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False return lawsuits spur IRS into action

Last August, CNBC reported an alarming form of identity theft that undoubtedly made U.S. taxpayers worried: tax refund fraud. According to a report released by the IRS inspector general, the government body had doled out billions of dollars in refunds to scam artists that had filed fraudulent returns under the names of unsuspecting citizens.

A false return may stop you
from getting your funds.

Such scams are reportedly commonplace, the source states, a fact that may be due to the short-staffed agency's negligence.

"Unfortunately, the IRS is not using information that it currently has, nor information that could be available to them," Inspector General J. Russell George told the media outlet.

George is not alone in that estimation. Last month, Tampa Bay Online reported that 16 individuals launched suits against the IRS over the matter. Because of the false returns filed in their names, the taxpayers were unable to collect the money the IRS legally owed them.

Regardless of whether the IRS fraud could have been detected and prevented by the agency beforehand, the plaintiffs, all represented by a  Florida attorney, have voiced their frustration with how they've been treated by the IRS in the aftermath.

The local news outlet reported that "they get the runaround from the IRS. They make promises that are not kept," and  "They're told it will take 60 days. Nothing happens. Then they call back and are put off again."

It appears that there have been repeated attempts to file a class-action suit against the financial body on behalf of identity theft victims still awaiting their refunds. However, his efforts have deflated by a recurring event: Once the plaintiffs take legal action against the entity, they receive their refunds shortly after filing.

Tax attorneys have the specific experience necessary for navigating the IRS within this legislative minefield, and can prove to be invaluable asset for those seeking recompense from the IRS.

As a tax attorney with over 30 years of experience, Steve Moskowitz says "usually the IRS is very good about routine administrative matters, though I haven’t reviewed the pleadings in this case, I am a little surprised that the taxpayers have had to resort to such measures in order to obtain their tax refunds. Further, my law firm, Moskowitz LLP, a tax law firm based in San Francisco has been watching the Department of Justice’s tax prosecutions of various tax frauds closely. I'd bet that the IRS has learned a lot from prosecuting these cases and will make adjustments to their security protocols."     

Tax attorneys have been specifically trained to navigate the bureaucracy within this legislative minefield, and can prove to be invaluable asset for those seeking recompense from the IRS.

Just how is the Expatriation Tax Calculated?

Introduction

It has been all over the news lately, wealthy U.S. taxpayers, such as, Eduardo Saverin (a Facebook founder), Denise Rich (songwriter), and another eighteen hundred, or so, have forfeited their U.S. citizenship for U.S. tax reasons.    Federal law provides that some U.S. taxpayers who elect to renounce their U.S. citizenship must pay a so-called federal exit tax or expatriation tax. The computation of this tax is incredibly complex. Only by reviewing the originally enacted expatriation tax in 1966 and the intervening modifications to the expatriation tax law over a four decade period can one begin to understand how to properly compute the so-called “exit tax” regime.

In our International Tax Practice, we have found individuals seeking to learn how the Exit Tax came to be and some of the considerations commonly sought.   This article provides an overview of the federal law governing expatriation tax and the modifications to the law over the past four decades.

The Original Expatriation Tax Provision as Defined by the Foreign Investors Tax Act of 1966

The expatriation tax was introduced to U.S. tax law by the Foreign Investors Tax Act of 1966 (“FITA”). FITA introduced Sections 877, 2107, and 2501 to the Internal Revenue Code.

Section 877 imposed a tax, calculated at higher rates applicable to nonresidents who were not former U.S. citizens or at the rates applicable to U.S. citizens, on the U.S. source income of former citizens who expatriated for a principal purpose of tax avoidance for 10 years following expatriation. In order to correctly determine an individual’s expatriation tax rate, it was necessary to make two calculations known as the “alternative tax” regime.

U.S. source income for purposes of FITA was defined to include gains from the sale of exchange of property (other than stock or debt obligations) located in the U.S. as well as gains from the sale or exchange of stock or debt obligations issued by a domestic corporation or U.S. person. In addition, gains from the sale or exchange of property having a basis determined by reference to such property, in whole or in part was treated as U.S. source income for a 10 year period in order to capture gains from non-U.S. property.

Under Section 2107, added by FITA, if an expatriate subject to the alternative tax regime of Section 877 died within 10 years following expatriation, his or her U.S. estate was assessed the expatriation tax. The expatriation tax was also assessed shares held at the death of the individual comprising a 10 percent or greater direct or indirect interest in a foreign corporation considered to be owned by more than 50 percent by the decedent, directly, indirectly, or constructively, in portion to the foreign corporation’s underlying U.S. situated property. In addition, Section 2501(a)(3) was enacted by FITA. Section 2501(a)(3) provided that the normal gift tax exclusion did not apply for gifts made within 10 year period of expatriation.

For purposes of the expatriation tax, if the IRS was able to establish that it was reasonable to believe that a U.S. citizen expatriated with a principal purpose of tax avoidance, the burden of proof on this matter was placed on the expatriate or his estate to prove otherwise.

Amendments Made to the Expatriation Tax through Health Insurance Portability and Accountability Act of 1996

In 1996, Congress enacted changes to the rules governing expatriation tax through the Health Insurance Portability and Accountability Act (“HIPAA”). Under this act, the category of “covered expatriates” was expanded to include “long-term resident aliens,” defined as “lawful permanent residents” (green card holders) residents for expatriation tax purposes if the individual was a resident in the U.S. in eight of the prior 15 tax years. For purposes of HIPAA, expatriation was considered to have occurred at date stated for citizens under U.S. immigration law (the date of an expatriation act) and for long-term residents under tax residency rules.

HIPPA also introduced the notion of “presumptive tax avoidance purpose” based on a number of economic factors that pertained to the taxpayer seeking to expatriate. A tax avoidance motive was presumed if an individual’s net average U.S. income tax liability in the 5 years preceding expatriation was $100,000 or more (“income tax liability test”) or if his net worth at expatriation exceeded $500,000 (“net worth test”).

In addition, HIPAA significantly enlarged the categories of income considered to be U.S. source income. For example, income and gains derived from former controlled foreign corporations (“CFC”) were considered controlled by an expatriate if held within two years prior to expatriation and were considered to be U.S. source income for tax purposes.

Finally, HIPAA expanded federal tax law to require an expatriating U.S. citizen to provide an information statement, including a statement of net worth, to the Department of State when applying for expatriation.

The Impact of the American Jobs Creation Act of 2004 on the Expatriation Regime

The American Jobs Creation Act of 2004 (AJCA) adopted a number of changes to the tax laws governing expatriation. The AJCA removed the requirement that an individual have a principal tax avoidance purpose and changed the income tax liability test. The income tax liability test threshold was changed to “greater than” $124,000 (indexed annually), the net worth test standard was increased significantly to $2,000,000 (not indexed). In addition, the AJCA added a third test which provided that an expatriate certify that he has fully complied with all U.S. tax requirements for the five years preceding expatriation.

The AJCA also amended the expatriation gift tax rules to add a provision which imposes tax on gifts of a foreign corporation owned by the expatriating taxpayer ten years subsequent to the expatriation period.

In addition, AJCA added Section 7701(n) to the Internal Revenue Code which provides that an individual will continue to be treated as a U.S. citizen or long-term resident until he both gives notice of his expatriation to the Department of Secretary or Department of Homeland Security, and furnishes an information statement. Furthermore, the AJCA increased the information reporting rules requiring that an expatriate file an annual information statement for each of the ten post-expatriation years regardless of whether the expatriate had any U.S. source income for each year at issue. Expatriating taxpayers were now required to Form 8854 advising the Government of his or assets.

Finally, the AJCA added a new residency classification to the expatriation taxing regime. Under this new rule, an individual who has expatriated will suffer U.S. worldwide income tax if he or she is physically present in the U.S. for more than 30 days during any of the ten years preceding expatriation. Typically, a non-resident alien is permitted an average of 121 U.S. days per year without becoming a U.S. tax resident.

The Heroes Earning Assistance and Relief Tax Act of 2008 and the Impact of this act on Expatriation Taxation

Prior to Section 301 of the Heroes Earning Assistance and Relief Tax Act of 2008 (“HEART Act”), expatriates generally were subject to a ten year “alternative tax” regime on U.S. source income as discussed in FITA.

Section 877A replaces the former alternative tax regime on U.S. source income of “covered expatriates” with a mark-to-market tax on gains in excess of $600,000 (indexed for 2012 to $651,000) from a deemed sale of an individual’s worldwide assets on the day prior to the individual’s expatriation date. The term “covered expatriate” includes individuals who renounce or relinquish U.S. nationality or terminate their status as long-term permanent residents (i.e. green card holders for at least eight of the 15 taxable preceding expatriation) and whose average net income tax liability for the five years preceding exceeds $124,000 indexed for inflation (for persons expatriating in 2012, $151,000) 1 or whose net worth at the date of expatriation equals or exceeds $2 million (not indexed).

