- 1 Unforeseen US Tax Consequences of Opening Foreign Accounts
- 2 Case Study Example of Tax Consequences when Opening Foreign Accounts
- 3 Foreign Account Interest Income & US Tax Implications
- 4 Foreign Mutual Funds & US Tax Implications
- 5 Proceed with Caution
- 6 Golding & Golding: About Our International Tax Law Firm
Unforeseen US Tax Consequences of Opening Foreign Accounts
Unforeseen US Tax Consequences of Opening Foreign Accounts: One common misconception that many US taxpayers have, is that when they open up a bank or investment account offshore, there are no US tax implications. This is incorrect. Not only might there be tax implications, but there are also IRS reporting requirements that most US persons will have to comply with when it comes to reporting foreign accounts. These reporting requirements are not predicated on there being any income associated with the accounts.
It is important for taxpayers to keep in mind that the reporting and the tax are two separate requirements.
Let’s go through an example of the US Tax Implications of Opening Foreign Bank & Investment Accounts.
Case Study Example of Tax Consequences when Opening Foreign Accounts
Marla is a US Legal Permanent Resident (aka Green Card Holder). She returns to her home country for holidays and after visiting with her financially-savvy cousins, she decides she wants to invest some money in a high-yield interest-rate account (aka fixed or term deposit) and purchase some mutual funds in that home country.
As to the term deposit, it will accrue interest income each year, but the bank does not distributed it to Marla until year five (5). As to the mutual funds, they are growth account funds which are expected to bring a high-yield return over the next few years — but no dividends or other distributions are expected from the fund.
When Marla goes to the foreign financial institution, they asked her if she has a local ID. She does and presents it to the investment professional adviser.
She looks down at the document the adviser gave her and notices that it asks whether she is a US person.
Must Marla Identify as a U.S. Person?
Yes. Even though Marla has a local ID card and that card can be used for address and other local purposes, it does not give Marla the opportunity to omit her US person status.
If she does not reveal her US status now, it can become a slippery slope in years to come. By identifying as a foreign person and not a US person, she may be issued a W-8BEN instead of a W-9 — and the misrepresentations perpetuate…until they catch up to her at a later date.
If she gets audited and this information comes out, it could lead to a willfulness designation and serious fines and penalties.
Foreign Account Interest Income & US Tax Implications
The bank representative explains to Marla that the term deposit will accrue interest income each year, but that interest income is not distributed out of the account. If Marla accesses that money before she reaches the five-year mark — she will be penalized on the withdrawal.
Is Marla Subject to U.S. Tax on the Accrued Income?
Common sense would dictate that Marla would not pay tax on that money until she reaches the five-year mark and it is distributed out. But that is not the case.
The income is accruing each year. Therefore, unless there is an applicable exception, exclusion, or limitation, then Marla is subject to tax on the accrued growth each year and must include it on her U.S. tax return. In other words, simply because the money accrues but is not distributed does not exclude that income from the US taxes.
Later down the line when she receives the distribution, she will have already paid tax on the income incrementally each year.
How does Marla Report the Bank Account?
Marla must report the bank accounts on the FBAR and Form 8938 (if she meets the max-balance requirements). Depending on whether the term deposits are associated with a main bank account and if they have their own individual term deposit numbers will determine how it is reported on each IRS international information reporting form. There are various nuances to consider depending on how the account to structured and the availability of information Marla can get.
Foreign Mutual Funds & US Tax Implications
After opening the term deposit account, she opens a mutual fund account as well.
She invested $90,000 to purchase six mutual funds in a single portfolio account. Let’s assume for purposes of this exercise that none of the funds issue any income such as dividends or capital gains.
Is Marla Subject to U.S. Tax on the Mutual Fund Income Growth?
Most likely, not yet (presuming PFIC rules apply), but when she does, it will be a doozy.
Welcome to the wild wacky world of PFIC. PFIC refers to passive foreign investment companies. Typically, traditional foreign mutual funds are considered PFIC. With a PFIC, the general rule is that accrued income that does not leave the fund is not taxed in the growth phase. But, at a later time when the fund pays out and the excess distribution rules kick in (especially in the first few years it pays out). The tax rate for excess distributions is the highest tax rate available for each year the PFIC was owned, aside from the current year of distribution in which it is the taxpayer is taxed at their progressive tax rate.
It gets complicated, and there are various elections that can be made presuming that you have a cooperative foreign institution — which is presuming a lot of the foreign institution.
How does Marla Report the Mutual Funds?
It depends. Generally, the full value of the mutual fund account is reported on the FBAR — but the individual mutual funds within the account are not necessarily reported separately on the FBAR. For the PFIC aspect on the U.S. tax return, Marla should use a Form 8621. Since the Form 8621 is used to track each individual fund, usually Marla will have to identify each fund separately on a separate Form 8621 (not all PFICs are mutual funds, so reporting varies amongst different PFIC types).
Different practitioners may have their own pattern and practice for reporting foreign mutual funds on the tax return but when it comes to the IRS, it is generally better to err on the side of over-reporting or duplicate reporting — versus what may be considered noncompliance.
Proceed with Caution
There may be significant tax implications when opening a foreign bank account or investment account. Therefore, it is important that when a US person opens a foreign bank account that they keep in mind they may have both the US tax and reporting requirement along with IRS reporting requirements on one or more international reporting forms.
Golding & Golding: About Our International Tax Law Firm
Golding & Golding specializes exclusively in international tax, and specifically IRS Offshore Compliance and Voluntary Disclosure.
Contact our firm today for assistance.