At times young children have trouble sleeping as they are afraid of the monster under their bed or in the closet. This, of course, is imaginary. At other times US citizens in Bermuda may have trouble sleeping because they have not properly filed their US income tax returns. These nightmares are about to become a reality.

Internal Revenue Service Targets Bermuda

We recently learned that a senior international agent of the Internal Revenue Service spent time in Bermuda earlier this year assessing the amount of non compliance with US income tax and reporting requirements. Why Bermuda?

Bermuda is an easy target for the Internal Revenue Service. One, you have President Obama's frequent comments about it being a tax haven, so you can make the boss happy by investigating Bermuda.

Two, the recently signed "Exchange of Information Treaty" gives the Internal Revenue Service access to information that may not have been available to them in the past.

Three, European and other Western countries have income tax treaties with the United States that do not subject the residents of said countries to US income tax if they spend less than 183 days in the United States. There is no such clause in the US/Bermuda treaty. Also, US citizens residing in said countries usually pay a higher rate of tax than what they would have paid in the US. Subsequently, if they are caught for not having filed a US tax return, the foreign tax that they paid usually will totally offset the US income tax.

So in a sense, concentrating on non compliance in Bermuda is akin to picking low-hanging fruit.

US Citizens Who Have Failed to File A US Tax Return

US citizens and resident aliens who reside in Bermuda can elect a $91,400 foreign earned income exclusion and a foreign housing exclusion. These exclusions are elective and must be made with a timely filed return. A US citizen earning $100,000 in Bermuda is likely to pay no US income tax if the exclusions are elected.

However, if you receive a letter from the Internal Revenue Service asking why you have not filed, you can no longer elect the exclusions and will likely owe income tax in the amount of $20,000 plus penalties and interest of about $10,000. You may be able to avoid the tax, penalties and interest by immediately filing all past year's returns and providing the Internal Revenue Service with a good reason for not filing.

How Will the Internal Revenue Service Find You?

Have you registered your name and address at the US Consulate? When you fly to the US do you use your Bermuda address when you go through immigration? Both these lists are readily available to the Internal Revenue Service, and it is likely easy for them to cross reference your name and address with returns filed by US citizens living in Bermuda.

And under the recently signed "Exchange of Information Treaty" with Bermuda, perhaps they can ask the Bermuda government for a list of US citizens who have work permits and residency status in Bermuda.

Bermuda Nationals and Other Foreign Nationals Residing in Bermuda Who Periodically Work In the US

As noted in prior columns, if a Bermuda national periodically works in the United States and earns more than $3,000 he or she is subject to US income tax. You do not have to be employed by a US company to realise US source income.

If you work for a Bermuda company, earn $100,000, and work 200 days a year with 10 of those days worked in the US you have $5,000 of US source income and are subject to US income tax. Failure to file a US tax return will subject you to the same tax, penalties and interest a US citizen would pay.

Bermuda Companies Which Send Employees to Work in the United States

This category will likely yield the largest amount of tax and penalty for the Internal Revenue Service. If a Bermuda employer sends an employee to work in the United States, regardless as to whether the employee is a US citizen, a Bermuda national, or a foreign national, the employer is required to withhold US Federal income tax, State income tax, Social Security and Medicare tax, and Federal Unemployment tax from the employee and to remit theses taxes to the United States within a few business days at the end of the pay period.

Failure to do so will result in not only a request for the taxes due, but also a 100% penalty for failure to pay the tax due. And, the corporate officer responsible for failing to pay the tax can be subject to criminal penalties.

Internal Revenue Service International Agents

We were told that the number of Internal Revenue Service agents who specialise in dealing with taxpayers outside the United States will double in the next two months.

Given the increase in agents available for international audits and given that a preliminary review of non compliance has already been concluded, the open question is when the audits will begin.

Pursuant to the requirements relating to practise before the Internal Revenue Service, any tax advice in this communication is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties imposed under the United States Internal Revenue Code, or (ii) promoting, marketing or recommending to another person any tax related manner.

The tax advice given by this column is, by necessity, general in nature. You should, of course, check with your own US tax consultant as to how specific transactions affect you since tax advice varies with individual circumstances.

James Paul Sabo, CPA, is the president of ETS Ltd., PO Box HM 1574, Hamilton HM GX, Bermuda. Questions should be sent to: jsabo@expatriatetaxservices.com