Suddenly, there's no place to hide: Even if you move your money overseas, the Internal Revenue Service is determined to find it. And since the passage of a law last August, it's easier for them to do so.
Concerned about U.S. revenue lost from the improper use of offshore trusts, Congress passed a slew of onerous reporting requirements as part of the Small Business Job Protection Act. Offshore or foreign trusts are legal arrangements with a foreign bank or trust company that wealthy individuals use either to protect their assets--cash, securities, or other property--from existing or potential creditors or to avoid U.S. taxation. Although such trusts are perfectly legal, the IRS hopes the new reporting rules will help them both spot egregious cases of tax avoidance and collect revenue on U.S. income sheltered overseas.
HARSH PENALTIES. Indeed, the IRS now wants you to tell them about any gifts you receive from a foreigner as well as all money you transfer to, or receive from, an offshore trust, says Jennifer C. Snyder, a trusts-and-estates attorney at the Boston law firm Hale & Dorr. Not only does the IRS intend to collect ordinary income taxes on transfers and distributions but also failure to report such transactions within 90 days will result in harsh penalties of up to 35% of the amount, according to Edmund S. Cohen, an international tax attorney at Coudert Brothers in New York.
You might be surprised to learn just what the IRS considers a foreign trust. Previously, almost any trust set up overseas was considered foreign. Now, all trusts will be treated as foreign for tax purposes except those governed by a U.S. court and controlled by an American corporation or individual. However, be careful: If a domestic trust allows any foreigner to have veto power over important trust decisions, then it, too, is taxed as foreign, Cohen says. So if you are involved in any type of trust, it's a good idea to review carefully all transactions--such as deposits, withdrawals, or transfers--with a tax attorney before Apr. 15. Even better, do the review before the trust is established.
Since Aug. 20, 1996, when the new law went into effect, the grantor, or person who creates the foreign trust, as well as the transferor, the person who transfers the money, and the executor must notify the IRS within 90 days when a U.S. citizen or resident does the following: creates a foreign trust, transfers money or property to a foreign trust, or dies as the owner of any portion of such a trust.
The few exceptions mainly apply to trusts created prior to Aug. 20, 1996. Existing revocable trusts, those which can be terminated by the grantor, are exempt from the new reporting requirements. Also excluded are existing trusts where the grantor or his or her spouse is entitled to trust income. And last, a newly established foreign trust will be tax-free if only the grantor can terminate it.
The long arm of the IRS is hardly limited to foreign trusts. Even gifts made outside the trust are subject to the harsh new rules. Since Aug. 20, 1996, any gift from a foreigner--including stock, property, or cash--in excess of $10,000 must be reported. However, gifts used for qualified tuition or medical payments are excluded. Although such gifts will not be taxed, failure to report them within three months will result in a penalty of up to 25% of the gift's value, says Cohen.
PASSPORT POKER. If these reporting requirements are enough to make you want to leave the country, think twice before renouncing your citizenship. Why? Well, now there's a new tax designed to hit you up on the way out. An expatriate "exit tax" will be imposed on anyone with assets in excess of $500,000 who relinquishes his or her U.S. citizenship, since those individuals are presumed by the IRS to be leaving the country for tax-avoidance reasons. And if the IRS believes that is why you left, there is a good chance immigration officials won't let you return. However, there may be exceptions under future immigration regulations, Cohen says.
The tax is retroactive and applies to anyone who terminated U.S. residency or citizenship after Feb. 6, 1995. If all this isn't intimidating enough to discourage such extreme measures, keep in mind that you'll continue to owe tax on any U.S.-generated income for the next decade.
Indeed, before you spend precious time and money searching for a clever tax lawyer to help you bend the rules, remember that no one understands the game better than the IRS.
TAX TIP: With any kind of trust--foreign or domestic--have a tax lawyer review all plans or transactions