With the heighted interest in U.S. connected people and businesses in offshore banking, it is important to understand the importance of properly to the Internal Revenue Service and various State taxing agencies of foreign bank accounts and investments.

The Federal income tax rules regarding those who have interest in any Passive Foreign Investment Company (“PFIC”) are complicated, to say the least.  However, it is important to have a basic understanding of PFIC treatment for income tax purposes so that a holder will be able to have an adequate dialogue with his or her tax and legal professional.  Full detail of the treatment of PFICs can be found in the United States Tax Code §§1291-1298; below are some very basic notes to summarize the law.

A foreign corporation is categorized as a Passive Foreign Investment Company when it passes either the “asset test” or the “income test,” both of which relate to passive income.  Passive income is different from the standard income produced by the operation of a business and generally includes (but is not limited to) dividends, interest, royalties, rents, annuities, and certain gains from property transactions, commodities trading, and foreign currency, with exceptions.  The asset test is passed when at least 50 percent of the assets produce or are intended to produce passive income.  The income test is passed when at least 75 percent of the gross income is passive income.  Shareholders of a PFIC must file a form 8621 with the Internal Revenue Service every year during which the person recognizes certain gains or distributions, or makes a certain “election” (discussed below). 

Making a QEF Election

It is almost always advantageous for a U.S. taxpayer to elect to treat the PFIC as a Qualified Electing Fund (QEF), which can be done by the first U.S. person who is a direct or indirect shareholder of the PFIC.  The election should be made by the shareholder’s due date for filing taxes for the year for which the election applies and it will remain active until revocation.    When a PFIC is treated as a QEF, the income or gains will be included in income and increase the PFIC stock basis, with the income treated as ordinary income and the capital gain treated as long-term capital gain.  Distribution of income that is currently or was previously recognized will be excluded from income but will reduce the PFIC stock basis; however, any excess distributions will be treated as a capital gain.

If a QEF is Not Elected

When a QEF is not elected, distributions are subject to taxation in the current year.  “Excess distributions,” which are those greater than 125 percent of the average annual distributions received in the preceding three years (or shorter time period if held for less than three years) are allocated pro rata to every day the taxpayer held the shares.  For those days in the current year, QEF is treated as ordinary gross income.  For the amount allocated to previous years the amount is subject to the highest rate of tax applicable for the taxpayer plus interest.

Making the QEF Election in Later Years

While a taxpayer can make a QEF election in later years, there are complicated rules associated with not having the QEF in place from the first year, since the PFIC will be subject to both sets of rules.  Fortunately, taxpayers have some options to help with the situation.  One option is to treat PFIC shares as if they were sold at the beginning of the QEF election and pay any deferred tax.  Another option is to treat the PFIC shares as if they actually where part of a QEF from the beginning, either by taxing them appropriately or by filing a “protective statement.”  Certain requirements must be met to take advantage of any of these options.  

Making a Mark-to-Market Election

If the PFIC stock is “marketable,” a defined term that basically requires it to be traded on certain listed systems or marketable under other listed circumstances, the shareholder can make the “mark-to-market” election and may include in his or her income the excess of the fair market value of the stock over the adjusted basis.  Alternatively, the taxpayer will be allowed a deduction which must be the lesser of: (a) any excess of the adjusted basis over the fair market value or; (b) the excess of the amount of gain included in his or her gross income for prior tax years over the amount allowed as a deduction for a loss in prior tax years.

A Note on Controlled Foreign Corporations

Some PFICs are also Controlled Foreign Corporations (CFCs), which are defined as foreign corporations controlled more than 50 percent by U.S. shareholders who each own at least 10% of the foreign corporation.  The Taxpayers Relief Act of 1997 helped to simplify the rules associated with PFICs that are also CFCs by making the PFIC not subject to certain CFC pass-through rules for those U.S. shareholders that own at least 10 percent.

It is imperative to remember that this is an oversimplification of the rules relating PFICs and there are many exceptions, qualifications and further requirements regarding most of the circumstances discussed.  Additionally, these rules are based on the U.S. tax code and discussion of California tax treatment was beyond the scope of this article as it differs from the federal treatment.

Should you have any questions regarding your interest or potential interest in a PFIC, feel free to contact the professionals at the Law Office of Stephen Moskowitz, LLP.

This is a two-part blog post on the evolution of IRS voluntary disclosure programs.  The first post traces these programs from their inception through the 1990's.  The second post discusses the programs beginning in 2000 and carrying through to the present day. 

Overview 

Since the Justice Department sued UBS in 2009, people with foreign bank accounts have become the targets of the IRS’s efforts to crack down on tax evasion.  Clients of the Union Bank of Switzerland (UBS) and the Liechtenstein Global Trust (LGT) are amongst those that have already provided information to the IRS, whether by choice or by force.  Many have learned that it is better to volunteer your information before the IRS finds you because the criminal and civil penalties can be very severe.  The IRS offered a Voluntary Disclosure Program in 2009 that awakened many to the reporting requirements of people with money in foreign financial institutions.  But while the program itself was new, the idea behind it was not.  Here is a brief history of the various policies and programs that the IRS has offered through the years.

Prior to 1952

 The Treasury Department had a formal policy prior to 1952 in which they would not recommend prosecution of any taxpayer that fully disclosed any tax fraud, so long as they disclosed it before any civil or criminal investigation against them had begun.  In the early 1950s, the formal policy was discontinued after congressional hearings concluded that there was corruption and laxity in enforcement.

