Far-reaching new rules aimed at catching overseas tax cheats take effect July 1. Here’s what you need to know to avoid running afoul of the IRS

Offshore Accounts: What to Do Now

Far-reaching new rules aimed at catching overseas tax cheats take effect July 1.

LAURA SAUNDERS

Updated June 20, 2014 6:47 p.m. ET

The federal government’s campaign to track down money held by U.S. taxpayers in foreign countries shifts into high gear July 1.

That is when the main provisions of the Foreign Account Tax Compliance Act, known as Fatca, come into force.

The law, which Congress passed in 2010, is pushing tens of thousands of foreign banks and other financial institutions to disclose information about U.S. customers. It will make life more complex and expensive for many U.S. taxpayers with financial ties abroad, affecting everything from retirement savings to investments to divorce settlements.

“Fatca is an ambitious effort to root out wealthy U.S. taxpayers hiding money offshore and put an end to tax evasion as a profitable line of business for banks,” says Michael Graetz, a Columbia University law professor and former top U.S. Treasury Department official. “But U.S. authorities need to make an effort to avoid catching innocent middle-class citizens in its net.”

That could be hard. Unlike most other nations, the U.S. taxes citizens, green-card holders and residents on income earned anywhere in the world. (There is partial relief from double taxation.) It also imposes complex reporting requirements that come with severe potential penalties for those who fail to comply.

Yet many people don’t know the rules, and others don’t follow them. An estimated 7.6 million U.S. citizens live abroad, and millions of others have green cards that subject them to U.S. tax rules—yet only a few hundred thousand file required tax or disclosure forms annually.

Fatca could sweep up many of these people. In essence, it is an enforcement program that requires foreign firms to provide information about U.S. customers’ accounts totaling as little as $50,000, much as U.S. banks and brokerage firms report domestic income on 1099 forms. As in the U.S., the IRS will be able to match this information against tax returns and see who isn’t paying what they owe.

Congress gave foreign firms powerful incentives to cooperate. If they don’t, the firms and all their account holders could be docked 30% of payments—such as interest and dividends—from U.S. sources.

Thus, if a Philippine citizen with no U.S. ties has an account at a foreign bank that doesn’t comply with Fatca, then he could lose 30% of his interest payment from U.S. government bonds or his dividends from U.S. stocks.

By the Numbers

To avoid this hit, more than 77,000 banks and other financial firms abroad have agreed, effective July 1, to report data on U.S. accounts, including 784 in Singapore, 13 in Albania and four in Chad. They will start turning over data next March, though many will have up to two years to comply fully, says Jonathan Jackel, a lawyer at Burt, Staples & Maner in Washington.

Thirty-six countries have also signed agreements with the U.S. to help transfer information between firms located there and the IRS, and another 42 are close to doing so, according to the Treasury Department.

Fatca’s effects are being felt already. Some foreign firms are raising account minimums for U.S. customers to $1 million or more because of increased record-keeping costs. Others are signing up with the IRS to avoid the possible 30% hit—and then purging U.S. accounts to cut the new compliance costs.

In Zurich, 9-year-old Elliott Milne, the son of a Utah native, recently tried to open his first bank account, a rite of passage in Switzerland, and deposit 120 carefully saved Swiss francs. The bank officer “fawned over him—until she saw his U.S. passport. Her face fell and she rejected him,” says his father, Dustin Milne, an executive at Vontobel Swiss Wealth Advisers, an investment firm.

The ban on U.S. accounts isn’t just happening at high-end firms. A spokesman for National Savings & Investments, a British government program offering savings bonds, said it is closing the accounts of customers affected by Fatca because the administrative costs are “disproportionate and not a good use of U.K. taxpayers’ money.”

Some U.S. taxpayers are taking extraordinary steps to make sure Fatca’s long arm can’t touch a non-U.S. spouse’s assets. Robin Miranda, a risk analyst from New York who lives in Zurich with her German-born husband, says she doesn’t have power of attorney for her husband because that could make his assets reportable to the U.S.

Many others with global ties face high tax-preparation fees, often $2,000 to $4,000 a year or more. “It’s nearly impossible for U.S. taxpayers with global accounts to do their own returns,” Mr. Milne says.

The full range of challenges for U.S. taxpayers with global financial ties won’t become clear until U.S. authorities demonstrate how they intend to use the information Fatca will provide.

Until then, here is a rundown of issues you need to know about—whether you are a U.S. citizen living or working abroad, a foreign citizen working in the U.S., a U.S. resident with assets abroad or a green-card holder living abroad.

Asset disclosure. U.S. taxpayers must file an annual Foreign Bank Account Report, or Fbar, with the Treasury Department by June 30 if their foreign financial accounts held a total of more than $10,000 at any point in the prior year.

A list of reportable accounts is at IRS.gov, and it includes not just personal accounts but also those a taxpayer has power over. U.S. taxpayers also must report the full value of accounts held jointly with non-U.S. citizens.

