The IRS was looking for $34 Million from our client when he first came to us:
Later we received confirmation of what we knew from the beginning was the real tax due:
How could this happen?
You see, the Internal Revenue Service has several automated methods to help them enforce compliance – but those automated processes are often based on incomplete information that can result in errors (in other words, a higher tax liability than what would be due with complete information). For example, if you buy and sell stock, your brokerage house must report the following key information to the IRS through form 1099-B:
Name of Security bought/sold
Date of Sale
Gross or Sales Proceeds
Until tax year 2011, the Form 1099-B did not include information on when the security was originally bought and how much it was bought for. When you sell stock, you report a capital gain or loss on your tax return. Capital gains are calculated by deducting the original purchase price (known by the tax term “cost basis”) from the gross proceeds, as well as any direct costs. The resulting gain/loss is further classified into short term (shares held for less than a year) or long term (shares held longer than a year) – each with its applicable tax rate.
Since brokers were not required to report basis for any securities acquired before 2011, the IRS had incomplete information; they only had information on the gross proceeds.
The IRS uses the information reported by third parties (in this case brokers) with their Automated Under Reporter (AUR) system to identify cases where the income information associated with a tax return is less than what was been reported to the IRS.
In this case, our client had not filed a tax return and the IRS issued letters requesting that a tax return be filed for the under reported income (in this case not only was the income not reported a tax return was not filed); after a sufficient amount of time has passed the IRS will file a tax return on behalf of the taxpayer (known as a substitute tax return) based on their available information and submit a notice of tax due. If this notice of tax due is not acted on, eventually the IRS will issue a “Notice of intent to levy” and the taxpayer will enter into the IRS collection process, which is where we entered the picture.
This situation can be a common occurrence if you frequently trade stocks (i.e. as a day trader). Let’s look at this example to see how a large tax liability can easily happen:
- Day trader has $100 to work with.
- Every day, he buys and sells stock, rotating his $100 once and keeping the profit.
- He buys stock for 99.60, and sells for 100.00 everyday.
- His real profit is (100.00-99.60)*200 days he works in this example. His profit is $80.
- Given the client never replied to the letters, the IRS calculated his tax due with the information they had on hand, meaning:
(Gross Proceeds – Cost basis)*each transaction.
(100-0)*200, they would think his profit was $20,000.
6. Accordingly, the IRS calculates a much higher tax due based on this $20,000 of income (instead of $80).
It can be a frightening issue once a case has made it into the IRS collection process and often is not quickly resolved – months of interaction with different agents and call centers will be needed.
As if the above was not already a huge issue, In the example of the letter above, the individual was a non-resident alien (NRA) –not a green card holder, not a US citizen, no substantial presence and no ECI. Meaning, he is not subject to taxation by the USA. His broker simply failed to understand the reporting requirements for NRAs – something easily avoided by the broker providing the taxpayer a W-8BEN to complete. Hence, the reason why he did not file tax returns. But why would a non-resident alien have to incur fees with a professional in order to explain to the IRS that no tax is due? Shouldn’t there be much simpler process (like having a human look at a letter with such a large amount due and simply addressing it and fixing it rather than the taxpayer having to deal with myriads of departments and forms)?
Thankfully starting with TY2011, cost basis is also reported. Hopefully they will build in some safety checks for when no cost basis is available to be reported.
I believe most of us reading this situation would agree that it is understandable how such a mistake would happen, since:
- The bank reported the information for a non-resident alien in a way that only US persons should be reported (And that would’ve avoided this issue)
- The IRS clearly made the needed changes to the form, and
- The IRS did try to contact the client several times.
Automated? Sure, but it could have gone better… But at the end of the day I would consider this an honest mistake (I would not be so generous on how they handled it).
More than understanding the reasons why such a mistake could happen, I am more concerned with the effort placed by the IRS on the collection of taxes without taking into account the burden placed on the taxpayers nor acknowledging the shortcomings of their processes – and especially how they are not so forgiving themselves. I personally feel that taxpayers are treated as guilty until proven innocent – and that can take some time to address when dealing with clearly overworked IRS call centers with under-skilled workers.
I can see myself agreeing to the IRS stance that it is the taxpayers’ responsibility to educate themselves on the law that applies to them – but wouldn’t that place the burden on the IRS of providing one place with easy to understand material? How much research will be considered enough from a taxpayer when the instructions are not only challenging to find but more importantly impossible to understand for the common taxpayer?
Take the example of Americans living abroad:
By now we have all heard of the (in) famous FBAR forms (What is FBAR). But let’s turn the clock back to 5 years ago. While there was a checkbox that alerted you to the filing requirement on Schedule B – what if you had an account reportable under TDF 90 221 (the FBAR form), but had no dividend or interest income (from anywhere) and were hence under the perception that no Schedule B was required? How would you have known you had to still complete the Schedule B? There was no reference to foreign bank account reporting on the 2007 Form 1040 instructions (Nor the supplemental Publication 4655), other than a listing under the index reading “Foreign Accounts…..B-2*” and the * read: “To reduce printing costs, we have sent you only the forms you may need based on what you filed last year”.
I can understand the need to reduce printing and mailing costs, but we should consider the following scenario:
A taxpayer moves to a foreign country on November 2006. In December 2007, their bank account (unbeknownst to them) meets the filing requirement for Form TDF 90 221. The taxpayer doesn’t know about it, because it is not outlined in the 2007 1040 instructions, hence they miss the June 30, 2007 filing deadline, incurring an automatic $10,000 penalty. They find out about it either when they get the penalty letter or when they finally receive the instructions at their foreign address in 2008 based on the reporting of a 2007 tax return with a foreign address…. This would not constitute reasonable cause to abate the penalty. Instead, in this example I would have to incur about $3,000 in fees to get the $10,000 penalty reduced to say $500.
