Realizing that you owe back taxes and FBARs is enough to make anyone nervous. You may be concerned about having the IRS knocking at your door, being fined thousands of dollars, or even losing your citizenship. Though these are largely myths, the potential penalties and even legal implications can be alarming.
Here we explain how you can get back into compliance without big penalties.
Many Americans abroad don’t know they have to file US taxes
Many Americans abroad mistakenly think that as long as they earn under the Foreign Earned Income Exclusion limit, then they don’t need to file a tax return. This is incorrect. To claim the FEIE, expats must file a tax return and Form 2555.
Other Americans who have been overseas for extended periods may not even know that they still have a filing obligation.
“Accidental Americans,” who received citizenship at birth but who have not lived in the United States or only lived there for a period during childhood, are also frequently unaware of their filing obligations.
(Read our Guide to US Expat Taxes to learn about filing obligations, exclusions, deductions, and more.)
Some Americans abroad may owe decades worth of taxes before realizing they need to file. Their back taxes can result in steep penalties. Fortunately, the IRS offers a program to reduce the penalties. (More on that below.)
What is the penalty for filing taxes late?
US citizens (including Accidental Americans) must file a tax return regardless of where they live or how long they have been living outside of the US. The only thing that matters is whether their income exceeds the filing threshold.
The thresholds can be as low as $5 for someone married but filing separately from their spouse or $400 for self-employed people, independent contractors, and freelancers.
And, the IRS usually has hefty penalties for failing to file.
There are three primary penalties delinquent taxpayers could face:
- Late filing penalties – The penalty for filing taxes late is 5% of the unpaid tax amount for each month the tax return is late. This is limited to 25% of the unpaid taxes.
- Late payment penalties – Te penalty for failure to pay is 0.5% of the unpaid taxes per month in interest, with a maximum total of up to 25% of the amount of unpaid taxes.
- Interest penalties – Interest on owed tax starts accruing on the original due date of the return until the full payment of taxes is made. The interest compounds daily and the rate is determined quarterly.
In short, the penalties for not filing and not paying can be substantial.
Furthermore, failing to file a tax return is a federal crime that may result in more fines and even jail time.
In addition, unpaid taxes over a certain amount may prevent you from renewing your US passport.
And if that is not enough, US citizens abroad may face additional issues. They may lose out on significant exclusions and deductions that could have brought their US tax bill to zero.
Are you still eligible for the Foreign Earned Income Exclusion if you haven’t filed?
You must file a tax return to claim the Foreign Earned Income Exclusion (FEIE). Failure to file tax returns may make expats ineligible for the. This can have big tax implications as individuals in 2020 can exclude up to $107,600 from income taxes with the FEIE.
If you have claimed the FEIE in the past and fail to file the next year’s return, you may be banned from claiming the exclusion for the next six tax years. The IRS can also disallow the FEIE if you don’t file the return within one year of the original due date. In some cases, a compliance procedure may help avoid this. More about that below.
Don’t forget to disclose foreign bank accounts
Back taxes are not the only issue. If a US citizen did not file a Foreign Bank Account Report (FBAR) they could face additional fines.
The FBAR is an informational report to provide details about foreign financial accounts, such as bank accounts, pension accounts, investment accounts, and more. This is another filing requirement that many expats are unaware of. Learn more about who must file a Foreign Bank Account Report.
What is the penalty for not filing an FBAR?
The penalty for not filing FBAR depends on whether the failure to file was willful or non-willful.
For willful failure to file an FBAR, the penalty can be up to $129,210 (2020) or 50% of the foreign account balance, whichever is higher.
For non-willful failure to file an FBAR, the penalty can be up to $12,921. Those numbers are adjusted annually for inflation.
This is an area where expats need to be especially careful. In the last 10 years, there has been a push around the world for countries to share more information. The implementation of FATCA and the Common Reporting (CRS) show that the IRS takes foreign financial account reporting seriously.
Many Americans abroad have heard about FBAR but mistakenly believe that it applies only to foreign bank accounts. However, other types of foreign financial accounts like pension accounts, are also a part of FBAR and could put you over the threshold. If you’re not familiar with the details of foreign bank account reporting, please check out our article here.
Fortunately, Americans do have options for filing back taxes (and FBARs) without incurring burdensome fines.