Under the provision, a covered expatriate can irrevocably elect, on an asset by asset basis, to deter the payment of the mark-to-mark tax attributable to an asset until the due date of the return in which such property is sold or exchanged. In order to make the election, a taxpayer must provide “adequate security” (including a bond conditioned on the payment of tax and interest) and irrevocably waive the benefit of any U.S. tax treaty that would preclude assessment of tax. The election will terminate as to any property not sold or exchanged when a taxpayer dies or when the IRS determines that security is no longer adequate. In addition, certain property, including deferred compensation items, “specified tax deferred accounts,” such as individual retirement accounts and health savings accounts are exempted from the mark-to-market tax.

Expatriation date is defined to mean the date that a citizen relinquishes U.S. nationality or a long-term resident alien ceases to be a lawful permanent resident. A citizen is considered to have relinquished U.S. citizenship at the earliest of the dates: 1) he renounces his nationality before a U.S. diplomatic or consular officer; 2) he provides a statement of voluntary relinquishment to the Department of State; 3) the Department of State issues the individual a Certificate of Loss of Nationality; or 4) a U.S. court cancels a naturalized citizen’s certificate of naturalization.

Finally, for purposes of the mark-to-market taxing regime, all nonrecognition deferrals and extensions of time for the payment of tax are considered terminated the day before expatriation.

The HEART Act added Section 2801 to the Internal Revenue Code. Section 2801 imposes a tax, at the highest applicable gift or estate tax rates on the receipt by a U.S. person of a “covered gift or bequest,” which is defined as a direct or indirect gift or bequest from a “covered expatriate” within the meaning of Internal Revenue Code Section 877A. The tax is assessed on, and intended to be paid by, the recipient of a covered gift or bequest. The succession tax will be reduced by any foreign gift or estate tax paid. The new succession tax does not apply to gifts covered by the annual exclusion of Section 2503(b), currently at $13,000 per done per annum. It also does not apply to gift or bequests entitled to a marital or charitable deduction.

Conclusion

Over the past four decades, the expatriation tax has evolved into an extremely complex taxing regime. In 2009, the Treasury and the Internal Revenue Service (IRS) promulgated Notice 2009-85 to provide limited guidance to determine an expatriating individual’s tax liability. Unfortunately, the Notice fails to provide any meaningful guidance regarding Section 877 and 2801. The failure to provide meaningful guidance in regards to the expatriation tax. This failure only makes determining the proper the expatriate tax more difficult than is necessary which can result in disastrous consequences. This is because the failure to properly compute an expatriation tax may result in a bar of re-entry of former citizens who to the U.S.

In 1996, the so-called “Reed amendment” was enacted as part of the Illegal Immigration Reform and Immigration Responsibility Act. Because of a number of statutory defects, the Reed Act has never been enforced. 2 Even though the statutory language of the Reed amendment may be flawed, The Department of Homeland Security has been working to develop regulations to implement the Reed amendment. If this project is to move forward, former citizens or long-term residents could discover that their re-entry to the U.S. is bared if they fail to fully comply with their expatriation tax obligations. Given the current climate Washington regarding individuals seeking to expatriate from the U.S. for tax purposes, it is not to difficult to imagine regulations being promulgated by the Department of Homeland Security barring ex-citizens from re-entering the U.S. for failing to comply with their expatriation tax obligations. This could disastrous for former citizens with families and economic interests in the U.S.

Given the foreseeable consequences of failing to properly compute an expatriation tax, individuals considering repatriation should consult with a tax attorney to determine how the exit tax will impact them.    We welcome your feedback and questions regarding this article and your tax questions.    You can learn more about our firm at www.moskowitzllp.com or by calling our firm (415) 394-7200. 

  1. Rev. Proc. 2011-52, 2011-45.
  2. The Reed amendment has the following statutory flaws: 1) it is unclear from the language of the statute if it encompasses all acts of expatriation; 2) it is uncertain if the Reed amendment violates the Constitutional Due Process rights of certain former citizens by barring them from reentering into the U.S.


Moskowitz LLP, A Tax Law Firm, Disclaimer:   Because of the generality of this blog post, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.   Prior results do not guarantee a similar outcome.   Furthermore, in accordance with Treasury Regulation Circular 230, we inform you that any tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purposes of (i) avoiding tax related penalties under the Internal Revenue Code, or (ii.) promoting, marketing, or recommending to another party any tax related matter addressed herein.

Also see, No Easy Exit: The U.S. Expatriation Tax

U.S. Tax Effects of Treaties in the Context of Foreign Investment in the U.S.

Introduction

Foreign investors in the U.S. tend to have the same goals as their U.S. counterparts. Like U.S. taxpayers, foreign investors seek to minimize their income tax liabilities associated with their U.S. real estate and business investments. However, foreign investor’s objectives are clouded by the fact that they are not U.S. persons for tax purposes. In addition, foreign investor’s objectives may be complicated by income taxes of their home countries. Furthermore, the U.S. has a special income tax regime that is applicable to foreign persons. Specifically, if a non-U.S. person derives certain types of passive income, it is typically taxed at a flat 30 percent rate (without an allowance for deductions), unless an applicable tax treaty reduces this rate. On the other hand, if the U.S. activities of the foreign person rise to the level of constituting a “U.S. trade or business,” the foreign person will be taxed much like a U.S. person. This article addresses how tax treaties may be utilized to reduce a foreign person’s global tax liability. This article also addresses the recent developments in tax treaties. As an example of whether U.S. income taxation of a foreign investor would be impacted by a U.S. Income Tax Treaty, we shall address whether a foreign investor could utilize the U.S.-Hungarian Income Tax Treaty or the U.S.-Polish Tax Treaty.

U.S. Taxation of Foreign Persons

Two different U.S. tax regimes apply to non-U.S. taxpayers. First, non-residents engaged in a trade or business in the U.S. are taxed on income that is effectively connected with a trade or business. Such income is taxed at applicable graduated U.S. individual rates. A different tax regime applies to income that is not effectively connected with a trade or business in the U.S. Under this regime, a flat 30 percent tax is imposed on U.S. source fixed or determinable annual or periodic income such as (interest, dividend, rents, annuities, and other types of “fixed or determinable annual or periodical income,” collectively known as FDAP income). This tax is imposed on gross income, with no deductions allowed. In general, this tax is collected by withholding. The 30 percent tax may be reduced or eliminated by bilateral income tax treaties to which the U.S. is a party.

Impact of Tax Treaties

Even though the statutory rate of withholding on U.S. source payments of FDAP income to a foreign person is 30 percent, for the most part, income tax treaties will reduce and in some cases eliminate the U.S. withholding on FDAP income. For a non-U.S. taxpayer to be eligible for treaty benefits, the individual generally must be considered a “resident” of a particular treaty jurisdiction and must satisfy a so-called “limitation on benefits” (LOB) provision in the treaty. Under most U.S. income tax treaties, a foreign person will be considered a resident for treaty purposes if such person is “liable to tax therein by reason of its domicile, residence, citizenship, place of management, place of incorporation, or any other criterion of similar nature.” 1

Under most “modern” income tax treaties, a resident of a treaty country will satisfy the LOB provision if that resident is an individual, or a corporation that is at least 50 percent owned by citizens or residents of the U.S. or by residents of the jurisdiction where the corporation is formed and not more than 50 percent of the gross income of the foreign corporation is paid or accrued, in the form of deductible payments, to persons who are neither citizens nor residents of the U.S. or residents of the jurisdiction where the corporation is formed. However, in many cases, there is no such residency requirements under older income tax treaties in which the U.S. has negotiated with foreign countries.

U.S. Tax Planning Opportunities Utilizing Income Tax Treaties Without LOB Provisions Prior to the 2012 Calendar Year

Currently, it is the policy of the U.S. to include a LOB provision when negotiating a new tax treaty. With that said, certain older income tax treaties do not contain LOB provisions. As of the 2011 calendar year, the income tax treaties with foreign countries in which the U.S. did not contain LOB provisions where: 1) Egypt; 2) Greece; 3) Hungary; 4) Korea; 5) Morocco; 6) Pakistan; 7) the Philippines; 8) Poland; 9) Romania; and the former U.S.S.R. (which now applies to Armenia, Azerbaijan, Belarus, Georgia, Krgyztan, Moldova, Tajikstan, Turkmenistan, and Uzbekistan. The benefits of these treaties were to reduce the rates for U.S. income tax purposes. For example, the U.S. treaties with Egypt, Hungary, and Poland reduce the withholding rate on payments of U.S. source dividends to as low as five percent for federal income tax purposes. In addition, the treaties with Greece, Hungary, and Pakistan completely eliminate the U.S. withholding tax on payments of U.S. source royalties. The combination of these reduced withholding rates, coupled with favorable local tax benefits in some of the foreign jurisdictions, provided significant worldwide tax benefits to a U.S. inbound foreign investors.

