FBAR: Challenges for Clients and Firms Alike

Form TD F 90-22.1, “Report of Foreign Bank and Financial Accounts” (commonly known as the “FBAR”), is an annual report that “U.S. persons” are required to file to disclose financial interests, or signatory or similar interests, in foreign bank and financial accounts (“foreign accounts”). While it is administered by the Commissioner of Internal Revenue (the “Commissioner”), the FBAR is required to be filed pursuant to Treasury Regulations relating to the Bank Secrecy Act, not the Internal Revenue Code (the “Code”).

The FBAR is not filed with the tax return, discloses no information about the income derived in a foreign account, and is not used for calculating any tax obligations. Yet the Internal Revenue Service (“IRS”) has converted the FBAR from a minor information report to a primary tool for pursuing hidden bank accounts.

This creates challenges and opportunities for law firms. U.S. law firms can be subject to the FBAR filing requirements, and as such, each firm should assess whether it has an interest in any foreign accounts. Law firms must also ensure that their partners are aware of these obligations, and that they may have a reporting obligation if they accept certain roles as directors, trustees, nominees, or escrow agents that give them access to foreign accounts. At the same time, this is an opportunity to bring great value to clients. Unless alerted by their trusted tax attorneys, many U.S. persons will be unaware of this sudden change in approach by the IRS, and the potentially devastating implications of failing to file outstanding FBARs.

Cause for Concern

Despite having no direct impact on taxes payable, the FBAR has caused substantial concern in recent months for two primary reasons.

First, the IRS has indicated a willingness to severely penalize U.S. persons who are not in compliance with their FBAR obligations. If the FBAR penalty regime was used to its fullest extent against U.S. persons, it would result in fundamentally unjust penalties, calculated with reference to the maximum value of the accounts, not the foreign income generated or the tax avoided. A failure to file an FBAR can attract a penalty equal to 50% of the highest balance of the account during the year (plus potential criminal penalties). Such penalties may be appropriate for financial crimes like money laundering, which the Bank Secrecy Act is geared to address. However, they are inappropriate in the tax context, as they can go well beyond any penalty the Commissioner is authorized to impose under the Code, and do not align the penalty with the tax avoided.

Second, the IRS is providing ambiguous and confusing guidance. When the penalties are so onerous, the instructions and guidance should be absolutely clear. The IRS has already been forced to suspend one significant change to the FBAR instructions as of October 2008 for one year, giving certain filers an extension to file beyond June 30, 2009 because they did not know of their filing obligation and could not obtain the information necessary to make the deadline.

FBAR Filing Obligations

There are four requirements before an FBAR needs be filed. First, the filer must be a U.S. person. Second, there must be a foreign account. Third, the U.S. person must have a financial interest, or signatory or similar interest, in the foreign account. Finally, any exceptions should not apply (for example, foreign accounts of a U.S. person need not be disclosed if the collective balance remains below $10,000 for the year).

U.S. Person

The FBAR instructions, which were issued in October 2008, state that “the term 'United States Person' means a citizen or resident of the United States or a person in and doing business in the United States.” In response to numerous questions and a high level of confusion about what it means to be “in and doing business in the United States,” on June 5, 2009 the IRS issued Announcement 2009-51, which effectively deferred the introduction of the new definition by one year. For the June 30, 2009 filing, United States person (“U.S. person”) means U.S. citizens, U.S. residents, domestic corporations, domestic partnerships, which would include most U.S. law firms, and domestic trusts or estates.

While this has alleviated some of the concerns for the June 30, 2009 filings, greater clarity is still required for future FBARs, which will be required to comply with the new definition in the instructions.

Financial Account

The second requirement is that there is a “financial account.” The definition of financial account is inclusive, rather than absolute, and specifically includes bank accounts of all sorts, securities accounts, securities derivatives accounts, and other financial instrument accounts. It also includes investments in commingled funds such as mutual funds.

It was not clear until June 2009 that the IRS considers foreign hedge funds and private equity funds, which are generally foreign corporations, to be commingled funds. Many practitioners have assumed that “commingled funds” were meant to be limited to trusts and joint ownership arrangements where the U.S. person has a beneficial interest in the underlying assets. If a corporation can be a commingled fund, the question arises as to what distinguishes a foreign corporation that buys, sells, and sometimes short sells portfolio interests in stocks and bonds, from a foreign corporation carrying on any other type of business.

The instructions do not mention foreign pension accounts, but these would seem to be subject to FBAR disclosure also.

Bonds, notes, and stocks that are directly held (i.e., not held in a brokerage account), should not be considered foreign accounts.

Interest in the Account

The U.S. person must have a financial, or signatory or similar interest, in the account before being required to report it. Where a person owns a foreign account, this is quite clear. However, a greater than 50% interest in a corporation, partnership, or trust can also create such an obligation for the shareholder, partner, or beneficiary, respectively. For example, if there is a foreign account owned by a U.S. corporation, which is owned by the U.S. shareholder, both the U.S. corporation and the U.S. shareholder will have a financial interest in the foreign account.

Similarly, when a U.S. person has signatory authority or other authority to direct where funds in the account are used, the U.S. person will need to report this account. Despite having no financial or beneficial interest in the account, a failure to file could still attract substantial penalties.

