What Additional Reporting Does the IRS Require of Foreign Inherited Assets?
“Death may be an avenue of escape from many of the woes of life, but it is no escape from taxes.” U.S. v. Wolin, 126 AFTR 2d 2020-6348 (DC NY) (quoting Kahr v. Commr., 414 F.2d 621, 626 (2d Cir. 1969).
Although the IRS will not tax the actual inheritance, U.S. citizens and green card holders are subject to tax on their worldwide income. This means that income outside of the United States is subject to IRS reporting and U.S. taxation. After satisfying the initial compliance obligations on Form 3520 when receiving a foreign inheritance, it must be assessed what type of IRS foreign asset reporting is required on an ongoing annual basis going forward. In the event that the inherited assets remain outside the US, there may be substantial income tax reporting requirements for foreign assets beyond the normal IRS Form 1040.
These reporting requirements include, but are not limited to, the timely filling of a FinCEN Report 114 (FBAR) and IRS Form 8938 (Statement of Specified Foreign Financial Assets) which merely report the existence of such assets. The IRS uses information reporting as a starting point to determine potential tax noncompliance. Inheritances come in many shapes and forms which require unique U.S. tax reporting:
Reporting Foreign Bank Accounts Holding Cash – Cash held in a foreign bank account is a relatively easy to report to the IRS. In addition to reporting the actual inheritance on Form 3520, there may be additional requirements on the FinCEN Report 114 (FBAR) or IRS Form 8938 (Statement of Specified Foreign Financial Assets). Interest earned must also be reported as income and is taxed no differently than interested earned in a U.S. bank account.
Foreign Investment Accounts (Stocks, ETFs, Mutual Funds, and other pooled investments) – Non-U.S. investment accounts and funds require more complicated U.S. tax reporting. Commonly, non-U.S. investment accounts hold non-U.S. investment products such as non-U.S. listed ETFs, mutual funds, and private investments. The IRS may classify these investments as passive foreign investment companies (PFICs). It is not a violation of U.S. tax law to own a non-U.S. fund classified as a PFIC, but complicated and ongoing annual reporting is required, even if no investments are bought or sold. Oftentimes selling a non-U.S. listed fund, even at punitive taxation rates, immediately upon receipt is the best action. A more detailed discussion of the PFIC problem can be found in the following white paper: “The PFIC Problem.” In addition to the complex reporting of investments in these accounts, disclosure of these accounts is required on the FBAR and FATCA 8938 form.
Non-U.S. Business Ownership – Inheriting ownership of a closely held non-U.S. business presents significant U.S. tax reporting obligations. Extensive reporting may extend deep into the corporate structure and even requires additional U.S. tax reporting by non-U.S. owners. Newer U.S. tax laws related to controlled foreign corporations and global intangible low-taxed income (GILTI, Section 951A) are incredibly complex. These topics are beyond the scope of this article and inheriting ownership in a foreign business requires extensive assistance from an international tax attorney and/or an international tax accountant (ideally prior to the inheritance to possibly create a more efficient ownership structure).
Art and Collectibles – When inheriting paintings, sculptures, clothing, furniture, books, jewelry, or other tangible items with potential for value, it is important to obtain a professional appraisal. An appraisal will document the current value which may be necessary for estate or inheritance tax purposes (filing Form 3520) and is useful for proper insurance estimates. No ongoing U.S. tax reporting is required of tangible items located in another country. However, should items be sold at a profit, there may be gain to report.
International Real Estate – The reporting of foreign real estate owned directly is relatively easy. Apart from the initial Form 3520, there is no special ongoing reporting required of non-U.S. real estate. This may change if the property is rented (requiring income tax reporting of rental income). A sale of property abroad may also need to be reported on U.S. tax filings.
Non-U.S. Life Insurance and Annuity Contracts – For many non-U.S. life insurance policies, there is no U.S. tax upon the death benefit received. However, there still may be decisions to review as some insurance companies will try to convert the deceased’s policy into an annuity, another insurance contract, or other non-U.S. investment vehicle. These investments will often use non-U.S. investment vehicles that will be classified as PFICs (and thus taxed at potentially higher tax rates) and create burdensome U.S. tax reporting issues. In rare circumstances, proceeds from a non-U.S. life insurance policy paid to a beneficiary may be considered taxable income.
Non-U.S. Trust Structures – U.S. taxpayers may become beneficiaries of a non-U.S. trust due to a death. A U.S. taxpayer who is a beneficiary of a foreign trust faces complicated U.S. tax reporting required by the trustee and beneficiary. Transfers to, distributions from and annual income and expenses of foreign trusts must be reported and could possibly be taxed in the U.S. Like ownership of a non-U.S. business interest, it is highly recommended that individuals who are settlors, trustees, or beneficiaries of a foreign trust (non-U.S. trust) obtain specialist tax advice.