New Reporting Requirements for U.S. Persons with Foreign Connection

Title: New reporting requirements for U.S. persons who have foreign connections under the Small Business Job Protection Act of 1996.

In response to an increased growth of asset-protection trusts or so called offshore trusts, the Treasury Department believed that offshore trusts were primary used as tax avoidance vehicles for many U.S. persons, and the existing reporting and compliance systems were insufficient to monitor the transactions of the foreign trusts with U.S. beneficiaries. Therefore, the new Small Business Protection Job Act increases required reporting requirements as well as penalty for non-compliance to curb any abusive practices.

Under the prior law, U.S. persons who had foreign trusts were not required to file any special reports to the Treasury Department unless they had taxable distributions from the trusts, which would be reported on their individual income tax returns. In addition, U.S. persons receive of foreign gifts were not taxed nor required to file any other information return. Effective August 20, 1996, a U.S. person who receives any distribution from a foreign trust are required by the amended Section 6048(c) to notify annually the Internal Revenue Service, with the following information:

1.the name of the trust,
2.the accumulative distribution amount in the tax year and
3.“other information” as required by the Treasury Department. The detail of the “other information” is yet to be prescribed by the Treasury Department.

Further, a U.S. owner of a foreign trust is responsible to file an annual return providing full accounting of the trust’s activities for the taxable year. If the proper records are not maintained by the beneficiary, interest charges based on Section 668 will be calculated as if all trust income is earned in the initial trust year. This will result in a much higher interest charged to the taxpayers. There is an exemption to abate the penalty, which applies only when the foreign trust appoints a U.S. agent to act as a limited agent before the IRS for service of process.

Congress expects the increased reporting requirement to provide the Treasury department with more information so that they can do their audits more effectively, discourage abusive use of offshore trusts, as well as enhance the IRS’s ability to collect taxes from U.S. beneficiaries who receive distributions from foreign trusts.

Congress decided that taxpayers needed to be encouraged to file all necessary information to the Treasury and to enforce the reporting requirement, Congress imposes severe penalties for non reporting. Amended Section 6677(a)(2) provides a penalty of 35 percent of the gross reportable amount if a person fails to report the transfer of property to a foreign trust or a distribution by a foreign trust to a U.S. person. The failure to file the trust’s annual activity report will result in a penalty of 5 percent of the U.S. person’s trust value at the end of the tax year. For failure to comply within 90 days after the mailing of an IRS notice, the U.S. person is subject to an additional $10,000 penalty per month until compliance. However, the penalty can be abated if “reasonable cause” can be shown. One little known tax trap is the new section 6039F, which is added by SBJPA Section 1905(c) to provide a new foreign gift reporting requirement. The new provision has a profound effect on foreign persons and their U.S. counterparts. The new law requires reporting of any U.S. person receiving gifts or bequests from foreign persons during the year totaling more than $10,000. The reportable gifts do not include qualified transfers for medical care and tuition expense as well as gifts properly disclosed and distributed to a U.S. beneficiary of a foreign trust. The minimum reportable amount of $10,000 is indexed to cost of living adjustment after 1996. This provision does not change the nontaxability of gifts, tangible or intangible property wherever it is situated, made by foreign persons to U.S. persons. The purpose of this provision is to allow the Treasury Department to account for all taxable income distributions. Currently the Treasury has not yet prescribed the procedures to report such gifts, any future regulations will likely to be retroactive back to August 20, 1996, the effective date of the provision.

If U.S. clients have funds transferred from the overseas, and non-resident aliens clients have made transfers to their relatives in the U.S., they should be advised of the filing requirement and gather all necessary information such as amount of gifts, date of the gifts and the nature of the gifts.

This provision caused a big alarm for people in the countries such as Hong Kong and Taiwan, where many of their relatives are U.S. immigrants or citizens. It is very common that foreign persons use their U.S. connection to invest in the U.S. as well as transfer their wealth out of their country to the U.S. due to the unstable political situations. The provision of the new law will require the U.S. persons to disclose the purpose of the funds. They have to determine whether the funds transfers are gifts, bequest or not to comply with the new law. Further, U.S. persons will also reveal their overseas connection to the Treasury Department, that many of them are reluctant to report.

The penalty of failing to file the required information without reasonable cause is severe. The gifts can be recharacterized by Internal Revenue Service as income, such determination can only be reversed if it is “ arbitrary or capricious”as defined by judicial review standard. In addition, a penalty equal to 5 percent of the amount of such foreign gift for each month up to a maximum of 25 percent will be imposed on the U.S. person.

The State of California has yet to conform with the changes in the new law. However, any redetermination of income raised due to the new law will definitely an issue for the California taxpayers.