Repatriating U.S. Profits to a Foreign Jurisdiction Utilizing Global Treaties to Minimize Worldwide Tax Liabilities

As discussed above, payments of U.S. source dividends to a foreign corporation are generally subject to a 30 percent federal withholding tax. While many treaties reduce or eliminate this withholding rate, not all U.S. foreign investors are residents to qualify for a treaty that provides for these reduced rates. These foreign individuals may utilize a strategy of establishing a company in a jurisdiction with a treaty with the U.S. that has no LOB provision and provides for a reduction in the U.S. withholding tax.

For example, prior to the 2012 calendar year, instead of a Bermuda resident investing directly in a U.S. corporation, the Bermuda resident was able to invest in the U.S. through a Hungarian corporation. Using this approach, a dividend paid from the U.S. would only be subject to a five percent U.S. federal withholding tax and the dividend received in Hungary would be completely exempt from Hungarian corporate income tax as a result of its favorable participation exemption.2 Moreover, a dividend paid out of Hungary could be completely exempt from Hungarian withholding tax.3 Since US-Hungary tax treaty entered into force on September 18, 1979 contained no LOB provisions, just about any non-U.S. person, regardless of residence eligible to take advantage of this structure. Prior to the 2012 calendar year, because of the favorable provisions in the US-Hungary tax treaty, foreign investors often utilized a Hungarian corporation as a vehicle to invest in the U.S.

Not only did foreign investors utilize the Hungarian-U.S. treaty to limit their exposure to taxes on FDAP gains, foreign investors often utilized the Hungarian-U.S. treaty to limit their exposure to gains realized from the disposition of real property. In order to better understand how foreign investors utilized the Hungarian-U.S. treaty to limit their exposure to U.S. tax on gains from real property transactions, we will first discuss the U.S. tax implications of foreign investors in the U.S. real estate market.

Foreign persons are typically not subject to U.S. income tax on U.S. source capital gains unless the gains are effectively connected to a U.S. trade or business.4 However, the Internal Revenue Code treats any gain realized by a foreign person on the disposition of a U.S. real property interest (“USRPI”) as if it were effectively connected to a U.S. trade or business. A USRPI is broadly defined by the Internal Revenue Code as: 1) a direct interest in real property located in the U.S. and 2) an interest (other than an interest solely as a creditor) in any U.S. corporation that constitutes a U.S. real property holding corporation (a corporation whose USRPIs make up at least 50 percent of the total value of the corporation’s real property interests and business assets).5

The regulations promulgated under Internal Revenue Code Section 897 provide an example as follows: “a foreign corporation lends $1 million to a domestic individual, secured by a mortgage on residential real property purchased with the loan proceeds. Under the loan agreement, the foreign corporate lender will receive fixed monthly payments from the domestic borrower, constituting repayment of principal plus interest at a fixed rate, and a percentage of the appreciation in the value of the real property at the time the loan is retired. The example states that, because of the foreign lender’s right to share in the appreciation in the value of the real property, the debt obligation gives the foreign lender an interest in the real property “other than solely as a creditor.” The example concludes that Section 897 will not apply to the foreign lender on the receipt of either the monthly or the final payments because these payments are considered to consist solely of principal and interest for U.S. income tax purposes.6

Therefore, the example stated in the Treasury Regulations concludes that the final appreciation payment that is tied to the gain from the sale of the U.S. real property does not result in a disposition of a USRPI for the purposes of Section 897 of the Internal Revenue Code because the amount is considered to be interest rather than gain under Internal Revenue Code Section 1001.

By characterizing a contingent payment on a debt instrument as interest for U.S. income tax purposes, the Income Tax Regulations promulgated under Internal Revenue Code Section 897 may permit non U.S. taxpayers to avoid U.S. income tax on gain arising from the sale of U.S. real estate. As such, a non U.S. individual could lend money from a company established in a jurisdiction such that has a treaty with the U.S. with no LOB provisions such as Hungary and have that interest on the loan tied to gain on the sale of the property. The interest that was tied to the gain of the sale of the real property was completely exempt from U.S. income tax under an applicable Hungarian-U.S. income tax treaty.

However, Hungary had a 16 percent corporate tax rate. In order to reduce this tax, foreign investors would establish a “financial branch” in a “low-tax” jurisdiction. Hungary has tax treaties with Switzerland and Luxembourg. Both these jurisdictions have a very favorable branch taxing regime. Consequently, investors utilizing the Hungarian-U.S. tax treaty to minimize U.S. taxes would register a branch in either Switzerland or Luxembourg. A finance branch registered in either of these two jurisdictions reduced the effective tax rate on interest income to as low as two percent. Therefore, by having a Hungarian corporation own a finance branch in either Switzerland or Luxembourg and by allocating loans and interest from those loans to such a financial branch, rather than to the Hungarian company directly, the foreign income tax imposed on the receipt of interest income was reduced significantly.

Under the above discussed financial structure, any income received by a foreign financial branch in either Switzerland or Luxembourg was exempt from corporate income tax in the jurisdiction of the corporation’s home country under respective income tax treaties.7

The benefit of the previous treaty with Hungary entered into force on September 18, 1979 was that it the treaty contained no “anti-triangular” provisions in the income tax treaties. Typically, an “anti-triangular” typically prevents a non U.S. taxpayer from utilizing treaty benefits if the income tax benefit received is attributed to a establishment located in a third jurisdiction and the combined tax rate of both jurisdictions is lower than the U.S. tax rate.

Recent Developments Regarding the Tax Treaty with Hungary

Recently, the U.S. entered into a new bilateral tax treaty with Hungary. The new treaty includes the LOB provision that is included in many other treaties entered into by the U.S. The inclusion of limitations on benefit provisions significantly eliminates the use of Hungary as a treaty shopping jurisdiction. It is no longer possible to place a Hungarian corporation between the U.S. and a third low tax country in order to significantly diminish global tax obligations. With the adoption of the new tax treaty with Hungary, foreign investors’ ability to treaty shop for international tax planning is limited further and very few opportunities now exist for planning in this context. Although the newly negotiated bilateral U.S.-Hungarian tax treaty is a blow to foreign investors, other opportunities still exist. The remaining countries with tax treaties with the U.S. that do not include limitations on benefits rules are Poland, Greece, the Philippines, Romania, and certain countries of the former U.S.S.R.

We started this article discussing how foreign investors were taking advantage of the U.S.- Hungarian tax treaty to reduce the U.S. income tax liability on gains from U.S. source dividends. Even though it is no longer possible to take advantage of the bilateral U.S.- Hungarian tax treaty to reduce taxes on U.S. source dividend gains, a similar type of plan can still be achieved through the use of a Polish corporation. The U.S.-Polish treaty currently provides for a five percent withholding rate on U.S. source dividends.8 Dividends can then be repatriated out of Poland tax-free to a branch office located in a legal European tax haven jurisdiction such as the island country of Cyprus. Cyprus may be an excellent jurisdiction to repatriate funds out of Poland to due to the fact that the jurisdiction has no withholding tax on dividends.

We also discussed how foreign investors were utilizing the U.S.-Hungarian bilateral treaty to reduce their exposure to U.S. taxes resulting from the gains in real estate. Although foreign investors can no longer take advantage of the U.S.-Hungarian tax treaty to reduce their exposure to U.S. taxes on gains in real estate holdings, the current bilateral U.S.-Polish treaty provides similar benefits to foreign investors as the now defunct U.S.- Hungarian bilateral tax treaty enacted in 1979. For example, suppose a foreign investor realizes a gain on a debt instrument on real property classified as interest under Section 897 of Internal Revenue Code. Like with the previous bilateral U.S.- Hungarian tax treaty, under current U.S.-Polish tax treaty, the foreign investor can lend money from a Polish company and have the gain of the real property completely exempt from U.S. income tax.

As discussed above, the Income Tax Regulations provide that a foreign person can utilize a foreign corporation to lend money to a U.S. individual without realizing taxable gain of a USRPI for purposes of Section 897. Under the U.S.-Polish bilateral treaty, a foreign investor can establish a Polish corporation to lend money to a U.S. individual holding real property. The Polish corporation could secure a mortgage on the U.S. property. Under the loan agreement, the Polish corporate lender would receive fixed monthly payments from the domestic borrower, constituting repayment of the principal plus interest, and a percentage of any appreciation in the value of the real property at the expiration of the loan. The Income Tax Regulations of Section 897 potentially allow a foreign investor to lend money from a company formed in Poland and completely exclude the gain on the real property from U.S. income tax.

