Is Foreign Income Taxable in the U.S.?
posted May 29, 2015 by Paul Oliveira, CPA
A simple question – Are U.S. citizens taxed only on their domestic income or are they taxed on their worldwide income? Many U.S. taxpayers are shocked to find out that they are taxed on their worldwide income including wages earned overseas. It is therefore not unusual to find an overseas U.S. taxpayer who has not filed U.S. tax returns for multiple years based on the belief that their foreign income is not taxable in the U.S.
The Cost of Non-Compliance
The lack of awareness by an overseas U.S. taxpayer can result in the taxpayer being out of filing compliance for many years. This situation can produce a litany of IRS penalties, such as:
- Penalties for failure to file
- Penalties for failure to pay
- Accuracy related penalties
- Information return penalties, including foreign bank account reports (“FBARs”)
These penalties, along with applicable interest, would be assessed for each year a tax return is not filed and may result in a total dollar amount of tens of thousands of dollars.
Voluntary Disclosure and Compliance for the U.S. Taxpayer
For many years, the IRS has had a voluntary disclosure practice which allowed taxpayers to come forward and be compliant. Today’s voluntary disclosure is the 2014 Overseas Voluntary Disclosure Program (OVDP) and Streamlined Filing.
A key difference between the two programs is whether or not the taxpayer’s failure to report foreign assets and pay the tax due on income relating to those assets is the result of willful conduct. If the taxpayer did not willfully fail to file the FBARs and income tax returns, then the more taxpayer friendly Streamline Filing procedures are available.
Non-willful conduct is defined in the certification forms 14653 and 14654 that are part of a Streamlined Filing. These forms state, “…that non-willful conduct is conduct that is due to negligence, inadvertence, or mistake or conduct that is the result of a good faith misunderstanding of the requirements of the law.” Both forms further state that the taxpayer, “... Provide specific reasons for their failure to report all income, pay all tax, and submit all required information returns, including FBARs.”
It can be challenging to provide specific reasons that clearly demonstrate that the conduct was non-willful. It is the behavior of the taxpayer that is at question. What objective evidence, if any, can be provided that supports non-willful conduct when the interpretation of one’s behavior can be very subjective? It is therefore imperative that the taxpayer seek out the assistance of a tax professional to determine if the facts and circumstances properly support non-willful conduct. Meeting the definition of non-willful conduct will qualify the taxpayer for Streamlined Filing.
Streamline Filing consists of submitting:
- A maximum of 3 years of delinquent tax returns or amended tax returns along with the required information forms (e.g., 3520, 5471,8938).
- A maximum of 6 years of delinquent FBARs.
A certification stating that:
- The taxpayer is eligible for Streamline Procedures,
- All of the required FBARs have been filed as of the date of the certification,
- The failure to report all income, pay all tax, and submit all required information returns, including FBARs, resulted from non-willful conduct,
- The miscellaneous offshore penalty is accurate.
- Payment of the tax due and all applicable interest.
- Payment of the Title 26 miscellaneous offshore penalty. (This is applicable only to U.S. taxpayers residing the U.S.)
The Title 26 miscellaneous offshore penalty is equal to 5 percent of the highest aggregate balance of the taxpayer’s foreign financial accounts during the 3 years being reported.
What Makes Streamlined Filing Attractive?
A taxpayer who complies with the streamlined offshore procedures will not be subject to failure to file and failure to pay penalties, accuracy related penalties, information return penalties, or FBAR penalties. This can save the taxpayer tens of thousands of dollars.
The OVDP program is for taxpayers who are concerned that their failure to report income, pay tax, and submit required information returns was due to willful conduct and therefore seek assurance that they will not be subject to criminal liability and/or substantial monetary penalties.
OVDP allows a taxpayer to come forward and come into compliance by submitting an Offshore Voluntary Disclosure Letter requesting acceptance into the program. Upon acceptance, the taxpayer must submit:
- A maximum of 8 years of delinquent tax return or amended tax return along with the required information forms, e.g., 3520, 5471, and 8938.
- A maximum of 8 years of delinquent FBARs.
- Payment of the tax due and all applicable interest
- Payment for the offshore penalty, accuracy-related penalty, and, if applicable, the failure-to-file and failure-to-pay penalties.
The OVDP filing is certainly more comprehensive and has more gravity than the Streamline Filing. However, when a taxpayer truthfully, timely, and completely complies with all provisions of the voluntary disclosure practice, the IRS will generally not recommend criminal prosecution.
Use of either program should only be undertaken with the assistance of a tax professional. If you would like to learn more about these options, contact a member of the KLR Global Tax Services team.