The Internal Revenue Service (IRS) has been examining the possibility of a direct e-filing system. Can you imagine that bypassing tax preparation software or return preparers and direct filing with the IRS may be on the horizon? The IRS’s contemplated plan would enable users to directly prepare and file their tax returns with the U.S. government. While this commendable move aims to bring the United States up to speed with some of its international peers and make the return filing process more accessible for taxpayers, I have come to the conclusion it cannot possibly work for the majority of US taxpayers living abroad. My article “Americans Abroad: IRS’s E-Filing Plan Won’t Solve the Problem!,” was published in Tax Notes International as well as Tax Notes Federal (subscriptions required) and examined the topic in greater detail.
Today’s post provides a short summary as well as an update on developments with the IRS Direct File program.
The Direct File Program: Current Pilot Underway
The IRS announced in October key details about the Direct File pilot for the 2024 filing season with several states planning to join the innovative effort. Arizona, California, Massachusetts and New York have decided to work with the IRS to integrate their state taxes into the Direct File pilot for filing season 2024. Taxpayers in nine other states without an income tax – Alaska, Florida, New Hampshire, Nevada, South Dakota, Tennessee, Texas, Washington and Wyoming — may also be eligible to participate. The limited-scope pilot program will enable IRS to further assess customer support and technology needs. IRS provided more information this month about the program.
It’s just the beginning. IRS has a long way to go if the agency thinks the program can be adapted to US taxpayers overseas. Such a system will not be feasible without at least 2 things: 1) a major overhaul by Congress of the US tax regimes that apply to US persons when foreign assets or businesses are involved in the tax picture and 2) IRS agents who are highly informed and knowledgeable about the sophisticated and complex US tax regimes that apply to many Americans abroad.
Tax Time for Americans Abroad – It’s a Nightmare
US taxpayers living abroad face a unique set of challenges when it comes to complying with US tax obligations. The complexity of the US tax system is daunting, and is exacerbated by various factors, making it a real challenge, even for experienced tax professionals. Key complexities faced by the overseas US taxpayer include:
- Controlled Foreign Corporations (CFC): Many Americans living abroad invest in foreign businesses or have ownership stakes in foreign corporations. Many of these qualify as CFCs. The taxation of income generated through these entities can be intricate and requires a deep understanding of subpart F income rules.
- Passive Foreign Investment Companies (PFIC): Investment in PFICs often leads to complex tax implications, as the tax treatment of these investments is unique and can result in significant tax consequences if not handled correctly.
- Global Intangible Low-Taxed Income: The introduction of GILTI rules in the 2017 U.S. Tax Cuts and Jobs Act added another layer of complexity for U.S. taxpayers with interests in foreign businesses. Complying with GILTI regulations demands a thorough understanding of international tax law.
- Foreign Assets Reporting: U.S. citizens are required to report their foreign financial accounts and financial assets. The failure to do so can result in severe penalties (please meet your good friend, Mr. FBAR) making it essential to navigate this aspect of tax compliance correctly. For the American abroad, these reporting issues arise all the time. For example, a pension from a foreign employer is a normal part of everyday life, as is a foreign life insurance policy. Yet, these require very special tax reporting, and for foreign life insurance, special filing and payment to the IRS of a 1 percent excise tax on annual premiums. Really? Who knew?
- Foreign Pensions: American expatriates often have foreign pensions or retirement accounts, which can be extremely challenging to report accurately under U.S. tax law. Some might qualify as “foreign trusts,”which require highly complex returns. Again, who knew?
- Lack of Competent Tax Help: American expats struggle to find good tax help. Online preparers and U.S.-based preparers often do not have the required expertise for the complicated filings typically required by expats. Solid international tax advice with a well-versed U.S. adviser is costly. Also, knowledgeable IRS assistance to overseas taxpayers has been dismal. Serious IRS service gaps for Americans abroad have eroded this group of taxpayers’ ability to navigate the tax rules.
A Futile Exercise
How can a direct e-file program address these complexities and problems? If seasoned tax professionals struggle with the issues raised by the tax regimes that typically affect the US taxpayer abroad, I cannot imagine a direct file program being able to get it right. How can a simplified direct file system ensure the accurate completion of these forms?
The risk of incorrect filings is huge and the penalties for getting it wrong are even larger. Take for example, the requirement to file various foreign information returns. As a general matter, aside from large dollar penalties for noncompliance, there is an open statute of limitations for the taxpayer’s entire tax return until the IRS receives the correct form(s). US taxpayers living abroad are more often required to submit these various foreign information returns than their US counterparts. Examples of these include the foreign bank account report (Form 114) and Form 8938, sometimes referred to as the Foreign Account Tax Compliance Act (so-called FATCA) reporting. Failure to file these or other international tax forms correctly (or omitting them) can result in substantial dollar penalties.
Take a peek at some penalty amounts, discussed in my earlier blog posts:
- Seriously? IRS Assesses US$5.1 Million FBAR Penalty for ‘Signature Authority
- Transfer of Property or Cash to a Foreign Corporation? Filing of Form 926
- Double Whammy — US Owner and Beneficiary of Foreign Trust Held Liable for 2 Separate Penalties!
- Taxpayer Wins! Foreign Gift Not Reported: DOJ Concedes He Had ‘Reasonable Cause
- Outrunning (and Outwitting) the IRS Using the Statute of Limitations
The inherent complexity of the US tax system for expatriates is an insurmountable barrier to a workable direct e-filing system for the majority of Americans living and working overseas. A comprehensive reform of the tax system is needed that is aimed at simplifying the tax code, providing clearer guidance to taxpayers, and reducing the risk of inaccurate filings.
Still Waiting
Congress must create more manageable tax laws for Americans abroad – a residence-based taxation system has been advanced by tax professionals for years. Nothing has changed. For its part, the IRS must recognize that its imposition of extreme penalties is inequitable when dealing with overseas taxpayers. IRS must educate its own agents about the tax issues faced by overseas taxpayers. Education and outreach efforts must be put in place to ensure that Americans overseas have the resources and support they need to fulfill their tax obligations accurately and efficiently. All of these things are truly long overdue.
Posted Dec. 21, 2023
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