Prologue
As an older post I wrote confirms, Americans abroad are subject to special provisions and those special provisions include a number of information returns!
My reason for writing and the purpose of this post
I am not a tax preparer. I am an expatriation lawyer. In this.capacity, I either:
– see U.S.tax returns prepared by a tax preparer; or
– discuss the necessity of U.S. tax compliance when a person wishes to become U.S. compliant through either the IRS streamlined or the IRS Relief Procedures Programs.
Americans abroad have many reasons for wishing to be U.S. tax compliant. In many cases it is associated with expatriation. In some cases it is part of estate planning (in many cases it is better to die without being a U.S. citizen). In. some cases it is to renounce and NOT create barriers to inheritance for U.S. citizen children. In some cases it is because they are likely to inherit U.S. income producing assets. In some cases it is because they fear noncompliance. In some cases (regardless of fears of penalties) they believe in. compliance with the law. The point is that U.S. tax compliance (it’s a huge industry) is an important part of people’s lives.
Regardless of one’s view of the U.S. citizenship tax regime, there are large numbers of Americans abroad who either attempt to meet their annual filing obligations or who desire to meet those obligations.
In this context I offer two important (I think) thoughts:
First, forms and tax returns are dangerous things and should be filed correctly. If you are going to file, you might as well do it correctly.
Second (and more importantly), for U.S. citizens abroad the filing of U.S. tax returns is a major cause of significant trauma in their lives. It is NOT a question of filing a. 1040 that just reports “foreign income”. It is, because of the large number of penalty-laden information returns, an accusation that is based on a presumption of “wrong doing”. (U.S. residents and their tax preparers who think this is hyperbole, just try living as a tax compliant American abroad!)
Therefore, the tax compliance question for Americans abroad is a question of how do they mange their trauma. The issue is how do they manage the tax filing issue in a way that minimizes the associated trauma. Are they likely to be audited? I don’t think so. Are they likely to think about the possibility of audit and penalties? Yes, many of them do. Furthermore, learning about previous filing mistakes is – for many people -incredibly traumatic.
The purpose of this post is to help with the management of trauma.
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The Organization Problem – How to read this post …
Identifying the information that is needed.
I have noticed that Americans abroad have difficulty organizing their information. Remember, tax preparers are not mind readers. They know very little about you. The simply process the information you provide. Sure, they have questionnaires (with varying degrees of detail). That said, I think it would be helpful to provide an overview of what it means to file a U.S. tax return, what information is relevant and how to think about retrieving that information. Those of you who wish to renounce U.S. citizenship will want to be in a position where you can certify five years of U.S. tax compliance.
I have written this post primarily from a Canadian perspective (I live in Toronto, Canada.) Although the information is generally applicable to all U.S. citizens living outside the United States, some of the information is specific ONLY to Canada. So, please don’t be lazy. Get informed! Stay informed!
While providing an overview, the information in this post cannot be complete. It is written for the average person, with a simple life and mainstream investments that are easily understood and characterized.
Finally, if you are filing U.S. taxes abroad for the first time, I suggest you should start with the following simple question:
“What would my U.S. tax tax return contain in terms of forms, schedules, etc.?”
In any case, I am writing this post because …
Yesterday I compared the U.S. tax return and the Canadian tax return of a U.S. citizen living in Canada. The Canadian return was 14 pages. The U.S. return was 59 pages. The person had a very simple life (retired and living off the usual pensions). He did NOT owe any U.S. taxes. That said, he was NOT compliant with his U.S. tax filing obligations. The reason was that his “foreign assets” were not reported properly on Form 8938. I suspect that this person had no idea how to properly identify and organize the foreign financial asset information to properly transmit it to his U.S. tax preparer. This is perfectly understandable. Assuming no Canadian Controlled Private Corporation (a presumptive instrument of tax evasion from a U.S. perspective), or other controlled foreign corporation, most tax filers will be required to file:
– FinCEN 114 AKA FBAR
– Possibly Forms 3520 and 3520A (make sure that you really are dealing with a Trust or have received a foreign gift)
– and possibly more
This post is to provide very simple advice on how to organize this information to provide to your tax preparer.