There has been plenty of media coverage so that now FBARs are common knowledge for expats – but could there be other examples as above?
I would guess that most expats are not aware that if they invest in a mutual fund that is based outside of the US (a foreign mutual fund), not only do they have to file Form 8621, but that their capital gains will experience a higher effective tax rate since the concept of Passive Foreign Investment Companies (PFICs) was designed to discourage capital leaving the US. (What is a PFIC?)
The penalty for not filing Form 8621 would need a thorough explanation of statutes of limitations, underreporting of income and underpayment of taxes. In short, not reporting your PFIC could create issues for which the IRS could audit you 25 years later – and asses taxes, penalties and interest.
Now, there are savvy expats that know about PFICs and FBARs, 5471s and nowadays 8938s. But think of this example: an expat transfers some property down to his Belize Corporation to be used in his cool beachside resort, and he does not realize that this gives him a filing requirement for Form 926. Not filing Form 926 would result in a penalty “equaling 10% of the fair market value of the property at the time of the exchange/transfer if the taxpayer fails to comply with the filing requirement. The penalty will not apply if the failure to comply is due to reasonable cause and not willful neglect. The penalty is limited to $100,000 unless the failure to comply was due to intentional disregard. Moreover, the period of limitations for assessment of tax upon the exchange/transfer of that property is extended to the date that is 3 years after the date on which the information required to be reported is provided.” See
https://www.irs.gov/businesses/small/international/article/0,,id=154207,00.html for additional details.
I mentioned Form 5471 above. If you don’t know about it, and you own a foreign corporation, it could mean another automatic $10,000 penalty (What is form 5471?). When more than 50% of a foreign corporation is owned by US persons, the IRS wants to know about it – it’s called an informational return. They want to know who owns the company, including social security numbers (if they are US citizens), what it does for business, the financial statements (reported using US GAAP), and all about the transactions between you and the company.
As you may imagine, this is not a simple form to complete – take for example the concept of subpart F income. I will not attempt to explain what it is in a short paragraph. It took a well-known expert in this area, Vern Jacobs, CPA, more than 12 pages to explain it in his book “U.S. Tax Compliance Guide for Offshore Investors-How to Venture Offshore Without Getting in Trouble with the I.R.S”.
In the past, reporting income for a foreign corporation was much simpler. Historically, the income from a foreign corporation (whether a Controlled Foreign Corporation or not) was not taxed until the US person actually received the money (dividends, wages, etc). Congress viewed this as a loophole for tax deferral, so in response they revised the tax code so that certain types of income would not be allowed such a tax deferral – in other words there would be taxation in the current tax year, giving birth to the concept of Sub Part F Income.
Nowadays it is infinitely more complex. It is possible that even if a taxpayer is familiar with Form 5471, it is very easy to completely overlook or misinterpret the Subpart F income regulations. In my opinion, this is completely understandable if you are not a CPA or tax attorney that specializes in this area of taxation. Nevertheless, not reporting Subpart F income results in an incomplete Form 5471 and an underpayment of taxes. The IRS considers an incomplete Form 5471 an unfiled form, which has an automatic $10,000 penalty.
The list could go on and on with other forms, like the new form 8938 Statement of Specified Foreign Financial Assets, or 8865 Return of US Persons with Respect to Certain Foreign Partnerships, but the general impact is the same. It is interesting to note that none of these forms are addressed in the 2007 Form 1040 instructions (Please note: Form 8938 is new for TY 2011).
And Finally, my point
My concern is: Why isn’t the IRS isn’t more understanding of the complex regulations they have set forth for Americans living and/or investing abroad and why isn’t there better information provided to understand compliance and reporting requirements? Expats are in a sense forced to fall out of compliance, as the time requirement to educate themselves and keep up with the changing regulations is too much of a burden, and often too complex to understand even if you have the time needed to attempt self study. This differs from taxpayers that live in the US who have access to a wealth of information and support (including self-service software and free tax preparation clinics), not to mention less costly support (frankly because the cost and time to understand and comply with the requirements is significantly simpler – and I say that without undermining the amount of time all tax preparers invest in continuing education). Expats that may have been used to paying as low as $50 for a tax return in the U.S. come to the realization that with an expat tax return, fees start at $300.
There are hundreds of thousands, if not millions of US Expats who have a filing requirement, but have no tax liability. Why not find a more reasonable solution for expats rather than to make them subject to the harsh penalties described above? Why not tie penalties to tax due? Meaning, if there is no tax due, then there should be no penalties. As it stands today, expats generally incur professional fees to file a tax return that tells the IRS they do not owe any tax. It would be nice to see this simplified in the future – but as is the case with Congress, it is likely that things will continue to become more complicated rather than simpler.
If that is not possible, why not explore a modification to the famous statement “Ignorance of the law is not an excuse” and list it as a reasonable cause under Code Sec. 6664? I do truly believe that there are expats that although “criminal” by definition (Not filing a tax return is considered a criminal offense), simply made an honest mistake in the form of omission. Kind of like the one the IRS made with our client above…
Every effort has been taken to provide the most accurate and honest analysis of the tax information provided in this blog. Please use your discretion before making any decisions based on the information provided. This blog is not intended to be a substitute for seeking professional tax advice based on your individual needs.