With the 2013 U.S. tax return filing season coming to an end on October 15, 2014 we have noted that U.S. citizens with brokerage accounts in Bermuda are likely either underpaying or overpaying their U.S. income tax.

Brokerage Accounts and Tax Reporting

If you have a brokerage account in the United States with entities such as Merrill Lynch or Morgan Stanley at the end of the calendar year you receive, with a copy to the Internal Revenue Service, a Form 1099 that clearly identifies the amount of dividends and interest income that you received, investment fees paid and a listing of stock sold during the year identifying the date of purchase, the date of sale and the sales price and cost basis.

I have not yet seen a Bermuda based bank or brokerage firm issue a Form 1099 to a U.S. or a Bermuda client. While most local entities will issue a monthly or quarterly report to clients, few will issue an annual summary such as what you would receive from a U.S. based broker. At best, you might receive a summary of dividends and interest received.

Why is this a problem? Locally, most purchases of U.S. stocks are through a 3^rd party usually through your bank or broker and not directly to your account using your social security number. One local bank told us that if client A wants to buy 100 shares of Facebook for their account that such request is forwarded to their Geneva bank who in turn hires a U.S. broker to purchase the stock and the transaction is eventually entered on the client’s records in Bermuda.

As the stock was actually bought by a Geneva bank, when Facebook pays a dividend of $1,000 the payor withholds 30% or $300 because the dividend is going to a foreign person. Client A has a $700 dividend recorded to his account. Some local entities will add a footnote indicating that $300 was withheld while most do not.

The U.S. citizen, client A, who is in the 40% tax bracket will tell us that they have a $700 dividend. If we report a $700 dividend on the tax return they will pay income tax of $280. The reality is that they paid $580 on the $1,000 dividend, the $300 withheld and the $280 they now owe. They should have reported a dividend of $1,000, paid income tax of $400 offset by the $300 that is withheld and owe $100 more, not $280 more.

The problem of overpaying does not end there. Client A has no proof that the $300 was withheld from his dividend other than a monthly bank statement showing the withholding as a footnote. The IRS has no record of the $300 being withheld from Client A. On examination, the $300 will likely be disallowed as a credit.

Thus, if you have a local brokerage account be sure that you are reporting the gross dividend and request that your local broker provides you with documentation that the 30% withholding tax is attributable to your account.

Over Reporting and Withholding on Form 1099 From U.S. Brokers

Another trend we have noted is your U.S. broker purchasing shares in public partnerships investing in gold and silver or oil and gas ventures. If you own shares of Facebook and they distribute a $1,000 dividend the only clarification you need is whether it is an ordinary dividend or a qualified dividend. Partnerships are taxed differently. A distribution could be composed of dividend, interest and capital gains or it could be a non taxable distribution. At the end of the year the partnership will issue a Form K-1 detailing what is taxable and what is not.

So what is the problem? While the partnership will issue you a K-1 the distribution goes to your U.S. broker who reports it on Form 1099. Some report it as a footnote while others record it as income and withhold a 30% tax.

There are actually 2 problems. The Form 1099 is wrong as it is reporting income that has already been reported on K-1 and it also has erroneously withheld tax. Getting your broker to amend the Form 1099 is close to impossible as they do not understand the issue and they will not let you speak to whoever made the decision to include the distribution as income. You may have to change brokers to rectify the problem.

Why are they doing this? One broker attributed it to the drastic penalty imposed by the IRS for failure to report and failure to withhold. As an example, suppose there is a dividend of $10,000 going to an address outside the U.S. If it is going to a U.S citizen there is no need to withhold but if it is going to a foreign national $3,000 should be withheld. But if there is uncertainty and no withholding takes place if it turns out that the dividend actually went to a foreign national the payor will still have to forward $3,000 to the IRS and then will be assessed a 100% penalty for failure to withhold or another $3,000. Hence, to avoid the draconian penalty, 30% withholding takes places anytime there is an iota of doubt as to the recipient.

In conclusion, if you have a local broker be sure to ascertain the gross dividend and obtain documentation as to the 30% tax withheld. If you have a U.S. broker who had purchased public or private partnerships for your account you need to carefully read Form 1099 to ascertain how they have been reported.

Pursuant to the requirements relating to practice 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 U.S. tax consultant as to how specific transactions affect you since tax advice varies with individual circumstances.