Professionals who engage in international estate planning faced growth and change in 2019, thanks to increasingly global clients and the Tax Cuts and Jobs Act (TCJA). Here’s a rundown of some of the significant developments.
Growth in Professional Practice
The biggest change in international estate planning in 2019 has been growth in this area of professional practice. Families are becoming increasingly global, so they’re encountering more international estate-planning challenges and opportunities. Meanwhile, governments are gathering more information about assets and financial activity within their borders, and they’re sharing this information with other governments worldwide. This process of gathering and exchanging information has been ongoing, and it’s been expanding. The United States continues to actively pursue penalties for taxpayers’ failure to properly report their foreign assets, so clients and practitioners recognize the need for expertise in this area. Several large law firms expanded their international estate-planning capacity in 2019 by adding groups and individual partners with expertise in this area of law. Meanwhile, at estate-planning conferences and continuing education programs around the country, increasing amounts of time have been devoted to international estate-planning topics.
New Income Tax Protocols
Perhaps the most exciting U.S. international legal development in 2019 was the ratification of four income tax protocols with Japan, Luxembourg, Switzerland and Spain. Protocols modify existing treaties. These are the first treaty documents ratified by Congress since 2011, following years of political opposition in the Senate. These ratifications evidence a political shift, and we may see more tax treaty updates in 2020.1
TCJA
In 2019, we also gained greater perspective on the TCJA’s impact on international estate-planning structures and family businesses. At first glance, income tax legislation might seem unrelated to estate planning, but this law changed the financial landscape for foreign corporations owned by U.S. persons. Foreign corporations frequently appear in international estate plans as holding companies for foreign real estate or other foreign assets or as closely held business interests. These holdings may not be a significant share of our clients’ assets, but even small holdings can generate significant U.S. income tax and reporting issues.
Two parts of the TCJA have changed the taxation of controlled foreign corporations (CFCs). As a result, CFCs can no longer build certain active income free of U.S. income tax.
Part 1: From 2018 forward, the Global Intangible Low-Taxed Income regime causes U.S. taxpayers to realize active income and gains inside CFCs annually, just like they must realize income and gains from passive income in foreign corporations annually. This is a big shift in tax policy. Previously, U.S. persons could grow money indefinitely in CFCs that were actively engaged in business. The growth would be free of U.S. income tax as long as no dividends were issued.
Part 2: To capture all the previous years of untaxed income in foreign corporations, the TCJA also includes a one-time tax on any untaxed property held in a foreign closely held corporation on certain dates in 2017. This is the Internal Revenue Code Section 965 Transition Tax (965 Tax). Technically, the 965 Tax was payable in 2018 so it might have been old news by now. However, the Internal Revenue Service didn’t issue final regulations or an official form for the 965 Tax until 2019. The IRS asked tax preparers and taxpayers to re-report their 965 Tax with their 2018 returns. For all these reasons, even though the law creating the 965 Tax may be old news, its impact on U.S. taxpayers became clearer over the course of 2019.
In light of the TCJA, clients with CFCs should ask their tax advisors to review the pros and cons of electing pass-through or disregarded status for future reporting periods. This election isn’t available for all foreign entities, but in some cases, converting to a pass-through or disregarded entity can greatly simplify the taxpayer’s reporting and save taxes.
As a reminder, the TCJA also granted non-U.S. persons the ability to own S corporation (S corp) shares through electing small business trusts (ESBTs). This can be an incredibly valuable tool for families with multinational descendants and for foreign trusts. The S corp’s tax status and U.S. ownership can be preserved by holding the foreign person’s shares inside a trust that qualifies as an ESBT.
Financial Action Task Force
From 2018-2019, a U.S. representative served as president of the Financial Action Task Force (FATF), an international organization dedicated to combating money laundering and terrorist financing. For many years, FATF has published at least one report each year with guidance regarding how to better combat money laundering and terrorist financing. Many recommended measures involve due diligence and expanded know-your-customer requirements and suspicious activity reports. The most recent evaluation of compliance in the United States concluded that our banks and financial institutions have implemented strong due diligence procedures. However, there are “significant gaps” in the U.S. regulatory framework, particularly with regard to coverage of investment advisors, lawyers, accountants, real estate agents and trust service providers (other than regulated trust companies).2
Although the United States hasn’t fully implemented FATF’s due diligence and suspicious activity report requirements for lawyers and other advisors, other countries have implemented many portions of these guidelines. In multinational transactions, clients will be subject to due diligence in each jurisdiction that’s involved. Also, each advisor will review the transaction according to his country’s FATF reporting standards, which may be more stringent than those in the United States. U.S. advisors should be aware of this expanding regulatory framework worldwide.
Willfulness Penalties for FBARs
Also notable in the world of international private client advising, in 2019, various U.S. courts issued a series of decisions that together clarify what constitutes civil “willfulness” when a client has failed to file a foreign bank account report (FBAR). Civil willfulness penalties can be up to 50% of the value of an unreported bank account, and there are still many clients with unreported foreign accounts. While it’s good to have clarity from the courts, the resulting sketch of who’ll be subject to 50% penalties is quite harsh. The courts have dismissed the argument that FBAR penalties should be limited to a $100,000 maximum. Instead, the highest applicable penalties remain at 50% of the highest unreported account value. Also, courts have continued to uphold the 50% penalty when taxpayers have been willfully blind or have demonstrated reckless disregard of reporting requirements. The IRS only needs to prove its case by a preponderance of the evidence. The courts have clearly stated that taxpayers will be held to know the law regarding income tax reporting and information reporting.
The current state of the law suggests that many more taxpayers may face willfulness penalties in future years. For many years, the Form 1040 income tax return has asked taxpayers to check a box, “yes” or “no,” to report that they owned a foreign bank account. In past years, many accountants and taxpayers haven’t paid much attention to those boxes. Many taxpayers have inadvertently responded “no” to that question, even though they’ve owned reportable foreign accounts. Following current precedent, taxpayers who inadvertently responded “no” and who also failed to file FBARs may be found willful and may face a maximum penalty of 50% of the unreported account. They’ll be held to know the law and the contents of their returns. Willfulness penalties may be supported even if the taxpayers reported all income and paid all tax related to the foreign account in a timely way. For now, courts are upholding willfulness penalties as a necessary means to promote proper reporting of foreign accounts.
Endnotes
1. https://home.treasury.gov/news/press-releases/sm763.
2. www.fatf-gafi.org/publications/mutualevaluations/documents/mer-united-states-2016.html.