It is our policy not to have a client enter into a state voluntary disclosure program or file amended state tax returns until after their federal standard full offshore voluntary disclosure (OVD) has concluded.
Why? First, states rarely prosecute for income tax evasion. The chances of needing criminal protection is nil if you are taking your time to properly file amended state tax returns and are using a state voluntary disclosure program. Second, states do not have horrific FBAR penalties they can assess; FBARs are strictly a federal issue. If you were to be audited by a state revenue department, the taxes you would be assessed would likely be the taxes you owed, and not some insanely high penalty based upon an account value.
Now, on to the traps.
Trap Number one: Paying too much and missing your refund window
The inspiration of this article was an incredible comment left on our state voluntary Disclosure programs article. In the comment, the taxpayer explains that through his attorney he filed his amended federal 2004-2012 tax returns for the 2102 OVDP, and then filed amended North Carolina state tax returns for 2004-2012.
Doesn't sound like a big deal, right?
Here's the problem: the amended 1040's he submitted for his OVDP did not properly calculate his Adjusted Gross Income (AGI). In fact, it calculated the AGI way too high (this is common as foreign tax returns are incredibly hard to get right). Luckily, during the examination of his offshore income, the OVDP auditor discovered the errors and lowered our commenter's AGI.
You may ask — what does your federal AGI have to do with your state tax due? The answer is, nearly everything. Your state tax due is mostly based on your federal Adjusted Gross Income (and there is an important exception we will discuss below). If your federal AGI goes up, so does your state tax. If your federal AGI goes down, so too, your state income tax liability.
Hopefully now you can see the issue: the taxpayer's attorney overstated his federal AGI for 2004-2012 with incorrect 1040's, which led to an inflated federal tax bill. And this AGI overstatement also led to inflated North Carolina tax bills for 2004-2012 (or 2006-2012, if the assessment was time limited for 2004 & 2005).
Fortunately, the AGI errors were caught and reduced for federal tax purposes. However, the overstated North Carolina tax bill was paid in 2012, and this date is important as I will explain.
Usually this shouldn't be much of a problem — a taxpayer can simply file a claim for refund by filing amended returns of the previously amended returns. Yet, there is a problem with the North Carolina refund. A claim for refund with states is usually time-limited like it is with the IRS. That is, you can file a claim for refund for a tax as long as it hasn't been more than three years since the return was due, or you can claim a refund of any amounts paid within the last two years.
However, it was not until late 2015 that his federal AGI was finally adjusted downward and agreed to with the signing of Form 906 (and yes — OVDPs do take that long, if not longer to process; we still have OVDI opt-outs from 2011 open).
Do you see the issue now? It's been over 2 years since the over-payment on the North Carolina assessment and all the returns, with the exception of 2012 (which could have been due as late as October 15, 2013, with a properly filed extension) which were due more than three years ago.
This means the taxpayer would be prevented from claiming a refund on an overpaid state tax. Luckily there is a recent exception in North Carolina that allows a refund within one year of a final determination of a federal AGI in which to claim a refund pursuant to NC Gen. Stat. 105‑241.6(2)(b)(1).
Our commenter indicated that he has made such a claim, but has still not gotten his money back. And in this case, the refund he hopes to get form North Carolina is about a million dollars! So you can imagine his stress.
Wouldn't it be better not to have overpaid the state in the first place? Wouldn't it be better to have your million dollars and not have to hope a state revenue agency will agree with your interpretation of the facts and the law? After the gauntlet of a full OVDP, haven't you've been through enough?
With full OVDP, can you see why you really want to wait until your OVDP is concluded before you file your state amended returns or enter into a state voluntary disclosure program. Not all states are like North Carolina — many give you a shorter amount of time, if any, to contest your state liability after your federal determination has been made.
Note: This does not apply with Streamlined Domestic Offshore Procedure as there, state returns can be filed simultaneously as there are usually months between filing and the adjustment to your federal AGI – not the years of a full OVDP. If an error is detected the two-year refund rule will provide enough time to make a claim to correct.
Trap Number Two: Over (or under) paying taxes on PFIC income
Essentially, Passive Foreign Investment Companies (PFICs) are foreign mutual funds. They can also can appear in situations where the taxpayer has someone else managing an account overseas that earns passive income. To learn more about PFICs click here. The higher the balance, the more likely it is that we will see PFICs somewhere in our clients' portfolios.
No matter where on the globe one of our clients has offshore accounts, we are always on the lookout for PFICs as their tax treatment during an OVDP are rather strange. We have even seen PFICs in foreign life insurance policies.
PFICs do not have a great tax treatment for federal tax purposes. The odd thing is that during a full OVDP, PFIC income does not "hit" your federal AGI. Rather, it hits your "account" as "other tax." This is important as some states don't have a place to put this "other tax" on their income tax return (or don't tax "other tax"), so it may be income you can entirely leave out and not have to pay state taxes on.
Some states like New York, and yes, North Carolina, capture your PFIC income elsewhere on your return other than the federal AGI line. Specifically in North Carolina, you would have to add the market-to-market income amount (not the 20% OVDP FAQ 10 tax) to Schedule S line 3o of the D-400 of your North Carolina income tax return.
We are willing to bet that most people with PFICs — in every state that has income tax — are not doing this. Why? I can tell you that even our tax software, CCH – the best available tax software in our opinion, does not prompt you to put PFIC income in. You have to know enough to override the systems to file the return correctly.
So our advice on your state tax returns while in OVDP?
You really want to wait until your full OVDP is over before submitting a state tax return. If you filed a state tax return and time is running out on claiming a refund, you may want to have someone check your amended state tax returns to see that they are filled out correctly. You want to get those filed ASAP so you do not miss out on the time to claim a refund. That is, if you have filed and paid, do not wait until your OVDP is completed to verify the state amount if correct.
Of course, OVDP clients who live overseas or in states like Alaska, Florida, Nevada, South Dakota, Texas, Washington, Wyoming, with no state income tax, do not have to worry about this issue. And no, we are not forgetting about Tennessee or New Hampshire — while they do not tax wages, both of these states tax worldwide income from investments.
If you are feeling a little overwhelmed by all of this information, contact us. We can help. Call us at 888-727-8796 or email info@irsmedic.com.
