This is the first in a series of blogs, which will hopefully shed some light on how we file our taxes and why we need to be filing them.
I often meet US citizens living abroad who are not current with their annual US income tax filing requirement. In some cases, their returns have not been filed for a decade or more. In my experience, this failure to file is usually the result of receiving bad information from friends, or advisors, or a misunderstanding of the Internal Revenue Code, and not an overt attempt to evade paying US taxes.
There are complications that grow over time, however, when tax returns are not filed, and the longer the failure to file goes on, the more the taxpayer starts to look like a tax evader. It may be worthwhile to note that failure to file is a federal crime that can have undesirable consequences for the evader. You can be fined up to USD 25,000 and imprisoned for up to one year for each year you fail to file. If you file, even if you can’t pay the taxes, interest, and penalties, you won’t face prosecution.
Most expats who are delinquent in filing don’t hear from the Internal Revenue Service (IRS) about it like they would if they were living and working in the US. Expats who are compensated “locally” don’t receive a US compliant 1099 or W-2 (documents delivered each tax year by employers to both the taxpayer and the IRS). Expats are on the honor system to report their income. In the US, the IRS matches W2 and 1099 documents they receive from employers with tax returns filed by the taxpayer, and if returns aren’t filed, the IRS knows, and typically initiates a Taxpayer Delinquency Investigation which generates a letter to the delinquent tax payer demanding the missing tax return. In this regard, expats may be, for the moment, “off the grid”.
What to do? Up to you. But here are a few things to keep in mind:
The IRS requirement for all US citizens is to file an annual income tax return. The requirement is not necessarily to pay taxes. Tax avoidance is the American way; tax evasion is a crime. Be sure you know the difference. Expats often have a lower US tax liability than their US resident counterparts, and may not owe any US income tax, for a number of reasons. Most US expats qualify for the Foreign Earned Income Exclusion (USD 99,200 in 2014). Some US expats have deductible expenses not available to US residents, such as the Foreign Housing Exclusion and Deduction. Many US expats have a higher income tax liability in their country of domicile than they do in the US, and a tax treaty between their country of residence and the US prevents double taxation, resulting in no tax due to the US. None of these, however, excuse the US citizen from the requirement to file a tax return.
In general, the IRS has three years to audit you after you file a tax return. If you under report your US income by 25 percent or more, or you fail to report more than USD 5000 of your foreign earned income, the window expands to six years. If you don’t file a return, the three year clock never starts and the IRS may audit you as far back as they want to. A bigger problem may start when expats repatriate to the US and start receiving a W2 or a 1099 again, causing the IRS to wonder what happened during the missing years. In this case, failing to file tax returns may have created a virtually unlimited window for the IRS to audit your past.
A more draconian environment was created with the implementation of FATCA (Foreign Account Tax Compliance Act) in 2010. Designed to require foreign financial institutions to report the identity of their US citizen clients to the IRS, the effects are proving to be long reaching and are affecting expats in ways not previously considered. The bottom line: the IRS and the US Treasury are demonstrating that they don’t intend to observe any limits on their ability to require US citizens to report worldwide assets and worldwide income, and they will apply increased pressure not just to US citizens, but to any and all financial institutions worldwide to aid them in their quest to uncover unreported assets and income.
With the caveat that I am neither an accountant nor a tax attorney, my advice to you, if you are in arrears in filing your US tax returns, is that you make a good faith effort to become current. Most accountants advise that, at the least, you file for the current year and keep on filing. Some accountants and attorneys advise filing (up to) the most recent six years of delinquent returns. The cost to do this is nominal, especially in light of the possible downside of demand for compliance from the IRS if they contact you before you contact them. In most matters with the IRS, a good faith effort to comply carries weight, and no effort to comply looks like tax evasion.
In the next blog we will focus on what needs to be filed, what forms to file them on and how to file them yourself.
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About William Frisby
William originally arrived in Beijing as a finance guy on a bicycle and will probably leave as a finance guy on a bicycle. He works for Premium Finance Group (PFG), a financial consultancy that has been established in China for over ten years. PFG offers clients no-nonsense, personalized advice and serves the whole of China from their Beijing and Shanghai offices. Services include international property, investment, insurance and financial planning. To contact William, email email@example.com.