NEW YORK (Reuters) - The Internal Revenue Service's crackdown on overseas tax cheats is having an unintended consequence on American expats. It's prompting many of them to pay penalties for failure to file paperwork that may be drastically out of proportion to the actual amount of taxes owed.
After Reuters ran an article on November 9 (link.reuters.com/cyw45s) about the latest developments in the IRS's search for unpaid taxes on foreign accounts, many American expats and dual citizens contacted us with tales of woe. In phone conversations and emails with more than a dozen people during the last three weeks, we heard stories of stress, fear and attempts to do the right thing before the latest voluntary disclosure window closed in September.
These people included U.S. citizens married to foreigners who'd left this country decades ago, retirees whose lives spanned multiple countries, Vietnam War draft-dodgers who'd long since received amnesty and dual-taxpayers trying to do their U.S. taxes themselves from places where accountants versed in U.S. tax obligations were a rarity.
One woman called from Australia on a Sunday night and started crying on the phone; another said she'd gotten psoriasis from the stress. A few were considering expatriating as soon as they could get their taxes in order.
Marvin Van Horn, a 62-year-old U.S. citizen and permanent resident of New Zealand, is one of those caught by the IRS's effort. Van Horn, who is semi-retired, bought a home in New Zealand with his Australian wife more than a decade ago. He first heard about the foreign-income reporting requirements in 2009, while listening to National Public Radio during a trip to the U.S.
Van Horn scrambled to get his paperwork in for the first voluntary-disclosure period in 2009. After completing tax returns for a six-year period required by the voluntary disclosure program, Van Horn says, he realized he owed some tax, which he had no problem paying. However, he says, "the penalty was out of proportion to the tax failure. You look for reasoned justice, not mandatory sentencing."
As he went through the process, Van Horn tried to calculate his penalty for failing to file the foreign bank account reporting form, known as the FBAR."I figured, 'Oh my God, it's going to cost around $90,000,'" he says. "I am not rich, and that's not chicken feed anymore. That eats up retirement savings. It hurts."
Worse, when the IRS examiner reviewed his voluntary disclosure file, he says, she wanted to know if he'd ever rented out his house when he wasn't there. Because the answer was yes, she told him, his house would go into the penalty calculation. Van Horn was incredulous: "I said, 'You want to apply the penalty based on my house?' So then my penalty went from $90,000 to $172,000. I said, 'This is ridiculous. For a tax failure that's less than $20,000 over six years and a failure to file a form, you want to charge me a penalty of $172,000?' "
Van Horn contacted the IRS's Taxpayer Advocate Service, which agreed to work on his case. After a series of offers and counter-offers, he says, the result was a single "non-willful" FBAR penalty of $5,000 per year, or $25,000 total. While relieved with the outcome after 26 arduous months, Van Horn wonders: "Why the hell couldn't the IRS devise a method to separate the minnows from the whales at the beginning of the process?"
The IRS had no comment for this story, but said in past statements that 30,000 people have come forward during the tax amnesties so far, and that it collected a total of $2.2 billion from those who participated in the 2009 program, and an additional $500 million as of September 15 (a number that does not include penalties).
But this may just be the tip of the iceberg. There are between five and six million Americans living abroad, and another 39 million immigrants in the U.S. (who face similar issues with overseas disclosure if they have accounts back home). Yet, in 2009, there were just 534,043 FBARs filed, according to a report by the Treasury Inspector General for Tax Administration.
In a recent article in Tax Notes, Scott Michel, president of Caplin & Drysdale in Washington, D.C., and Mark Matthews, a tax partner at Morgan Lewis & Bockius in Washington, D.C. wrote that they saw few of the stereotypical offshore tax cheats in their practices. Instead, many had inherited foreign assets from foreign-born parents and other relatives (during the first program) or they had lived abroad for years (in the second).
"They built the program for criminals, and they just can't figure out how to deal with all these innocents who've been caught up in it," says Matthews, a former top IRS official. "A program that is a pretty good deal for a criminal is devastating for someone who didn't really do anything wrong."
Two voluntary disclosure programs offered amnesty from criminal prosecution, but the monetary penalties were steep. In the latest window, the penalty for failing to report foreign accounts was generally 25 percent of the highest aggregate balance between 2003 and 2010, plus an additional penalty of $10,000 for each FBAR not filed. The FBAR filing is required for any U.S. person with at least $10,000 in a foreign financial account.
Even the IRS may realize there's a problem. There is now a special 5 percent penalty for those who owed little or no tax, and an opt-out mechanism for those believe they might get a better deal outside the official voluntary-disclosure program.
Canada has the largest population of dual citizens and other U.S. taxpayers, and has been the location of intense political maneuvering between the two countries.
Many Canadians, like Ruth (who spoke on condition that her last name not be used), a 53-year-old stay-at-home mom in Kingston, are struggling to cope with the rules, wondering whether they might receive some leniency. Ruth was born in the United States; her husband is Canadian. Once she discovered the rules on overseas disclosure, she felt she had little choice but to enter the voluntary-disclosure program. But she's so anxious and angry now that she's considering renouncing her U.S. citizenship.
"Nobody comes to Canada to get away from taxes," Ruth says. "Most of us in Canada don't owe any taxes to the United States because of the tax agreements in place. But you still owe the FBAR penalties of $10,000 per year, and if you have a checking account and a retirement account, it adds up pretty quickly."
In Canada, Ruth says, there's particular anger that the Canadian retirement accounts are included in the overseas asset penalty calculations. She also worries that money her Canadian mother-in-law gave to her Canadian son (who is not a dual citizen) to help pay medical bills could also be included in her penalty calculations. But she won't know what the actual penalty calculation will be for some time. "It's the middle-class and the retired who are really being hit," she says. "It's unconscionable that we are put in this position where we have to give up our citizenship or put our families under this stress and strain."
Perhaps even stranger is the story of L. (who spoke on condition that her name not be used). She's a 54-year-old Canadian, who was born in Canada and has only worked in Canada, but who recently discovered that she's a dual citizen for tax purposes because her mother, then a U.S. citizen, registered her with the embassy at birth. Before she could even file for voluntary disclosure, she had to cross the border from Vancouver to get a Social Security number. As the rules on citizenship were changed, L. says, "they failed to tell me about this change, and now they want to take a good chunk of my retirement savings."
She figures she may owe a little bit in back taxes, but if the full penalties are applied, they could total $75,000. As she says: "Every single bank account I have is an offshore account for tax purposes, because I am a Canadian."
What next? The IRS will need to process the paperwork filed by all those who filed for voluntary disclosure this year, a painstaking process that will determine a penalty calculation for each filer.
"There are all sorts of shades of culpability in a program that the IRS couldn't deal with when it had to move a lot of people through," says Jack Townsend, a Houston tax attorney who writes on these issues at his Federal Tax Crimes blog. "The people who made out well are the real crooks who have been doing this for years, while the people who don't have that culpability are getting hammered because of the one-size-fits-all rule."
The author is a Reuters contributor. The opinions expressed are her own.
Editing by Lauren Young and Beth Gladstone