Why you should catch up on back taxes before it’s too late
Avoiding harsh penalties is a big reason to get back into compliance. Being able to claim the FEIE and potentially not owing taxes on approximately $100,000 of foreign earned income is another important benefit.
In addition, Americans overseas have kids who may eventually want to apply for college financial aid in the US. To apply for this, parents need proof of being in tax compliance.
Lastly, Congress recently passed a law disallowing the renewal of passports for individuals who have an outstanding tax liability of $53,000 or more. This law may even be used to revoke a passport. While $53,000 may seem high, if you allow the IRS to calculate the taxes you owe and add their penalties to the balance, the amount can be reached rather quickly.
If you haven’t filed previous years of tax returns or FBARs, the situation may seem bleak. Fortunately, there is a solution. Through an IRS program called Streamlined Compliance Procedure, US taxpayers can get back into compliance without penalties.
What is the Streamlined Compliance Procedure?
The Streamlined Compliance Procedure is a way for individuals to catch up on back taxes and FBARs without incurring high penalties. Taxpayers who use the Streamlined Compliance Procedure need to file a tax return and FBAR for the current year, plus three prior years of tax returns and six prior years of FBARs.
Moreover, the Streamlined Compliance Procedure is for taxpayers whose failure to file and report was not willful. On the other hand, if the failure to file and report was on purpose, then the US taxpayer is not eligible and should seek legal advice.
Are there penalties with the streamlined procedure?
No. Taxpayers who use the streamlined procedure only need to pay back taxes owed plus interest. The 5% failure to file penalty is waived. The streamlined program also waives fines for delinquent FBARs.
Importantly, the IRS streamlined procedure does not trigger an audit. Instead, the returns are processed as usual and have the same chance of being selected for an audit as a timely-filed return.
What do you need for the streamlined procedure?
For the Streamlined Procedure taxpayers typically must provide proof of income and foreign taxes paid. They should provide records for the last three years of back taxes and six years of FBARs.
Useful documents include:
- Tax return(s) from the host country to show foreign income and any foreign tax paid
- Records of income or business income and expenses if self-employed
- Records of other types of income, including:
- Interest and dividends from stocks
- Interest from bonds or savings accounts
- Purchase and sale of real estate or property
- Pensions, annuities, IRAs or other retirement accounts
- Rental income statements
- Distributions from partnerships or trusts
- Any other income
- Records of capital gains or losses
- Records of time spent in the US to calculate the FEIE
- Bank records
US persons using the streamlined procedure also need to fill out Form 14653. In this form, they write a narrative about why they failed to report their income and information.
It is important to work with a tax expert on this form because it is one of the most important parts of the streamlined compliance procedure. Our experts have a lot of experience with guiding our clients through this form.
Other options for filing late taxes
The Streamlined Program is not the only option for getting back into tax compliance but it is the most common. The majority of delinquent tax filers can use it and avoid penalties.
Could you just quietly file the missing returns with the IRS? You could. It is called Quiet Disclosure. But we don’t recommend it. While it sounds like the quickest and easiest strategy, it carries significant risks. Unlike with Streamlined, the IRS may still levy high penalties.
If you qualify, we usually recommend that you use the Streamline Procedure. It provides the peace of mind that the IRS accepted the submitted missing forms and waived the penalties.
However, if the IRS is already knocking on your door, or you willfully failed to file, you should immediately seek the counsel of an experienced tax accountant or tax attorney to evaluate your options.
Getting help filing back taxes
Realizing you owe back taxes and FBARs can be scary. With the help of our accountants, you can get caught up, get back into compliance with the IRS, and restore your peace of mind. Our firm has filed hundreds of successful Streamlined packages for our clients.
Unlike most US-based accountants, we have experience correctly calculating the FEIE for prior years and claiming all exclusions and credits available to expats.
It’s important to act soon since IRS amnesty programs are only available for a limited amount of time. Once the IRS determines that enough time has passed for taxpayers to gain awareness and use the procedure, then they may change or close the procedure. They already closed one of their earlier programs, the OVDP.
In fact, is possible that the Streamlined Program may be closed by the end of 2020. For help with the Streamlined Compliance Procedure and to save when filing back taxes, sign up for a consultation with one of our expert accountants.