Foreign Income and Asset IRS/Tax Reporting Requirements

In an increasingly interconnected world, many individuals find themselves earning income from foreign sources and/or have assets in a foreign country.  Whether it’s through employment, business ventures, or investments, US taxpayers with foreign income or assets are required to report these earnings and assets to the Internal Revenue Service (IRS). Failing to properly disclose either of these can result in penalties and legal consequences. This article aims to provide a comprehensive guide for US taxpayers on how to report foreign income or assets on their tax returns.

Foreign Income

Understanding Foreign Income:

Foreign income refers to any income earned from sources outside the United States. This includes wages, self-employment income, rental income, dividends, interest, capital gains, and any other form of income generated from foreign assets or activities. It is important to note that US citizens, residents, and certain non-resident aliens are obligated to report their worldwide income to the IRS, regardless of where it is earned.

Determining Tax Residency Status:

Before addressing the specifics of reporting foreign income, it is crucial to determine your tax residency status. US citizens and permanent residents are generally considered tax residents and must report their global income. Non-resident aliens, on the other hand, have different reporting obligations based on their US-sourced income and income effectively connected with a US trade or business.

Foreign Income Reporting Requirements:

Form 1040: All US taxpayers, including those with foreign income, must file Form 1040, the US Individual Income Tax Return. This form is used to report income, deductions, credits, and other relevant information.

Form 1040 Schedule B: If you meet certain thresholds (e.g., if you have foreign bank accounts), you may need to file Form 1040 Schedule B to report foreign accounts and financial assets.

Form 8938: Taxpayers who meet specified thresholds for foreign financial assets must file Form 8938, Statement of Specified Foreign Financial Assets, to report these assets to the IRS.

Foreign Bank and Financial Accounts (FBAR): If the aggregate value of your foreign financial accounts exceeds $10,000 at any time during the calendar year, you must file FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR), separately from your tax return.

Foreign Tax Credits and Exclusions:

To avoid double taxation, the US tax system provides certain mechanisms for taxpayers with foreign income:

Foreign Tax Credit (FTC): If you paid income tax to a foreign country on your foreign earnings, you may be eligible to claim a credit against your US tax liability for the foreign taxes paid.

Foreign Earned Income Exclusion (FEIE): For US citizens or resident aliens who meet certain requirements, a portion of their foreign earned income may be excluded from taxable income, up to a specified limit. This exclusion is subject to annual adjustment.

Foreign Mutual Funds:

The US uses a certain accounting standard for mutual funds which the IRS approves.  However, mutual funds overseas use different accounting methods.  The IRS requires the taxpayer to, in essence, reconcile these two methodologies and pay tax, if applicable, on the difference.  

The Passive Foreign Investment Company (PFIC) rules apply to foreign mutual funds that meet certain criteria. Here are key points to consider regarding PFIC rules for foreign mutual funds:

Definition of a PFIC:

A PFIC is a foreign corporation in which at least 75% of its gross income is passive income or at least 50% of its assets generate passive income.

Passive income generally includes dividends, interest, rents, royalties, and gains from the sale of assets that produce such income.

Taxation under PFIC Rules:

By default, the PFIC rules impose a default tax regime that is generally unfavorable for US taxpayers.

The default treatment includes an excess distribution regime or mark-to-market regime, depending on the taxpayer’s election.

Excess Distribution Regime:

Under the excess distribution regime, any distributions received from a PFIC in a given tax year that exceed 125% of the average annual distributions over the previous three years or the taxpayer’s holding period, whichever is shorter, are subject to additional taxes and interest charges.

The excess distribution is allocated to each year of ownership and subject to taxation at the highest ordinary income tax rate for that year, plus an interest charge.

Mark-to-Market Regime:

US taxpayers have the option to elect the mark-to-market regime for their PFIC holdings.

Under this regime, the taxpayer includes the increase in the value of the PFIC investment as ordinary income each year.

The taxpayer also includes any distributions received as ordinary income.

Reporting Requirements:

US taxpayers who own shares in a PFIC are generally required to file Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company.

The form is used to report ownership, earnings, and distributions related to the PFIC.

The reporting requirements apply even if the taxpayer does not receive any distributions during the tax year.

Qualified Electing Fund (QEF) Election:

US taxpayers may also make a Qualified Electing Fund (QEF) election to avoid the default PFIC taxation.

