The New Rules of Offshore Accounts

Crucial deadlines are approaching for millions of U.S. taxpayers who live abroad or have offshore financial ties.

For expatriates, the annual income-tax filing deadline is normally June 15, instead of April 15. In addition, all U.S. taxpayers with offshore accounts totaling more than $10,000 in 2014–regardless of where they live–have until June 30 to file FinCen Form 114, known as Fbar, a report giving details of the accounts.

Despite the prospect of stiff penalties for nonfiling that can claim 50% or more of an offshore-account balance, many people who probably should be filing the necessary forms aren’t doing so. The U.S. State Department recently raised its estimate of the number of U.S. citizens living abroad to 8.7 million from 7.6 million, not including military personnel–yet fewer than one million people a year file forms that are often required for routine foreign accounts.

“Even if half of Americans abroad are children or have too little wealth to file, there’s a huge compliance gap,” says Philip Hodgen, an international tax lawyer practicing in Pasadena, Calif.

Taxpayers confronting these issues often face tough decisions, such as how or whether to come clean about past missteps and comply with especially onerous rules in the future. Some of them are even considering whether to retain their U.S. citizenship.

Unlike most countries, the U.S. taxes citizens, residents and green-card holders on income earned anywhere in the world, with only partial relief from double taxation. The rules are intricate and compliance costs often are high, and there can be costly glitches.

Allen Cutler, a 70-year-old U.S. citizen living in the Philippines, says he recently paid $73,406 to the Internal Revenue Service and $40,000 in attorney and accountant fees to correct partial noncompliance for past years. He wanted to settle with the IRS, “and my goal was accomplished,” he says.

But now there is another issue: He says he can’t tap a $6,488 refund he recently received from the IRS because his Philippine bank won’t clear the IRS check–which took more than two months to reach him by mail–and he can’t find a workable alternative. His case is now with the Taxpayer Advocate’s office but, he says, “I’m not sure I’ll ever get the money.”

A spokesman for the IRS says it is prohibited by law from discussing individual taxpayer cases.

Here is what U.S. taxpayers making decisions ahead of the June deadlines need to know.

The U.S. cracks down

For decades, the rules on offshore accounts weren’t enforced. That changed in 2009, when U.S. officials learned that foreign banks, especially in Switzerland, were encouraging U.S. tax evasion.

In response, Congress passed the Foreign Account Tax Compliance Act, or Fatca, in 2010. This ambitious provision requires foreign financial institutions to turn over information about U.S. account holders so that the IRS can track taxpayer compliance.

More than 165,000 foreign firms have signed up to comply, because if they don’t, they risk severe consequences affecting all account holders. This is the first year they are turning over information, so some U.S. taxpayers with undeclared foreign accounts now could be “outed”–even if they weren’t intentionally disobeying the law or even aware of it.

At the same time, expats aggrieved by the U.S. crackdown on offshore accounts are pushing back through groups such as American Citizens Abroad, a nonprofit advocacy group based in Rockville, Md. Many resent what they see as ill- conceived laws and policies that don’t take their circumstances into account.

Congress is listening now. In December, a Senate Finance Committee staff report said, “The U.S. needs to rethink its taxing rules for nonresident U.S. citizens.”

In the wake of the crackdown, record numbers of people have renounced their U.S. citizenship or turned in their green card. The 2014 total of 3,415 exceeded the 2013 figure of 2,999, which itself was a record.

Know the rules

Taxpayers should first be sure they know Uncle Sam’s requirements for reporting both offshore income and financial assets. They must file U.S. income-tax returns if their gross income is above certain minimums, which were as low as $ 400 for 2014. (See IRS Publications 54 and 501.)

While U.S. taxpayers living abroad must report income from a job or business, each individual gets an exemption of about $100,000. Housing allowances also can be tax-exempt.

Expats also can claim a credit for foreign taxes paid on either earned or unearned income–such as from investments–although the credit may not fully offset double taxation.

