Reporting your foreign assets to the U.S. government is detailed subject that requires you to know and prepare multiple IRS forms. The purposes of this article is to give you a high-level overview of what the foreign asset reporting process entails and the forms involved.
Determining the level of reporting that is required upon you depends mainly upon your citizenship status with the U.S., where you live throughout the year, the value of your specified foreign assets and accounts. U.S. citizens have higher reporting requirement levels in contrast to nonresident aliens and those U.S. citizens living abroad. If you want to know the difference between a U.S. citizen and a nonresident alien, please refer to Series 103: Taxation of U.S. Resident v. Nonresident Aliens [insert link] for a full break down on their differences.
So what are the general IRS forms and foreign assets they require reported? Well, they are FinCen 114 (better known as an Foreign Bank and Account Report, or FBAR), Form 8938, Form 3520, and Form 3520-A. We will take turn exploring each one of these IRS forms and what they require.
FinCen Form 114 – Foreign Bank and Account Report (“FBAR”)
To put it simply, an FBAR requires a an U.S. person to report their interest in foreign financial accounts in which they have a financial interest or signatory authority, so long as the aggregate max values of the accounts are in excess of $10,000 at any point in the year. For example, if a taxpayer has three foreign bank accounts, each of which have a corresponding max value of $4,000, $5,000, and $6,000 through the year, the taxpayer will be required to file an FBAR and report their interest in such accounts. This is because the aggregate max value of the accounts in the year, $15,000, exceeds the $10,000 filing threshold.
The test for filing an FBAR can be broken down into three basic tests—(1) your must be a U.S. person; (2) you must have a financial interest or signatory authority over foreign financial accounts; and (3) the max value of the foreign financial accounts must be in excess of $10,000.
For the first test, an “U.S. person” is defined as an U.S. citizen or resident. Although it may seem easy to determine who is a U.S. citizen and resident, there are nuances to this test. As discussed above, you can find an analysis of these terms in Series 103: Taxation of U.S. Resident V. Nonresident Aliens [Insert Link]. But as a rule of thumb, if you are a U.S. citizen or reside in the U.S. and not a foreign country for the whole year, you meet this definition.
The second test requires you to have a financial interest or signatory authority over foreign financial accounts. A financial interest is defined as being a owner of records on an account owned by an entity (i.e. corporation, partnership, disregarded entity, trust, etc.) of which you have more than a 50% ownership interest in. Signatory authority is met if a person can control the disposition of assets held in a specified account. Finally, a foreign financial account includes, but is not limited to, a securities, deposit, savings, checking, brokerage, or other account maintained with a financial institution that is located in a foreign country outside of the U.S.
Finally, if you have an interest in one or more foreign financial accounts, you must look at the aggregate max value of each account throughout the year and determine if it was in excess of $10,000. Generally, this is done by looking for a running total on monthly statements provided for the account. Well, what if the account in denominated in a currency that is not the USD? In that case, you will have to convert the values of the account using the end of year foreign exchange rate for the foreign currency into the USD. You can find these rates via the United States Treasury.
Some words for the wise—an FBAR filing is a complicated area of U.S. international tax law. If you have foreign financial accounts, please consult an tax advisor who deals in this area. If you do not, and your FBAR filing is not correct, you could be in store for some major hurt if the IRS finds out before you do. For non-willful mishaps of not reporting an foreign account, the penalties can range anywhere from a warning letter in lieu of a penalty, all the way up to a $10,000 per account, per year penalty. While a non-willful penalty already seems harsh, the penalty for willful non-reporting is far above and beyond that. For willful non-disclosures of foreign financial assets, a person can be penalized upwards of $100,000 or 50% of the value of the account, whichever is higher. Beyond this, the IRS can refer such non-reporting to their criminal investigation unit, which ultimately could lead to prosecution and jail time.
If you are in a situation where you failed to accurately report your foreign accounts on an FBAR, all hope is not lost. Please refer to Series 108: Options for Those Who Failed to Correctly Report Income/Assets. This article gives an in-depth overview of the different voluntary disclosure program the IRS offers to those taxpayers who are non-compliant with their international filing requirements. The voluntary disclosure programs provide varying levels of protection, both civil and criminal, and generally impose a penalty regime as the price of disclosing such assets.
