file Form 3520 by filing an extension to file their tax return for that year. Similar to Form 8938, there is no specific Form 3520 extension form required beyond requesting an extension of the underlying tax return.

Form 3520-A

Form 3520-A is used to report US ownership of a Foreign Trust. Unlike Form 3520, Form 3520–A is usually due in March and not April. In addition, the rules for filing an extension for Form 3520-A are different as well (subject to the substitute filing rules). In order to extend the due date to file Form 3520-A, the taxpayer must file a separate Form 7004 extension form.

Form 5471 

Form 5471 is used to report the ownership of certain foreign corporations. The filing date is the same as when a person’s tax return is due — and if the taxpayer files an extension for the underlying tax return, Form 5471 will go on extension as well. In recent years, Form 5471 has become infinitely more complex — so taxpayers should be cognizant of the different filing requirements and plan accordingly.

Late Filing Penalties May be Reduced or Avoided

For Taxpayers who did not timely file their FBAR and other international information-related reporting forms, the IRS has developed many different offshore amnesty programs to assist taxpayers with safely getting into compliance. These programs may reduce or even eliminate international reporting penalties.

Current Year vs Prior Year Non-Compliance

Once a taxpayer 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 who 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. 

Need Help Finding an Experienced Offshore Tax Attorney?

When it comes to hiring an experienced international tax attorney to represent you for unreported foreign and offshore account reporting, it can become overwhelming for taxpayers trying to trek through all the false information and nonsense they will find in their online research. There are only a handful of attorneys worldwide who are Board-Certified Tax Specialists and who specialize exclusively in offshore disclosure and international tax amnesty reporting. 

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.