May 28, 2018, Jurate Gulbinas
The IRS Large Business and International Division (LB&I) approved six new compliance initiatives. You can see the full list here at the IRS website. Five out of six new campaigns are related to the international compliance:
Form 3520/3520-A non-compliance and campus assessed penalties
According to the IRS, this campaign will take a multifaceted approach to improve compliance concerning the timely and accurate filing of information returns reporting ownership of and transactions with foreign trusts.
At our office we noticed that for the past 12-16 months the IRS was issuing Form 3520/3520-A notices asking for an omitted Foreign Grantor Statement, verifying trust assets reported on Form 3520, etc. The notices seemed to be computer generated and sometimes were not very accurate. However, the fact that the IRS started issuing notices concerning Forms 3520/3520-A reporting implied the higher interest in this particular area.
Our clients sometimes do not even know that they have a foreign trust. A foreign pension plan can be a foreign trust. It depends on the particular plan details whether it could be classified as a grantor trust, hence Form 3520/3520-A filing requirement, or a so-called "employee trust," hence generally no Form 3520/3520-A filing requirement.
Large monetary gifts from foreign persons could be needed to be disclosed on Form 3520. Same for the inheritance from a foreign person. A division of assets under the divorce decree when one spouse is not a U.S. person can result in a Form 3520 filing requirement.
Forms 1042/1042-S compliance
Per IRS website, this campaign will address withholding agents who make payments of certain U.S.-source income to foreign persons and comply with the related withholding, deposit, and reporting requirements.
Both foreign and U.S. taxpayers should keep Form 1042 in mind when a U.S. person makes a payment to the non-resident individual. Often overlooked payment is rental income. Many foreign individuals own real property in the U.S. Without an IRC 871(d) election to treat U.S. rental income as effectively connected with a trade or business in the U.S., foreign individual should be taxed at a 30% (or lower treaty) rate and the property manager, or tenant, has a withholding requirement.
Nonresident Alien Tax Treaty Exemptions
The IRS noticed that some nonresident taxpayers either misunderstand or misinterpret applicable treaty articles and improperly claim treaty benefits and exempt U.S. source income from taxation.
Tax treaty exemption is a quite complicated area. Nonresident taxpayers receive income from the U.S. and often misinterpret that income as either effectively connected, thus taxed at the regular U.S. individual income tax rates, or as Fixed, Determinable, Annual Periodical (FDAP) income, therefore taxed at 30% (or lower treaty) rate. Besides, treaty exemption can be applied to the income that is not eligible according to the treaty document and visa versa, income is reported as subject to the U.S. tax when there is a treaty exemption available. As an example, U.S. pension income could be exempt from the U.S. tax if paid to a treaty resident.
Nonresident Alien Schedule A and Other Deductions
The IRS wants to increase compliance with the itemized deductions. This is a highly misunderstood area, and Form 1040NR Schedule A (itemized deductions) is often incorrect as nonresident taxpayers try to claim various expenses that are not eligible to be declared on Form 1040NR. This usually occurs when a foreign person lives in the U.S. for several years, files U.S. individual income tax returns as a U.S. tax resident, and then one day decides to move out and still has an income coming from the U.S. sources. Having been filing U.S. income tax returns for several years, this person assumes that the deductions that were allowed in the past can be claimed on Form 1040NR.
Nonresident Alien Tax Credits
The IRS noticed that some nonresident income tax returns claim tax credits that are not allowed to be claimed by foreign individuals. Education credits, certain child and dependent credits are quite often misunderstood by many taxpayers.
As you can see, the IRS is focusing on foreign trusts and nonresident alien income tax returns and how income is reported on Form 1040NR. It is always advisable to talk to the tax preparer and clarify U.S. income tax return, and compliance obligations before the tax return is submitted to the IRS.
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