Form 8938 – Statement of Specified Foreign Financial Assets
Form 8938 has a similar reporting requirement to that required on an FBAR, and requires U.S. citizens and resident to report their interest in foreign assets. Generally, Form 8938 must be filed if you are a U.S. citizen or resident, you have an interest in specified foreign financial assets, and the either the max or ending value of those assets is more than the foreign asset reporting threshold set out for your filing status.
Sounds very similar to an FBAR, right? Generally, the assets you report on an FBAR will also be reported on your Form 8938, but the opposite cannot be said. Form 8938 has broader reporting requirements for foreign assets. Additionally, a lot of people assume that if they file an FBAR, they are relieved of filing an Form 8938—please be careful because that is not true.
If you want to know if you qualify as a U.S. citizen or resident for purposes of reporting a Form 8938, please visit Series 103: Taxation of U.S. Resident V. Nonresident Aliens for a breakdown on this definition.
So what are the assets that must be reported on an Form 8938? Once again, this is a definitional term that requires some fleshing out. The instructions for Form 8938 state that a taxpayer’s “interest in specified foreign financial assets” are to be reported. Generally, a “specified foreign financial asset” includes—
- Financial accounts maintained by a foreign financial institution.
- The following financial assets if they are held for investment and not held in an account maintained by a financial institution:
- Stock or securities issued by a non-U.S. entity;
- Any interest in a foreign entity; and
- A financial instrument or contract issued by a counterpart that is not a U.S. person.
To break down this technical definition, a “specified foreign financial asset” generally includes any foreign bank account, securities, or brokerage account or a direct interest held in a non-U.S. entity. It is the latter half of this breakdown that separates Form 8938’s reporting from that of an FBAR—generally, and FBAR reporting will only require you to report actual foreign financial accounts held and not interests held in foreign entities outside of a brokerage or securities account. For example, say a taxpayer holds stock certificates in a foreign corporation directly in his name, and not through a brokerage account the value of which exceeds both the reporting threshold for Form 8938 and an FBAR form. For purposes of reporting his foreign stock certificates, they would only be required to be reported on Form 8938 and not on an FBAR because they are not held through a foreign financial account.
Now that we know what qualifies as a “specified foreign financial account”, we now have to determine if you hold a qualifying interest in that account. Generally, a person is deemed to hold an interest in an foreign financial account, if any income, gains, losses, deduction, credits, proceeds, or distributions from the holding or disposing of the asset are or would be reported on their income tax return. Essentially, if you would be required to report income from your holdings, then you qualify as having an interest in it. This is even the case if the underlying asset does not generate any reportable income or deductions in a given year.
What about foreign assets that are held by entities you own? For example, if you hold an interest in a U.S. domestic corporation that ends up holding and interest in a “specified foreign financial asset”, are you required to report it? The answer with respect to that question is no, but it really depends on the type of entity hold for tax return purposes.
- Disregarded Entities: For assets held by disregarded entities (“DRE”), so long as you are the owner of the DRE, then you are deemed to have an interest in any “specified foreign financial assets” owned by the DRE;
- Non-Disregarded Entities: In most cases, you are not considered to own an interest in an “specified foreign financial asset” held by a partnership, corporation, trust or estate solely as a result of your status as a partner, shareholder, or beneficiary;
- Grantor Trusts: Grantor trusts are very similar to that of DREs such that they are not recognized for tax purposes. Thus, if you are the owner of a grantor trust, and that grantor trust has an interest in “specified foreign financial assets”, you must report said financial assets on your Form 8938.
- Foreign Estate and Trusts: An interest in a foreign trust or estate is not a “specified foreign financial asset” unless you know or have reason to know of the interest. Example, if you receive a distribution from a foreign trust, then you have reason to know it, and thus report it on your Form 8938.
