Background
So, you’re a U.S. citizen living abroad, and you've recently learned you need to file U.S. taxes. Or perhaps you heard something about it a while ago, but you’ve procrastinated since you think it can’t be that serious. Maybe the opposite is true, and you’re so worried about how serious it is, that you’ve been reluctant to open that can of worms and really dig in. Regardless, let's jump in.
First things first. If you want to brush-up on how the U.S. taxes citizens living abroad, see this other blog post to get high-level overview. Hopefully after reading that, you understand the importance of getting in the good graces of the IRS and staying ahead of your U.S. tax issues. If you’re okay with that, let’s dig in a little deeper and address next steps.
So, let’s say you’ve never filed a U.S. tax return before and you decide to turn over a new leaf. You file a return for the first time. Mind you, you’ve been living in Canada for 10 years or so, and you’ve never reported anything before, but you’re starting fresh – you’re being responsible. The IRS should simply appreciate your willingness to clean up your act and welcome you into the U.S. tax world with open arms, right? Let bygones be bygones? WRONG. Well, mostly wrong.
In the other post mentioned above, we discussed how the IRS might catch someone who is noncompliant, even if that person lives abroad. However, by filing a return, you’ve essentially done this work for them. Now, it’s still better to file a tax return than to not (not filing when you’re supposed to is illegal, and that’s no good), but you’ve now alerted them to your presence. Filing one year is all well and good, but they might start asking for more. There’s nothing stopping them from doing so. In fact, lest you think the clock might run out the years, the statute of limitations (usually 3-6 years) doesn’t even start until a return is filed. That means they could go back after any previously unfiled year if they felt motivated to do so. Obviously filing 10 years of missed returns is a bit much, so is there another, more reasonable option? Fortunately, the answer may be “yes.”
Filing Late or Delinquent Returns
Before we get into how many years to file and how to do so, let’s talk dollars and cents. There are three main issues that taxpayers face when filing late:
Tax owing
Penalties
Interest
The first one is pretty straightforward. You file a return, and you pay any tax owing. Hopefully it’s not much, since many countries, including Canada, have higher tax rates than the U.S., and foreign tax credits may wipe out a lot of the U.S. tax liability. However, there are a number of events that could trigger tax in the U.S. while none is triggered in Canada (e.g., sale of a principal residence, capital dividends, capital gains exemption, TFSA and RESP income, etc.). Couple that with the numerous anti-deferral regimes the U.S. has in place specifically for people who have money offshore, and things can add up quickly. Though it may seem daunting, it’s better to square your shoulders and deal with this rather than delaying, as we'll explain regarding penalties and interest.
The second one is a doozy. For the uninitiated, the IRS loves penalties. They really do. Some of them are quite hefty - $10,000 USD minimum per form, per year in some cases. You could have a corporation, a trust, and some foreign accounts, and you could already be staring down the barrel of at least $50,000 USD in potential penalties per year. This doesn’t even include underpayment or late payment penalties related to the tax you owe – so add that on top. Now, the IRS doesn’t always assess these penalties, but they certainly have the ability to do so. Some penalties, like those associated with trusts, seem to be assessed with great alacrity – they’re computer automated and tough to fight – whereas some appear to be assessed less frequently. Regardless, for obvious reasons, these penalties don’t exactly incentivize people to come forward and get compliant.
The last thing is interest. Generally speaking, when you owe money to the IRS and don’t pay it on time, whether it be tax or penalties, they charge interest. It’s not usually as significant as the penalty portion of the equation, but it’s still something.
Okay. Pretty gloomy news. Fortunately, there is a way forward.
Streamlined Filing Compliance Procedures
The What
In its mercy(?), the IRS has created an amnesty program called the Streamlined Filing Compliance Procedures. It can apply both to people who haven’t filed returns (delinquent filers) as well as to people who filed incomplete or incorrect returns that need amending. It’s specifically designed to address foreign reporting issues. For purposes of this post, we’re focusing specifically on the Streamlined Foreign Offshore Procedures reserved for people who spend the vast majority of their time abroad, but be aware that there are also the Streamlined Domestic Offshore Procedures, which are still helpful but provide less penalty relief. For the rest of this post, when I say “Streamlined,” I’m referring to the Foreign Procedures.
