May 12, 2011
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What could the U.S businessman have done to avoid the stress, aggravation and financial loss of this encounter with the IRS? For U.S. taxpayers with international business structures, foreign financial accounts, holdings and properties here in Costa Rica (and other foreign jurisdictions) U.S. tax laws can be confusing and filled with potential pitfalls. At the same time, new laws have strengthened federal compliance enforcement and penalties. It is more important than ever before for U.S. taxpayers to be internationally tax compliant and understand tax compliance.

Nothing illustrates that fact better than the case of a U.S. businessman who unwittingly ran afoul of U.S. international tax reporting compliance and found himself in a position he could never have imagined (for lack of tax compliance).

The businessman operated a successful family business in the U.S. While on a Costa Rican vacation, he fell in love with the country, and decided to buy a piece of property there. He chose a lovely home near the Pacific coast, and transferred $500,000 from his U.S. bank account to a trust account in Costa Rica to pay for his dream home.

Within three years of the purchase, the Internal Revenue Service audited both his personal and business returns. The auditor happened to notice a $500,000 wire transfer to Costa Rica listed in a bank statement. When asked the reason for the transfer, the businessman explained to the auditor that the money was used to buy a piece of property for his family’s exclusive use rent-free for three months each year. What ultimately happened stunned him.

Because he bought the home as a Costa Rican Sociedad Anónima (a C Corporation under U.S. tax law) for the family’s exclusive use for three months a year, a dividend was attributed to him on his U.S individual income tax return(s) equal to the fair market rental value of the house. This led to additional income tax for the periods under audit. He was further penalized $10,000 for failing to attach Form 5471, the appropriate form for disclosing his ownership of the foreign C Corporation to his personal return. And he was also penalized $100,000 for failing to timely file a Report of Foreign Bank and Financial Accounts (FBAR) disclosing the couple of days his money was in a trust account in Costa Rica awaiting the purchase of his home there. Total proposed penalties for one year: $110,000 plus taxes, and interest. The FBAR penalty was subsequently negotiated down to $25,000 when it was disclosed to the IRS auditor that the CPA who prepared the original return had knowledge of the wire transfer, the purchase of the home in the foreign C Corporation and the personal use of the home by the U.S. taxpayer/shareholder and his family. The CPA paid significant “paid preparer penalties” for his failure to include the necessary forms and advise the client appropriately.

What could the U.S businessman have done to avoid the stress, aggravation and financial loss of this encounter with the IRS? Prior to entering into the transaction, he could have hired a U.S. licensed tax attorney or CPA experienced with international transactions and reporting.

Even though the U.S taxpayer did not seek pre-transaction planning and advice, being represented before the IRS by an experienced U.S. licensed tax attorney and CPA during his audit enabled him to significantly reduce the amount of his financial exposure to the FBAR and form 5471 penalties.

It is well known by those of us who handle international tax compliance matters that taxpayers who may not be compliant, but who willingly come forward to correct the problem, are treated better than those who don’t.

Affected taxpayers can also take comfort in knowing that although the government is more aggressively pursuing those who are not in compliance, it is offering a carrot along with the stick.

The IRS has offered two international voluntary disclosure (amnesty) programs, the first of which began and ended in 2009 (TT, April 29). On Feb. 8, the IRS announced its 2011 Offshore Voluntary Disclosure (amnesty) program that expires August 31, 2011.

At stake for the federal government is an estimated $345 billion in tax revenues lost each year, partly as a result of non-compliant international reporting by U.S. taxpayers. In March 2010, President Obama signed what is arguably the toughest law yet – the Foreign Account Tax Compliance Act (FATCA) provisions included in the Hiring Incentives to Restore Employment Act or HIRE.

By 2013 foreign financial institutions will be required to provide information about each of their U.S. – owned or controlled accounts, disclose information to the IRS and withhold U.S. taxes on these accounts if necessary or risk losing their U.S. correspondent banking relationships and risk the imposition of a 30 percent withholding being placed on the earnings from their U.S. investments.

The IRS has set up shop in foreign jurisdictions and has allocated funds and manpower toward its mission of collecting taxes and enforcing U.S. tax laws. Many taxpayers have learned, when dealing with the IRS, that while voluntary annual compliance may be everything, voluntary disclosure is surely the next best thing.

Stanley Foodman CPA, president and CEO of Foodman CPAs & Advisors, P.A., is a forensic accounting and litigation support professional and an expert on international tax.