In addition, if the transaction is property arranged, the foreign investor could mitigate or avoid Polish corporate income tax which currently has a corporate tax rate of 19 percent. In order to mitigate Polish corporate tax, a “finance branch” may be established in low-tax third party jurisdiction. Poland has bilateral tax treaties with Switzerland, Luxembourg and the United Arab Emirates. These jurisdictions have a very favorable branch taxing regime. Consequently, a “finance branch” could be registered in either of these countries to reduce the effective tax rate on the gains from U.S. real estate activities to a marginal tax rate of less than two percent.9

Under such planning, any income derived by the “finance branch” is exempt from Polish corporate tax under the respective tax treaty. Unlike many newer bilateral income tax treaties with other jurisdictions (including the recent treaty with Hungary), the bilateral U.S. treaty with Poland has no “anti-triangular” provisions. In general, the purpose of this provision is to prevent non-U.S. taxpayers from claiming treaty benefits if the income received by the non-U.S. treaty party is attributed to a permanent establishment in a third jurisdiction.

Conclusion

As the result of favorable world-wide income tax treaties, foreign investors in the U.S. may be able to arrange their business transactions in the U.S. without realizing any U.S. tax liability. The transaction may also be planned to significantly reduce global income taxes. Particular attention must be paid to both the tax treaties of different countries and also the additional tax savings in planning the use of multiple tax treaties and multiple entities to legally avoid the taxes that would otherwise be paid.

To better understand this intricate area of tax law, consult with a tax attorney at Moskowitz, LLP by calling (415) 394-7200 or via our Tax Law Firm’s website.

  1. Article 4(1) of the U.S.-Netherlands Income Tax Treaty.
  2. In general, all dividends received by a Hungarian corporation will be exempt from corporate income tax unless the paying corporation is a “controlled foreign corporation” (CFC), as that term is defined for Hungarian tax purposes. A CFC is defined in Hungary as a foreign corporation that is subject to an effective tax rate below 10.67 percent (which is 2/3 of the 16 percent Hungarian corporate tax rate), unless that foreign corporation has a real economic presence in the jurisdiction.
  3. The exemption from withholding tax on dividends out of Hungary applies only if the recipient is a corporation. Therefore, the individual can own the shares of the Hungarian corporation through a low-tax jurisdiction, such as the British Virgin Islands or the Cayman Islands.
  4. IRC Section 871(a)(2).
  5. IRC Section 897(c)(2).
  6. Treas. Reg. Section 1.897-1(h).
  7. See Article 23(1)(a) of the Hungary-Switzerland Income Tax Treaty; Article 24(1)(a) of the Hungary-Luxembourg Income tax Treaty.
  8. Poland currently has a 19 percent corporate income tax rate. Poland grants a foreign tax credit for foreign taxes paid as long as the Polish corporation owns at least 75 percent of the U.S. corporation.
  9. See Article 23(1)(a) of the Poland-Switzerland Income Tax Treaty; Article 24(2)(a) of the Poland-Luxembourg Income Tax Treaty; and Article 24(1)(a) of the Poland-UAE Income Tax Treaty.

Moskowitz LLP, A Tax Law Firm, Disclaimer: Because of the generality of this blog post, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations. Prior results do not guarantee a similar outcome. Furthermore, in accordance with Treasury Regulation Circular 230, we inform you that any tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purposes of (i) avoiding tax related penalties under the Internal Revenue Code, or (ii.) promoting, marketing, or recommending to another party any tax related matter addressed herein.

Are you eligible for federal employment if you owe taxes?

Legislation Pending to Require Higher Tax Accountability for Federal Employees

On July 31, 2012, the United States House of Representatives passed H.R. 828, also known as the “Federal Employee Tax Accountability Act of 2012”, by a majority of 263 to 114.  It has since been referred to the United States Senate where it has been read twice and further referred to the Committee on Homeland Security and Governmental Affairs.


The bill, if enacted, looks to limit eligibility of delinquent taxpayers to be employed by the federal government, including delinquent taxpayers that are discernible as those taxpayers who have an outstanding tax debt and have had a notice of lien filed against them in public record.  This includes both those seeking employment and those currently employed by an “agency” as defined in § 7381 (3) of the bill to include Executive Agencies, United States Postal Service, the Postal Regulatory Commission and employing authorities in the legislative branch.  The bill allows for exceptions, some of which are:

  • Debts being paid in accordance to a payment arrangement or offer-in-compromise
  • Debts which currently have a collection due process hearing or relief, requested or pending
  • Debts granted relief

These exceptions, along with the fact that several members of Congress have, or have had, delinquent tax problems, exemplify what I have advised people for decades:

The taxing authorities of the United States understand that certain life events happen that create a situation where an individual or business owes a tax they cannot pay.    The Internal Revenue Service is not in the business of making life more difficult for those who are remedying the situation and do not consciously or routinely shirk their tax payment obligations.

What this bill does aim to do is add corollary consequences (employment) for those who are shirking their tax payment duties.  These corollary consequences are in addition to civil and criminal consequences provided for by the U.S. Tax Code and IRS regulations.  

While this bill has not yet been enacted, persons with tax debt currently employed by a United States Government agency or seeking to be employed by a government agency should examine options available to settle any tax liability.  Meeting with a tax attorney can illuminate the best path forward to manage tax obligations.

We strongly encourage taxpayers to learn your rights and solutions to your tax debt problems. You can learn more information about tax debt collection resolution and other tax related information on our website or call us for more information. 


Moskowitz LLP, A Tax Law Firm, Disclaimer:   Because of the generality of this blog post, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.   Prior results do not guarantee a similar outcome.   Furthermore, in accordance with Treasury Regulation Circular 230, we inform you that any tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purposes of (i) avoiding tax related penalties under the Internal Revenue Code, or (ii.) promoting, marketing, or recommending to another party any tax related matter addressed herein.

 

Non-Citizens Risk Immigration Status for Offshore Bank Accounts

The increased focus by the IRS on foreign income has generated a lot of news and a slew of criminal prosecutions.  While US citizens need to consider the possibility of monetary penalties or a long prison sentence, resident non-citizens (green card holders) also need to worry about the possibility of being deported after they serve their prison sentence and are stripped of their assets.  What is required of resident non-citizens and what are the consequences for failing to disclose offshore accounts and foreign interest income?

All “United States persons,” including green card holders, are compelled to report all their global income, including interest income earned in foreign bank and financial accounts, to the Internal Revenue Service.  According to the general definition in Internal Revenue Code Section 7701(a)(30), both United States citizens and non-citizen residents qualify as “United States persons”.  The international portion of a “United States person’s” income is required to be reported on the following forms:   See Offshore & Foreign Compliance

Form 1040, Schedule B, Part III

This form contains three yes/no questions you must answer regarding any foreign accounts and trusts that you have an interest in and directs you to two additional forms to complete, Form TD F 90-22.1 for foreign accounts and Form 3520 for foreign trusts.  In the event that you are required to file Form TD F 90-22.1, you must also report on Form 1040, Schedule B, Part III where the financial account(s) are located.

Form TD F 90-22.1

The Report of Foreign Bank and Financial Accounts, also known as the FBAR, is required when the total value of foreign financial accounts held is in excess of $10,000 USD at any time within the calendar year.  This includes accounts in which you had signature authority but not an ownership interest.  The form is filed separately from your tax return and reported to the Department of the Treasury.

Form 3520

A separate Form 3520 is required to be filed with your tax return for each qualifying foreign trust transaction or qualifying foreign gift received.  Examples of qualifying transactions include distributions received from foreign trusts and gifts of more than $100,000 from nonresident alien individuals or foreign estates.  A full list of qualifying transactions and exceptions can be found in the Form 3520 instructions.

Form 8938

In tax years beginning after March 18,2010 (for most this is their 2011 filing), “United States persons” meeting the asset thresholds are also required to file the new Statement of Specified Foreign Financial Assets (Form 8938).  For unmarried and married persons filing separately that reside in the U.S. the threshold is $75,000USD at any point during the year or $50,000USD at the end of the tax year.  Married persons residing in the U.S. filing a joint return are required to file this form when their total foreign financial assets exceeds $150,000USD at any point in the year or $100,000USD on the last day of the tax year.  Full filing requirements including exceptions and qualifying assets can be obtained through the Form 8938 instructions.

Failure to file any forms required to disclose the existence of any offshore financial accounts or any income acquired from said foreign financial accounts opens a “United States person” to the possibility for Criminal Tax Crimes and criminal penalties as well as Civil Tax Assessments and penalties.

Filing a False Tax Return

If an individual is proven by the IRS or Department of Justice to have willfully signed or filed a tax return or other document such as the FBAR that he or she did not believe to be true and correct in a material matter, they could be convicted of filing a false tax return.  An individual may also be prosecuted for filing a false tax return if it is proven that the individual willfully aided or assisted in the preparation of a tax return, affidavit, claim, or other document that is fraudulent or false as to any material matter with knowledge that the document would be submitted to the IRS.

