We've all heard this a million times by now-- expatriate tax returns can be tricky. Here, we'll show you why it's so important to file your tax returns and pay your tax liabilities on time, and how to minimize the damage if you're late.
Let's assume the best case: your tax returns from the past couple of years have been perfect, and have no potential for any extra taxes, interest or penalties to be added on. Unfortunately, you have what's known as an “audit red flag” stuck on there because some auditor thought he saw some suspect reporting info. This kicks off the whole IRS investigation. (A red flag can also be assigned if you didn't file one or more tax returns. If the IRS auditors believe any of these discrepancies look like an honest mistake, they only have up to 10 years to factor in anything else you might owe them. However, if it looks like you omitted or misled them intentionally, they can pursue your case indefinitely.)
Remember, the tax auditor has a lot of tools at their disposal when looking for signs of tax evasion or tax liability understatement:
- Questioning current and past neighbors, co-workers, employers, employees, and creditors.
- Having a detailed look at your credit history, including all aspects of your financial transactions, not limited to: bank accounts, insurance, credit union and brokerage accounts, as well as other investment contracts or arrangements
Here are a few of the most common criminal penalties that can be applied if the IRS believes you understated your tax liabilities, or if you failed to file a tax return:
- Attempt to Evade or Defeat Tax: this is a felony. If convicted, you can face prison time up to 5 years, pay up to $250,000 in fines, or both.
- Improper Disclosure of Bank Accounts: since foreign banks are considered complicit if they help taxpayers fraudulently shelter money, the IRS really goes after this one.
Often, many of these penalties can be stacked on top of each other, so a defendant may be hit with more than one at a time. Here is a brief list of some of the most common penalties:
- Failure-to-Pay Penalty: each month, you have to pay back 0.5% of the liability, until entire liability is paid off. There's no upper time limit, so you may be paying this back for a long time.
- Late-Filing Penalty (i.e. Failure-to-File): 5% - 25% of the tax liability, per month
- Fraud Penalties: 15% - 75% of the tax liability, per month
- Accruacy-Related Penalty (20% of the underpaid amount) and Substantial Understatement Penalties (these apply if you understate your tax liability over 10%)
- Frivolous Return: this applies if the IRS is convinced your return has an unfounded and frivolous argument. It has recently jumped from $500 up to $5,000 (that's 1000%!).
- Levy: once you have a levy applied, all these penalties only increase!
Your unpaid tax liability will continue to accrue interest until the whole liability is paid off. The applicable federal rate (AFR) currently 4% per year, but could change quarter to quarter.
If the courts agree with the IRS that there was intentional fraud (rather than taxpayer ignorance or honest mistake), the taxpayer can be at risk for additional criminal charges.
While you can see there is a whole slew of potential penalties, there are also a few things on your side to consider. Most require the help of an experienced international tax lawyer and CPA, because of how complicated the penalties can be. Here are a few tools a good tax attorney can use to help you:
- Penalty Exclusions: As long as you correctly disclose your tax treatment, some penalties allow you to claim exclusions if you can show good reason for why you accounted for a suspect income item in a particular way.
- Statutes of Limitations: If not found guilty of fraud, the IRS can only look back as far as 10 years.
- Striking Evidence from inclusion: This applies to material that was acquired with improper gathering and discovery.
An experienced team of tax attorneys and CPAs can serve two functions: 1) they protect you from getting in trouble to begin with by helping you navigate the intricacies of expatriate tax code, 2) they can act as damage control if you find yourself on the IRS's bad side, by minimizing all the penalties and interests you may be subject to. To get the best possible outcome, bear in mind that expatriate tax laws can be much more complicated than domestic ones, so your tax professional has to be able to contend with all the complicated international tax treaties as well as the IRS tax code. Therefore, it's definitely in your best interest to find a tax attorney has the appropriate experience to adequately defend and protect you from the IRS and US Department of Justice. With effective professional help, you'll save yourself a lot of headaches and grief.
I.J. Zemelman, EA is the founder of Taxes for Expats