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.
Overview
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.
Form confusion
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.
Smashing the US$1,500 threshold with currency movements
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.
@Eric – a brilliant piece of research with the issues well explained. To bottom line it:
U.S. persons abroad should NOT under any circumstances invest in any tax deferred plan, unless it is specifically covered by a tax treaty. The Canadian RRSP is covered by the treaty provided that the form 8891 is filed and the proper election is made. Now, in the case of an RRSP, what do you think happens if the RRSP election has not been properly made?
Answer, it becomes a foreign trust and is subject to the 3520 filing rules/penalties. In addition, it is very common for an RRSP to hold PFICs (aka mutual funds) in that RRSP. The penalty for owning non-U.S. mutual funds is so high, that they will likely wipe out any and all gains.
These things are so unfair and these problems are so serious that (in my experience of trying to educate) that people cannot believe this is true. I don’t even think your average IRS employee could imagine that this is true.
As I have said, over and over and over and over again.
Renounce U.S. citizenship and renounce it now! If you don’t you will end up in the gutter begging for food!
(No country should allow a U.S. citizen to immigrate. U.S. citizens are very dangerous to the financial stability of all nations (including their own). Why? Because of what I call the “”IRS discount” associated with being a U.S. person.)
P.S. Your concrete analysis of the effects of the exchange rate are graphic and helpful.
P.P.S. For Mr. Dooley to acknowledge that the 3520 exists only to calculate penalties is very telling. This, is a man who has repeatedly stated that:
1. The IRS is the world’s best revenue agency; and
2. Shulman is a great IRS commissioner.
Thanks, Eric. Thanks, badger. Thanks, renounce.
This is very, very difficult for any one of us or others to get their minds around. As usual, no one, NO ONE, really takes all this into account until they are the victim.
In connection with the latest IRS Instructions, I wish there were main media coverage, telling the whole story, entitled New IRS Streamlined Filing Compliance Procedures = Stealing from Canadian Pensioners. Would that catch anyone’s interest in understanding?
Pingback: The Isaac Brock Society - Last Dance: New Filing Compliance Procedures for Non-Resident U.S. Taxpayers – Effective September 1, 2012 – A Preliminary Analysis
Thanks everyone for demonstrating the ‘Pandora’s Box’ of US tax compliance. It is such an injustice that we, in compliance, are facilitating our own demise…and paying accountants thousands to do it! I am seething.
*Great analysis Eric, but to say that they are “stealing”from Canadian pensioners is being too kind. There are other, more inflammatory terms that have crossed my mind but I’ll leave it at that! I am now wondering how they would treat a union pension plan funded by employer contributions which is only taxable here upon receipt of those funds. We report the contributions as a “pension adjustment”, which in turn, reduces or eliminates the allowable RRSP contribution for the year. I am sure that they would like to tax those pensions out of existence given the chance! The collection efforts are also disturbing. If they decide to pursue uncooperative minnows, could they use collection agencies for non- filing penalties, and how would that affect credit ratings?
This issue has also been reported on here….
http://www.accountingtoday.com/news/aicpa-widespread-problem-erroneous-irs-letters-63822-1.html
@Eric
What a great post. Have read it many times in an attempt to even begin to understand the complexity. I wonder how many folks are filing their own U.S. tax returns from abroad and are actually doing them wrong. Maybe having the mistakes caught, maybe not!
Read the Accounting Today article’s first comment and laugh or cry.
*Maybe this is a stupid question, but “foreign trust” means “Swiss Second Pillars”, meaning that I’m supposed to be filing this form?
*@Eric, you’ve hit the nail on the head!! I’m actually more concerned longterm about possible penalty assessment for failure to file forms 3520 and 3520A for my pension fund here in the UK than I am about FBAR and even 8938.. As I earn less than $30,000 and only have about $1500 per year being paid into it, I am very worried that the IRS may eventually decide that I should have been filing these trust forms…but the thing is, I would have to be paying more to my accountant each year in fees to complete the form than I am actually contributing into the pension, itself!!!
Fortunately, the accounting firm agrees that it’s ludicrous and feels that they could argue reasonable cause on my behalf if the IRS ever came back over it. Fortunately for the UK, they believe that the US/UK treaty protects US persons over here from US taxation on the growth within the pension fund (though don’t fully understand all the technicalities). But as they’ve honestly pointed out, it’s still a grey area without any final ruling so they’ve decided to take an approach that’s more favorable for me, though all too painfully aware that I could still face aggro further down the road if the IRS develops an even greater fetish for enforcing the 3520 form.
I fully agree with what others have said here how they’re using these foreign trust forms more for penalty generation than to make compliance easier. They’re only making things more and more complicated and expensive.
As others here probably know, I am NOT comfortable with renouncing and am going to hang in there for now and try to make it work…but my ongoing annual compliance costs are going to run at between $2000 and $3000 even after having gotten fully compliant and without filing this form. They sensibly think that as my pension fund is fairly small that the IRS are probably not going to aggressively audit me over it but it’s the one thing I realize I can’t get out of, unlike the PFIC’s which I sold and/or gifted to my spouse last year. At least in the UK, once a pension fund is set up, it’s impossible to close it till at least 55 and with US laws, it will have to be at least 59 1/2.