Tax Evasion

Willfully attempting to defeat or evade a federal tax due and owing or evasion of payment of an assessed tax can lead to prosecution for tax evasion.

Willful Failure to File an FBAR

Choosing not to file an FBAR can lead to criminal prosecution.  There are increased penalties if this violation occurs concurrently with the violation of other laws or is part of a pattern of illegal activity involving more than $100,000USD in a 12-month period.

Conspiracy to Defraud

If two or more individuals agree to commit a substantive offense against the United States or to defraud the United States, and if the commission of the overt act is in furtherance of the conspiracy, charges could be brought forward for conspiracy to defraud the United States.

IMMIGRATION ASPECTS OF TAX CRIMES

In addition to the formerly mentioned criminal penalties, various civil penalties can be charged, as well as various penalties under state law, for failing to disclose offshore income.  The implications of conviction go further.  Persons failing to disclose foreign account(s) and/or foreign source income and suffering a criminal conviction could face incarceration, serious fines, loss of child custody or even termination of pension benefits.  Some aliens receiving criminal convictions may even face deportation.

One such judgment resulting in deportation is “aggravated felony”.  Aggravated felony includes offenses that, as defined in Title 8 of the United States Code §1101(a)(43)(M),”(i) involves fraud or deceit in which the loss to the victim or victims exceeds $10,000; or (ii) is described in section 7201 of Title 26 (relating to tax evasion) in which the revenue loss to the Government exceeds $10,000.”  Aliens in the United States receiving an aggravated felony conviction are not eligible for review from deportation or asylum.  Therefore, it is important for noncitizens with previously undisclosed foreign bank accounts or foreign source income to obtain competent legal counsel to advise them of any immigration consequences that may result from a tax crime criminal conviction.

Unfortunately, not all criminal attorneys representing noncitizen taxpayers are properly prepared with the necessary knowledge of immigration law to competently represent their clients.  This fact was illustrated in the case of Padilla v. Kentucky, 130 S Ct. 1473 (2010).  Padilla, a long-time lawful permanent resident, was charged with a drug offense.  The Kentucky state court charged the defendant with the transportation of marijuana.  Assured by his attorney that his immigration status was secure due to the length of his residence, he accepted a plea bargain.  However, the mere acceptance of his plea bargain caused him to be deportable without the opportunity for relief.  After realizing the consequences of his plea, the defendant attempted to challenge his guilty plea citing ineffective counsel, but the Kentucky Supreme Court denied his challenge on the grounds that the Court did not view deportation as a direct consequence of his conviction and therefore outside the purview of the Sixth Amendment’s guarantee for “the effective assistance of competent counsel.”  The United States Supreme court disagreed with the ruling and overturned the lower state court’s decision.

The lesson to be learned from the Padilla v. Kentucky case is that attorneys representing noncitizens in felony class cases need to be knowledgeable of immigration law.  This understanding is even more pressing when plea agreements are being negotiated on behalf of the client.

As stated by Judge Stevens, addressing the Court, in the case of Padilla v. Kentucky:

Changes to our immigration law have dramatically raised the stakes of a noncitizen’s criminal conviction.  The importance of accurate legal advice for noncitizens accused of crimes has never been more important.  These changes confirm our view that, as a matter of federal law, deportation is an integral part—indeed, sometimes the most important part—of the penalty that may be imposed on noncitizen defendants who plead guilty to specified crimes.

The Supreme Court went on to rule that it is the duty of criminal defense attorneys to competently advise noncitizen clients when pending criminal charges may carry adverse immigration consequences and equally important, when deportation is certain.  By obtaining a qualified criminal defense attorney, the defense counsel may be able to construct a plea that minimizes the possibility for deportation.  In cases relating to undisclosed foreign source income or offshore accounts, noncitizens should look for an attorney competent in immigration law or associated with counsel competent in immigration law, as well as an attorney prepared to promptly discuss the consequences of a criminal conviction.

As previously discussed, an aggravated felony charge can results in an automatic deportation without the opportunity for a discretionary review by the immigration court.  Until recently, the immigration court determined whether a charge fit the definition of an aggravated felony by looking at the language of the statute under which the defendant was convicted.  Generally a categorical approach to review was taken foregoing examination of the underlying facts and circumstances of a conviction.  In the 2009 case of Nijhawan v. Holder, 129 S. Ct 2294, 2300, the United States Supreme Court seems to have changed this approach to an extent.  As the United States Supreme Court discussed whether a conviction for conspiracy to commit fraud was an aggravated felony as defined in 8 U.S.C. §1101(a)(43)(M)(i), it was determined that in order to come to a conclusion it was applicable to review the circumstances of the defendant’s crime to determine the amount of the victim’s loss.  Further, that while the amount of loss suffered by the victim(s) is a legitimate matter to be gleaned from the record of conviction; an actual figure of loss does not need to be included in the conviction.  As such, the immigration court should continue to conclude from the statutory language of the offense whether it included “fraud or deceit,” and then utilize the criminal proceeding records to calculate if the loss exceeded $10,000USD.

As previously discussed, tax evasion is the only tax crime specifically listed in 8 U.S.C. §1101 as being categorized as an “aggravated felony,” when the loss exceeds $10,000.  Among the various Supreme Court circuits, there has been debate as to whether congress meant to exclude other tax crimes from being categorized as “aggravated felonies” or merely wished to ensure that tax evasion is seen as an “aggravated felony.”  All previously mentioned criminal penalties include an element of fraud or deceit and thus at the discretion of the court could meet the first test as to whether or not the offense qualifies as an “aggravated felony.”  Tax offenses that can potentially be classified as fraudulent or deceitful are not limited to those that have been discussed.  As such, it is extremely important for defense attorney(s) representing noncitizen taxpayers to be mindful of the language of offenses being negotiated in a plea and when appropriate specify a tax loss that is less than $10,000 to ensure it does not later come into contention.

U.S. Taxation of Fideicomisos under the FATCA Rules

Overview of Fideicomisos

If you own a home or a vacation home in Mexico, chances are that your property is held in a fideicomiso. A fideicomiso is a contractual arrangement that is arguably something in between a trust and a custodial agreement. Under Mexican law, a fideicomiso is a written contract whereby the trustee receives funds or property for the purpose of carrying out a lawful objective.

Fideicomisos are required by the Mexican Government for many U.S. persons for development and acquisition of real property in areas of Mexico where foreign investment is either restricted or limited. In such instances, a transaction may be planned whereby a foreigner may acquire an interest in the fideicomiso itself rather than taking title to the underlying property.

A trustee must be appointed to oversee the fideicomiso. Under Mexican law, the trustee of a fideicomiso is obligated to act in a fiduciary capacity with respect to both the grantor and the beneficiary and must be an approved bank or credit institution. The trustee holds legal title to the property, while beneficial ownership remains vested in the grantor. The grantor retains the sole power to make decisions regarding the sale or transfer of property. Upon the termination of the fideicomiso agreement, the grantor receives legal title except where the grantor is a foreigner and the property held in trust consists of residential real property located in a zone where foreign ownership is prohibited.

Introduction to the Hiring Incentive Restoration Employment Tax and the New Law’s Implications on U.S. Persons that Have an Interest in a Fideicomiso

The Hiring Incentive Restoration Employment (HIRE) Act was signed into law on March 18, 2010. The HIRE Act contains several provisions that change the rules applicable to foreign trusts and their beneficiaries, causing the use of trust property to be treated as a deemed distribution. The HIRE Act broadens the grantor trust rules which treat U.S. settlors of foreign trusts as owners of trust property for federal income tax purposes. The new law was intended to target individuals who utilized foreign trusts to avoid U.S. taxes. However, the HIRE Act has some serious unintended consequences to U.S. Persons or U.S. investors who have an interest in a Mexican fideicomiso.  This article will discuss the U.S. implications tax and reporting to U.S. persons that hold an interest in a fideicomiso.

The Implication of the Grantor Trust Rule to Foreign Trusts with a U.S. Beneficiary

Sections 671 to 679 of the Internal Revenue Code contain the so-called 'grantor trust rules,' which treat certain trust settlors (and sometimes persons other than the settlor) as the owner of a portion or all of a trust's income, deductions and credits for U.S. tax purposes. A trust where the settlor (or other person) is treated as the owner of the trust assets for U.S. tax purposes is referred to as a 'grantor trust.' The grantor trust rules apply to both foreign and domestic trusts, but in different ways.

