Watch Out for Foreign Mutual Fund Investments

We have learned that a lot of US expats are being sold foreign mutual funds or shares in foreign corporations that invest solely in securities. They are being told that those investments will grow tax free (legally) until such time as they decide to take a distribution. That statement is true but the brokers and sales people are not telling their US citizen and permanent resident clients all of the facts how a distribution will be taxed when it is finally made.

When you purchase a foreign investment company or mutual funds it is general classified for US tax purposes as a Passive Foreign Investment Company (PFIC). These have special treatment under US tax law. To learn the technical details read the instructions to IRS Form 8621.

It is true that you are not taxed until a distribution is made, but unless you file a special election and special IRS form to have the fund marked to market each at the end of each calendar year the results can be disastrous. When the distribution is finally made (if no election has been made and no form 8621 filed) it will all be taxed at the highest personal income tax rate then in effect and the profit included in that distribution will be treated as if earned ratably during each year the investment was held without distribution. You cannot get capital gains rates on capital gains or any qualified dividend rate on dividends. In addition to paying the highest tax rate, you must pay interest calculated on those ratable earnings for each year on the taxes you should have paid if it were taxed in each of those years you did not take a distribution. The interest added onto the tax rate can mean you pay 50 to 75 percent or more of the distribution in taxes and interest on your US tax return. .... depending on how long you held it without making a distribution, leaving you with little net cash profit.

If you own a PFIC you can avoid this result by electing to mark the fund value up to market at the end of each year and paying tax on any gain at ordinary income rates with your tax return that year. You will not then owe any interest on past distributions and if you are not in the highest tax bracket, you will only pay taxes at the rate you are in for that year. Their is a third choice which is difficult to comply with and rarely used.

So if you do own a PFIC, it is important under most circumstances to file Form 8621 each year and make the mark to market election (you can also take losses if that is the result of the year) on your tax return. If you delay, you may have to pay a lot or almost all of your profits as taxes and interest. How do you avoid this problem? Invest directly in a foreign stockof an individual foreign company. Then the dividends will be taxed as such each year (and if there is a treaty with the country of incorporation those dividends might be qualified) and when you sell the stock you can pay tax on the gain at long term capital gains rates.

TOUGH NEW EXPATRIATION TAX LAW ABOUT TO BECOME LAW

Hidden in the Soldiers Relief Act is new tax law which is about to be signed by the President and has been passed by Congress. The law will cause many of those who wish to expatriate and surrender their US residency or Citizenship to pay a significant amount of tax on the appreciation of their assets upon surrender of their citizenship as well as other measures. Click on the title to this article to go to our webpage which contains two links to articles about the new tax law.

Foreign Bank and Financial Account Information Report Deadline is 6/30, and IRS is Enforcing Penalties

The IRS has announced that it intends to enforce penalties for FBAR noncompliance – as far back as 6 years. It might be possible to negotiate for one year of penalties if compliance is started. Effective March 24, 2008, IRS has delegated the authority (Delegation Order 4-35) to handle such enforcement to various government officials, including: investigation of possible civil violations of the FBAR requirements; issuance, service and recommendation of enforcement of summonses; preparation and filing of proofs of claims for FBAR penalties; referral to the Justice Department for the institution of proceedings; issuance of administrative rulings; and approval of written agreements relating to a person’s civil liability for a FBAR penalty.

Tax practitioners with clients with foreign bank accounts should notify clients of their responsibility to file the "Report of Foreign Bank and Financial Accounts" (Treasury Form TD F 90-22.1, referred to as FBAR) on or before June 30, 2008. The AICPA also reminds tax practitioners that when gathering information for Form 1040s and Form 1120s to ask clients about the existence of foreign bank accounts and to disclose the information in Question 7, Part III of Form 1040, Schedule B, Interest and Ordinary Dividends, and disclose it on Line 6a of Schedule N of Form 1120. Taxpayers who are currently filing Form 5471, Form 8858, Form 8865 or Form 3520 may also be subject to FBAR reporting requirements. Be aware that a new TD F 90-22.1 is being developed and expected to be released possibly over the next year.

