Options for Non-compliant US Citizens Facing Increased Scrutiny from the IRS
By Monica Martinez, CPA, CA, CPA (Illinois)
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There are few tax scenarios more daunting than those facing dual citizens of the United States and Canada – or, for that matter, the United States and anywhere.
Let’s start with some basic facts: Anyone born in the US is a citizen of the US, unless their parents have diplomatic status. Unlike most countries which levy taxes based on where taxpayers live, the US requires US citizens to file annual US tax returns reporting their worldwide income, regardless of where they live.
For example, a former Canadian client was born in the US only because the nearest hospital was there. He spent only two days in the US hospital before returning to Canada. He was not aware of his US filing obligations until he was an adult, and was shocked to learn that, in his case, this would cost him an additional $20,000 a year in taxes. There are numerous other examples of people in this category referred to as “accidental Americans” – unaware they are legally American citizens with US tax obligations.
Even those who are aware of their US citizenship status get caught. They have spent little or no time in the States as adults, never worked there and never held a US passport, but are shocked to learn that they are legally subject to IRS rules. It seems counter intuitive, because even if all of their income is 100 per cent Canadian, it does not mean they are off the IRS hook. Although they may not owe U.S. tax, they are subject to cumbersome annual US filings. And if the IRS contacts them first to become compliant, they could face significant penalties and interest.
Small change in FACTA Rules
The stakes are now higher for non-compliant US citizens living in Canada.
The so-called Foreign Account Tax Compliance Act (FATCA), passed 10 years ago in the States, is now putting increasing pressure on Canadian financial institutions to get in line and provide the IRS with information on their US citizen customers.
FACTA requires Canadian financial institutions to report to the Canada Revenue Agency (CRA) all of their US citizen clients as well as information on the accounts held by them. CRA then passes this information on to the IRS.
The change to the FACTA requirements is that a grace period expired on January 1, 2020, now enforcing financial institutions to provide a US social security number (SSN) for all their US citizens customers. Under its agreement with the IRS, the CRA has the authority to fine Canadian financial institutions if they fail to report this information.
Financial institutions are now applying pressure on their US citizen clients to provide their US SSNs. The problem is that many US citizens living in Canada, especially “accidental Americans”, may not have a SSN. To avoid hefty fines, financial institutions may resort to closing investment and banking accounts of US citizens who cannot provide a SSN.
At the same time, once the IRS reviews the information supplied by the CRA and identifies US citizens who do not have a SSN, it can lead to other problems.
A SSN is necessary to file a tax return with the IRS. If a US citizen does not have a SSN, the IRS will know they have never filed a US tax return and it may not be long before they come knocking on their door to become compliant. Significant penalties and interest can be assessed if the IRS contacts them before they voluntarily become compliant. This may be especially true these days, as the cash-strapped US government looks for new sources of tax revenue to cover their significant deficit resulting from the Covid-19 pandemic.
Last year, the CRA sent the IRS 900,000 financial records belonging to Americans living in Canada. This number is only expected to increase going forward resulting in higher scrutiny of Americans living in Canada who are non-compliant with their IRS obligations.
Renouncing US Citizenship
The implications can be so complex, so potentially punitive, that many dual citizens are looking to renounce their US citizenship rather than continuing to meet the demands of the IRS.
Unfortunately, it is not that easy. Individuals who renounce their US citizenship must clear their IRS tax obligations for the five years prior to renouncing and for the year of renunciation, otherwise they face exposure to a detrimental “exit tax” and other punitive US tax implications (i.e., the “expatriation provisions”).
Here’s the main message to dual Canadian-US citizens: BE PROACTIVE. Contact the IRS and catch up on your US tax filings before the IRS contacts you.
Fast-Track Voluntary Disclosure Programs
There is some good news. In September last year, the IRS announced a fast-track voluntary disclosure program for those who have or want to renounce their US citizenship and meet their US tax obligations in one shot. If specific eligibility criteria are met, they can become compliant with the IRS without having to pay back taxes, penalties and interest, nor be subject to those punitive “expatriation provisions” that some face when renouncing US citizenship. They don’t even need to have a SSN to become compliant under this program.
For those Canadian residents who are undecided about renouncing their US citizenship but want to catch up with their obligations anyway, there is another fast-track process, called the Streamlined Foreign Offshore Procedures. If you qualify for this program, you can become compliant by filing back three years worth of returns and six years of Foreign Bank Account Reports (“FBARs”). This process also avoids penalties, which can otherwise be significant.
The key under both voluntary disclosure programs is to be proactive (that word again!) and get ahead of the IRS to show ‘non wilful conduct’ – meaning that you had no idea of your obligations, have just learned about them, and you want to comply.
Don’t wait for the IRS to get to you first, or you will not qualify under these voluntary disclosure programs – abatement of significant penalties will be a non-issue and the burden will automatically become much more costly and complex. Further, there is always the possibility that these voluntary disclosure programs could come to an end without much notice.
It’s complicated and attempting to juggle the demands of the CRA and the IRS without expert help is not advisable.
Start now. It’s never too early to get the ball rolling.
Monica Martinez is GGFL’s Principal, U.S. and Cross-Border Tax & Advisory Services