Had I know how complicated I would be making things for myself, I would never have opened a pension fund in the first place but, like many others, had done my financial planning like a native as hadn’t been aware of the US tax complications at the time. All this is thus going to force me to stick with this accounting firm since they take an argument that is favorable to me but is nonetheless on the aggressive side, as a more conservative accountant would have said that it was my tough luck and that I would have to file the 3520 anyway in spite of the professional costs being even higher than my contributions!!
It’s as I’ve said many times before: I feel that I’m being forced to rely on my accountant as a form of protection money from the IRS… a further tax on tax. I’ve decided that I’m going to see how things go over the next term and hope that things will improve for expats because it just seems to be getting harder and harder to be compliant without it costing a fortune in fees. The IRS want to catch us out, it would seem so they can hit us with penalties any way they can!!
I imagine that they will step up their game after FATCA has taken full effect as they will have the net fully in place to draw in all the minnows as well as the whales for revenue generation purposes… But if things show no sign of getting any easier in, say, four years, I will then probably do the unthinkable and actually renounce even though I may offend several loved ones over it. To sum up, I believe the IRS will shift from FBAR and look to 8938 and 3520 for penalty generation because they are Title 26 penalties and thus directly enforceable by the IRS vs. FBAR’s Title 31 penalties which would need the DOJ to pursue through the courts.
@monalisa
Pay up to 10% of your gross income to prove you have little or no tax owing? Last year’s 5% is unsustainable for me! This is undeniable hardship.
*@Bubble, indeed it is. Admittedly, I’m taking the line of least resistance right now though…I hate confrontations. I am a convoluted person….feel that it’s onerous but that as I chose to move to England that it’s my duty to be US tax-compliant. No one made me come here to live. I’ve got to take the rough with the smooth…
Of course, I completely empathize with why others are renouncing and even I may eventually choose that route too. I am not wealthy by any means but probably have more disposable income than many here so can grudgingly afford the compliance costs, albeit with much resentment. My husband pays the household bills so my tax compliance costs and personal spending money are my only real living expenses at the present time… though of course realize that things would become much harder to manage if he ever predeceased me, (fifteen years older than me).
Furthermore, while next years’ filing costs may be around $2500 plus another $1500 in US capital gains taxes, I could see the accounting firm’s prices eventually rising. I’ve thus concluded that if my long-term compliance costs rose above $5000 per year (in today’s prices) that I would no longer be able to afford to keep my citizenship.
I agree with everyone else here that why on earth can’t the US see how onerous all these compliance requirements are becoming????
*Another thing that has occurred to me is that I’d imagine that a lot of expats will eventually request private letter rulings regarding their pensions. It might be the only realistic way to get around the 3520 requirements.
In my bill, I already repeal the FBAR, but I’m starting to think that I should include a repeal of all these other reporting requirements too. PFIC, CFC, foreign trusts, foreign retirement plans, foreign mutual funds, foreign financial accounts, foreign gifts and inheritance, these things are either not taxable or effectively taxable as any other kind of income (PFIC may require tax before gains are realized, but in the end the tax is the same), so these intricate reports with huge penalties don’t make any sense. What on Earth can the IRS possibly do with this information? Does it think that someone would be stupid enough to report the transactions or assets and not pay tax on the associated income? It seems like the immigration forms that ask people if they are terrorists.
FATCA already doubles the penalties on unpaid tax for not reporting foreign income (40% instead of the usual 20%), so additional penalties on the assets not reported are evil and illogical. I cannot understand what went through the minds of the congressmen who invented these rules. A penalty of 5% per month? On things that are not even taxable? WTH? No, the insanity has to stop. I’m including more repeals in my bill.
Another thing. The goal of taxes is to provide money to the government (what the government does with the money is another discussion). Any tax form that does not affect taxes should not exist.
@Shadow Raider
I was thinking about your project today. My thought was:
Notice that whenever the word “foreign is used” it is an indicator of penalties to come.
“PFIC, CFC, foreign trusts, foreign retirement plans, foreign mutual
funds, foreign financial accounts, foreign gifts and inheritance, FBAR”
From the perspective of the IRS the “F” word is “Foreign”.
The great narcissist (Form Nation) takes offense at the idea of any other country having an independent existence. Therefore they must be punished.
@Mona
In my experience with this $2500 – $3000 is very low end for accounting and tax prep fees. Consider yourself lucky! The only people who will pay less are people with one salary and that’s about it. Once you have a “Foreign something”, the reporting requirements are too expensive. But, since you had always filed, and were therefore always in the system, you had no choice except to clean this problem out. You took the only real option you had. But, my prediction is that you will final be forced to renounce. Good news: you are tax compliant and the renunciation should be smooth sailing.
Monalisa1776 ,You will continue to have a real “rent” decision to make going forward. Is it worth it, will be a constant question.