This TD F 90-22.1 form is required to be filed by U.S. citizens and residents (including an individual, corporation, partnership, trust or estate) who have a financial interest in or signature or other authority over any financial accounts (including bank, securities, mutual funds or other types of financial accounts in a foreign country), if the aggregate value of such accounts exceeded $10,000 at any time during 2007. For more information on this, see the forms and instructions for TD F 90-22.1 and see related IRS international tax forms instructions and publications for the definition of a financial interest, frequently asked questions on FBAR,.

Making False Statements to IRS is a Crime

Former NFL player Dana Stubblefield pleaded guilty to lying to an IRS agent. AP report dated Jan. 18, 2008. Under a plea agreement he may spend up to 6 months in the federal penitentiary. He lied about using steroids.

We generally think of persons getting into criminal difficulties with IRS when they affirmatively make false statements in writings that were signed subject to stated penalties of perjury (maybe appearing back in the instructions). Indeed, Code Sec. 7206 imposes such a rule. However, there are other federal statutes that can turn an oral statement made to a revenue agent in the course of an audit into a trip to the penitentiary.

Code Sec. 7201 is the general “attempt to evade or avoid” section, which can apply to such oral misstatements. U.S. v. Beacon Brass Co, (1952, S Ct) 42 AFTR 654 , 344 US 43 . More threateningly, 18 USCS 1001 can apply. This is the general statute making it a crime to make false statements to federal agents.

Brogan v. U.S., 118 S. Ct. 105 (1998) ruled that a taxpayer that falsely says “no” when asked if he engaged in tax evasion can be criminally liable. Apparently this means that the correct answer is to plead the Fifth Amendment in that case, and otherwise say nothing.

The presence of these statutes, and the way they have been historically applied, makes it very difficult for IRS to carry off the model of being a customer service agency. Taxpayers need to remember that they can be liable for criminal prosecution for even casual conversations with IRS agents in the course of their duties, without any written penalties of perjury statement being violated.

ANTARTIC CONTINENT DOES NOT QUALIFY AS FOREIGN COUNTRY FOR EXPATRIATE FOREIGN EARNED INCOME EXCLUSION

The U.S. Tax Court just held that a married couple and 150 similarly situationed taxpayers could not exclude form their income amounts earned for services performed in Antarctica because Antarctica (the South Pole) is not a foreign country. Kunze v. Comissioner T.C. Memo 2007-179 (7/5/07).

SEAMEN ON YACHT QUALIFY FOR FOREIGN EARNED INCOME EXCLUSION

Myron and Thelma Struck, TC Memo 2007-42 The Tax Court has concluded that taxpayers employed on a yacht that was operated primarily in foreign territorial waters met the foreign physical presence requirement and could claim the foreign earned income exclusion under Code Sec. 911.
Background. A U.S. citizen who has a tax home in a foreign country and meets either the bona fide foreign residence test or the foreign physical presence test can elect to exclude foreign earned income from his gross income. (Code Sec. 911(a)(1)) The exclusion can't exceed his foreign earned income for the year, as computed on a daily basis at an annual rate of $80,000, indexed for inflation for post-2005 years ($82,400 for 2006; $85,700 for 2007). (Code Sec. 911(b))
A taxpayer meets the foreign residence test if he is a bona fide resident of one or more foreign countries for an uninterrupted period including an entire tax year. A taxpayer meets the foreign presence test if, in any period of 12 consecutive months, he is present in one or more foreign countries during at least 330 full days. (Code Sec. 911(d)(1)) A foreign country includes airspace, lands, and territorial waters under the sovereignty of a country, territory, or possession other than the U.S. Because international waters are not under the sovereignty of any one country, time spent in international waters generally does not apply toward the 330 foreign day requirement.
A taxpayer who has an abode in the U.S. is not treated as having a tax home in a foreign country. (Code Sec. 911(d)(3))

