Case Study: Montreal-based doctor in trouble with the IRS

Client profile

Svetlana Klepakhov*, 51, is a family physician with her own practice, living in London, Ont. She moved from the U.S. to Canada with her parents when she was 19. She’s married to Matvei; they have no children. Matvei’s an actor, performing mostly in theatre productions. His income rarely tops $70,000 and can be as low as $45,000.

Svetlana’s followed recent media coverage of the IRS crackdown on the non-compliance of Americans living abroad. She files income tax returns every year, but because she’s had her own professional corporation for 20 years, she’s worried she hasn’t been complying with more complex filing requirements. She has an accountant, but turns to a dedicated cross-border shop for a second opinion.

*This is a hypothetical scenario.

The experts

Mindi Banach

cross-border tax lawyer at Morris Kepes Winters LLP in Toronto.

Veronika Chang

cross-border tax lawyer at Morris Kepes Winters LLP in Toronto.

The situation

Issue #1: IRS Form 5471

The biggest problem is her failure to meet filing requirements for foreign corporations. This isn’t unusual, says Mindi Banach, a cross-border tax lawyer at Morris Kepes Winters LLP. Many U.S. citizens in Canada assume there’s no special filing for their corporations.

From an IRS perspective, Svetlana’s medical practice is a foreign-controlled corporation, and that means annually filing Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations (see “Why someone has to file Form 5471,” below). The penalty for not filing gets Svetlana’s attention: $10,000 for each year she should have filed.

When the IRS discovers someone’s non- compliant, it sends a notice. At that point, the taxpayer has 90 days to get the form in; if it’s late, there’s an extra $10,000 penalty for each full or partial 30-day period beyond the 90-day window. The maximum penalty is $50,000 for each failure to file. So, it’s conceivable someone could rack up multiple $50,000 fines for successive failures to file. Failing to file Form 5471 can also result in a reduction of foreign tax credits.

6

Degree of difficulty

6 out of 10

Svetlana’s problems are complex, but the solutions are made easier by the fact her recordkeeping is detailed and well-organized. Banach and Chang note clients are often surprised by the accounting and other costs for the Streamlined Program. In Svetlana’s case they’ll be between $5,000 and $10,000.

Veronika Chang, also a cross-border tax lawyer at Morris Kepes Winters LLP, notes Svetlana will need to submit balance sheets and other information from her corporation’s financial statements with Form 5471.

Svetlana’s accountant will also need to convert Canadian dollar figures to U.S., using the rate as of December 31 given by the U.S. Treasury Department’s Bureau of the Fiscal Service. Completing the form is a job for a pro, says Banach. “For a U.S. accountant who’s familiar with it and has the background knowledge, it’s not the biggest deal and it’s not going to cost a lot. But if you’ve never filled it out before, it’s going to take a very long time.”

How long? The IRS estimates some filers will need 16 hours and 14 minutes to learn about the law or the form and another 24 hours and 17 minutes to prepare and send the form to the IRS.

Issue #2: Investment income within corporation

Svetlana’s made another mistake: she has investment income within the corporation. Tax experts refer to this as Subpart F income. “It’s essentially passive income,” notes Chang.

Here’s Svetlana’s problem: she hasn’t distributed the income, and CRA won’t tax it until she does; but the IRS taxes it the year it’s earned—distributed or not. So she has to pay the IRS without getting any foreign tax credits, since she’s paid no Canadian tax. But when she later distributes the income, CRA gets its cut. “So essentially there’s double tax,” says Chang.

Issue #3: Income splitting

Svetlana hasn’t been income splitting with Matvei, and it’s not completely clear she should be, notes Banach. “There are conflicting opinions on whether someone in Svetlana’s circumstances can income split.”

If the roles were reversed and the higher- earning Svetlana was a Canadian-only citizen and Matvei a U.S. person, they would in most cases be able to income split.

The IRS normally has no jurisdiction over the income of a non-resident alien, and the extra income would appear on Matvei’s U.S. return. The ambiguity arises in cases like Svetlana’s, where a U.S. person is the higher-earning spouse who wants to split income with a non-U.S. person. Banach notes income splitting is essentially Canada’s answer to the tax breaks U.S. couples get through joint filing.

And while Banach knows U.S.-certified accountants who wouldn’t income split for people like Svetlana, she says there’s no rule specifically stating it’s not allowed. “The law in this area is unclear.”

The solution

Here’s what Banach and Chang suggest Svetlana should do:

Issues #1 and #2: IRS Form 5471 and Subpart F income

She should take advantage of the IRS’s Streamlined Program. It offers leniency to taxpayers whose non-compliance wasn’t willful (see “IRS streamlines its Streamlined Program,”).

This involves back-filing three years of Form 5471, which must be attached to an amended income tax return (Form 1040X). Svetlana also has to certify she’s submitted her FBARs, and provide an explanation of her previous non- compliance. In addition, she must sign a document certifying her non-compliance wasn’t willful; should the IRS find evidence to the contrary, she could be prosecuted for perjury.

Chang says, assuming Svetlana’s fully cooperative, it’s highly likely the IRS will waive penalties and interest triggered by her failure to file, but she’ll still have to pay tax on unreported Subpart F income.

And from now on, adds Banach, Svetlana should distribute the corporation’s investment income every year. This will ensure there’s no Subpart F income.

“She’ll still have the filing requirement,” but no double-tax problem.

Issue #3: Income splitting

Says Chang: “I would tell Svetlana, ‘From a tax standpoint, there’s a savings. However, you have to realize […] there might be a risk the IRS will say the income technically belongs to you, so you should be paying tax on it.’ ”

Why someone has to file Form 5471

Having a controlling interest in a foreign corporation is only one reason why a U.S. person would have to file Form 5471. There are four active categories of filers.

Category 1 Filer:

Category 1 was removed in 2004.

Category 2 Filer:

A U.S. citizen or resident who is an officer or director of a foreign corporation that has at least one U.S.-person shareholder with a stake of 10% or more.

Category 3 Filer:

A U.S. person who owns 10% or more of a foreign corporation. This category can also include “a U.S. person who disposes of sufficient stock in the foreign corporation to reduce his or her interest to less than the [10%] stock ownership requirement,” says the IRS.

Note: there are different definitions of “U.S. person” that apply to different filer categories. For Category 2 and 3, the definition of a U.S. person is a:

• U.S. citizen or resident;
• domestic partnership;
• domestic corporation; or
• domestic estate or trust.

Category 4 Filer:

A U.S. person who owns or controls more than 50% of a foreign corporation. This is the category Svetlana’s in. For Category 4, a U.S. person is a:

• U.S. citizen or resident;
• nonresident alien (e.g., a Canadian-only citizen living in Canada) who elects to be treated as a U.S. resident to allow joint filing with his or her U.S.-citizen spouse (See “Advising same-sex couples with U.S. ties,”);
• domestic partnership;
• domestic corporation; or
• domestic estate or trust.

Category 5 Filer:

A U.S. shareholder in a foreign- controlled corporation. (The definition of “U.S. person” for Category 5 is essentially the same as for Category 2 and Category 3.)

Client acceptance

5/10

Svetlana submits a Streamlined Program package and waits for the IRS’s decision. She gives income splitting serious consideration, but decides she doesn’t want to risk another run-in with the IRS. Since she’s going through the Streamlined Program, she’s worried about giving the taxman reasons to scrutinize other aspects of her situation.

Dean DiSpalatro is a Toronto-based financial writer.