Avoiding IRS penalties when an estate includes a foreign account

Usually when considering an estate, people think assets. Debts and liabilities, however, may pass to the next generation and can greatly reduce the value of an estate.

Credit card bills, a mortgage or medical debt may remain unpaid. These creditors may agree to discount the amount owed for a lump sum payment. A federal student loan on the other hand is discharged when the individual who took out the loan dies. The situation changes with a co-signor on a private student loan dies. In this situation, the balance may immediately become due in full.

Other liabilities may include unpaid or disputed taxes or penalties to the State of New York or the Internal Revenue Service. One of the issues that may crop up relates to foreign accounts.

Voluntary disclosure of an offshore account

Offshore accounts have been in the news lately as the Treasury gears up to implement the Foreign Account Tax Compliance Act that goes into effect on July 1, 2014. The IRS has been on the hunt for those with undisclosed offshore accounts. All U.S. citizens and residents need to disclose accounts held at foreign banks on a Report of Foreign Bank and Financial Accounts (FBAR) form if the value is above $10,000 during the fiscal year.

If you had an elderly relative who immigrated to the U.S. from Europe, but left money accruing interest income over the years in an undisclosed Swiss bank account there could be some liability issues. The penalties for failure to report are steep and even criminal when willful.

As an heir of the account, you could avoid criminal charges by filing a disclosure. The offshore voluntary disclosure program requires a taxpayer to pay taxes on the income earned as well as interest that accrued over an eight-year look back period. In addition, a FBAR penalty ranges from five percent to 27.5 percent of the highest balance in the account. The capital gains tax, interest and the penalty could take a substantial portion of an account.

The voluntary disclosure programs started in 2009. Since the initial round, almost 50 percent of the individuals paying the penalties inherited offshore accounts from a relative, according to research by the Government Accountability Office.

Penalties and taxes tied to a foreign bank account can reduce an inheritance. As the IRS continues to receive more information from foreign banks about depositors, quiet disclosure may not protect you from paying back taxes. The IRS statute of limitations allows the agency plenty of time to collect on back taxes, so it is best to take care of issues relating to a foreign account promptly.

Utilize financial accounts that will avoid probate

Various types of accounts can avoid probate and tax penalties. An annuity that you fund to provide pension-like retirement income also usually carries a death benefit. You can designate a beneficiary and this has the benefit of financial privacy for you and heirs by avoiding probate. Proceeds of a life insurance policy may also avoid probate and flow to a beneficiary without tax consequence.

When questions arise about how a transfer of an asset, debt or liability will affect heirs, consult an experienced estate planning attorney. Failure to have a plan in place could result in IRS penalties or a lengthy probate process.