Welcome to CPA at Law, helping individuals and small businesses plan for the future and keep what they have.

This is the personal blog of Sterling Olander, a Certified Public Accountant and Utah-licensed attorney. For over seven years, I have assisted clients with estate planning and administration, tax mitigation, tax controversies, small business planning, asset protection, and nonprofit law.

I write about any legal, tax, or technological information that I find interesting or useful in serving my clients. All ideas expressed herein are my own and don't constitute legal or tax advice.

Basics of Foreign Income Taxation

From a U.S. perspective, personal income taxation is based on (1) citizenship, (2) residency, and (3) income source. U.S. citizens are taxed on U.S. source and foreign source income, regardless of residence. Non-citizen residents (those who possess a green card or who were present in the U.S. 31 days during the current year and 183 days over the last three years) are taxed the same as U.S. citizens. Non-citizen, non-residents are usually taxed only on U.S. source income.

Different applications of these basic principles apply to the U.S. territories. For example, U.S. citizens residing in Puerto Rico are taxed similar to non-citizen, non-residents even though Puerto Rico is a U.S. territory: only U.S. source income is taxed by the U.S. In contrast, U.S. citizens residing in American Samoa are taxed on worldwide income but can exclude American Samoa source income; each territory is different.

Those who are taxed on worldwide income by the U.S. and who also have foreign source income and pay taxes to foreign countries may be able to (1) exclude foreign source income from reported U.S. gross income, (2) deduct foreign taxes paid from U.S. gross income, or (3) receive a credit against U.S. taxes for foreign taxes paid. These rules are intended to prevent the same income from being fully taxed by two different countries.

For those not taxed on worldwide income, properly determining the source of income for tax purposes is critical. In general, the U.S. considers personal service income to be sourced from where the services are performed. Interest income is sourced to the payer of the interest. Dividend income is U.S. source if paid by a U.S. corporation and foreign source if paid by a foreign corporation (but different rules apply where a foreign corporation is generating income "effectively connected" to the U.S.) With some exceptions, rents and royalties are sourced to the location of the property generating the income. Income from the sale of personal property is sourced to the seller's location, with special rules for inventory and intangibles. Gains from the sale of real estate is sourced to the location of the real property.

This is a broad overview of general principles that apply to U.S. worldwide income taxation. Other issues that could arise include tax withholding on U.S. source income of foreign persons, tax treaties between the U.S. and foreign countries, and foreign account reporting requirements, to name a few. It is never a bad idea to engage local counsel when dealing with foreign income and tax reporting.

Foreign Account Reporting Requirements

The U.S. reporting requirements for individuals with foreign assets are complex. This post will focus on the reporting requirements for a citizen and resident of the U.S. with a foreign financial account. The starting point for these requirements will be Schedule B, Interest and Dividends, for Form 1040, U.S. Individual Income Tax Return.

Part III of Schedule B, Question 7, asks whether the taxpayer had, in the past year, "a financial interest in or signature authority over a financial account... located in a foreign country." The question also asks whether the taxpayer is required to file FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR) to report that interest or authority. The FBAR is a different form, independent of Schedule B or Form 1040 in general, but with nearly identical definitions and requirements. In fact the instructions to Schedule B direct the taxpayer to refer to the FBAR for additional information. If the answer to Question 7 is "yes," the taxpayer should plan on filing an FBAR as well.

A U.S. person must file an FBAR by June 30 of the following year if the aggregate value of the foreign financial accounts in which the person has a financial interest or or over which the person has signature authority exceeds $10,000 at any time during the reporting year. A U.S. person who is the owner of record or holder of legal title, or is able to control the owner of record or holder of legal title, of a foreign financial account meets the definition of having a "financial interest." Signature authority is defined as the authority (alone or in conjunction with another) to control the disposition of assets held in the account by communicating to the institution that maintains the account.

Depending on how the foreign asset came to be owned by the taxpayer, Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts may be required. This form is referenced in Question 8, Part III of Schedule B to Form 1040, which asks whether the taxpayer received a distribution from, was the grantor of, or was the transferor to, a foreign trust. U.S. persons who, among other things, received either (1) a gift or bequest of more than $100,000 from a nonresident alien individual or a foreign estate or (2) a gift of more than $15,102 from a foreign entity, must file Form 3520.

Another potentially required form is Form 8938, Statement of Specified Foreign Financial Assets, which accompanies the personal income tax return. The requirements for this form are similar to the requirements for an FBAR; in fact, the IRS has published a Comparison of Form 8938 and FBAR Requirements. In short, Form 8938 is required when a U.S. person has a foreign financial asset, including a foreign financial account, worth more than an applicable threshold, which thresholds are summarized on page 2 of the instructions.

While this discussion has focused on the reporting requirements applicable to foreign financial accounts, the following instructions for Form 8938 are instructive in providing an idea of what is required when dealing with other kinds of assets:

"You do not have to report any asset on Form 8938 if you report it on one or more of the following forms that you timely file with the IRS for the same tax year.
  • Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts.
  • Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations.
  • Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.
  • Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships.
  • Form 8891, U.S. Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans."

Source: Carolyn Reers, U.S. Tax Compliance for U.S. Persons With Interests in Foreign Accounts, Trusts, Corporations and Partnerships, ST008 ALI-ABA, September 2011.