- Jointly Owned Assets: A joint owner of an assets is deemed to hold an interest in the entire asset;
- Interests Held in Financial Accounts: If you have an interest in a U.S. financial account that holds “specified foreign financial assets”, you do not have to report the assets held in the account;
Once you know you are a U.S. citizen or resident who holds an interest in a foreign financial asset, the last item to determine is whether the max or ending values of such assets exceeds the foreign asset reporting threshold set out by the IRS. This reporting threshold depends on your filing status and where your resided during the tax year. For a full breakdown of this reporting threshold, you can visit Series 102: People Who Are Required to File U.S. Taxes. To break it down generally for you, if you are a U.S. citizen or resident who resided in the U.S. for the tax year, use the Single filing status, and either (1) the max value of your foreign assets is greater than $75,000 at any time in the year; or (2) the ending value of your foreign assets is greater than $50,000 at the end of the year, then you meet the filing threshold. For those with the status of Married Filing Jointly, these reporting thresholds are increased to $150,000 for max valuation and $100,000 for end of the year value.
So how do you make this determination if your specified foreign financial assets are set out in terms of a non-U.S. currency? In such case, you must convert the foreign currency to USD using the applicable foreign exchange rate as of the end of the applicable tax year. Generally, you must use the foreign exchange rates put out by the U.S. Treasury Bureau of the Fiscal Service.
The final form we will talk about in this article is Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts. If the formal name of this IRS form didn’t give it away, Form 3520 is used to report a U.S. person’s transactions with foreign trusts, ownership interests in foreign trusts and the receipt of gifts of a specified foreign property or inheritances in excess of a specified threshold amount.
Specifically there are four situations where a Form 3520 should be prepared and filed for a given tax year—
- You are the responsible party for reporting a reportable event that occurred during the current tax year, or you are a U.S. person who transferred property (including cash) to a related foreign trust (or a person related to the trust) in exchange for an obligation or you hold a qualified obligation from that trust that is currently outstanding.
- You are a U.S. person who, during the current tax year, is treated as the owner of any part of the assets of a foreign trust under the rules of Internal Revenue Code 671 through 679.
- You are a U.S. person or an executor of the estate of a U.S. person who received a distribution from a foreign trust during the current tax year; or you are a U.S. person who is a U.S. owner or beneficiary of a foreign trust and in the current tax year, you or a U.S. person related to you received (1) a loan of cash or marketable securities (including an extension of credit) directly or indirectly from such foreign trust, or (2) the uncompensated use of trust property; or you are a U.S. person who is a U.S. owner or beneficiary of a foreign trust and in the current tax year such foreign trust holds an outstanding qualified obligation of yours or a U.S. person related to you.
- You are a U.S. person who, during the current tax year, received either:
- More than $100,000 from a nonresident alien individual or a foreign estate that you treated as gifts or bequests; or
- More than $16,388 from foreign corporations or foreign partnerships that you treated as gifts.
If you a transaction that would also qualify you to report an FBAR or Form 8938, you will have to separately report it on Form 3520. However, some Form 3520 filing you exempt you from reporting certain “specified foreign financial assets” on your Form 8938. Essentially, if you are required the value of a foreign trust, estate, or other bank account on Form 3520, you are exempt from having to report the value of this “specified foreign financial asset” again. In order to do this, you will have to notate on Page 1 of Form 8938, Part IV the amount of Form 3520s you report the “specified foreign financial asset.”
While a Form 3520 is due at the same time that an individual’s Form 1040 is due (April 15th, and October 15th if a proper 6-month extension is filed), it has its own filing address.
The failure to properly file a Form 3520 can lead to large penalties. Generally, the penalty is the greater of $10,000 or the following—
- 35% of the gross value of any property transferred to a foreign trust for failure by a U.S. transferor to report the creation of or transfer to a foreign trust;
- 35% of the gross value of the distributions received from a foreign trust for failure by a U.S. person to report receipt of the distribution;
- 5% of the gross value of the portion of the foreign trust’s assets treated as owned by a U.S. person under the grantor trust rules (sections 671 through 679) for failure by the U.S. person to report the U.S. owner information.
However, not all is lost if you make a mistake on your Form 3520 filing. If you can demonstrate your failure to properly report or file a Form 3520 is due to “reasonable cause” and not willful neglect, your penalty will be abated.
If you need assistance in determining whether your are required to file Form 3520, prepare and file a Form 3520, or are currently out of compliance with your 3520 filing requirements, please contact us or a tax professional to assist with your foreign asset reporting needs.