1961

 The IRS announced a voluntary disclosure practice in 1961 in which a taxpayer that had disclosed information in a timely manner and prior to any IRS investigation would receive certain benefits.  Among other things, the IRS would consider the disclosure with the other facts in order to decide whether to recommend prosecution.  It did not go so far as to say that the IRS would guarantee not to prosecute the taxpayer; but in the vast majority of cases the government decided not to prosecute.  Also, Section 707 of the IRS’ Regional Counsel Enforcement Division Manual officially defined what it would consider timely.  According to their definition, “timely” meant that the information was communicated to the IRS when the IRS was not actively considering information which is virtually certain to lead to evidence that the taxpayer committed a tax crime.

1972

 In January of 1972 the immunity afforded previous tax evaders became less defined and the Treasury Department changed its voluntary disclosure policy.  They decided that voluntary disclosure of tax fraud to an appropriate IRS official before any investigation was no longer a basis for declining prosecution.  They did stipulate, however, that the fact that a taxpayer voluntarily tried to rectify a false return would be given weight.

1974

 The IRS withdrew Section 707 of the IRS’ Regional Counsel Enforcement Division Manual and redefined the term “voluntary”.  Previously it had an objective definition but it was replaced by a subjective standard, which not only took into consideration a taxpayer’s timeliness, but also their motivation.  A disclosure was not deemed voluntary if it was “triggered” by an outside event.  The vague natures of these definitions caused some confusion and, as a result, they have been constantly refined over the years.

The Early 1990’s

 Taxpayers in the early 1990’s had become afraid to voluntarily disclose information that they did not include on previous tax returns because of the uncertainty of the punishment.  In late 1992, IRS Commissioner Shirley Peterson confirmed that the IRS’ intention was to not recommend criminal persecution of non-filers who voluntarily disclosed their failure to file.  Essentially, her statement said that the IRS would not recommend criminal prosecution if the non-filer did all the following:

• informed the IRS that he or she had not filed one or more tax returns or did not disclose all sources of income
• only had income from legal sources
• made the disclosure before being contacted by the IRS
• filed true and correct tax returns and/or cooperated with the IRS in ascertaining his or her correct tax liability; and
• made full payment of the amount due or made arrangements to pay

In April of 1993 the Internal Revenue Manual was modified to coincide with the statements made by Peterson.  The certainty for taxpayers achieved by this change did not last long.  In 1995 the IRS again amended the Internal Revenue Manual and changed it back to the policy in effect prior to the Peterson Announcement.

 This is the second post of a two part series on the history of IRS's voluntary disclosure programs. This post outlines such programs from the early 2000's to present day.

2002

 On December 11, 2002, the IRS again redefined the word “timely” in connection with a voluntary disclosure in an effort to reduce the number of confused taxpayers.  The IRS decided they would consider a voluntary disclosure timely if they received the disclosure before they had initiated an investigation or examination, and before they had received information from a third party or another criminal enforcement agency concerning the specific taxpayer’s noncompliance.  In keeping with previous versions of the voluntary disclosure practice, the disclosure had to be truthful and complete, with the proceeds coming only from legal sources.

2003

 The next month, January of 2003, the IRS announced an amnesty program called the Offshore Voluntary Compliance Initiative (OCVI) for taxpayers who had failed to report foreign account income, and/or to file foreign account forms.  This was different than the update to the voluntary disclosure just one-month prior.  The major characteristics that differentiated this from other voluntary disclosure policies was that OCVI targeted a precise class of violator, negated exposure to certain civil tax penalties, and provided immunity from criminal tax prosecution.  It also provided protection against the foreign account reporting a penalty; a topic never addressed by other amnesty programs.  To qualify, the taxpayer could not be any of the following:

• Currently under civil examination or criminal investigation;
• Already known to the IRS to be noncompliant
• Had promoted or solicited others to participate in offshore noncompliance; and
• Had income from illegal activity or had participated in any illegal activity in connection with the offshore arrangements

This was a short-lived opportunity, ending only a few months later on April 15, 2003.  Although amnesty was no longer an option after this date, taxpayers continued to participate in the voluntary disclosure program put in place prior to the OCVI.

2009

 On March 26, 2009, the IRS announced a new program centered on Foreign Bank and Financial Accounts.  This is the most recent voluntary disclosure program that was discussed in the news in connection with UBS and LGT.  The program utilized the IRS voluntary disclosure practice previously set forth in the Internal Revenue Manual.  It was designed to be available until October 15, 2009.  The incentive was that criminal prosecution was eliminated and monetary penalties were reduced for a person who disclosed the existence of their foreign bank account.  The same qualifications that applied to the earlier versions of the voluntary disclosure program applied to this program (not to be confused with the OCVI). 
Today

 Although taxpayers that have not properly disclosed their foreign bank accounts can no longer qualify under the voluntary disclosure program that ended October 15, 2009, the voluntary disclosure program is alive and well.  It has been the experience of our tax law firm that in almost all cases that although the government could chose to criminally prosecute someone that has provided information under the voluntary disclosure program the government has instead in almost all cases after a careful review of all the evidence submitted has decided not to prosecute, which is the basic premise of the program, which is essentially correct what was done wrong, avoid criminal prosecution and pay, or make arrangements to pay a greatly reduced civil penalty. Seeking the protection of the voluntary disclosure program is a major decision and should be done properly.  We at the law firm of Stephen Moskowitz, LLP have many years of substantial experience with the voluntary disclosure program and what goes with it.  Let us explain to you how this program could relate to you, whether you have an unreported foreign bank account, or if you could be accused of other tax wrongdoing.  Call 415-394-7200 or email at steve@stevemoskowitz.com for your complimentary attorney client privileged consultation with the senior partner of our tax law firm.