Moving to a new country is no easy task. More often than not, aspiring immigrants have to go through a long and stressful process, with an uncertain outcome. They then have to deal with the logistics of moving to a new country. That usually involves figuring out housing, transportation, and what to do with all the stuff that’s gonna be left behind. After arriving, it’s time to get all needed documentation in place. Things like driver’s license, social security number, company onboarding paperwork, to name a few.
With so much on their plate, most people forget to consider one very important aspect when going through the immigration process: taxes. The United States has a series of tax laws and reporting requirements that, although not aimed directly at them, impact immigrants. This is especially true for not so young adults that move to the U.S. leaving behind assets in their home countries. What is unfortunate about all this is the fact that most people, including their accountants, are unaware of these requirements. They risk facing severe consequences for not being compliant.
I was one of these people. I moved to the U.S. in 2012, after a 10-year career in Brazil, leaving behind an active financial life. For three years I was oblivious to such laws and requirements. But that changed in 2015 when my then new CPA broke the news. What followed next was one of the most stressful years of my life.
Some Background
I had a lot going on back home when I took that one-way flight to the U.S: an incorporated business, a rental property, ownership on a family partnership my parents use to hold all their assets, several bank accounts, and a few investments.
The business and rental property were both generating decent income. I had no use for the extra money at the time and decided not to send it to the U.S. Instead, I kept investing the excess cash in my home country. I ended up with a mix of CDs, bonds, mutual funds, and savings accounts.
To further complicate things, I got married in 2014. She’s also from Brazil and moved to the U.S. shortly after our wedding. Like myself, she had a few foreign financial assets that she brought into our marriage.
Reality Sinks In
For the first couple of years, I had been using a one-person accounting firm to do my tax returns. They were not very sophisticated and never asked many questions. In 2014 though, after my CPA went AWOL, I switched to a new firm. They introduced me to one of their partners, who was specialized in foreign affairs.
Different than the other firm, they asked a lot of questions. They specifically wanted to know about our financial situation in our home country. Things like income, number of bank accounts, and types of investments. They even asked for a report of all of our trips to the U.S. in the prior three years. Once they got their answers, they sent me a quote for the job.
To my surprise, the number was pretty large. They said the reason for such a big price tag was due to “many international issues that may be present”. After some back and forth I decided to do some research on my own to better understand what they were talking about. That was when I realized how big of a hole I got myself into!
Getting the Facts Straight
As a U.S. person (aka U.S. tax resident), you must report and pay taxes on all income you make anywhere in the world. You must also, if you cross certain thresholds, disclose all your foreign financial assets to the IRS and the Department of Treasury. Not doing so could subject you to severe penalties and even criminal charges.
You are considered a U.S. person for tax purposes if you are a citizen, a permanent resident, or if you meet the Substantial Presence Test. This means that these rules also apply to people holding temporary, non-immigrant visas like the H-1B visa for example.
It turns out I did meet this test sometime in 2012 and became a U.S. person for tax purposes effective February 5th, 2012. From that date forward I had the same tax and reporting obligations as any American citizen and permanent resident. Except that I did not get the memo until it was too late.
Assessing the Damage
After a lot of research and back and forth with the accountants, we figured out everything I did wrong and the work needed to fix it. From unreported income to failing to comply with important reporting requirements, there was a lot to address, and the potential fines were pretty steep.
Unreported Income
Let’s start with the most obvious problem: unreported income. I was generating some pretty good income from my business, rental property, and investments in Brazil. So much so that in 2012 my foreign income was over 50% of my total income for the year. I totally did not report any of that income nor paid any taxes on them to the IRS. I had no idea I was required to do so after all.
As I later found out, the penalty for underreported income can be as much as 20% of the underpayment of the taxes owed on the underreported amount. You can also actually end up in jail! Don’t worry, such punishment is reserved for those deliberately committing tax fraud, which wasn’t the case here. On the other hand, the IRS can sometimes waive the penalties if you have a reasonable cause for such underreporting.