I have expressed it here in this comment at Jack Blog’s discussing the E-trac system.
*I agree with Bubblebustin that having to budget for 10% or even 5% of net take-home pay for annual tax compliance costs is a hardship, especially if one’s assets are not that liquid (such as having the money in investments that would require selling and thus capital gains taxes or even locked up in savings bonds). Though I agree with Renounce that probably having to pay annual accounting fees of $2000 to $3000 is probably not even that expensive compared to what the Big Four firms would charge to file tax returns for expats. Tax preparation companies such as Greenback or TaxesForExpats which charge substantially less than even I paid are therefore probably only appropriate for people with fairly simple situations, though hope I’m wrong!
Though it has to be remembered that I will have had to pay close to $15,000 in total to amend several earlier years’ returns in accounting fees, along with a another lower five figure sum to the IRS which I still think is pretty awful, given that I’ve never been a high earner. Most of the taxes were due to having held PFICs (invested mainly via my English husband’s BRITISH-sourced income) and the resultant phantom capital gains on them over the years. I also had to pay close to $4000 to hire a dual US/UK-compliant financial planner. So though I haven’t had to pay out a fortune to get back into compliance, I still have had had to pay out the equivalent of over two years’ salary which I’d say is pretty harsh when I haven’t lived in the US for well over twenty years!!
If having to pay out ongoing annual accounting fees of over $3000 is considered ‘lucky’ and on the low side, it just goes to show how crazy and unreasonable all this is…how burdensome it all is. It’s as though Voldermort has taken over the US spirit.
I still love America and feel a tribal loyalty to it. One of my forebears had been very high up in the US Tax Court so I still feel a strong patriotism in spite of my many criticisms. But as I’ve mentioned before, if keeping compliant starts costing me more than $5000 in today’s prices, I simply won’t be able to afford to pay the membership dues!! My US citizenship is still precious to me though and want to do all I can to try and keep it. I just wish though that things could be reformed because I want to believe that the USA is still a force for good (in spite of being a royal PITA). 😉
I agree with Just Me that I am going to have to determine over the next several years if the ‘Rent’ charges are worth maintaining my US citizenship for and earnestly hope that Congress will listen to Shadow’s brilliant proposals in his bill. I want this story to have a happy ending, not just for me, but for all expats, immigrants and other US Persons inadvertently swept up in all this mess Congress has created via the IRS.
@monalisa
I hope I’m wrong, but I fear that it will be a long while before things get better for us considering things will likely have to get a lot worse first. The happy ending may be that through fate we’ve all ended up in lifeboats after the sinking of the USSUS, figuratively speaking.
@bubblebustin,
I agree with you (and also hope it’s wrong). My lifeboat is the country I moved to decades ago, where my children were born and raised. We have woven ourselves into the fabric of Canada’s society and, I feel, have been contributing members in so many ways. One of my real worries is the fate of my family still living in the US.
@monalisa,
I suspect that your American family would not / could not fault you for making decisions that affect your own well-being. Good luck in making all of your hard decisions.
*monalisa1776, I’m ashamed that I paid $50 for TurboTax, wishing that I had saved the money instead, and you guys are talking about $2000, $3000 or even $15000!
monalisa1776 – I commend you for sharing your story to the extent of solidly exemplifying the depredations of the existing system. I wish that the longer history of US treatment of extraterritorials offered any support to your hopes for some sort of turnaround. The saddest thing about being forced to engage specialists to achieve the required compliance is that you pay big money for no assurances. Ultimately, they do the math, and then you take the responsibility for what they nor you nor the IRS really understand. And those “experts” make big mistakes (this is testimony). That means living with a perpetual knot in your stomach, no matter how hard you try, no matter how much you pay. Way back when, I wrote about this state under the heading of Uncertainty. Out of lived experience, US extraterritorials are gaining personal phenomenological grounding in how it felt to be a serf under the whim of a lord or a slave under the whim of a master. Wake up every day asking what’s coming next. Fundamental to our notions of freedom is the ability to relocate to more favorable circumstances out of intolerable situations. The chains of citizenship and passport went into the forge in the early twentieth century. Now the United States is arguably the most unfree nation in the world because it is making itself so hard to leave behind, which hundreds of thousands are still due to realize.
“Oppression and harassment are a small price to pay to live in the Land of the Free.”
Charles Montgomery “Monty” Burns, The Trouble With Trillions.
Accounting Today finally referenced this newest super Minnow amnesty program… It is posted here. Roger and I added a comment.
Also, I see that Roy Berg asked Jack Townsend a good question about the IRS Question 12 “Did the taxpayer know he had a FBAR filing obligation when he failed to file an FBAR?” here….
That is a trap if I ever saw one!
To take my analogy even further, who would want to live the rest of their days in a lifeboat when renunciation means a ticket to dry land to live among their countrymen?
@usxcanada,
‘hundreds of thousands are still due to realize’
Are you referring to the number of extraterritorials who are due to be made aware of the FATCA decree and those who will wish to flee the US? If so, your estimate may be low.