US Residency “First Year Election” and FBAR – The Devil is in the Details

Recently, I presented a webinar for tax pro’s earning CPE credits; the topic involved our favorite character, Mr. FBAR. The FBAR, Form 114, is more formally known as the Report of Foreign Bank and Financial Accounts.  The webinar will be available soon as a CPE credit “self-study” program.  Send me an email if you wish to be notified when the self-study is available.

An interesting question came up during the webinar:  whether an FBAR filing duty arises for a foreign individual who makes an election under IRC § 7701(b)(4), commonly referred to as the “First-Year Election”.  In general, the First-Year Election is used by nonresident alien individuals who arrive in the US after the middle portion of the tax year and do not obtain a green card in that year.  Since they do not obtain a green card that year, they will not qualify as a resident alien under the “Green Card Test.” Due to the limited days of physical presence in the US, they will also not qualify as a resident alien under the “Substantial Presence Test” (SPT). Since these individuals do not meet either the SPT or the Green Card Test, they are not considered US resident aliens for the tax year of arrival. They can change this result by making the First-Year Election. Under this election the individual may be considered a US resident alien for part of the tax year, as opposed to being considered a nonresident alien for the entire tax year.  IRS provides a helpful International Practice Unit. 

The election applies for income tax purposes, but what does making this election mean for FBAR purposes?

It is a good time to remind readers of some basics before we tackle this question.

Title 31 v. Title 26 – Bank Secrecy Act v. Internal Revenue Code

The FBAR has its genesis in the “Bank Secrecy Act” (BSA) contained in Title 31 of the United States Code.   Implementing regulations (Regulations) are issued by the Financial Crimes Enforcement Network (FinCEN) of the US Treasury.  The BSA was enacted in the 1970’s.  The BSA is not part of the US tax laws comprising the Internal Revenue Code (IRC) which is found in Title 26 of the United States Code. While the FBAR doesn’t trigger tax since it is an information reporting form,  incorrect FBAR filings or non-filing can trigger stiff penalties.

Since the FBAR is not part of the US Internal Revenue Code, one must be very careful in applying the rules. Common terms are defined differently for FBAR and US tax purposes.  For example, a financial account located in a US territory or possession (e.g., Puerto Rico, Virgin Islands, Guam, American Samoa) need not be reported on the FBAR. Such accounts are treated as a US account for FBAR purposes since Title 31 defines the term “United States” as including US possessions and territories. By contrast, Title 26 defines the term “United States” as excluding US possessions and territories.  As such, a financial account located in a US territory or possession will be treated as “foreign” for US tax purposes, including the duty under IRC Section 6038D to file Form 8938, with respect to so-called “specified foreign financial assets”. (My blog post here provides everything you need to know about Form 8938).

Nuances also exist in the definition of a “US person” required to file an FBAR. For FBAR purposes, the FBAR instructions provide that a “United States person means United States citizens (including minor children); United States residents; entities, including but not limited to, corporations, partnerships, or limited liability companies created or organized in the United States or under the laws of the United States; and trusts or estates formed under the laws of the United States… The federal tax treatment of an entity does not determine whether the entity has an FBAR filing requirement. For example, an entity that is disregarded for purposes of Title 26 of the United States Code must file an FBAR, if otherwise required to do so.”

By way of example, a trust created under US laws can be treated as a “foreign” trust for US income tax purposes. It may have no US income tax liability whatsoever if all income is earned from non-US sources. Yet that trust will have FBAR filing duties since it is a “United States person” under the BSA.

US “Resident” Only by Section 7701(b) Election

Let us return to the nonresident alien individual who fails to meet either the SPT or the Green Card Test for the year he arrives in the US, but who makes the First-Year Election for US income tax purposes.  What are his FBAR duties?

According to the FBAR instructions, “[t]o determine if the filer is a resident of the United States apply the residency tests in [IRC § 7701(b]). When applying the residency tests, use the definition of United States in these instructions.”  The First-Year Election is contained in IRC § 7701(b)(4)(B) and implemented in Treasury Regulations § 301.7701(b)-4(c)(3). As such, an individual making the election will qualify as a “resident” for FBAR purposes.   Under the First-Year Election, however, an individual is treated as a resident alien for income tax purposes for only part of the tax year, i.e., only for the period covered under the election.

This gets a bit confusing as to what and how to report foreign accounts for the individual making the First-Year Election.  What if he closed many foreign accounts just prior to the elected residency period?  Are these accounts counted for purposes of computing the $10,000 threshold?  If the threshold is met regardless, are these accounts reported on the FBAR since they were in existence for part of the calendar year to which the FBAR relates?  Ah, the joys of being Mr. FBAR! With all this confusion it is no small wonder he can collect so much in penalties.

According to the preamble to the final FBAR regulations (“Preamble”), “FinCEN believes that individuals who elect to be treated as residents for tax purposes under section 7701(b) should file FBARs only with respect to foreign accounts held during the period covered by the election.”  The Preamble is here see page 10,238, excerpt below.  Evidently, many tax pro’s were confused on this issue. At least the Preamble provides some help!

“[C]ommenters sought clarification on the treatment of individuals who make certain elections under section 7701(b) of the Internal Revenue Code. FinCEN believes that individuals who elect to be treated as residents for tax purposes under section 7701(b) should file FBARs only with respect to foreign accounts held during the period covered by the election”.

Takeaway

The lesson here: Look first to Title 31 when it comes to FBAR issues. Title 26 may be implicated as well, but the first port of call is the BSA and its regulations. The other lesson: It’s complicated. Engage a tax professional with the proper international experience to assist with such US tax and FBAR matters.

Want more information about FBAR?  Check the FBAR category on my US international tax blog.  Need help with FBAR matters?  Send an email to arrange a consultation vljeker@us-taxes.org

Posted June 2, 2022

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