With a QEF election, the taxpayer includes their share of the PFIC’s ordinary income and net capital gain annually on their tax return.

Foreign Assets

Understanding What is a Foreign Asset:

For IRS purposes, a foreign asset refers to any financial account or investment held outside the United States by a US taxpayer. These assets can take various forms and may include:

• Foreign Bank Accounts: This includes any checking, savings, or other deposit accounts held with financial institutions outside the United States. It encompasses accounts held individually or jointly, as well as corporate or business accounts.
• Foreign Securities: These are investments in foreign stocks, bonds, mutual funds, or other financial instruments. It includes ownership in foreign corporations, partnerships, or trusts.
• Foreign Retirement Accounts: This includes pensions, retirement savings plans, or other similar accounts held with foreign financial institutions or administered by foreign governments.
• Foreign Life Insurance Policies: Certain types of life insurance policies issued by foreign insurers, including cash value policies or annuity contracts.
• Foreign Partnership Interests: Investments or ownership interests in foreign partnerships or entities that are treated as partnerships for US tax purposes.
• Foreign Trusts: Interests in foreign trusts, including grantor trusts, non-grantor trusts, and certain employee benefit plans.

Foreign Asset Reporting Requirements:

FinCEN Form 114 (FBAR):

The Report of Foreign Bank and Financial Accounts (FBAR), FinCEN Form 114, is a mandatory filing for US taxpayers who have a financial interest in, or signature authority over, one or more foreign financial accounts with an aggregate value exceeding $10,000 at any time during the calendar year. The FBAR must be filed electronically with the Financial Crimes Enforcement Network (FinCEN) by April 15th of the following year, with an automatic extension available until October 15th.

Form 8938 (FATCA):

The Foreign Account Tax Compliance Act (FATCA) requires certain US taxpayers to report specified foreign financial assets on Form 8938, Statement of Specified Foreign Financial Assets. This form applies to individuals whose total foreign assets meet specific thresholds, such as $50,000 for single taxpayers or $100,000 for joint filers living in the US. The threshold amounts are higher for individuals residing abroad. Form 8938 is filed as part of the taxpayer’s annual income tax return (Form 1040) and is due on the regular tax filing deadline, including extensions.

Form 3520 and Form 3520-A:

US taxpayers who have received certain gifts or inheritances from foreign individuals or entities, or who are beneficiaries of foreign trusts, may be required to file Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts. Form 3520 is separate from the tax return and is due on the regular tax filing deadline, including extensions. Additionally, if a foreign trust has a US beneficiary, the trustee of the foreign trust must file Form 3520-A, Annual Information Return of Foreign Trust with a US Owner, providing information about the trust’s activities and its US beneficiaries.

Form 5471, Form 8865, and Form 8858:

US taxpayers who have an ownership interest in certain foreign corporations, partnerships, or disregarded entities may be required to file Form 5471 (for foreign corporations), Form 8865 (for foreign partnerships), or Form 8858 (for foreign disregarded entities). These forms provide information about the taxpayer’s interest in the foreign entity, its operations, and any transactions between the US taxpayer and the foreign entity. The filing requirements for these forms depend on the taxpayer’s ownership percentage and other factors.

Penalties and Compliance:

The IRS places a strong emphasis on compliance when it comes to reporting foreign income and assets. Failure to disclose foreign income or assets can lead to severe penalties, including monetary fines, criminal charges, and potential imprisonment. It is crucial to ensure accurate reporting and compliance with all applicable regulations.

Seek Professional Assistance:

Navigating the complexities of reporting foreign income and assets can be challenging. Consulting a tax professional with expertise in international tax matters is highly recommended. These professionals can help ensure compliance with reporting requirements, provide guidance on claiming credits and exclusions, and minimize the risk of penalties.

This area of the law is extremely complex and requires a lot of diligence.  If you are a client of Bluerock, we are glad to help you think about your steps in being compliant with these rules.

Hightower Advisors, LLC is an SEC registered investment adviser. Securities are offered through Hightower Securities, LLC member FINRA and SIPC. Hightower Advisors, LLC or any of its affiliates do not provide tax or legal advice. This material is not intended or written to provide and should not be relied upon or used as a substitute for tax or legal advice. Information contained herein does not consider an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. Clients are urged to consult their tax or legal advisor for related questions.