Failure to File FinCEN Form 114, aka FBAR
If you own or have signature authority over one or more financial accounts located outside the U.S. and the aggregate value exceeds $10,000 at any time during the year, you must disclose these accounts to the U.S. Department of Treasury. You do that by filing the FinCEN Form 114, also known as FBAR.
Those who fail to comply can face fines from $10,000 up to 50% of the value of each unreported account, per year. To make it even worse, filing delinquent FBARs late doesn’t necessarily get you off the hook for the penalties. This is definitely a form you don’t want to miss!
I had about 10 foreign financial accounts by the time I found out about this requirement and had failed to comply for 2 years. It doesn’t take a rocket scientist to figure out that the penalties could’ve easily wiped out those accounts and then some.
Failure to File FATCA Form 8938 – Statement of Specified Foreign Financial Assets
FATCA Form 8938 is similar to the FBAR in many aspects. If you own, or have signature authority, over one more financial asset located outside the U.S., you must disclose them by filling this form with the IRS. Note the term financial assets, instead of financial accounts. This includes ownership of foreign businesses.
On top of the 10 or so foreign financial accounts, I also had ownership of a couple of foreign businesses. Like with the FBAR, I should’ve had reported all of these accounts and the businesses for the prior 2 years. The penalty for failing to file this form is $10,000 per year.
Failure to File Form 8858 – Information Return of U.S. Persons With Respect to Foreign Disregarded Entities
Any U.S. person that owns directly, or indirectly, a Foreign Disregarded Entity (FDE) is required to file Form 8858. If you don’t, you face a penalty of $10,000 per report. Also, if you don’t file within 90 days of the IRS sending you a notice, you are charged an additional $10,000 penalty for every 30 days you remain non-compliant after the initial 90 day period, up to $50,000. Your foreign tax credits can also be reduced.
As I’ll explain later in this post, my business was an FDE and I remained non-compliant for 2 years. That would’ve added up to at least $20,000 in penalties.
The Dreaded PFIC
Not all income is created equal. A great example of this is income from foreign mutual funds. While U.S. domiciled mutual funds are pretty straight forward, the IRS treats foreign domiciled mutual funds as a whole different animal. One that you probably won’t wanna get too close to.
Without going into details, a foreign mutual fund is most likely considered a Passive Foreign Investment Company, or PFIC. Suffice to say that PFICs have their own set of compliance rules and can be very complicated to maintain. Failure to comply with these rules can be costly as the default tax treatment is very onerous.
I had shares in two fixed income mutual funds, both of which were considered PFICs. My foreign business actually owned these shares. This made the business itself also a PFIC. The family partnership I owned shares of was also a PFIC. That’s what I call a perfect storm.
Cleaning Up the Mess
I had many calls with the accountants and at some point, we also brought in a couple of different tax lawyers. We obviously had to clean up the issues from prior years but fixing things moving forward was also as important. The businesses were the things that would’ve kept causing me problems in the future. We decide to fix them first and only then worry about the tax and compliance problems from prior years.
My Own Business
Owning a foreign business is not really a problem. Lots of people do it. The problem with it is all the complex reporting requirements that come along. My specific case was even worse as the business was a PFIC, due to the large fixed income investment I had.
Luckily there was an easy way out. I first applied for an Employer Identification Number, or EIN, via form SS-4. With the EIN in hand, I then filed a Form 8832 requesting the business to be treated as a Disregarded Entity. To put it simply, this means that the business would not exist for tax purposes.
This election usually only applies for the current tax year and forward, but that’s where I got really lucky. The IRS has this thing called late classification relief where they allow businesses to file an election retroactively. You can do this within 3 years and 75 days of the effective date of the election. I filed 3 years and 54 days after my desired date!
Once the election was approved the PFIC classification went away, for good, and the reporting requirements became dramatically simpler.
