What Triggers an Expatriate Tax Return Audit, Case Study

An IRS Expatriate Audit, Case Study of an Expatriation Audit

An IRS Expatriate Audit Case Study

Expatriation is the process in which a U.S. Citizen (USC) or a Long-Term Lawful Permanent Resident (LTR) formally renounces their U.S. citizenship or terminates their Lawful Permanent Resident status. For some taxpayers, the expatriation process is relatively painless. Even though they may be required to file Form 8854 (because they fall into one of the two above-mentioned categories), they are not considered covered expatriates — and therefore are not subject to any exit tax. Other taxpayers who are considered covered expatriates may become subject to exit tax when they formally expatriate from the United States, which can sometimes result in a significant exit tax. While many taxpayers may be familiar with the mark-to-market exit tax, there are various other types of exit tax categories as well, such as:

• • • Eligible Deferred Compensation

    • Ineligible Deferred Compensation

    • Specific Tax-Deferred Accounts

    • Ownership of Foreign Trusts

An update to our original 9/2020 article.

Were Your Expatriation Tax Documents Accurate?

Sometimes, a taxpayer is ready to expatriate but not ready to pay any exit tax they may owe on an asset that has a very high unrealized gain. Take for example a Taxpayer who may have acquired a stock at $20 a share and now wants to expatriate because they have no further use for being a U.S. person — but the shares are worth $600 per share. The taxpayer has no intent of actually selling the stock, so trying to come up with hundreds of thousands of dollars if not millions of dollars of taxes on an asset that they did not sell can be difficult if not impossible.

What About Delaying the Exit Tax Payment?

While taxpayers who are subject to exit tax may be able to defer payment of the exit tax, in reality, this is almost impossible due to the high cost of obtaining and maintaining a bond. This may lead some taxpayers to file false or fraudulent expatriation documents in which the taxpayer substantially undervalues certain assets that they have. This can become a problem, especially in recent years where the IRS has significantly ramped up audits and examinations.  Let’s take a look at the expatriation audit process through an example.

Expatriation Examination

Jennifer is an LTR. A few years ago, she submitted her USCIS Form I-407. The following year, she submitted her dual-status tax return along with Form 8854. She claimed her net worth to be $1.85 million and certified under penalty of perjury that she has been five years tax compliant. In addition, Jennifer did not qualify as a covered expatriate under the net income average tax liability either, because even though she earned a high six-figure income in the most recent prior years, she also paid a significant amount of foreign tax on her income — and once the foreign tax credits were applied to her tax return she did not meet the five-year net income average tax liability threshold. A few years later, Jennifer found herself under examination for her expatriation paperwork. The IRS had several inquiries into Jennifer’s prior filings to determine whether or not she was five years tax compliant and whether or not she met the $2,000,000 net worth test.

Here are some issues Jennifer should be cognizant of during her audit.

Section 965 Repatriation Tax

As part of the Tax Cuts and Jobs Act (TCJA), taxpayers who had previously untaxed income generated from Controlled Foreign Corporations were required to pay a one-time repatriation tax (aka 965 Transition Tax). While currently this issue is up with the Supreme Court in the case of Moore at the time Jennifer repatriated, the law was valid.  Before Jennifer relocated to the United States, she had a foreign corporation. Unfortunately, the corporation was in a country in which the U.S. considers it a per se corporation, so she was not able to disregard the entity. In addition, she was the only owner of the corporation and therefore all the income is imputed to her.

When the IRS examined her tax returns for the past few years, they found that not only did she not properly complete Section 965 but she also did not report GILTI or Subpart F properly.  Finally, during the examination, the IRS required Jennifer to explain her valuation of the business because the IRS believed that she may have undervalued the company.

• • Issue: if the Internal Revenue Service determines that there was outstanding income tax due to Section 965, GILTI, or Subpart F, the IRS could take the position that she was not actually tax compliant for the past five years which could change her to covered expatriate status. She may also have an outstanding tax liability, penalties, and interest.

