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The IRS Gets Ripped for Allowing Unsupported Foreign Tax Credit Claims: What It Means to Americans Living Abroad

30/09/2015


Americans living abroad are subject to U.S. tax on their worldwide incomes. There are two main ways to avoid U.S. taxation of foreign-source income: The Foreign Earned Income Exclusion (FEIE), and foreign tax credits.

The FEIE only applies to earned (salary and business) income and tops out at $100,800 for 2015. So in order to avoid (or at least mitigate) double taxation, many Americans living abroad claim foreign tax credits (FTCs) on their U.S. returns.

The Treasury Inspector General for Tax Administration (TIGTA) is effectively an auditor of the IRS. TIGTA monitors the IRS to ensure that it is doing its job properly and efficiently. Recently TIGTA focused on how the IRS processes FTC claims, and indirectly, that’s bad news for taxpayers abroad.


What TIGTA found

Over the course of 2010-2, TIGTA found estimated errors that ordinary people would find astounding. Remember, these were the errors missed by the IRS:

  • $95 million of FTCs that were improperly claimed on about 65,500 returns.

  • $250 million of FTCs were claimed without having form 1116 attached, where it was required.

  • $3 million of FTCs that were also claimed as a deduction from income (double-counting is a no-no).

  • $40 million of FTCs where the third-party documentation (1099 forms and the like) did not support the claim.

What’s more, after finding cases that met the threshold for referral to international examination specialists (the IRS has people that focus on these types of issues), it didn’t make the referral. It didn’t even monitor or track assessments made on these types of cases.

Believe it or not, the Internal Revenue Manual (which guides IRS auditors) did not mandate that an auditor contact a taxpayer who as required to file form 1116, but failed to do so. This omission has since been corrected. Importantly, 73% of the returns with errors were prepared by professionals.


TIGTA recommendations 

TIGTA recommended that the IRS:

  • Establish controls to ensure that the Form 1116, Foreign Tax Credit, is attached when required;
      
  • Ensure that any training materials and additional guidance related to FTCs are updated and that employees comply with the updated guidance;
      
  • Develop a compliance strategy to address the risks identified with taxpayer FTC issues;
      
  • Capture and maintain key FTC statistics;
  • Improve education, outreach, and enforcement activities to correct the paid preparer issues related to the FTC; and
      
  • Revise the Internal Revenue Manual and the Specialist Referral System User Guide to clearly define the referral criteria that will be followed to ensure that tax returns in the examination function inventory with FTCs are referred as required. Currently, FTC claims under $25K are not referred to a specialist.

IRS officials agreed with five of TIGTA’s recommendations and have taken or plan to take corrective actions. However, there are limitations on the IRS’ ability to gather additional statistics, due to budget restrictions.


What this means for Americans abroad

Tax professionals have been aware that the IRS’ FTC software is outdated and unreliable. Consequently, auditors rarely rely upon it. Their historical FTC approach has been “if the preparer looks like he knows what he’s doing, let it go”.

Americans abroad are, not surprisingly, the largest group of FTC claimants who are required to file form 1116 (in most cases, if the creditable taxes are under $300/person, the form is not required, so that cuts out most U.S. domestic filers).
This report adds political pressure to the IRS in this area. The anticipated IRS response will be more auditing in this area.

As if Americans abroad haven’t been annoyed enough with the introduction of FATCA, this change will add fuel to the fire. Remember, most Americans abroad live in high-tax countries, where the FEIE and FTC usually eliminate the U.S. tax. This fact makes the increased audit work unlikely to yield much additional revenue.

This means that preparers (including the taxpayers themselves) need to do a better job of calculating FTCs. They had better be ready for more scrutiny. For taxpayers who use paid preparers – even good ones – this audit activity will mean more aggravation and higher fees.