As many expatriates residing in Costa Rica are aware, U.S. persons (citizens or corporations) with a financial interest in, or authority over, financial accounts in a foreign country are required to report these accounts to the Internal Revenue Services (IRS). This reporting obligation is imposed if the aggregate value of the accounts exceeds $10,000 at any time during the calendar year.
Not so widely known is another filing obligation that has been off tax advisors’ radar screens. In Costa Rica, this obligation applies to U.S. persons holding stock or partnership interests in a Sociedad Anónima (S.A.) or, in certain circumstances, a Sociedad de Responsibilidad Limitada (S.R.L.). By law, U.S. persons with a corporate or partnership interest in a “controlled foreign corporation” have an annual filing requirement on IRS Form 5471 and those with an interest in a “controlled foreign partnership” must file IRS Form 8865, regardless of whether or not any U.S. tax is due directly from such a corporation or as a result of its activities. Furthermore, there is no minimum threshold regarding the value of the holding in a controlled foreign corporation or partnership that triggers the reporting requirement.
In connection with the Foreign Bank Account Reporting (FBAR) filing obligations, the IRS, through its Amnesty Program, extended through Oct. 15, 2009 the deadline for U.S. taxpayers to conform to the filing obligations, with penalties waived for non-timely disclosure of these return forms. The Amnesty Program was available even to U.S. persons with unreported taxable income and unpaid taxes, although certain penalties apply to the understatement and underpayment of such taxable amounts.
The relevant issue now concerns the Amnesty Program’s expiration in October 2009 and actions that U.S. taxpayers with controlling interest in a Costa Rican S.A. or S.R.L. might take to comply with the law.
Unfortunately, the statutory penalty for failure to file Form 5471 or 8865 with the IRS is $10,000 per return, per year, per taxpayer for each year in which the required returns are not filed. This penalty is applicable regardless of whether or not the S.A. or S.R.L. in question generated any income or caused the U.S. person to understate taxable income. The penalty applies as a result of the failure to file the return. In addition, where such returns have not been filed, the statute of limitations with respect to such penalty never commences to run, meaning that the obligation will not disappear with time.
In essence, if the IRS were to learn of the existence of such an S.A. or S.R.L., and the year in which the taxpayer took possession of the stock or partnership interest, even though many years had passed, the IRS could seek the $10,000 per return, per entity penalty without regard to any statute of limitations defense.
In this situation, the recourse of the taxpayer is to provide a “statement of reasonable cause” to the IRS, requesting a full waiver of the non-disclosure penalties. Through this statement, a delinquent taxpayer can provide information returns to the IRS, satisfying his or her filing obligation while at the same time asserting that such error was due to reasonable cause, and thus requesting that the penalty be abated.
It has been the author’s experience that alleging lack of knowledge and understanding with respect to foreign reporting of controlled foreign corporations and partnerships has been helpful to taxpayers faced with this situation. Even taxpayers using professional tax return preparation firms with knowledge of their client’s interest in controlled foreign corporations and partnerships have failed in this filing obligation.
Thus, taxpayers who have reported and paid tax on all taxable income from these controlled foreign entities will be in the best possible position to conform to their information filing requirements and establish reasonable cause to avoid the penalties. In addition, even U.S. persons with underreported income can file past due returns and establish reasonable cause for non-timely filing. Obviously, past due taxes and interest and potential penalties would be applicable.
Given the current level of attention by the IRS to reporting of foreign income and interests, it seems reasonable, at least to this practitioner, that where U.S. persons with interests in controlled foreign corporations partnerships have not evaded U.S. income taxes, but have simply failed to file IRS disclosure forms, it will be much easier to support a reasonable cause petition to preclude the imposition of penalties.
The author is a partner in the firm Fulbright & Jaworski L.L.P. in San Antonio, Texas. www.fulbright.com/jfriedman.