Classification of Taxpayers for U.S. Tax Purposes

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U.S. law treats U.S. persons and foreign persons differently for tax purposes. Therefore, it is important to be able to distinguish between these two types of individual taxpayers.  This area of the tax law can be quite confusing.

For an individual to be classified as ”United States person” for tax purposes means he or she is one of the following:

  • A citizen of the United States
  • A resident of the United States who holds a Green Card or “H1B” Visa
  • A resident of the United States who meets the “Substantial Presence Test” for the calendar year

The following individuals if NOT residents or citizens of the U.S. should be treated as foreign persons:

  • An individual temporarily present in the United States as a foreign government-related individual under an “A” or “G” visa.
  • A teacher or trainee temporarily present in the United States under a “J” or “Q” visa, who substantially complies with the requirements of the visa.
  • A student temporarily present in the United States under an “F”, “J”, “M”, or “Q” visa, who substantially complies with the requirements of the visa.
  • A professional athlete temporarily in the United States to compete in a charitable sports event.

Under the “Substantial Presence Test” you will be considered a U.S. resident for tax purposes if you meet the substantial presence test for calendar year 2013. To meet this test, you must be physically present in the United States on at least:

  1. 31 days during 2013, and
  2. 183 days during the 3-year period that includes 2013, 2012, and 2011, counting:
    1. All the days you were present in 2013, and
    2. 1/3 of the days you were present in 2012, and
    3. 1/6 of the days you were present in 2011.

Example.

You were physically present in the United States on 120 days in each of the years 2011, 2012, and 2013. To determine if you meet the substantial presence test for 2013, count the full 120 days of presence in 2013, 40 days in 2012 (1/3 of 120), and 20 days in 2011 (1/6 of 120). Because the total for the 3-year period is 180 days, you are not considered a resident under the substantial presence test for 2013.

If you are determined to be a U.S. person, you are required to report your world-wide income on your U.S. income tax returns and annually disclose all foreign bank accounts to the U.S. Treasury where the aggregate value of those accounts exceed $10,000.00.

For those U.S. persons who have not satisfied these requirements in any of the last six calendar years, in addition to the back taxes, interest and penalties, the government may impose include a fine of not more than $500,000.00 and imprisonment of not more than five years, for failure to file a report, supply information, and for filing a false or fraudulent report.

The IRS has established the Offshore Voluntary Disclosure Initiative (OVDI) which allows U.S. persons to come forward to avoid criminal prosecution and not have to bear the full amount of penalties normally imposed by IRS.  U.S. persons who hire an experienced tax attorney in Offshore Account Voluntary Disclosures should result in avoiding any pitfalls and gaining the maximum benefits conferred by this program.

Beware the Potential Tax Pitfalls of Investing in Offshore Mutual Funds – “PFIC” Concerns

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U.S. persons ought to be aware of the potential tax heartaches associated with investing in mutual funds held by foreign banks or foreign brokerage firms. When making such investments through U.S. firms, any appreciation or depreciation of value of the funds is not recognized as gain or loss until the fund is sold or liquidated.  This is not the case with the same type of investments in foreign firms.  Each year the U.S. investor must pick up as income or record a loss in the appreciation or depreciation of value of the funds even though there was no sale or liquidation of the funds.  Essentially, such an investor looses the advantage of deferring gains which is enjoyed by those investors dealing with U.S. firms.

To understand how this operates – Under the Internal Revenue Code, there is a concept called Passive Foreign Investment Company or “PFIC”.  A foreign corporation is classified as a PFIC if it meets one of the following tests:

  1. Income Test– 75% or more of the corporation’s gross income is passive income (interest, dividends, capital gains, etc.)
  2. Asset Test– 50% or more of the corporation’s total assets are passive assets; passive assets are investments that produce interest, dividends or capital gains.

The IRS has extended the characterization of a PFIC to include most foreign-based mutual funds, hedge funds and other pooled investment vehicles.

A. U.S. taxpayer with these investments is required to fill out Form 8621 and include it with his Form 1040 along with the appropriate PFIC income and tax computations.  The IRS offers various complicated methods of reporting PFIC income.  Under one such method, “Mark-to-Market”, the IRS requires the reporting of the value of a mutual fund from year to year and taxes any appreciation in the mutual fund values from year to year.  The tax rate that applies is 20%. This is in addition to the normal taxation of dividends and capital gains that domestic mutual funds are taxed on.

Reporting the appreciation of a mutual fund from year to year may end up being no small task as oftentimes a typical stock portfolio will contain twenty to thirty funds which may involve lots of trade activity over the course of many years.  The taxpayer needs to keep accurate and comprehensive records of all information on the mutual fund(s) including share basis, yearly balances, and any sales or purchases from year to year.

If you have never reported your foreign investments on your U.S. Tax Returns, the IRS has established the Offshore Voluntary Disclosure Initiative (OVDI) which allows taxpayers to come forward to avoid criminal prosecution and not have to bear the full amount of penalties normally imposed by IRS.  Taxpayers who hire an experienced tax attorney in Offshore Account Voluntary Disclosures should result in avoiding any pitfalls and gaining the maximum benefits conferred by this program.

Reporting Foreign Bank Accounts to IRS

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The Bank Secrecy Act requires that a Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (FBAR), be filed if the aggregate balances of such foreign accounts exceed $10,000 at any time during the year. This form is used as part of the IRS’s enforcement initiative against abusive offshore transactions and attempts by U.S. persons to avoid taxes by hiding money offshore.

The FBAR covers a calendar year and must be filed no later than June 30th of the following year (regardless of whether you file an extension for you Form 1040) and includes any interest a U.S. person has in:

Offshore bank accounts
Offshore mutual funds
Offshore hedge funds
Offshore variable universal life insurance policies
Offshore variable annuities a/k/a Swiss Annuities
Debit card and prepaid credit card offshore accounts

The penalties for FBAR noncompliance are stiffer than the civil tax penalties ordinarily imposed for delinquent taxes. The penalties for noncompliance which the government may impose include a fine of not more than $500,000 and imprisonment of not more than five years, for failure to file a report, supply information, and for filing a false or fraudulent report.

Taxpayers who hire an experienced tax attorney in Offshore Account Voluntary Disclosures should result in avoiding any pitfalls of non-disclosure or incomplete disclosure.