Under the grantor trust rules, a U.S. person who transfers property to a foreign trust is generally treated for income tax purposes as the owner of that portion of the trust attributable to the transferred property, even if the trust would not have been a grantor trust had it been domestic.  This is the result for any tax year in which any portion of the foreign trust has a U.S. beneficiary. A foreign trust is treated as having a U.S. beneficiary for a tax year unless (i) under the terms of the trust, no part of the trust's income or corpus may be paid or accumulated during the tax year to or for the benefit of a U.S. person, and (ii) if the trust is terminated at any time during the tax year, no part of the income or corpus could be paid to or for the benefit of a U.S. person. The Treasury Regulations under Section 679 of the Internal Revenue Code generally treat a foreign trust as having a U.S. beneficiary if any current, future or contingent beneficiary of the trust is a U.S. person.

Informational Return Filing Requirements of U.S. Persons Having a Financial Interest in a Fideicomisos

Section 6048 of the Internal Revenue Code imposes reporting obligations on foreign trusts and persons creating, making transfers to or receiving distributions from such trusts. For example, a U.S. person who transfers property to a foreign trust must report the transfer to the Internal Revenue Service (IRS), and a U.S. beneficiary who receives a distribution from a foreign trust must report the distribution. Both reports are made on IRS Form 3520 and the failure to file the form in a timely manner results in a penalty generally equal to 35 percent of the gross value of the transfer or distribution per year. In addition, if a U.S. person is treated as the owner of any portion of a foreign trust under the grantor trust rules, the U.S. person is responsible for ensuring that the trust files an annual information return on Form 3520-A and provides information to each U.S. person who is treated as the owner of any portion of the trust, or receives (directly or indirectly) any distribution from the trust.

The Combination of the Grantor Trust Rules and the New HIRE Combine to Produce a Perfect Storm for U.S. Beneficiaries of Fideicomisos

The HIRE Act broadens Section 643(i) of the Internal Revenue Code to provide that any use of foreign trust property after March 18, 2010 by a US grantor, a U.S. beneficiary or any U.S. person related to a U.S. grantor or U.S. beneficiary will be treated as a distribution for federal income tax purposes to such U.S. grantor or U.S. beneficiary of the fair market value of the potential to use the property where it is actually used or not. As discussed above, the recipient of the deemed distribution will be required to file Form 3520 to report the distribution from the foreign trust. Not only will a beneficiary of a fideicomiso have to report the fair market value of the use of the property held in the fideicomiso on a Form 3520, a U.S. person holding an interest in a fideicomiso may have to report the fair market value of the use of the property held in the fideicomiso on his or her federal income tax return, whether it is used or not. This deemed distribution rule will not apply to the extent that the foreign trust is paid fair market value for the use of the property within a reasonable period of time. There is no indication as to what period of time will be considered 'reasonable' and the IRS is likely to provide guidance on this issue.

Conclusion

On June 24, 2011, dated November 17, 2010 and released on June 24, 2011, the IRS Office of the Chief Counsel took the position that as “general information only,” any U.S. person who transfers property to or who has an interest in a Mexican fideicomiso must treat the entity as a foreign trust for purpose of filing Forms 3520 and 3520-A. The new tax laws promulgated by the HIRE Act took elevated this matter. Under the HIRE Act, the United States has moved beyond collecting information on fideicomisos and now seeks to impose tax on a U.S. taxpayer’s interest on a fideicomiso. Clearly, U.S. taxpayers who hold an interest in a fideicomiso must file applicable Form 3520s reporting the fair market value of the use of the property held by the entity. In addition, the new HIRE Act imposes unforeseen federal income tax on U.S. persons who established a fideicomiso or have a beneficial interest in a fideicomiso. Whether the IRS can impose a federal income tax liability against the grantor or beneficiary is unclear, however, please refer to Section C. of our client update regarding foreign trusts for potential tax filing obligations.

Under Article 27 of the Constitution of Mexico, only Mexicans by birth or naturalization or Mexican companies may “acquire direct ownership of lands or waters within a zone of hundred kilometers along the frontiers and of fifty kilometers along the shores of the country.” A fideicomiso is a property-ownership arrangement to comply with Article 27 of the Mexican Constitution under which a Mexican Bank Trust obtains legal title to a piece of real estate within a prohibited zone, and a foreigner, as the beneficiary of the trust, enjoys the beneficial interest in the property, including all the usual rights of ownership.

Section 643(i)(3) of the Internal Revenue Code, as amended by the HIRE Act, provides that the U.S. grantor, or U.S. beneficiary, must report the fair market value rental value of the use of any property placed in a trust. Article 27 of the Mexican Constitution clearly defines a fideicomiso as a trust. Since a fideicomiso is classified as a trust under Mexican law, the IRS will take the position that a U.S. grantor or U.S. beneficiary of a fideicomiso will take the position that the fair market value of the potential use of the property placed in the trust will be taxable on an annual basis, whether it is actually used or not. Currently, U.S. persons who hold an interest in fideicomisos have the use of property that is located in some very expensive and desirable coastal areas. Given the new HIRE Act imposes a duty to recognize a tax liability on the fair market value of the value of real estate placed in a foreign trust, the beneficiaries of fideicomisos may be subject to a very unwelcome new annual federal income tax, unless the person takes effective steps to avoid it.

Unless the grantors or beneficiaries of fideicomisos can distinguish it from a foreign trust, it seems that the realization of a new federal income tax will simply become an enormous cost of having an interest in a fideicomiso. In other words, an argument must be made that a fideicomiso cannot legally be classified as a trust. Given the current state of Mexican law and the wording of most fideicomiso agreements, arguing that a fideicomiso is not tantamount to a trust does seem realistic. Under Mexican law, most fideicomiso agreements will never permit the Mexican property held in the fideicomiso to revert to the U.S. grantor. Fideicomiso agreements are typically limited to a term of years, typically 50 years. Given the very nature of the fact that the usage of the land held by the fideicomiso is limited to a term of years, and title to the property held by the fideicomiso can never pass to the beneficiary or his or her heirs, a compelling position can be taken that a true trust agreement has not been established. Instead, the U.S. person acquiring a property interest in the fideicomiso holds a long term lease on property where foreign ownership is prohibited.

Since the time period which a U.S. person and his or her heirs can enjoy the property is limited by a term of years and title to the property can never revert to the U.S. beneficiary of the fideicomiso, a strong argument can be made that a fideicomiso should not be characterizes as a foreign trust for U.S. tax purposes. Instead, a fideicomiso should be treated as a custodial, nominee arrangement or even a lease agreement in which a U.S. person leases land in Mexico for term of years. And, a Mexican Bank is appointed to hold title to the property at issue.

At this time the rules governing the U.S. taxation of an interest in a Mexican fideicomiso remains in flux. Given the uncertainty in this area, U.S. taxpayers with an interest in a fideicomiso should consider obtaining a private letter ruling to determine the IRS position on the U.S. tax consequences of that particular entity.

Please do not hesitate to contact us to learn more.  

 

Like any Law Firm, we need to add a disclaimer:    Because of the generality of this blog post, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on your particular situation(s).    Furthermore, in accordance with Treasury Regulation, Circular 230, we inform you that any tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purposes of (i) avoiding tax related penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any tax related matter addressed herein.  

Tax Return Preparers, Crimes, and Penalties


with thanks to Elizabeth E. Prehn, Law Clerk

The Internal Revenue Service and lawmakers across the nation have introduced a bill to Congress to Increase Tax Preparer Penalties.    While this bill, introduced as the Fighting Tax Fraud Act, is aimed at blatant schemes by tax preparers to defraud taxpayers, it is also a symbol of the increased scrutiny of tax preparers are facing.

A.    WHO IS A TAX PREPARER ?

In general, an income tax return preparer is any person who prepares for compensation, or who employs (or engages) one or more persons to prepare for compensation, all or a substantial portion of any tax return or claim for refund of a tax under the Internal Revenue Code.   26 C.F.R. §301.7701-15.

While this does answer one question, closer examination of the definition raises more questions and requires further analysis to fully grasp the implications.  The most prominent being, what is recognized as “compensation”?  Further, what is included in determining a “substantial portion” of the return’s preparation?  When does the employer of a tax return preparer become liable as the “true” tax preparer?  Does this statute have any exemptions?  And not least, what are the penalties for understating income as a “tax return preparer”?

For Compensation

It seems obvious that if you were paid for your work you were compensated, but what if you complete a tax return for a friend and he takes you out to dinner in thanks.  Is this gesture considered compensation?  As per Treasury Regulation §301.7701-15(f)(1)(xii), the intention of the tax preparer determines if the action is seen as compensation.  So if you prepare a tax return not expecting anything in return, then you are not a tax return preparer.  However, if you expect to be rewarded for your efforts, even something as inconsequential as a thank you dinner, then you are considered a tax return preparer.