Facts. Myron Struck was employed as a yacht captain and his wife, Thelma, was employed as a chef and stewardess on a yacht that was operated primarily in foreign territorial waters. Except for approximately 2 weeks when on vacation in the U.S., the Strucks lived on the yacht. In addition to unimproved property, they owned a townhouse in California, which was rented out and managed by real estate professionals. They apparently claimed a state property tax homeowner's exemption (allowed to a owner-occupied principal residence) on the townhouse. They also maintained bank accounts, registered and garaged two vehicles at a relative's property, and maintained their driver's licenses in California.
For the years at issue, 2001 and 2002, the Strucks each claimed the foreign earned income exclusion, including with their returns a Form 2555-EZ, Foreign Earned Income Exclusion. On the Forms 2555-EZ, they listed the address of a relative in California for their “foreign address” and indicated an applicable period of Jan. 1 to Nov. 30, 2001, and Jan. 1 to May 15, 2002.
Concluding that the Strucks did not have a foreign tax home for 2001 and 2002, IRS disallowed the exclusions. During the audit, the Strucks amended their Forms 2555-EZ, listing a Costa Rica foreign address and new applicable periods of Nov. 30, 2000 to Nov. 30, 2001, and May 16, 2001 to May 15, 2002.

Taxpayers qualify for the exclusion. The Tax Court concluded that the Strucks met the foreign physical presence requirement for both years in issue. They were physically present in foreign countries—including foreign waters that counted as part of foreign countries—for 330 days for 2001 (using an applicable period of Jan. 7, 2001 to Jan. 6, 2002) and for 333 days for 2002 (using an applicable period of May 16, 2001 to May 15, 2002). The Court based its conclusion on Myron's testimony, which it found credible, and other evidence, including a review by the U.S. Navy of the log in which Myron entered the yacht's longitude and latitude coordinates every 4 hours while at sea.

During 2001 and until May 5, 2002, the Strucks' business consisted principally of traveling in international and foreign waters to foreign countries on the yacht. They had neither a regular or principal place of business, nor a specific abode in a real and substantial sense during this time. However, while the Court concluded that the Strucks were itinerants, it also found that they had a foreign tax home during the 300-plus days they were physically present in a foreign country during the applicable periods and that they therefor they had a foreign tax home for purposes of the claimed foreign earned income exclusion.

RIA observation: The Court noted—without further comment—that IRS didn't argue that as itinerants the taxpayers had no foreign tax home for purposes of the Code Sec. 911 foreign earned income exclusion. For purposes of Code Sec. 162(a)(2), an itinerant taxpayer is treated as having no tax home and so denied an “away from home” business travel expense deduction.
Noting that neither Code Sec. 911 nor its regs define “abode,” the Court concluded that the Strucks, who had limited ties to the U.S. and whose townhouse was leased to others and unavailable to them, did not have an abode in the U.S. during the applicable periods.

It also found that IRS had erred when it treated each day that involved a partial day of travel in international waters as a nonforeign day in calculating the Strucks' foreign physical presence. Reg. § 1.911-2(d)(2) and Reg. § 1.911-2(d)(3) clearly provide that a partial day of travel in international waters in traveling from one foreign country to another foreign country is to be treated as a full foreign day.

Proof of Mailing - Leaving with Deskclerk Not Sufficient

A recent Tax Court decision holds that leaving a Fed Express envelope with a hotel desk clerk with the understanding that the package would go out that day with Federal Express and hand marking the date on the package is not sufficient to prove that the tax materials were timely mailed. No one knows what happened, but the Federal Express package was officially marked by Federal Express in its printed code the next day (a day too late to avoid problems). The Tax Court stated that the Official Federal Express date was for filing purposes the only valid date that could be accepted. It is important that you make certain if filing by UPS, DHL or Fed Express that it has been dated in print by Federal Express the date you intended it to be sent. You cannot rely on others and you must be certain Federal Express does not date it the next day in error.