U.S. tax filings are more about the disclosure of information than about the calculation of tax
Generally, you can assume that ANY and ALL financial accounts and financial assets (brokerage accounts, pensions, individual shares in non-U.S. corporations) must be reported. The reporting issue is distinct from the tax issue.
Foreign real estate owned directly by Americans abroad is NOT (at present) subject to separate reporting (although income earned from them is taxable).
Preparation for the filing of a U.S. tax return should be viewed as four categories of. tasks:
Category A – Identifying The Relevant Information
Category B – Deciding How That Information – In Terms Of The Relevant Forms – Is To Be Reported
Category C – Reporting The Information On The Relevant Forms
Category D – Deciding Whether Any Information Returns Must Be Filed Even If A Tax Return Is Not Required (For example: Form 5471, 8621 and Form 3520 and Form 3520A may have a filing requirement even if a 1040 is not required!)
Category E – Does Your Country Of Residence Have Rules Requiring The Reporting Of Foreign Assets (similar to FBAR, Form 8938, etc.)?
Be careful!!
Canada (and other countries) have very strict rules governing the reporting of foreign assets.
Once these three tasks have been. completed, one is ready to place the income on the actual tax return (1040 or 1040NR) and Schedules.
What follows are the ten steps that should prepare you to give your information to your tax preparer.
Step I – Identifying your financial accounts:
1. Start with ALL bank accounts which are in your name or which are jointly owned by someone else. All of these accounts musts be reported on FinCEN 114. To the extent that the taxpayer has a beneficial ownership in those accounts they must be reported on Form 8938 (if Form 8938 is required). You are concerned with identifying the highest balance in the calendar year.
2. Next, consider whether you own any shares in non-U.S. corporations that you own outide of brokerage accounts. If you own shares in a Canadian Controlled Private Corporation and you are NOT required to file Form 5471, those shares must be reported on Form 8938.
3. What about life insurance policies? An interest in a life insurance policy with an ivestment component (often called “whole life”) are reportable on Form 8938 and possibly FBAR.
4. Do you have a private pension plan from an employer? This is a foreign financial asset that is reportable on Form 8938.
5. Registered accounts (TFSA, RESP, RRSP, etc.) -these are reportable as foreign financial assets on Form 8938 and FBAR.
6. Check all information slips that you receive. Your Canada Revenue Agency file will include a list. Make sure that they are accounted for.
7. Crypto? The law on this is in a state of evolution. I will leave that to you to figure out.
8. Do any of the accounts you have identified contain non-U.S. mutual funds or ETFs? If so, does the value exceed $25,000 USD on December 31 of the year. If so AND these funds are held outside of your RRSP, then the individual funds should be separately noted. They may be PFICs and subject to the PFIC regime.
8. NOTE that Canadian Pension Plan and Old Age Security are NOT foreign financial assets and therefore not reportable as foreign financial assets. In addition, please note that under the Canada/US Tax Treaty Canada Pension Plan, Old Age Security and U.S. Social Security are taxable ONLY by Canada!
For FBAR and Form 8938 reporting: Note that for valuation purposes in USD you use the U.S. Treasury exchange rate in effect on December 31 of the year in question.*
Step II – Where To Report – Form 8938, FinCEN 114 (FBAR) Or both?
Once you have identified the relevant accounts and the values you must decide where they are to be reported. For most people, the accounts will be reported on both FBAR and Form 8938. (Note that if the accounts are joint the FULL amount of the account is to be reported.)
That said, there are differences between FBAR and Form 8938. Form 8938 focuses on beneficial ownership of assets and FBAR focuses on signing authority. Not everything reportable on Form 8938 will be reportable on FBAR (and vice versa).
Here is an excellent description from the IRS that explains the difference:
https://www.irs.gov/businesses/comparison-of-form-8938-and-fbar-requirements
Note that FBAR and Form 8938 have different reporting thresholds.
Step III – Are Any Of The Assets You Have Identified Trusts, Partnerships or Corporations?
If so, they may be subject to reporting on additional forms (3520, 8858, 5471, etc.)
(Most tax preparers do NOT believe TFSAs and some other registered accounts are “trusts”.)
