7 Offshore Investments that have U.S. Tax Traps for Americans

Offshore Investments that have U.S. Tax Traps for Americans

Offshore Investments that have U.S. Tax Traps for Americans

With the globalization of the U.S. marketplace, it has become increasingly common for Americans and other U.S. Taxpayers to invest in offshore assets, investments, and accounts. Unfortunately, when Americans invest in offshore assets, they must be mindful of many tax traps and tripwires before investing. For example, when a Taxpayer invests in a foreign mutual fund, they may have inadvertently acquired a PFIC. Likewise, if a U.S. Person opens a foreign corporation and that corporation is considered a Controlled Foreign Corporation (CFC) the American may become subject to taxes on income that has not even been distributed in accordance with GILTI and Subpart F. While there are many different types of tax traps that Americans must be careful of when making offshore investments, let’s take a look at seven (7) common offshore investments that have unforeseen tax traps for many Americans and what taxpayers can do if they find themselves in this situation.

Offshore Investments and Worldwide Income

One common theme is that Taxpayers are under the common misconception that income generated from offshore is nontaxable in the United States because it is foreign-sourced, but that is incorrect. The United States follows a worldwide income tax model, which means U.S. Citizens, Lawful Permanent Residents, and foreign nationals who meet the Substantial Presence Test are subject to U.S. taxes on their worldwide income. This is true, even if the Taxpayer lives overseas and the income is sourced from abroad.

Foreign Mutual Funds and ETFs (PFIC)

For taxpayers who want to invest in foreign mutual funds and ETFs, it is important to note that these investments are typically categorized as PFIC under U.S. tax law. A PFIC is a Passive Foreign Investment Company, and while a U.S.-based mutual fund income generally qualifies as “Qualified Dividends” and is taxed at 15% or 20%, dividends generated from foreign funds typically result in a 37%+ percent tax rate — in addition to interest for the amount of time that the asset is held in the foreign financial institution. Taxpayers may qualify to make certain elections to minimize the tax damages, but not all taxpayers are eligible to make an election.

Foreign Holding Company (PFIC /CFC)

It is very common in some countries to hold all their investments in a foreign corporation such as a Canadian corporation, BVI, or Hong Kong Private Limited. These types of foreign holding companies can also be considered PFIC when a majority of the assets and/or income is generated from passive assets and will lead to the same high tax rate. There is also a crossover between PFIC and Controlled Foreign Corporations and while the PFIC has excess distributions which are taxed at a higher tax rate, Controlled Foreign Corporations have Subpart F Income and GILTI, which can also result in a high tax rate — noting that for Subpart F income and GILTI, the Taxpayer may be taxed even if the income is not been distributed to him.

Per Se Corporation (5471)

It is becoming much more commonplace for U.S. persons to operate overseas and when doing so to open a foreign corporation in that country — primarily to protect the assets of the company in the foreign country. Sometimes, a Taxpayer may be able to disregard the entity under U.S. Tax Law, but other times the corporation may be considered per se which means the taxpayer does not have the opportunity to disregard the entity for U.S. tax purposes. This may result in the taxpayer becoming subject to Subpart F and GILTI income taxes.

Foreign Grantor Trust Ownership (3520-A)

Taxpayers who are Americans but may have wealth and family overseas may want to form a foreign grantor trust to distribute income to foreign relatives. Most of the time, the taxpayer will want to maintain control over the trust and thus at least a portion of the trust would be considered a grantor trust as opposed to a non-grantor trust. In this type of situation, even if the American distributed income to non-U.S. persons through a foreign grant or trust, it is the taxpayer who owns the trust that is taxed on the income and not the beneficiaries that the income is distributed.

Foreign Partnership (8865)

While forming a partnership with a foreign national may seem like a profitable investment — especially in joint venture types of opportunities — there may be additional U.S. reporting requirements for foreign partnerships on Form 8865. Depending on the nature of the partnership and the extent of the reportable transactions, an American who partners with a foreign person may become subject to extremely onerous tax and reporting requirements.

Living Overseas, Exit Tax and Treaty Election Tripwire

One final issue to consider is that some U.S. Taxpayers who live overseas will decide they no longer want to be treated as a U.S. person for tax purposes. This is primarily for Green Card Holders who live overseas in a treaty country. Oftentimes this becomes an issue when the Green Card Holder realizes that they may become subject to an exit tax because they would qualify as they covered expatriate. One very important tripwire to be aware of is that if a Green Card Holder already qualifies as a Long Term Lawful Permanent Resident and files an IRS Form 8833 treaty election form to be treated as a foreign person, non-resident alien for tax purposes, this is the equivalent of the expatriating act. And if the Permanent Resident is already a Long Term Resident, they may be considered a covered expatriate — so U.S. Taxpayers who have had their green card for multiple years should be very cautious before filing a Form 8833 to be treated as a non-resident alien for tax purposes.

Late Filing Penalties May Be Reduced or Avoided

For Taxpayers who did not timely file their FBAR and other international information-related reporting forms, the IRS has developed many different offshore amnesty programs to assist Taxpayers with safely getting into compliance. These programs may reduce or even eliminate international reporting penalties.

Current Year vs. Prior Year Non-Compliance

Once a Taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, Taxpayers should consider speaking with a Board-Certified Tax Law Specialist who specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties. 

Need Help Finding an Experienced Offshore Tax Attorney?

When it comes to hiring an experienced international tax attorney to represent you for unreported foreign and offshore account reporting, it can become overwhelming for Taxpayers trying to trek through all the false information and nonsense they will find in their online research. There are only a handful of attorneys worldwide who are Board-Certified Tax Specialists and who specialize exclusively in offshore disclosure and international tax amnesty reporting.  *This resource may help Taxpayers seeking to hire offshore tax counsel: How to Hire an Offshore Disclosure Lawyer.

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure.  Contact our firm today for assistance.