Over the last ten or so years, the IRS has gotten very aggressive on United States persons disclosing their interests in foreign bank accounts and certain foreign investments. The basis for their aggressive behavior is that the IRS believes far too many Americans were hiding their assets outside the US and not paying income tax on the income and gains associated with the foreign-based assets. United States citizens and green card holders are required to report and pay tax on their world-wide income and the IRS was concerned that far too many Americans were failing to do so, potentially costing the Treasury billions of dollars annually in tax revenue. Therefore, FBAR and tax reporting of your foreign investments is imperative.
So how does the foreign bank account reporting rules and other foreign investment reporting requirements apply to retirement accounts. Well, in some instances the answer is very clear, and in other cases the answer is not as clear.
- Many Americans try to hide assets held outside of the country
- FBAR and tax reporting must be done for assets held with retirement plans
- Failure to file may lead to stiff IRS penalties
Foreign Bank Account Reporting (FBAR)
The IRS Foreign Bank Account Reporting (FBAR) rules only apply if you are making certain foreign investments. In general, a United States person, including a citizen, resident, corporation, partnership, limited liability company, trust and estate, must file an FBAR to report:
- a financial interest in or signature or other authority over at least one financial account located outside the United States if
- the aggregate value of those foreign financial accounts exceeded $10,000 at any time during the calendar year reported.
In general, a U.S. person, with a financial interest in a foreign bank account over $10,000, must file the following forms:
- FinCen Form 114
- IRS Form 8938
FinCen Form 114
FinCen Form 114, (Report Foreign Bank and Financial Accounts) is used to report a financial interest in or signature authority over a foreign financial account. Starting at various times in 2013, FinCen forms supersede TD F 90-22.1 (the FBAR form that was used in prior years) and are only available online. FinCen 114 must be filed electronically by April 15. Unlike Form 8938, the FBAR (FinCen Form 114) is not filed with the IRS. It must be filed directly with the office of Financial Crimes Enforcement Network (FinCen), a bureau of the Department of the Treasury, separate from the IRS.
IRS Form 8938
IRS Form 8938 filing requirement does not replace or otherwise affect a taxpayer’s obligation to file FinCen Form 114 (Report of Foreign Bank and Financial Accounts). Form 8939 is due April 15 and attached to the individual’s tax return.
The good news for custodian controlled Self-Directed IRA investors is that FinCen Form 114 and IRS Form 8938 have a specific exception for IRAs and 401(k) plans. The instructions to Form 8938 are clear, “Individuals don’t need to report foreign financial accounts held in individual retirement accounts (described in Internal Revenue Code Sections 408 and 408A) and tax-qualified retirement plans (described in IRC Sections 401(a), 403(a) or 403(b)) on the FBAR.”
Hence, if you are using a custodian controlled Self-Directed IRA to make foreign investments and signatory authority over a financial account that has over $10,000, you will not be required to file FinCen Form 114 or IRS Form 8938. This is a huge relief for retirement investors as the penalties for failing to file are immense.
Controlled Foreign Corporation
Certain U.S. citizens and residents who are officers, directors, or shareholders in certain foreign corporations file Form 5471. In general, a controlled foreign corporation is categorized by the amount of stock owned by U.S. shareholders. If more than 50 percent of the stock is owned by U.S. shareholders, the corporation is considered a controlled foreign corporation (CFC). A U.S shareholder is defined as a U.S. person that owns greater than 10% of the stock of a foreign corporation. In other words, to have a CFC, you need to own at least 10% of the stock of a foreign corporation and that foreign corporation must be owned by greater than 50% by U.S. persons.
However, based on the instructions to IRS Form 5471, it appears that one would be required to file the form if they just owned greater than 10% of a foreign corporation without having the foreign corporation being owned by greater than 50% by 10% U.S. shareholders. It would appear that you need to file IRS Form 5471 by just owning greater than 10% of a foreign corporation.