Be aware that certain information returns are required even if a tax return. is NOT required!
Step IV – Have You Received Gifts From Foreign Persons? – Form 3520 May Be Required
U.S. citizens abroad married to non-citizens may receive gifts from those non-citizens. If these gifts exceed $100,000 USD they must be reported to the IRS. Your tax preparer will tell you more.
Step V – Have you made gifts to individuals exceeding $17,000 USD?
You may be required to file a Form 709 (gift tax return)
Step VI – Do you own 10% or more of the shares in a non-U.S. corporation?
If so, you may have Form 5471 reporting requirements.
Step VII – Identifying The Income Earned In Each Of These Accounts
The income earned inside these accounts will be taxable on your U.S. return even if not taxable in Canada. For example, income earned inside a Canadian TFSA is taxable on your U.S. return. Therefore, for each account you must identify both the amount and the type of income. For example, is the income: dividends, interest or capital gains.
Three specific areas of confusion:
Income reported in both Canada and the United States but where the amounts reported are different
– Dividends from Canadian corporations: Canada has a system where the amount of the actual dividend is “grossed up” for Canadian tax purposes. For U.S. tax purposes you want the ACTUAL amount of the dividend and NOT the grossed up amount.
– Income splitting is a concept under Canadian tax law and not under U.S. tax law. For U.S. purposes you should report your actual income from all sources.
Income NOT reported in Canada but which IS reported in the United States
– Income earned in TFSA, FHSA, RESP, etc.
– sale of a principal residence by a U.S. citizen living in Canada. The United States does tax the capital gain on the sale (IRC 121 provides an exclusion of $250,000 per taxpayer provided certain conditions are met.)
Income that may be “out of sight and out of mind” and which can be forgotten
– Distributions from mutual funds that are reinvested. These should be shown on your Canadian tax information slips. But, remember that distributions from mutual funds that are reinvested ARE income for U.S tax purposes.
Again, you must identify the actual amount of the income that comes from each of the different accounts.
For income reporting: the non-U.S. income can be converted to USD at the average exchange rate for the year.**
Step VIII- Determining Capital Gains
Generally a capital gain is the amount of profit that you make when you sell something. Let’s imagine that purchased 500 shares of Stock A. You purchased the shares on January 1, 2010 and you sold the 500 shares on January 1, 2020. In the 2020 year you have a taxable capital gain which is calculated as:
The proceeds received on sale less the amount. you paid to acquire the shares.
A decent outline from the IRS explaining capital gains:
https://www.irs.gov/taxtopics/tc409
For capital gains: if the purchase and sale takes place in non-U.S. currency both the proceeds of sale and acquisition cost must be converted to USD at the prevailing exchange rate on the date of the transaction.***
Step IX – What Exchange Rates to Use For Different Purposes?
Interestingly different exchange rates are used for different purposes. To recap what has been mentioned in previous parts:
*For FBAR and Form 8938 reporting: Note that for valuation purposes in USD you use the U.S. Treasury exchange rate in effect on December 31 of the year in question.
**For income reporting: the non-U.S. income can be converted to USD at the average exchange rate for the year.
***For capital gains: if the purchase and sale takes place in non-U.S. currency both the proceeds of sale and acquisition cost must be converted to USD at the prevailing exchange rate on the date of the transaction.
Step X – In Conclusion …
Nothing is more frustrating than meeting the reporting requirements imposed on Americans abroad. Tax preparers work with the information you provide to them
An ounce of prevention is worth a pound of cure!
I hope that this short post helps you better organize your information for. your tax preparer.
Remember information can change. It’s up to you to confirm the accuracy of this information. That said, I hope that this post helps you organize your accounts.
I am NOT a tax preparer. As an expatriation lawyer I have seen many instances of mistakes that could have been avoided by putting. serious thought into how you organize the information you provide to your tax preparer.
Please understand that this is a brief introduction and is not legal or any other kind of advice. It is designed to help you better under understand how to organize your information.
I urge those of you with Canadian Controlled Private Corporations or Trusts in your family to seek specialized advice!!
John Richardson – Follow me on X.com @Expatriationlaw