As is the case for stateside taxpayers, people living abroad can use IRS Form 4868 to get an extension to file until Oct. 15–but the extra time is to prepare the return, not to pay taxes owed. After June 15, penalties can apply.

Nonfinancial assets such as real estate, jewelry or art don’t need to be reported unless they are held in a trust or other entity–which, experts say, is often the case. Such assets should be reported on IRS Form 8938.

U.S. citizens, residents and green-card holders also must file annual Fbar reports by June 30 that disclose certain bank, brokerage and other financial accounts they own or control.

Beware of pitfalls

Even returns that seem simple can be surprisingly complicated.

Taxpayers face complex rules for many offshore investments, because in the past they often were used to hide money abroad.

In particular, many foreign retirement, savings and pension plans–even some government-sponsored plans in places such as Australia and Canada that resemble individual retirement accounts and 529 education-savings plans–aren’t recognized as tax-exempt by the U.S.

In such cases, the investment growth is considered taxable, and the reporting can be extremely complex if the account holds foreign pooled investments such as mutual funds.

U.S. taxpayers who own businesses abroad should seek professional help, experts say. For example, if seed money targeted for a startup sits too long in an offshore account, it could be considered a passive foreign-investment company.

Foreign life-insurance policies also can pose problems if they have an investment component, which could be considered an offshore investment subject to complex rules.

Also take care with foreign trusts. Because such trusts often have been used to hide assets, reporting requirements are stringent and potential penalties high. For example, Mr. Hodgen says, there can be a 35% penalty for not reporting the transfer of an asset to a trust.

Experts say that if even one beneficiary of a foreign trust is a U.S. taxpayer–such as the only U.S.-born grandchild of an Indian man who set up a trust for the offspring of his five children–the trust could need to be reported to the U.S.

Watch for changes

As the crackdown continues, things are changing that could make the situation easier or more difficult for taxpayers with global ties.

Last year, the IRS introduced a new “streamlined” limited-amnesty program designed for U.S. taxpayers–often expats–who didn’t intend to evade U.S. taxes. Many people eligible for the program won’t owe a penalty, as long as they file three years of tax returns and pay amounts due.

At the same time, the agency also boosted penalties for intentional cheats who haven’t confessed about having secret accounts at certain banks.

Lawmakers and policy makers are also becoming aware of how current rules can be burdensome. American Citizens Abroad is pushing to ease Fatca reporting rules if a U.S. taxpayer lives in the country where the foreign account is held.

But new issues are cropping up. Bills with support in the House and Senate could allow the revocation or denial of passports to people with unpaid taxes of more than $50,000, says Marylouise Serrato, executive director of American Citizens Abroad.

The group worries that if the provisions become law, expats could suffer. Some could owe taxes they are unaware of and lose their passport, even though the debt might later be reduced or eliminated by the IRS.

“For Americans living overseas, a U.S. passport is the only official document proving they’re American,” Ms. Serrato says, so being without one can make living abroad not only difficult but risky.

Fessing up

Many people with offshore issues are considering their options for coming into compliance with U.S. tax rules, given the threat of exposure due to Fatca and the potentially stiff penalties.

But choosing the right way to go about it isn’t easy, and advice is often expensive.

Mr. Hodgen, the Pasadena lawyer, has helped hundreds of U.S. taxpayers with offshore issues. He cautions people with problems not to give into “fear-mongering” by advisers.

“Unless there’s a red flag in your tax history that presents a risk of prison, you probably don’t need to enter the IRS’s main confession program,” he says. That program–the OVDP, which stands for Offshore Voluntary Disclosure Program- -is a limited amnesty that has higher penalties than the Streamlined Disclosure option available to many expats.

Red flags include moving undeclared funds from account to account, perhaps in Switzerland or Israel, where banks are under U.S. scrutiny; hiding assets in trusts or foundations typically used to obscure ownership; and being a tax professional, such as a lawyer or an accountant, who should have known the rules. The larger the account, Mr. Hodgen adds, the more alluring it is as an IRS target.