Who Employs (or engages) one or more persons to prepare tax returns for compensation

As an employer, liability is always an important concern, and as an employer of tax return preparers, liability for their actions is also a concern.  According to the court Schneider v. United States,”[…] being an employer of one or more persons who prepare a tax return for compensation is sufficient to qualify one as an income tax preparer.” 257 F Supp. 2d 1154, 1160 (2003).    Schneider, a Certified Public Accountant, signed off on a return prepared by an employee.  The employee incorrectly calculated the business deductions causing an understatement of income.  Schneider was charged the penalty.

All, or a substantial portion, of any tax return or claim for refund

Defining what constitutes a “substantial portion” of the tax return is slightly more complicated.  Both advice given and a physical return can be considered when calculating the “substantial portion” of the tax return.  In the case of advice, giving advice prior to the client completing a transaction is not part of the “substantial portion” of the tax return.  Treasury Regulation §301.7701-15(a)(2)(i).  On the other hand, advising a client once the transaction has occurred comprises part of what is figured into the “substantial portion” of the tax return preparation.  As an example, if prior to a merger (the transaction) accountant Karl advises his client of potential tax outcomes; Karl is not seen as a tax preparer.  Yet, should Karl continue to give advice once the merger concluded, his actions would then be seen as those of a tax return preparer.

Further examination of what compromises the “substantial portion of the tax return” reveals the IRS’s position.  This is illustrated Goulding v. United States, 957 F.2d 1420 (7th Cir. 1992).  Goulding, who was the tax return preparer for a partnership return, was found by the IRS to also be the tax return preparer for the individual return of one of the partners, despite the fact that he did not physically complete the latter.   The IRS’s reasoning, which was upheld by the 7th Circuit, being that the return he did complete equated to a substantial portion of the taxpayer’s overall income and tax liability.  An example of this situation in a corporate context can be found under Treasury Regulation §301.7701-15(b)(3)(iii).

B.   CRIMES

Tax Preparers have a duty to uphold the Internal Revenue Code and a standard of professional care to their clients.    They can face charges stemming from intentional conduct of their own, such as, schemes intending to defraud their clients, and the conduct the individual surrounding the tax return being prepared, such as,  charges for aiding and abetting their client’s wrongful tax conduct.   They can also face charges for negligent preparation.      The Department of Justice, Internal Revenue Service - Criminal Investigation Division and Office of Professional Responsibilities are the primary authorities overseeing tax preparers.   However, the Attorney General for a State, various consumer protection authorities, such as the Federal Trade Commission, have been known to investigate and prosecute tax preparers’.      As such, it is important to consult with a criminal tax attorney if you are a tax preparer (whether you knew it or not) if investigated by any government agency.

i.  CRIMINAL TAX CRIMES OF TAX PREPARER

Recent examples of criminal tax preparer cases:

State of California prosecution:  Home Based Tax Preparation by Couple

Chino Hills, CA:     A home based tax preparation business, Al Vivo, 56, and Rachel Vivo, 48 were sentenced to serve 180 days in jail by the State of California for preparing 3 fraudulent tax returns plus their own.

Federal Tax Crime, Department of Justice prosecutions results in: Two Sentenced for Preparing Fraudulent Tax Returns

On June 1, 2012, Anita Montelongo, was sentenced for one count of tax fraud, was ordered to serve 24 months in federal prison, one year of supervised release and ordered to pay $16,632 in restitution to the IRS..

Her partner, Susan Gloria, who plead guilty to one count of tax fraud, was sentenced to 30 months in prison, one year of supervised release and was ordered to pay $194,966 in restitution to the IRS.

According to court documents, from February 2008 through April 2010, Gloria and Montelongo worked as tax preparers for Z & Z Bookkeeping & Tax Service. Both prepared income tax returns that contained false W -2s and false "Other Income" amounts. Their intent was to increase the amount of the refunds for the taxpayers and maximize eligibility for the Earned Income Credit.

Return Preparer Sentenced for Tax Fraud (see IRS.gov)

On May 31, 2012, in San Jose, Calif., Samuel S. Fung, of Medford, Ore., was sentenced to 27 months in prison and ordered to pay more than $1.7 million in restitution to individual victims and the IRS. Fung pleaded guilty on September 14, 2011, to conspiring to defraud the United States. According to court documents, Fung provided services for clients of National Trust Services, including preparing tax returns, under his business names Cortland Tax Management and Professional Business Consultants, LLC. From August 1997 through March 2006, Fung and others agreed to defraud the United States by impeding or obstructing the lawful government functions of the IRS in the assessment and collection of federal income taxes. Fung and others established fictitious business names through which they received income and held assets in order to conceal their assets and income from the IRS. Fung admitted to preparing at least 65 false fraudulent income tax returns for taxpayers and entities for tax years 1998 through 2002.

Alabama Sisters Sentenced for Their Roles in Stolen Identity Refund Fraud Scheme (see IRS.gov)

On May 16, 2012, in Montgomery, Ala., Loretta Fergerson and her sister, Tracey Fergerson, were each sentenced to 115 months prison for their involvement in a conspiracy to file claims for false income tax refunds using stolen identities.  The Fergerson sisters were also ordered to pay $504,305 in restitution to the IRS.  According to court documents, Loretta Fergerson owned and operated a tax return preparation business called Fast Tax Cash in Montgomery, Ala. From 2005 through 2008, Loretta and Tracey Fergerson filed tax returns using stolen identities to claim fraudulent tax refunds. Additionally, Loretta Fergerson and her employees filed tax returns for Fast Tax Cash customers that contained false information to obtain higher refunds for customers.  Court records established that Tracey Fergerson participated in the scheme by gathering stolen personal information and cashing refund checks for tax returns that were filed using the stolen personal information. Tracey Fergerson also recruited customers and coached them to provide false information. She further admitted that she improperly obtained personal information to have false tax returns prepared at Fast Tax Cash.

California Return Preparer Sentenced for Defrauding IRS of Nearly $8 Million (See IRS.gov)

On April 24, 2012, in Los Angeles, Calif., Mario Placencia, an accountant and tax return preparer, was sentenced to 60 months in prison and ordered to pay $1,213,789 in restitution to the Internal Revenue Service (IRS).  Placencia pleaded guilty in July 2011 to two counts of aiding and assisting in the preparation of fraudulent tax returns and one count of submitting false documents to the IRS in an attempt to substantiate the false deductions taken on tax returns.  According to the plea agreement, for the tax years 2003 through 2009, Placencia admitted that he caused the government to incur a tax loss of $7,982,043 by intentionally inflating the amounts of home mortgage interest that he reported on his clients’ federal income tax returns.  Some of Placencia’s clients received notices of audits for the 2004, 2005, and 2006 tax years.  During the audits, Placencia provided the IRS with false documents to convince auditors that the clients had incurred expenses that he knew the clients had not incurred and were entitled to deductions that Placencia knew had been fabricated.

California Tax Preparer Sentenced for Mortgage Fraud and Tax Fraud (See IRS.gov)

On April 23, 2012, in Fresno, Calif., Patricia Ann King, of Bakersfield, was sentenced to 37 months in prison, three years of supervised release, and ordered to pay $530,300 in restitution to the victim lenders and $174,002 in restitution to the Internal Revenue Service (IRS).  According to court documents, King admitted to willfully aiding and counseling a taxpayer in preparing and presenting a fraudulent income tax return to the IRS. The 2005 tax return falsely claimed Schedule A and Schedule C expenses that King knew were not valid.  In the mortgage fraud case, King admitted that from October 2005 to July 2006, she helped other defendants submit false documentation in support of loan applications to defraud mortgage lenders. During this time, King was a tax return preparer and owned The Tax Kings, a tax return business in Bakersfield. King prepared and provided to her co-defendants false and misleading verification letters that purported to verify loan applicants’ self-employment history and income, among other information. King also falsely claimed to be a CPA. King received compensation payments from the co-defendants for providing the verification letters.