The Why
Why is Streamlined so great? The biggest thing is that it wipes out penalties. That means no failure-to-file penalties, failure-to-pay penalties, accuracy-related penalties information return penalties, or FBAR penalties, when you correctly submit returns via Streamlined, as long as no previous penalties have already been assessed for those years. The tax and the interest on that tax are still owed, but the penalties are gone.
The other benefit is that it provides some degree of closure. While there’s nothing stating the IRS will never look at previous years, this is the program they’ve put in place to help you get on track. You’re coming forward on their terms, and from our experience, they’re generally satisfied with that (again, no guarantees, but that’s been our experience and the experience of many other practitioners). Be aware, however, that returns submitted via Streamlined could be audited just like any other returns.
The Who
Who qualifies for this? Let’s go through the eligibility criteria:
The taxpayer must certify that the conduct was not willful. You can’t have been intentionally noncompliant. Non-willful is defined as “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.”
No previous IRS audits or criminal investigation. If the IRS has audited you for any year in the past, regardless of the reason, you’re out. Note, however, that this is not the same as a notice. Receiving a notice from the IRS isn’t a nail in the Streamlined coffin.
Previous penalties must be paid. If you previously filed returns, including under “quiet disclosure,” (i.e., outside of a specified amnesty program), you have to pay those penalties first. You can’t use Streamlined as a way to get out of a penalty you were already given.
You need a valid Social Security Number. If you’re a U.S. citizen but don’t have one, you’ll net to get one before the submission is made.
Failed to report income from a foreign financial asset. You have to have missed income on previously filed tax returns (or you didn’t file a return at all, so didn’t report anything because of that), and that income needs to be from a “foreign financial asset,” which generally includes things like dividends, interest, and gains on the sale of securities.
Nonresidency requirement. This one has two prongs:
You must not have had a U.S. abode in any of the years included in the filing. This doesn’t mean you can’t have had a vacation property there or something similar, but it does mean you can’t have been living there in a sort of permanent sense.
You were physically outside the U.S. for at least 330 full days during at least one of the years included in the filing.
Let’s reiterate a point here – you need to meet both “a” and “b” above in only one of the years included in the filing, but it must be the same year.
The rules are a bit different for individuals who aren’t U.S. citizens or lawful permanent residents, but we’ll leave that aside for now. One point here is that these procedures don’t work for filing Form 1040NR according to IRS commentary.
The How
Streamlined generally includes submitting three years of tax returns for which the due date or a properly applied for extended due date has passed. This includes all the relevant informational returns. The returns are filed together along with Form 14653. This is the form where some summarizing information about the returns as well as the certification of eligibility is made.
In addition to the three years of 1040s (that’s the form number for tax returns for individuals, if you weren't aware), you also have to file 6 years of FBARs, again, for which the due date has passed. FBARs are filed electronically and aren’t mailed in. For those who don’t know, the FBAR is a form where all your non-U.S. accounts are reported. It’s not technically part of the tax return, but it’s often prepared alongside the 1040.
There are some exceptions to the three-year general rule. First of all, nothing stops you from including additional years if you want, such as if you’re renouncing your U.S. citizenship and are certifying 5 years of compliance to avoid the application of the exit tax (this is another matter entirely, but it’s something to keep in mind). Another example is if the Section 965 Transition Tax applies. That’s a whole other issue as well, but in short, it’s a tax that kicked in for certain U.S. owners of foreign corporations at the time the 2017 Tax Cuts and Jobs Act was passed. If the transition tax applies to you, you’re required to go back to the year of the relevant inclusion (2017, or sometimes 2018) and include it as well as all subsequent years in the Streamlined submission.
The When
The best time to move forward is now! Streamlined doesn’t have a permanent shelf life – we don’t know how long the amnesty program will be around. Pull the trigger and get compliant – don’t try and wait out the clock for things to magically get better. The IRS has more funding than ever, and they have ways to find you.
The Where
At Blomfield Tax, we can help you navigate the Streamlined Procedures and get your U.S. filings in order. Reach out, and we’ll work to get things done right.
This post is for informational purposes only and should not be relied upon for official tax advice.