My earlier blog posting covered some of the basics of Form 5471, “Information Return of U.S. Persons with Respect to Certain Foreign Corporations”. The Form is notoriously complex and consumes hundreds of man-hours in record-keeping and preparation time. If a taxpayer fails to “substantially complete” the Form 5471, as that term is interpreted by the US Internal Revenue Service (IRS), trouble lies ahead. As detailed in my prior post, not only can stiff penalties be imposed, the statute of limitations for that particular tax year can remain open indefinitely.
Form 5471 is also of great concern to taxpayers who are expatriating. Why is this so?
Tax Compliance and Expatriation
If an individual expatriates and is treated as a “covered expatriate”, the tax laws exact a very hefty pound of flesh. First, the individual will be subject to the “Exit Tax” or “Mark-to-Market” regime. Under this regime, generally, all property owned by the covered expatriate worldwide is treated as sold for its fair market value on the day before the expatriation date. This ‘phantom’ gain is then taken into account for the tax year of the deemed sale and subject to tax, usually at capital gains rates. In addition, a 3.8% “net investment income tax” will likely also apply to this deemed gain if certain modified adjusted gross income thresholds are met. You can read more here about the 3.8% surcharge. The Exit Tax must be computed via one’s Form 1040 with the gain or loss being reported on the relevant part of the 1040 for the part of the year that the taxpayer is still considered a US person.
The tax burdens don’t stop there. Special onerous tax rules apply to the covered expatriate’s deferred compensation plans and specified tax deferred accounts. Generally in cases involving US (domestic) plans this means imposition of a 30% withholding tax on later distributions. In cases involving foreign plans, the tax treatment can be even harsher resulting in immediate taxation by calculating the present value of the covered expatriate’s interest in the deferred compensation item and including it in taxable income for the year of expatriation. Remember, the individual will not have received the deferred compensation payouts – so he is being taxed all at once without the cash to pay the tax.
In addition to the Exit Tax, US recipients of any gift or bequest at any time in the future from the “covered expatriate” will be hit with a special tax upon receiving that gift or inheritance. Under current rules, this special transfer tax is set at 40% of the gift or bequest. This law provides an alternative way for the US to recoup US Gift or Estate taxes that it would otherwise have received (upon the making of lifetime gifts, or upon death) had the individual not given up his US citizenship or long-term residency. More information about the current expatriation tax regime can be found on my tax blog posting here.
Who is a “Covered Expatriate?”
Under the US expatriation rules, an individual will be treated as a “covered expatriate” if any of the following tests apply:
- The individual’s average annual net income tax (that means tax paid to the IRS) for the 5 years ending before the date of expatriation or termination of residency is more than a specified amount that is adjusted for inflation (the amount is $161,000 for 2016).
- The individual’s net worth is $2 million or more on the date of expatriation or termination of residency.
- The individual fails to certify on Form 8854 that he or she has complied with all US federal tax obligations for the 5 years preceding the date of expatriation or termination of residency.
Form 8854 and Certification of US Tax Compliance
When a US citizen or long-term green card holder expatriates, the individual must submit Form 8854, which is a very detailed form, to the IRS along with the final tax return. Part of this form requires the individual to certify under penalties of perjury whether he has complied with all of his tax obligations for the past 5 years including but not limited to income tax, employment tax, gift tax, filing of information returns as well as having met all obligations to pay tax, interest and penalties. If the person has not complied with these tax obligations, he will be a “covered expatriate”. This so-called tax certification requirement, is the trigger with which we are concerned when Form 5471 has either not been filed or, if it was filed, it was not “substantially complete”. If either of these errors occurred during the five year period prior to the year of expatriation, the taxpayer will lack full tax compliance and will be tarred with the “covered expatriate” brush.
When is Form 5471 “substantially complete”? The IRS has set a pretty high bar, at least for purposes of imposing the penalties discussed in my earlier blog post. I imagine the guidelines set out by the IRS for penalty imposition purposes will be equally applicable in determining “tax compliance” for expatriation purposes. Congress and the IRS are not happy with expatriates. Do not expect leniency if your Form 5471 is examined and found lacking.
IRS Sets the Bar
The IRS concedes that “substantial compliance” with regard to filing Form 5471 is not specifically defined in the Internal Revenue Code or Treasury Regulations. The IRS draws from other sources in making its determination of “substantial compliance”. Below are some highlights from the IRS “International Practice Units” (IPU). IPUs were recently designed by the IRS to tackle the lack of knowledge within the IRS of the complex tax laws. The IPUs will be of strong interest to the IRS’ LB&I (Large Business and International group) which specializes in international matters. The IPUs will assist revenue agents who are not highly specialized in international tax matters to review transactions and to assess taxes and penalties in the international context.
With regard to Form 5471 a special IPU was designed and the issue whether the form is “substantially complete” is addressed (commencing page 17):
According to the IRS, the Form 5471 is not “substantially complete” if it is filed with any of the following errors on page 1 of the Form:
- Item B: If the “Category of filer” is omitted or incorrect, such that the required schedules to Form 5471 are missing or cannot be determined;
- Item 1a: If the “Name or address of foreign corporation” is omitted, such that other information provided on Form 5471 cannot be associated with a specific foreign corporation;
- Item C: If “the total percentage of the foreign corporation’s voting stock … owned at the end of its accounting period” is omitted (when no Item B category was indicated) or incorrect (when compared to the Item B category indicated), so the schedules to Form 5471 that are required to be completed cannot be determined;
- Items 1b(1) and 1b(2): “Reference ID number” under 1b(2) (only required for foreign corporation tax years beginning in 2012 and later) is omitted when the “Employer identification number” under 1b(2) is not provided, such that other information provided on Form 5471 cannot be associated with a specific foreign corporation; and
- Schedules required to be attached to Form 5471 are not included.
Other factors that can result in the Form 5471 failing to be “substantially complete”:
- Stating that required information will be furnished upon request or audit;
- Providing computer-generated Form 5471s that are not IRS-approved and not conforming with the requirements of the IRS form;
- Failing to provide financial statements for controlled foreign corporations;
- Providing consolidated financial statements of two or more foreign corporations;
- Providing required balance sheet and income statement amounts that are “not in accord with US Generally Accepted Accounting Principles (GAAP)”;
- Providing income statement and income tax amounts that are not in both functional and US currencies.
The IRS guidance also indicates that in determining if the Form is “substantially complete”, the benchmark will be examining compliance on a “significant item by significant item” basis rather than based on an “aggregate approach” (e.g., looking to whether the taxpayer provided more of the required information than not). In addition, a “facts and circumstances” analysis will be used for determining if the Form is “substantially complete” in contrast to a strict interpretation of the regulations that any over-reported or underreported transaction amount means the Form was “substantially incomplete.” The IRS will also look to whether the error was significant and whether the IRS’ ability to gather information necessary to conduct an effective examination was impacted by the error(s) made on the Form.
What Should You Do?
If you are planning to expatriate, make sure you can certify full tax compliance for the prescribed 5-year period. Hire a professional to carefully review your tax situation and all of your tax filings. Don’t guess! It’s a once-in-a-lifetime opportunity to do things right or, like Mr. Gerd Topsnik, pay the price later.
Follow me on Twitter: @VLJeker