Penalties for failing to file the form can be severe—as much as 50% of the highest account balance each year. This past week, the IRS raised penalties for willful nonfilers and greatly eased them for taxpayers who unintentionally violated the law.

Taxpayers also may need to report accounts on IRS Form 8938 with their tax returns, which has higher reporting thresholds than the Fbar. (A comparison of the two forms is available at IRS.gov.)

In general, nonfinancial assets such as real estate or collectibles like jewelry or art don’t need to be reported unless they are held in a trust or other entity. But safe-deposit boxes often are linked to reportable accounts.

Wages and other foreign earned income. U.S. taxpayers living abroad must report income from a job or a business, but each individual gets an exemption, currently around $100,000. They also can claim a credit for foreign taxes paid on both earned and unearned income—such as that from investments—though the credit may not completely compensate for double taxation.

Retirement, savings and pension plans. For many people, such plans raise vexing issues. Contributions to and investment gains in foreign plans often don’t qualify for tax deductions or deferrals, even though they are similar to U.S. plans that do offer those advantages, such as individual retirement accounts, Roth IRAs and 529 education-savings plans.

Thus, if an Australian who has that country’s version of an IRA relocates to take a job in the U.S., the annual appreciation in that account is considered taxable under U.S. law.

In addition, the account is subject to complex reporting requirements as a “foreign trust” (see the section on trusts below). Reporting mutual funds held in the account will add another layer of complexity.

Recent Fatca agreements concluded with some governments, including Canada and Australia, have exempted foreign firms from reporting many such accounts to the IRS, but individuals still have to disclose them. It isn’t clear whether the IRS can provide relief to individuals or Congress has to change the law.

1.  Offshore investments—often used to hide money abroad in the past—have their own complex tax and reporting regimes for U.S. taxpayers. The penalties for noncompliance can be severe.

In particular, people who hold offshore mutual funds must file IRS Form 8621 for each investment, even if several different funds are held in a single account. The IRS estimates that each form will take more than 35 hours to complete—after the taxpayer spends 11 hours to learn the requirements.

Business ownership. U.S. taxpayers who own businesses abroad should seek expert help to navigate tax requirements that could trap the unwary.

For example, if startup money sits too long in an offshore account, experts say, it may be classified as an investment fund. There also are harsh penalties for not reporting stakes in either corporations or partnerships.

Social insurance taxes. While employees of foreign firms are often exempt from Social Security and Medicare taxes, self-employed people abroad typically aren’t. One way around the requirement is to incorporate the business, though that can present reporting headaches.

On the other hand, U.S. taxpayers who pay these levies can collect Social Security benefits later, even if they live abroad. People who paid into the system but renounce their citizenship still can receive benefits, says Phil Hodgen, an international tax lawyer in Pasadena, Calif.

Life insurance. Foreign-issued life-insurance policies often are subject to a 1% U.S. excise tax on premium payments. Policies with an investment component often qualify as offshore funds rather than insurance products, with the same complicated reporting requirements as other investments, experts say.

Home mortgage interest. U.S. taxpayers living abroad can claim a deduction for mortgage interest if it also would qualify for a deduction in the U.S., and it often does, Mr. Hodgen says.

Charitable contributions. Contributions must be made to qualified U.S. charities and other nonprofits to be deductible on U.S. tax returns, unless the deduction is allowed under a tax treaty, Mr. Hodgen says.

1.  Because trusts have been notorious vehicles for hiding assets offshore, reporting requirements often are complex and potential penalties high.

Taxpayers often must file two forms in addition to claiming income on personal tax returns. The nonfiling penalty can be as high as 35% of both contributions and withdrawals, plus 5% of assets.

In addition, if a foreign trust has even one beneficiary who is a U.S. taxpayer—such as the American spouse of a German man whose grandfather set up the trust—that could make it reportable to the U.S.

1.  The IRS may take a closer look at divorce settlements as Fatca takes effect, says Jonathan Lachowitz, a cross-border investment expert at White Lighthouse Investment Management, which is based in Lexington, Mass., and Lausanne, Switzerland.

Arrangements that work in other countries may not pass IRS muster. For example, what counts as an alimony payment abroad may not be tax-deductible under U.S. law, or a routine division of marital property may be deemed a taxable sale or a gift. Issues can be especially tricky in countries with community-property laws, Mr. Lachowitz says.

Estate and gift taxes. Fatca also may prompt the IRS to scrutinize estate- and gift-tax issues involving U.S. taxpayers and non-U.S. spouses. As with the income tax, world-wide assets are subject to U.S. estate and gift taxes.

There are many potential pitfalls, says Mr. Lachowitz. One is that non-U.S. spouses can’t receive unlimited gifts or inherit assets tax-free in the way U.S. spouses can. And if the U.S. spouse inherits from a non-U.S. partner, he or she must disclose amounts over $100,000 to the IRS or risk a stiff penalty.