Thinking of taking the IRS up on their offer of “simplified” compliance procedures for U.S. Persons abroad? Well if you have a “foreign” retirement or purpose savings account, you should be warned that the paperwork is so complicated that even the IRS doesn’t understand it — and thanks to how the U.S. taxes “foreign trusts”, you may end up classified as a “high risk” taxpayer simply for having a retirement account like every one of your neighbours, especially if the U.S. dollar has fallen against your country’s currency during the recent financial crisis.
From a blog post by Brian Dooley as well as a comment by badger, we learn of a recent letter by the American Institute of CPAs to the IRS complaining of grossly inappropriate automated penalty letters being sent out to multiple taxpayers, Canadians among them, in response to accurate, complete, and timely Form 3520 filings — filings which the IRS erroneously classified as incorrect, incomplete, or late because the taxpayers left some blank spots on the form for items which the instructions correctly told them not to fill out.
As Mr. Dooley describes the situation:
Here is what happens. Americans receive a gift or bequest from a family member who is a non-citizen. Being tax compliant they hire and pay a CPA to prepare Form 3520 …
The taxpayer receives an penalty notice for 35% of the gift or bequest. They or their CPA writes to the IRS, but the IRS computer continues to send out the penalty letter. The letter has no contact person or telephone number. Eventually, the computer starts the collection process.
The taxpayer receives repetitive terrorizing letters, until it goes to collection. Now, the good news is that for a few $1,000 dollars you can hire an attorney to stop the collection process. Until then, expect sleepless nights.
The confusion comes from the fact that Form 3520 has a bunch of different purposes. Most of us are familiar with it in the context of reporting “foreign trusts”, the ridiculous IRS name for bog-standard retirement savings plans like Hong Kong MPF or ORSO accounts, Swiss Second Pillars, and more which we and all of our neighbours have, or other kinds of purpose savings accounts like Canadian RDSPs and RESPs or Singaporean Medisave accounts. However, for some reason known only to the people who designed the stupid form, it is also used for reporting gifts and bequests from non-U.S. Persons.
The taxpayers who received these threatening letters from the IRS had filed Form 3520 for the second purpose — a non-U.S. relative had given them a gift, or left some property behind for them after passing away. That means that among the six fun-filled pages of Form 3520, there are certain trust-related items that these taxpayers did not have to fill out. There is no “trust” involved and so these questions were clearly inapplicable to their situation — questions like “did you make any transfers to the trust and receive less than fair market value?” or “enter the gross value of the portion of the foreign trust that you are treated as owning”, and the like.
Of course, the IRS was unable to tell the difference between the two use cases for the form, and so sent letters to the taxpayers in question telling them they hadn’t provided all the information the form asked for and so their filing would be treated as late and incomplete and would be subject to giant penalties.
This is a lot like the old State Department “Questionnaire: Information for Determining U.S. Citizenship”, which was used both by people who had relinquished citizenship voluntarily, but also by people against who wanted to contest a finding of loss of citizenship which State had made against them. Naturally this produced huge workflow confusion and incorrect processing of cases, until State realised that it might be a good idea to redesign their forms to separate out the two use cases. How long do you think it will take the IRS to get the same clue?
Don’t hold your breath. The IRS doesn’t care about making these forms understandable or easy to complete. As Mr. Dooley points out:
No income tax is due on a bequest, inheritance or gift … So, why is the Form 3520 required? As far as I can tell, merely to assess a penalty.
The purpose of these garbage forms is primarily to give the IRS a handle on honest and law abiding people who live outside the U.S. or have relatives there — so that it can terrorise them. If you haven’t been filing your forms, the IRS can threaten you with life-altering penalties, and use the threat of those to herd you into some so-called amnesty on terrible terms. And even if you are one of the minority who have been filing all your paperwork, the IRS can find something “wrong” with your filings and terrorise you anyway.
Unfortunately, in the case of “foreign trusts”, unlike “foreign” gifts or bequests you may owe some U.S. tax. How much tax? This has become a very crucial question under the recent “streamlined” compliance procedures. There’s a ceiling of US$1,500 per year in tax owed for each of the past three years if you want to be classified as “low risk”. It’s far easier to hit that threshold than you imagine.
