IRS Targets Globally-Mobile Individuals and Businesses:
The Importance of Proactive Planning
By Attorney Morris N. Robinson, CPA, LLM
April 21, 2017
IRS targets globally-mobile individuals and businesses through its Global High Wealth Industry Group and its Large Business and International Division. Targeted taxpayers find these audits distracting, taking time from important duties such as managing businesses. Some targeted taxpayers suffer from significant, unremitting anxiety. These audits are also expensive since tax-audit representation requires a high level of expertise from the taxpayer’s advocate. For all these reasons, well-advised taxpayers will want to minimize their exposure to significant audit adjustments and to complete their tax audit as soon as possible. This article provides guidance on how advance planning may further both goals. This article also suggests, in Section (3), how taxpayers with inadequate financial disclosure of foreign entities and transactions may become fully compliant with United States tax law.
1. Using the Statute of Limitations to Limit Audit Exposure
The running of the statute of limitations limits audit exposure. Absent fraud, in most cases the statute of limitations is three years from the date of the return was filed. (IRC, Section 6501(a)). Thus, well-advised taxpayers will want their tax advisors to obtain documentary evidence that their returns were timely filed, confirming that the statute of limitations clock has begun to tick.
2. Statute of Limitations: The Foreign Financial Disclosure Trap
The statute of limitations does not begin to run unless foreign financial disclosure returns are filed, AND unless these disclosure returns reflect “substantial compliance” with our tax laws. (IRC, Section 6501 (c)(8)). These foreign financial returns include:
Form 8938: Certain Foreign Financial Assets
Form 5471: Certain Foreign Corporations
Form 926: Transfers to Foreign Corporations
Form 8858: Foreign Disregarded Entities
Form 3520: Foreign Trusts and Receipt of Gifts/Inheritances from Non-Resident Aliens
There are severe penalties for failure to timely file “substantially complete” foreign financial disclosure forms. Thus, well-advised taxpayers will also want their tax advisors to confirm (1) that all financial disclosure returns are filed; and (2) that these foreign disclosure returns, as filed, reflect “substantial compliance” with our tax laws.
3. Financial Disclosures Involving Foreign Entities
IRS examines cross-border business activities to determine if all income was properly reported and if all foreign disclosure forms were timely filed and properly completed. The obligation of a taxpayer to file foreign financial disclosure forms and report foreign income often hinges on whether the taxpayer had “control” or a “beneficial interest” in the foreign entity or a foreign financial asset, such as a bank account. Sometimes, the degree of “ownership”, “control” or “beneficial interest” over foreign entities and foreign financial assets is ambiguous, especially when globally-mobile taxpayers do not use lawyers to structure their deal.
All this may sound esoteric, but the consequences are very practical. If the taxpayers had the requisite “ownership”, “control” or “beneficial ownership”, taxpayers are required to file foreign financial disclosure forms and (sometimes) to report so-called “Subpart F income”. If the taxpayer failed properly to file one or more of these forms and/or report “Subpart F income”:
- The taxpayer may be exposed to severe civil penalties (or even criminal sanctions for an intentional violation of a known legal duty); and
- The statute of limitations on the taxpayer’s income tax returns does not begin to run. See Section (2), above.
Thus, well-advised taxpayers will want to:
- Work with competent tax attorneys to structure their business relationships with non-resident aliens of the United States;
- Document their cross-border financial arrangements and transactions with non-resident aliens of the United States; and, if appropriate,
- Arrange for the delinquent filing of foreign financial disclosure forms through an IRS voluntary disclosure program.
Ideally, the structuring and documentation should be done contemporaneously, as the transactions evolve. If this was not done, the taxpayer should structure and document cross-border transactions after-the-fact and before IRS commences an audit. For pre-audit,
- Taxpayers may take advantage of IRS programs which permit the delinquent filing of foreign financial disclosures without penalty, as long as all foreign income was reported.
- Further, if taxpayers did not report all foreign income, they may (and should) come forward with a voluntary disclosure. Although penalties will be imposed by IRS, these penalties will typically be far less than the penalties imposed by IRS following an audit.
4. The Critical Importance of Contemporaneous Records
Well-advised taxpayers will want their tax advisors to confirm that contemporaneous records support all significant wire transfers and filed income tax returns. Supporting documents confirm dollar amount and clarify the reasons for a payment or other transaction. Supporting documents include both formal contracts, informal contemporaneous notes of meetings, as well as cancelled checks, wire transfer documents, and bank and credit card statements. Contemporaneous records are a critical tax-audit defense for globally-mobile individuals and businesses who conduct business across borders. Why is this so? Here is a flavor of how we use contemporaneous documentation in our tax audit defense practice.
- Documenting Cross-Border Wire Transfers
Cross-border wire transfers are transfers between a bank account maintained with a United States bank and a bank account maintained with a foreign bank. In our experience, cross-border wire transfers sometimes cause the United States bank to generate a “suspicious activity report” to the United States Treasury Department. This report is ultimately referred to IRS for investigation. While IRS audit personnel typically do not say so, their tax-audit investigation typically does not end until after the taxpayer has made a full disclosure of the factual circumstances surrounding the wire transfers, along with the submission of appropriate supporting documentation from contemporaneous records.
- Documenting Cross-Border Financial Arrangements
Where appropriate, we have analyzed and summarized contemporaneous documentation to prove to IRS that our client did not have the requisite “ownership” or “control” that would require the filing of Foreign Bank Account Reports (FinCEN Form 114, commonly called FBARs) and other financial disclosures listed earlier. See Sections (2) and (3), above.
- Defending Pass-Through Losses
IRS carefully scrutinizes significant pass-through losses. IRS asks: Was the taxpayer active in the business (IRC, Section 469)? Was there a profit motive, or was the activity a “hobby” (IRC, Section 183)? Did the taxpayer have a risk of loss (IRC, Section 465)? Where the taxpayer’s motivation and level of business activity are important, the existence and quality of contemporaneous written records cannot be overstated.
- Defending Charitable Contribution Deductions
Gifts of cash must be supported by contemporaneous letters from the charity indicating that the donor did not receive goods or services in return. Contributions of property to charities require appropriate appraisals and other supporting documentation enumerated in United States Treasury Regulation 26 CFR 1.170A-1 et seq. There are also significant penalties for the negligent preparation of appraisals used to support the fair market value of property contributed to charity. (IRC, Section 6662 (e)(1)(A)).
- Defending Basis Calculations
Losses are limited to “basis”, that is tax cost. To prove basis IRS may ask taxpayers to confirm, in detail, transactions that occurred many years ago – even if the statute of limitations “ran” on the year in which the original transaction occurred. For although the statute of limitations on the original transaction may have expired, the taxpayer still has the burden of proof to confirm the accuracy of basis numbers used on a return currently under audit.
About M. Robinson Tax Law
We are tax advisors as well as tax advocates. As tax advisors, work with our client’s attorneys and certified public accountants to plan transactions to minimize their taxes and their exposure to tax audits. As tax advocates, we defend our clients at audit, on appeal, before the United States Tax Court and the Massachusetts Appellate Tax Board, and before federal and state courts. For further details, please visit our website: http://www.mrobinson.com/