Tax Court Upholds Penalties On Expat’s Failure To Disclose

Ephraim Moss

In a new decision, the Tax Court upheld heavy penalties imposed by the IRS on a U.S. expat taxpayer who failed to report his ownership in two foreign corporations. The decision certainly serves as a cautionary tale for expats – the IRS is serious about foreign reporting and the U.S. court system has its back.

Reporting of Foreign Corporations

Under U.S. tax rules, certain U.S. individuals who own an interest in a foreign corporation may be required to report their interest to the IRS by including Form 5471 with their annual U.S. tax return. The form instructions delineate categories of owners and transactions that are subject to 5471 reporting. It is important to keep in mind that entities that are not considered corporations under foreign law may be considered corporations for U.S. tax purposes and thus may fall within the U.S. tax rules related to foreign corporations.

In general, Form 5471 assists the IRS with gaging the scope of a U.S. taxpayer’s foreign holdings that may facilitate U.S. tax deferral. The form is useful for keeping track of the earnings and profits of U.S.-owned foreign corporations, determining whether a foreign entity is a controlled foreign corporation (“CFC”) generating so-called “subpart F income” (generally passive-type income of a CFC that a 10% U.S. shareholder must include currently in gross income), and tracking possible IRC Section 956 inclusions (i.e., investments in U.S. property by CFCs that can trigger a current inclusion in a 10% U.S. shareholder’s gross income).

The IRS can apply a number of penalties for failure to accurately file Form 5471:

  • Civil penalty of $10,000 for each year’s failure. If the information is not filed within 90 days after the IRS has mailed a notice of the failure to the U.S. person, an additional $10,000 penalty (per foreign corporation) is charged for each 30-day period, or fraction thereof, during which the failure continues after the 90-day period has expired. The additional penalty is limited to a maximum of $50,000 for each failure.
  • 10% reduction in any foreign tax credits claimed from the relevant foreign corporation.
  • The IRS audit statute of limitations remains open indefinitely when information is required to be reported.
  • Criminal penalties may also apply in certain egregious circumstances.

Flume vs. Commissioner

The court case involved Mr. Flume, a U.S. citizen living in Mexico. He had ownership interests in two companies. The first was a Mexican company that owned a fast food franchise. It was owned by Mr. Flume and other individuals. The second was a Belizean company owned by Mr. Flume and his wife. In order to avoid the U.S. tax and reporting obligations associated with 10% ownership of the companies, Mr. Flume signed back-dated documents showing that he had sold his interests in the companies, reducing his interest percentage to 9% in each company. He then provided late Forms 5471 with respect to the Mexican company and continued to fail to report the Belizean company.

The Court found that Mr. Flume was subject to the penalties assessed by the IRS for failure to file Form 5471 with respect to both companies. The Court essentially rejected Mr. Flume’s story about selling his ownership rights, which would have nullified his Form 5471 reporting obligations. It reasoned that Flume maintained company control and failed to precisely indicate when the reduction in ownership occurred or to sufficiently dispute the evidence that suggested that the change did not occur during the years in issue. In the Court’s view, Flume only provided self-serving testimony and a backdated document to support his claims, and this was not sufficient evidence.

In the end, the Court upheld penalties totaling $110,000, a steep price to pay for merely not reporting information about foreign corporations to the IRS.

Filing Accurately is a Serious Matter For Expats

Understanding your tax obligations and filing your taxes correctly are both essential in staying compliant and avoiding IRS penalties. At Expat Tax Professionals, we pride ourselves on getting it right each and every time. Our proven filing process ensures that all of your required forms will be properly prepared, including those forms that are unique to U.S. citizens living abroad.

For delinquent taxpayers, programs are provided by the IRS to prevent potentially disastrous outcomes that could otherwise result from nondisclosure. However, depending on the facts and circumstances, a taxpayer may fail one or more of the program’s eligibility requirements and have to look at other potential solutions.

Mr. Moss is a Tax partner in a boutique U.S. tax firm specializing in the areas of international taxation and expatriate taxation. The practice focuses on servicing U.S. individuals and small business located outside the U.S. with their U.S. and international tax matters and includes both tax planning as well as annual tax compliance (tax return preparation). He has extensive experience with filing delinquent returns under the IRS Streamlined procedure, FBARs, FATCA reporting (Form 8938), reporting interests in foreign corporations (Form 5471) and partnerships (Form 8865) as well as foreign trust reporting (Form 3520 and Form 3520/A). He works very closely with clients utilizing the various international tax treaties in order to maximize benefits through smart tax planning. Previously he held a senior position in the international tax practice of Ernst & Young. He is an attorney licensed in the State of New York.

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