Unfortunately, the instructions to IRS Form 5471 does not include any reference to retirement accounts and does not specifically provide any exception to filing the form for a retirement account. Thus, a Self-Directed IRA that owned greater than 10% of a foreign corporation would seemingly need to file IRS Form 5471, which is due April 15 and must be attached to a personal income tax return. Hence, a Self-Directed IRA owning 10% of a foreign corporation should file IRS Form 5471 and probably attach the form to their personal tax return, even if the entity is owned by a retirement account and not you personally. Because the penalties for failing to file are high (minimum $10,000), it is strongly advisable to file IRS Form 5471.
Controlled Foreign Partnership
Like IRS Form 5471, IRS Form 8865 is a form that a U.S. person must file if they are a greater than 10% investor in a controlled foreign partnership (CFP) and not a corporation. The same filing rules apply to foreign partnerships as foreign corporations. Accordingly, a Self-Directed IRA that owns greater than 10% interest in a foreign partnership should file IRS Form 8865. The Form is due April 15 and should be attached to your income tax return even though the investment is owned by your retirement account.
Passive Foreign Investment Company
A passive foreign investment company (PFIC) is a foreign corporation, which exhibits either one of two conditions, based on either income or assets:
- At least 75% of the corporation’s gross income is “passive”—that is, derived investments or other sources not related to regular business operations.
- At least 50% of the company’s assets are investments, which produce income in the form of earned interest, dividends, or capital gains.
If you have invested in a PFIC, you are required to disclose the investment to the IRS using Form 8621. However, the instructions to Form 8621 clearly state that an IRA is not treated as a shareholder of a corporation for PFIC purposes, and, hence, is not obligated to file IRS form 8621 on behalf of the IRA.
Investing with a Self-Directed IRA or Solo 401(k)
If you are using a Self-Directed IRA LLC, also known as a Checkbook Control IRA, to make a foreign investment, the question becomes do the exemptions found in FinCen Form 114 and IRS Form 8938 still apply? Unfortunately, there is no specific IRS guidance on this question. The exemptions specifically mention IRAs and 401(k) plans. Would the IRS consider the exemption not to not apply because the IRA or 401(k) plan invested through an LLC? Especially if the LLC is only owned by one retirement account and is considered a disregarded entity for tax purposes. Would the IRS take the position that, from a tax perspective, the IRA or 401(k) plan should be treated as owning the foreign account and, thus, be eligible for the filing exemption under FinCen Form 114 & IR Form 8938.
Accordingly, if one is using a Self-Directed IRA LLC to make a foreign investment, the safest approach would be to file FinCen Form 114 & IRS Form 8938 or use a custodian controlled Self-Directed IRA where there is little question as to the applicability of the exemption for retirement accounts. Whereas, in the case of a CFC, CFP, or PFIC investment, since no specific exemption seemingly applies directly to retirement accounts, it is advisable to file the requisite forms with the IRS based on the investment.
If you have a Solo 401(k) plan and have an interest in a foreign bank account with over $10,000 in assets or have made investments into a CFC, CFP, or PFIC, you should follow the rules outlined above.
In sum, the main advantage of using a Self-Directed IRA or solo 401(k) plan to save for retirement is the ability to take advantage of the power of tax deferral or tax-free investing while gaining the ability to better diversify your portfolio through the opportunity to invest in alternative assets, including foreign investments. However, when making foreign investments with a Self-Directed IRA (custodian controlled or checkbook control) or Solo 401(k) plan, it is important to keep the FBAR and other foreign reporting rules in mind depending on the type of foreign investment your retirement account is making. This is especially true in the case of CFC, CFP, and PFIC investments where there is limited IRS guidance. Consequently, it is good practice, that when in doubt, one should file all relevant forms as the penalties for failure to file are steep.
If you have any questions about FBAR and tax reporting, please contact us @ 800.472.0646 today!