With the implementation of FATCA in Israel, I have been approached by many American olim who have not filed US tax returns since they made Aliyah and want to know what they should do to meet their tax obligations.
Israeli banks and other financial institutions are now reporting their U.S. accounts to the U.S. government. Taxpayers with unreported income and assets whose accounts are disclosed to the IRS through FATCA may be subject to penalties and criminal prosecution.
Civil penalties can range from $10,000 for non-willful violations to the greater of $100,000 or 50% of the unreported account balance at the time of the violation for willful violations. Criminal charges and penalties may also be imposed.
Options for getting back to compliance: The IRS Streamlined Program vs. OVDP
I normally advise clients living overseas who have not filed returns in the past to consider the IRS Streamlined Program. It allows Americans abroad to get back to compliance by filing tax returns (or amended tax returns) for the last three years and FBARs (foreign bank account reports) for the last six years. Taxpayers filing under this program can avoid IRS penalties and pay only their tax due (if any).
In order to qualify for the IRS Streamlined Program for taxpayers residing outside the U.S., the following requirements must be met:
- Non-US residency: The taxpayer did not have a U.S. abode and was physically outside the United States for at least 330 full days in any one or more of the most recent three years for which US tax return due date has passed.
- The taxpayer’s failure to file US tax returns and FBARs was due to non-willful conduct (i.e. negligence, inadvertence, mistake, or a good-faith misunderstanding of the law).
- The IRS has not initiated a civil examination on the taxpayer’s returns for any taxable year and the taxpayer is not under criminal investigation.
- Taxpayers must have a valid social security number or taxpayer identification number (ITIN).
Taxpayers whose failure to report and pay US taxes was due to willful conduct (a conscious choice not to comply with the requirements) may risk legal prosecution if they use the streamlined program. In such cases, the Offshore Voluntary Disclosure Program (OVDP) may be appropriate. This program allows delinquent taxpayers to avoid criminal prosecution after all disclosures are made. The OVDP requires submission of US tax returns, information returns and FBARs for the most recent eight tax years for which the due date has already passed. Under OVDP, taxpayers must pay failure-to-file and failure-to-pay penalties plus a flat penalty on their maximum foreign account values during the reporting period. This penalty is normally 27.5%, but it can be 50% if the account is held through a foreign financial institution that is under investigation by the IRS or the Department of Justice.
In some cases, taxpayers who did not commit willful violations may still be advised by their tax accountant or lawyer to use the ODVP. For example, when there are indications that the taxpayer made a conscious effort to avoid learning about FBAR and other international reporting requirements, the IRS will probably impose willful penalties. This is called willful blindness. The IRS sometimes considers taxpayers’ failure to answer questions regarding their foreign banks on Schedule B of their federal income tax return to be evidence of willful blindness.
Other risky cases involving non-willful violations include US citizens holding accounts in foreign financial institutions that are under investigation by the US government, or in sensitive locations that are normally used as tax havens. A tax professional should be consulted to determine the best way to file and minimize the risk of civil and criminal penalties.
Alternatives for taxpayers who only failed to file FBARs or information returns
Americans abroad who filed complete and accurate tax returns and paid their taxes but failed to file FBARs may use the Delinquent FBAR Submission Procedures to avoid penalties.
Taxpayers who failed to file one or more international information returns but are otherwise in compliance may use the Delinquent International Information Submission procedure to file these delinquent forms. Information returns include form 8938 for foreign financial assets, form 5471 for foreign corporations, and form 3520 for foreign trusts or gifts, among others.
In order to qualify for a waiver of penalties under this procedure, taxpayers must establish in writing that their failure to file information returns was due to reasonable cause and they acted in good faith. Reasonable cause is generally defined as an honest misunderstanding of fact or law that is reasonable given the experience or knowledge of the taxpayer. Reliance on a tax professional alone does not demonstrate reasonable cause, but it may be considered by the IRS in cases when such reliance was reasonable.
The content of this article is intended to provide general information on the subject and does not constitute legal or tax advice. You should consult with a tax professional where appropriate.