By David Kuenzi, Thun Financial Advisors
U.S. Treasury officials are trumpeting the fact that more than 77,000 financial institutions have registered with the Internal Revenue Service, as required by the Foreign Account Tax Compliance Act (Fatca), ahead of a July 1 deadline. Fatca requires these institutions to report on the financial holdings of their U.S. clients with the aim of reducing the incidence of off-shore tax evasion by wealthy Americans. Yet officials are less willing to discuss how Fatca worsens the already profoundly unjust tax treatment of millions of middle-class Americans living abroad.
The vast majority of U.S. expatriates living abroad harbor a strong sense of patriotism that includes a willingness shoulder their fair share of the nation’s tax burden. Deep resentment arises, however, when they confront the byzantine complexity of preparing a tax return that includes non-U.S. income and non-U.S. financial accounts. Fatca demands rigorous compliance with arcane rules that the IRS has until now never even attempted to enforced on a widespread basis. For Americans abroad, desperately trying to comply, the outcome to family finances is often disastrous.
In one case, a California school teacher lost her Swiss husband of 30 years to cancer. In the ensuing family trauma, she failed to file a foreign asset disclosure form to report her husband’s Swiss pension. Despite having paid all of her U.S. taxes on time, she is advised by a California law firm to enter the IRS’s Off-Shore Voluntary Disclosure Program. She paid the firm a retainer fee of $124,000 to begin the OVD process and was told to expect penalties of up to $800,000.
In Malaysia, a modest, local family business was thrown into financial turmoil when the authorities discovered that because one of the founder’s daughters, a partial owner of the business through a family trust, married an American and took U.S. citizenship. The entire business was, as a result, subject to complex U.S. accounting and U.S. tax reporting requirements.
In Toronto, an American-born professor made no investments in anything other than bank saving accounts for fear of running afoul of one of the scores of obscure U.S. tax rules regulating investments outside the U.S.
These stories are not extraordinary anecdotes. They are the real burdens imposed by the U.S. tax code on overseas Americans who engage in normal middle-class financial activities such as participating in a company pension plan, starting a small business, or saving for retirement and college.
To fully grasp the problem, first recognize that U.S. retirement plans and insurance policies are set up to comply with federal tax laws. Yet financial products in Germany, France, or Hong Kong are not. This incongruity creates headaches for Americans who must report their foreign financial activities on their U.S. tax return.
U.S. reporting rules for non-U.S. registered mutual funds are a particularly good example of the problem. An American family living in Germany that buys five or six different German-domiciled mutual funds to create a diversified portfolio is faced with tax complications that almost defy belief. They will have to report each of their six non-U.S. mutual funds on separate forms, every year. The IRS Instruction manual for this Form 8621 estimates that the time needed to prepare the form include “Recordkeeping, 15 hr., 4 min; Learning about the law or the form, 11 hr., 13 min; Preparing and sending the form to the IRS 20 hr., 21 min.”
In other words, the U.S. government expects this family to spend more than 200 hours annually preparing and filing the forms necessary to report their six mutual funds bought from a local German investment advisor. Furthermore, once the filing is made, the tax payers will find their investment gains taxed annually and subject to a tax rate no less than 39.6%, and potentially much higher.
Few U.S. tax preparers have any understanding of the special rules regarding non-U.S. assets and income. So Americans abroad can routinely expect to find major mistakes in their returns. They can also expect to pay anywhere from three to 20 times as much to have a return prepared compared to the cost of a similar domestic filing. The point is that middle-class Americans abroad face a nearly impossible task in both saving for their future financial needs and properly preparing their U.S. tax returns.
One of the many ironies embedded in this Orwellian tax nightmare is that the complex foreign asset and foreign income reporting rules were not written with Americans abroad in mind. Their original purpose was to discouraging Americans living in the U.S. from using off-shore tax shelters. As originally intended, the rules were a reasonable legislative response to a gaping tax loophole. Applied to Americans living abroad, however, they are absurd.
When a wealthy American living in Chicago moves money to an account in the Cayman Islands or Switzerland the IRS has good reason to be suspicious. Yet there is nothing at all suspicious about an American living in Switzerland opening an account at a Swiss bank to invest in mutual funds. Unfortunately, the U.S. tax code makes no distinction between these two very different scenarios. Both taxpayers are treated by U.S. rules as if their actions indicate an intention to evade U.S. taxation.
When Americans go abroad as businesspersons, scholars or trailing spouses, they typically become highly effective ambassadors of American values. We should accord these Americans the same due process and rights that we accord other Americans and stop implicitly treating them as tax cheats.
Mr. Kuenzi is the founding partner of Thun Financial Advisors, a U.S. investment firm based in Madison, WI, that provides investment management and financial planning services to Americans abroad.