Family Partnership
My ownership of the family partnership turned out to be a non-issue. I had only about 5% ownership at the time and no financial interest whatsoever in the business. I was just a nominee and because of that, I had no tax or reporting obligations regarding this business.
With that said, I disposed of all my shares anyways to avoid any possible problems in the future.
Unreported Income and Delinquent FBARs
To get things squared away with the IRS and the Department of Treasury, I had to amend my previous tax returns and include the unreported income, as well as file the delinquent FBARs. And of course, pay my back taxes, interest, and late payment penalties.
One option was to do just that. By amending my tax returns, filing the late FBARs, and paying the back taxes, interest, and late payment penalties, I could’ve potentially gotten away with not paying the hefty FBARs penalties as well as the other penalties. There was a problem though. I had no guarantee the government wouldn’t come after me and impose all the other penalties they were entitled to.
Given my specific circumstances and the potentially life-changing penalties I could’ve faced, the accountants, lawyers, and I decided not to roll the dice and go a different route. Enter the Streamlined Domestic Offshore Procedures.
Streamlined Domestic Offshore Procedures
The Streamlined Domestic Offshore Procedures (SDOP) are one of the Streamlined Filing Compliance Procedures (SFCP) designed to help taxpayers with unreported income from undisclosed foreign financial assets.
In simple terms, this program allows you to come forward and fix all tax and compliance issues related to foreign financial assets. You still need to pay your back taxes and interest though. The difference is that this program consolidates all penalties into a single, usually much smaller, penalty payment, called Title 26 Miscellaneous Offshore Penalty.
Keep in mind that you can only use this program if the failure to comply was due to non-willful conduct.
I worked with the accountants to amend my tax returns and complete the delinquent FBARs. It was a long, painfully complicated, and expensive process. I then retained a tax lawyer specialized in these procedures to prepare all the extra documentation. We put it all together, attached a couple of checks, and sent it away.
I haven’t heard a word from the IRS about it since, which is good news!
How Much Did All of This Cost?
The short answer is: A LOT!
There were two accountants and two lawyers involved and the process took about six months from start to finish. I spent about $17,000 in legal fees alone! If you add the penalty and interest, the total cost was just over $35,000. And that does NOT include the actual back tax payment, but I don’t consider that a cost as I should’ve paid it regardless.
It was very expensive climbing out of the hole but I’ll just go ahead and say it was worth it. Had I been the lucky one and the government decided to come after me, the FBAR penalties alone could’ve easily been upwards of $200,000! Now add to that a bunch of other penalties, interest and back taxes, plus the (small) possibility of criminal charges. Well, I’d call it a no-brainer.
What Happened Next?
I did not make many changes to my foreign assets for a few years after this whole ordeal was over. At the end of the day, all I had was legitimate and profitable. All I needed to do is comply with the laws and regulations, which I did, and still do.
At some point, I decided to divest from my home country. From about mid 2018 until late 2020 I slowly disposed of all my foreign investments, closed most of my bank accounts, and wired all the cash to the U.S. The only asset left is my business, which I still operate and will continue to operate for the foreseeable future.
After years of paying an expensive accounting firm to prepare my tax returns, I’m finally able to just do it on my own. TurboTax can handle most of it except for one form that I still have to manually prepare myself, but it’s straight forward. There’s a good chance I won’t even need to file an FBAR in 2021! I have to admit, it feels good.
Takeaway
Don’t be me!
If you are an immigrant living in the U.S. and you have assets, financial or otherwise, in your home country (or any other country for that matter), consult with a specialized tax professional. Make sure you comply with the tax laws and reporting requirements, if any. It becomes even more important if you have substantial foreign income and/or transfer money between the two countries with some frequency.
For those of you that are in the process of moving to the U.S. but still live in your home country, I strongly suggest you consult with a U.S. based tax professional before you hop on that flight. It might be in your best interest to make some financial moves before you become a U.S. person. I sure wish I had done that.
