As most of you know, Esquire Group specializes in international taxation, including the preparation of tax returns reporting foreign income and/or assets.
Whenever I, or any of Esquire Group’s employees interview a new tax preparation client, at a minimum, we want to review the client’s most recently filed tax return; usually, we ask to review the three most recent returns. We do this for several reasons, but primarily to gain a better understanding of their tax situation and to assess the quality of their prior returns. We make it a point to ask the client if they are aware of any deficiencies in the returns, e.g. did you report all of your foreign income. Their most common responses are: I am not aware of any deficiencies, I am in compliance; I am not aware of any, but my previous tax preparer was not an international expert, so it’s possible there are errors; or, Yes, there are some deficiencies, and here is what they are.
Over the years, I have prepared and reviewed thousands of these tax returns. While there are some mistakes I have only seen once, others are fairly common. What is remarkable is that the most common mistakes are generally the simplest ones; caused by carelessness or lack of education and/or experience in preparing tax returns with an international component.
The following are some of the most common mistakes I see:
- Failing to check “yes” to question 7a on the bottom of Schedule B to indicate the client has a foreign financial account. In many cases, the tax preparer prepared a Foreign Bank and Financial Accounts (FBAR) for the client, which indicates he knew the client had a foreign account, and the client’s return includes Schedule B, but question 7a is not marked “yes”. In other cases, the tax preparer falsely believed that Schedule B is only required if the client has interest and dividend income to report, which is not the case. Having a foreign account in and of itself triggers a Schedule B filing requirement, even if the client has no interest and/or dividends.
- Failing to report small amounts of interest earned on bank accounts. Most foreign checking, and similar accounts earn a nominal amount of interest. This is almost always omitted, even though it is reportable.
- Claiming the Foreign Earned Income Exclusion (FEIE) rather than the Foreign Tax Credit (FTC), when the FTC would have been more beneficial. If you lived in a foreign country and had foreign earned income, chances are you claimed the FEIE. Many preparers ignore the FTC and claim the FEIE simply because they feel that Americans abroad can exclude a certain amount of income from U.S. income tax, so they should. They ignore the fact that the FTC often produces a better tax result with less hassle and fewer factors to trigger an IRS audit.
- Claiming the FEIE based on the physical presence test even though the taxpayer didn’t qualify for it. The physical presence test requires a taxpayer to be physically present in a foreign country for 330 days in a 12 month period. I can’t tell you how many times I have seen people claim the FEIE, based on the physical presence test when they have spent more than 35 days in the U.S., which would disqualify them for the exclusion based on the physical presence test.
- Using incorrect exchange rates. There are different exchange rates that must be used for reporting various amounts. Often inexperienced tax preparers incorrectly use only one exchange rate for everything.
- Using a filing status of single, rather than married filing separately, for taxpayers married to non-resident aliens.
- Failing to file Form 8621 to report ownership in Passive Foreign Investment Companies (PFICs). The most common PFICs are foreign mutual funds, which many taxpayers living abroad purchase as an investment or saving vehicles. The client rarely knows it is a PFIC, and most preparers do not take the time to review the client’s investments to see if there are any PFIC’s.
- Failing to report foreign currency gains/losses pursuant to IRC 988. The IRS requires taxpayers with investments denominated in foreign currencies to calculate the gain/loss on the disposition of those foreign currencies. When you exchange dollars for another currency or receive income in a foreign currency, you have to track when you received what amount of foreign currency and at what exchange rate. When you then convert the foreign currency back to dollars, pay an expense in that foreign currency, or purchase something with it, you are treated as if you sold that foreign currency at the current spot exchange rate. Because of exchange rate fluctuations between when you received the foreign currency and when you sold it, there will be a reportable currency gain/loss.
- Failing to file international information returns (Forms 5471, 8865, 8858, 3520, 3520-A). In most cases, if a taxpayer, or a member of the taxpayer’s family, owns over a certain percentage, generally 10%, of a foreign entity – such as a corporation or partnership – an international information return needs to be filed to report the ownership interest. Many tax preparers fail to file these forms because they aren’t aware of them—or if they do prepare them, they are riddled with errors. Also, even if they know about the forms and are capable of preparing them accurately, they often only ask the client about their ownership in foreign entities, and not about their family members’ ownership in foreign entities. Due to family attribution rules, you are usually considered to own any interest in a foreign entity owned by any of your family members.
- Omitting an underage child’s savings account from their parent’s FBAR. Many taxpayers open savings accounts, over which they have signatory authority, for their young children. Often the parents forget to include these accounts on their own FBARs. Additionally, if the child’s foreign financial accounts – including the savings account – exceeds the FBAR filing threshold, the minor child will need their own FBAR. If the child cannot sign his or her own FBAR, a parent or guardian must do so.
Hopefully, this information serves as a reminder that tax returns with international aspects, cannot be prepared by “just any” tax preparer. The rules are more complicated and require the expertise of professionals with the knowledge required to ensure they are accurately prepared to keep you in compliance. Esquire Group has that knowledge.