Unlicensed California Tax Preparer Sentenced for Preparing False Tax Returns (See IRS.gov)

On February 29, 2012, in Oakland, Calif., Diane Lipina Tuiono was sentenced to 18 months in prison, one year of supervised release and ordered to pay $135,803 in restitution. Tuiono pleaded guilty on November 23, 2011 to aiding and assisting in the preparation of false tax returns.  As part of her plea, Tuiono admitted she prepared tax returns from 2006 through 2009 although she was not a licensed return preparer and did not sign the returns she prepared. Many of her clients were low income families who were unaware of the details of state and federal tax laws. Sometimes her clients brought Forms W-2, 1098, and 1099 to prepare their tax returns and other times they did not have verifiable income or did not earn income at all during the year, but they would still ask her to prepare their returns.  In those situations, Tuiono would input an amount of income on the tax return in order to maximize the amount of the refunds. This resulted in her clients obtaining the Earned Income Credits and/or Child Tax Credits. Tuiono also admitted that she inflated refunds or reduced her clients’ tax liabilities by using several methods including: claiming false filing status, ineligible dependents, non-existent Household Help Income, false wages, exaggerated or fictitious Schedule A itemized deductions, false Schedule C businesses and expenses.  Sometimes she had the married couples file separate tax returns. Each return unlawfully listed each spouse as “Single” or “Head of Household.” In some cases Tuiono split the couples’ children between the two parents or listed ineligible dependents and claimed false income on each of the returns.  These fraudulent acts allowed each spouse to receive the highest refundable Earned Income Credit. For the tax years 2006 through 2009, Tuiono prepared 33 returns on behalf of 16 different people, resulting in a tax loss of $135,803. Tuiono received between $100 to $300 for the preparation of each tax return, which she did not report on her tax returns.

ii.  CIVIL CHARGES

In addition to criminal charges, tax preparers can face civil litigation by the taxing authorities wherein the agency attempts to shut down the business.    In fact, more than 255 permanent injunctions against tax preparers have been obtained and with this the heightened scrutiny we expect to see more suits.    Further, tax preparers also face charges of malpractice by their clients.   So even if you did not consider yourself to be a tax preparer, you may be held to the standards of a preparer under the statute, and you may face malpractice charges.

C.  TAX PREPARER PENALTIES

The bill recently submitted to Congress would essentially double the current penalties for tax preparers who are involved in certain unlawful activity.   Doubling the penalty increases the potential ‘reward’ for the prosecuting agency and the Internal Revenue Service.    In the last 30 years, I have seen the greatly increased penalty structures work in two ways:

  1. I believe it does serve its purpose and deter some people from committing the unlawful act;
  2. I believe that the agencies become more aggressive in their investigations and prosecutions when the stakes are higher.  Because of this unintended consequence, I believe that individuals who never even classified themselves as a tax preparer will face charges stemming from returns they prepared or had some involvement in the preparation.

Further, the IRS has greatly increased its staff of IRS agents whose full time job it is to police tax return preparers.   The IRS has publicly announced that it intends to aggressively prosecute tax preparers and enforce the criminal punishments, including prison time, massive fines (which are not dischargeable in bankruptcy and may stay with you for a lifetime) and barring you from preparing tax returns or work as a tax professional at all.

Therefore, determining whether or not you meet tax return preparer status is a complex and sometimes confusing process.  Many potential scenarios have not been discussed, including employers who do not sign the tax return.  Understanding the subtleties of how this area of law can be argued and defended is extremely important in protecting you from criminal charges and monetary penalties, and also in protecting your license and livelihood.  To better understand and defend yourself in this intricate area of tax law, consult with a tax attorney at Moskowitz, LLP by calling (415) 394-7200 or via our Tax Law Firm’s website.

Moskowitz LLP, A Tax Law Firm, Disclaimer:   Because of the generality of this blog post, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.   Prior results do not guarantee a similar outcome.   Furthermore, in accordance with Treasury Regulation Circular 230, we inform you that any tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purposes of (i) avoiding tax related penalties under the Internal Revenue Code, or (ii.) promoting, marketing, or recommending to another party any tax related matter addressed herein.

United States and South Korea Coordinate to Combat Monetary & Tax Crimes

To combat money and tax crimes, such as tax evasion and money laundering, the United States and Korean Governments have committed to a simultaneous criminal investigation program, SCIP.  The arrangement allows the respective tax departments; the United States’ Internal Revenue Service (IRS) and South Korea’s National Tax Service (NTS), to share records for the purpose of comparing and verifying data submitted to both agencies by South Korean Americans.

The NTS is concentrating on South Korean businesses and individuals participating in the illegal practices of transferring funds out of country, avoiding taxes and engaging in money laundering, while the IRS is concerned with U.S. taxpayers participating in illegal and legal investing in or holding money/assets in South Korea.  The SCIP requires Foreign Bank Account Holders (FBA) to properly report their assets.  The United States requires the same under its Reporting Requirements.   See 2012 Offshore Voluntary Disclosure Program; One Size Does Not Fit All, Criminal Tax Defense.


Previously, the NTS asked over 2000 individuals to voluntarily report their overseas assets.  As of last June, assets worth over 39 billion won of assets previously not reported.  S. Korea Investigates Cases of Offshore Tax Evasion, January 9, 2011, Lee Ji-yoon, The Korea Herald.   We suspect that many of these individuals may have U.S. connections as well or may have been involved with pooling money with Korean-Americans who will be identified to the IRS because of the reporting.    In December 2011, in light of the SCIP arrangement, the National Congress of South Korea and the NTS, invited Steve Moskowitz of Moskowitz LLP, A Tax Law Firm based out of San Francisco, California to explain how the program will affect South Koreans living and working in the United States and Korean - Americans who have family and assets in South Korea.

Moskowitz with the translation assistance of Shawn Kim, Fortis Law Group, P.C., spent 4 days addressing the Congress and Tax Officials and meeting with local bankers and individuals on specific considerations and avenues for compliance without criminal prosecution and minimizing or eliminating monetary penalties, on matters including, Offshore Disclosure Initiatives (ODI) of the U.S. Department of Justice,  Report of Foreign Bank and Financial Accounts (FBAR), repatriation, exit tax matters, and other currency related regulations which, if previously undetected, are now detectable by both the United States and South Korean Justice Departments.


According to Steve Moskowitz:

The United States government is targeting South Koreans living in the United States, who are suspected of crimes.  [It] has every right to request financial information from the South Korean government regarding Korean-Americans living in the United States.”  He adds, “[Information requested] could include real estate records, bank account information, tax returns and other pertinent information.  Many South Koreans living in the United States are nervous because they may have an inheritance from parents, they operate businesses in the U.S. and Korea, maintain assets in Korea and are unsure about reporting these assets, etc.

We have already seen an increase in monetary and tax crimes charged against individuals and corporations of Korean descent, which have included prison sentences and very large monetary fines.

For example:

Obstruction of Justice charges:

In May 2012, the U.S. Department of Justice filed felony charges in federal district court in Washington D.C., against a citizen and resident of Korea, Kyoungwon Pyo, for providing false documents to the U.S. Government in response to an inquiry.    He was charged with obstruction of justice which carries a maximum penalty of 20 years in federal prison and a criminal fine of $250,000 for individuals.   With the advice and counsel of qualified attorneys, Mr. Pyo pleaded guilty and will serve five months in federal prison.

Tax Evasion:

In January 2012, the U.S. Department of Justice filed felony tax evasion charges in federal district court in Maryland, against Chung K. Choi for felony tax evasion which carries a maximum penalty of 5 years in prison (per offense) and a $100,000 fine (per offense) in addition to remaining liable for the civil penalties, which remain available to the Internal Revenue Service and are substantial in nature.     Mr. Choi, with the advice of an attorney, pled guilty and was sentenced to 18 months in prison, 3 years of supervised release, and ordered to pay $739,253 in restitution.

This case is particularly interesting to note because part of the plea agreement included a sealed information.   Sometimes this means that the defendant agrees to provide additional information about others involved in similar or related conduct.    We will continue to monitor the Court for subsequent indictments of Korean business owners who Choi may have implicated as part of a plea (if in fact, information was required under the terms of the plea).

False Tax Returns

In May 2012, a criminal judgment was issued against Insoo Kim, age 57, of Cupertino, California.   He was charged with false tax returns, failing to collect employment taxes.  Mr. Kim pled guilty to filing false tax returns and was sentenced to two months in prison and 4 months of electronic monitoring.   What is interesting about this case is even though the total tax loss to the government was only $28,451, he still received prison time.   We believe that Mr. Kim’s case was aggravated by the fact that he had hidden bank accounts that the government eventually discovered on their own.

Failure to Withhold Federal Taxes and Failure to Timely Pay:
  -  The Government takes action to prevent her from operating her business
 
On March 20, 2012, the U.S. Attorney’s office filed a civil complaint against Jea-il, Inc, doing business as, NiteCap, owned by Lynn Kim.   The complaint alleges that Ms. Kim filed to withhold and pay employment taxes in the amount of $165,332.   The Internal Revenue Service has added over $65,000 to this amount in monetary penalties and now, through the U.S. Attorney’s office, seeks to stop Ms. Kim from operating her business.     We are not the attorneys in this case but will continue to monitor it and provide you with any relevant updates.

Other articles related to this post:

Immigration & aggravated felony convictions,
Foreign Account Tax Compliance Act (FATCA)

Moskowitz LLP, A Tax Law Firm, Disclaimer:   Because of the generality of this blog post, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.   Prior results do not guarantee a similar outcome.   Furthermore, in accordance with Treasury Regulation Circular 230, we inform you that any tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purposes of (i) avoiding tax related penalties under the Internal Revenue Code, or (ii.) promoting, marketing, or recommending to another party any tax related matter addressed herein.