Government transfer payments into purpose savings accounts are one problematic case. Consider, for example, Canada’s Disability Savings Grant payments into an RDSP. These kinds of payments are not taxed by the local government — meaning that they do not generate foreign tax credits. But of course, the U.S. government claims the right to impose taxes on the tax dollars of other countries, so these transfer payments are attributable back to the taxpayer as ordinary income. The small mercy tends to be that the amount of the payment is not large enough in and of itself to bring you to a US$1,500 tax liability. All you have to do is spend thousands of dollars filing the paperwork. (Of course, when the IRS finds non-existent errors in that paperwork, they’ll probably put you in the “high risk” category anyway.)
Retirement accounts may be problematic as well since these accounts often receive employer matching payments to supplement employee contributions. If those matching payments are considered the income of the “foreign trust” rather than the U.S. Person who owns it, they do not get the benefit of the Foreign Earned Income Exclusion. Furthermore, this matching contribution is ordinarily tax free under local law, so again there is no foreign tax credit available either to reduce the U.S. tax owed.
And of course, both of these kinds of accounts tend to have gains from investments. Account holders who were not aware of their U.S. tax filing requirements will likely have allocated the savings in these accounts to various asset classes without regard for how the U.S. taxes them. Thus they may be holding index funds and mutual funds — which as many of us have learned the hard way are U.S. PFICs and result in mark-to-market gains being attributed to the “foreign trust” — and most likely the U.S. Person accountholder personally as the tax owner of the “trust” assets. Worse, the mark-to-market gains include currency movement. This is where it gets ugly — the U.S. dollar has had some very bad years within the three-year period covered by the Streamlined Filing Compliance Procedures, for example against the Canadian dollar in 2009 or the Swiss Franc in 2011.
To give a simplified example, (edit: I modified the numbers in this example to account for the fact that you are generally supposed to use yearly average exchange rate for the current year against the last year, rather than the year-end rates), imagine you moved to Australia in 1980 and started out at a salary of AU$12,000 per year. You resolve to save 10% of your income into some kind of Australian tax free account (in reality, “Super” thresholds are more complicated than this, involving employer and employee contributions, but let’s ignore that). For further simplicity, let’s say your salary increases and your investment return are both a constant 4.5% per year — not even keeping up with inflation over the same period. This means your salary is below the Australian average for the entire time — you are not some “fat cat” living the high life Down Under. By the crucial year of 2010 you’d have AU$129,025 in your account.
Here’s a historical AUD/USD chart for your reference. The Aussie dollar had some very good times: it bought US$0.69087 on 1 January 2009, and by the end of the year it bought US$0.89439. The IRS’ yearly average AUD/USD rates are 0.751 for 2009, 0.882 for 2010, and 0.992 for 2011. In otherwords, the amount in our account would have seen a phantom currency gain of more than US$16,000 in 2010, not even counting the investment gains. If all the assets of that account were in PFICs (or worse, if you cashed out the account to pay for some expenses), that “gain” gets marked-to-market and attributed back to you, the account holder.
Even if you excluded your wage income with the FEIE, thanks to Chuck Grassley’s “stacking” provision your investment income will end up in the 25% bracket — and even after taking out the personal exemption of US$3,650 and the standard deduction of US$5,700 from that ye5r, there would still be enough “income” to push you over the US$1,500 tax threshold. Congratulations, the IRS thinks you’re a “high risk” taxpayer. (For all you Homelanders like Andrew Leonard who think this is just desserts for having such an impossibly huge amount in a “foreign account”, keep in mind that this is someone’s life savings and they have to use that amount to survive a two or three decade retirement — and in fact that amount is well below the U.S. median household net worth for people over 55.)
Coincidentally, you will note that the name “Streamlined Filing Compliance Procedures” has the exact same acronym as “Stealing From Canadian Pensioners”. I’m sure this is entirely unintentional.