Form 5471

Since the taxpayer owned a Controlled Foreign Corporation, each year she was required to file Form 5471. As part of the audit, the IRS wants the taxpayer to show that she filed Form 5471 each year and that each year she filed the form, it was substantially compliant. Luckily for Jennifer, she did file the form each year and while there were some mistakes in the forms, overall, she was substantially compliant. Also, Jennifer shut down the business a few years before she expatriated.

Form 3520/3520-A

Next during the audit, the Internal Revenue Service was interested in a foreign pension that Jennifer maintains and whether that was reported properly. Jennifer reported the pension on the FBAR and Form 8938. The IRS questioned whether the pension should also be reported on forms 3520/3520-A, because technically it is a retirement trust. Jennifer took the position that based on the value of the foreign pension along with the fact that it was in a treaty country, it was not required to be filed on forms 3520/3520-A because it should qualify as a tax-favored retirement trust under the proposed foreign trust regulations and Revenue Procedure 2020-17.

Foreign Trust Distribution or Gift

Jennifer was not the owner of the foreign trust and therefore she was not required to file a form 3520-A. Jennifer did receive a distribution from the foreign trust, which was a non-grantor foreign trust — but unfortunately, did not receive a Foreign Non-Grantor Trust Beneficiary Statement. Also, Jennifer did not file Form 3520 for the distribution. The IRS takes the position that since this was a trust distribution, Jennifer was required to file form 3520. Jennifer takes the position that it was a gift from the trust and not income and that it was from the corpus and it was below $100,000 so she was not required to file the form. Based on the recently proposed regulations and the fact that no beneficiary statement was issued to Jennifer, it may be difficult for Jennifer to challenge this fact, with the IRS agent allowing her to go back and obtain information sufficient to show that it was a gift and not income.

• • • Issue: If it turns out that the distribution is considered income, then that is income that Jennifer would have to have included in her tax return and can impact whether she was considered tax-compliant for covered expatriate purposes.

What Happens if Jennifer is Considered a Covered Expatriate?

If Jennifer is considered a covered expatriate, it can have a significant tax impact. Let’s take a look:

Foreign Pension

Jennifer had about $550,000 in a foreign pension that the IRS would have presumably categorized as ineligible deferred compensation. 

• • • Issue: Jennifer could have to pay an exit tax on the non-step-up portion of the distribution.

401K

This could also pose an issue. When Jennifer expatriated, she did not claim to be a covered expatriate and so she did not provide her 401K with information within 30 days.

• • • Issue: If the IRS deems her a covered expatriate, the issue will be whether she would have 30 days from that time to update her 401K company so that it was not deemed distributed – or if the IRS determines it relates to the original filing and thus deemed distributed.

IRA

Since Jennifer was not considered a covered expatriate, she did not have a specified tax deferred account income issue with her IRA.

• • • Issue: If she is considered to be a covered expatriate, then the IRA would lose the tax-deferred status and the value would be grossed up in her income tax return. since this is a Traditional IRA and not a Roth IRA she has no tax basis so all of the money would be taxable.

Post-Expatriation Gifts to U.S. Relatives

After Jennifer expatriated, she began giving gifts to her nieces and nephews in the United States. Typically, she gave about $50,000 to each child per year. Since the gift was $50,000, to U.S. persons, the U.S. Persons did not have to report the gift because it is below the Form 3520 threshold. Likewise, because Jennifer is not a covered expatriate, there was no 3520 issue above giving  ‘covered gifts.’

• • • Issue: If it turns out that Jennifer was considered to be a covered expatriate then there could be a considerably complicated issue with whether there’s any requirement to go back and file Form 3520, especially under the new proposed regulations.

Late Filing Penalties May be Reduced or Avoided

For Taxpayers who did not timely file their FBAR and other international information-related reporting forms and do not qualify for an exception or exclusion to FBAR filing, 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. 

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.