Assisting Clients

The IRS has announced a Voluntary Disclosure program, which is scheduled to end on Sept. 23, 2009. Prior to that date, attorneys should bring the FBAR disclosure obligations to the attention of their clients (which most will have done), but then probe their responses to be sure they have not forgotten any accounts or misunderstood what disclosures may be required.

This is especially the case for high-risk clients. Clients who tend to vacation in one part of the world every year, have a holiday house offshore, have family overseas, or who immigrated to the United States often have a financial interest or signatory interest in a foreign bank or securities account. Similarly, significant shareholders and directors of companies that invest abroad are likely to have an obligation to file.

Probing is important because many taxpayers simply do not register that there is a need to file an FBAR, or forget about accounts that are for personal use or are used infrequently. For example, a significant deposit could be made in a bank account in France prior to a family's vacation in Paris. These funds could be used while they are traveling, and the account could be left almost empty and dormant for the rest of the year. Another example is where money is sent to a foreign bank account to fund the purchase of an asset (for personal or business purposes). The funds may be in the account for a matter of days, but that is enough to trigger a filing requirement.

Directors and family members involved with family companies are also high-risk U.S. persons, as they are often given a broad range of authority and so may not remember (or may never have been told) that they have signatory authority over a foreign subsidiary's bank account.

Housekeeping

Meanwhile, law firms and their attorneys need to address their exposure to the FBAR obligations. If the firm has offices outside the United States, it will almost certainly have an offshore bank account. However, it may also have escrow accounts, a pension fund, and a range of other accounts that are potentially subject to the FBAR filing requirements. Where there are foreign accounts and specific partners have signatory authority on behalf of the partnership, the partnership and those partners may be required to disclose this on an FBAR.

Law firms should also assist their attorneys who are involved in cross-border transactions or have foreign clients to monitor and track their exposures to foreign accounts to ensure all director, nominee, and similar arrangements that give an attorney authority over a foreign account are identified. Firms should also ensure that such positions are formerly terminated as soon as the relevant transaction is completed.

The potentially devastating penalties have made the FBAR a priority issue that law firms and their clients cannot afford to overlook or take casually. Attorneys should carefully monitor their exposure, both personally and as a firm, to any interests in foreign accounts. By using knowledge of a client's activities, both in and out of business, attorneys can also be of invaluable assistance to their clients in identifying interests in foreign accounts and dealing with the FBAR.

Ryan Dudley is a director of international tax at Friedman LLP. He advises foreign corporations and individuals investing in the United States ' as well as U.S. multinationals investing offshore ' on commercial structures and financing strategies. His clients come from a wide range of industries including law, technology, pharmaceuticals, manufacturing, real estate, infrastructure, and private equity. The views expressed in this article are the views of the author, not Friedman LLP.

Form TD F 90-22.1, “Report of Foreign Bank and Financial Accounts” (commonly known as the “FBAR”), is an annual report that “U.S. persons” are required to file to disclose financial interests, or signatory or similar interests, in foreign bank and financial accounts (“foreign accounts”). While it is administered by the Commissioner of Internal Revenue (the “Commissioner”), the FBAR is required to be filed pursuant to Treasury Regulations relating to the Bank Secrecy Act, not the Internal Revenue Code (the “Code”).

The FBAR is not filed with the tax return, discloses no information about the income derived in a foreign account, and is not used for calculating any tax obligations. Yet the Internal Revenue Service (“IRS”) has converted the FBAR from a minor information report to a primary tool for pursuing hidden bank accounts.

This creates challenges and opportunities for law firms. U.S. law firms can be subject to the FBAR filing requirements, and as such, each firm should assess whether it has an interest in any foreign accounts. Law firms must also ensure that their partners are aware of these obligations, and that they may have a reporting obligation if they accept certain roles as directors, trustees, nominees, or escrow agents that give them access to foreign accounts. At the same time, this is an opportunity to bring great value to clients. Unless alerted by their trusted tax attorneys, many U.S. persons will be unaware of this sudden change in approach by the IRS, and the potentially devastating implications of failing to file outstanding FBARs.

Cause for Concern

Despite having no direct impact on taxes payable, the FBAR has caused substantial concern in recent months for two primary reasons.

First, the IRS has indicated a willingness to severely penalize U.S. persons who are not in compliance with their FBAR obligations. If the FBAR penalty regime was used to its fullest extent against U.S. persons, it would result in fundamentally unjust penalties, calculated with reference to the maximum value of the accounts, not the foreign income generated or the tax avoided. A failure to file an FBAR can attract a penalty equal to 50% of the highest balance of the account during the year (plus potential criminal penalties). Such penalties may be appropriate for financial crimes like money laundering, which the Bank Secrecy Act is geared to address. However, they are inappropriate in the tax context, as they can go well beyond any penalty the Commissioner is authorized to impose under the Code, and do not align the penalty with the tax avoided.

Second, the IRS is providing ambiguous and confusing guidance. When the penalties are so onerous, the instructions and guidance should be absolutely clear. The IRS has already been forced to suspend one significant change to the FBAR instructions as of October 2008 for one year, giving certain filers an extension to file beyond June 30, 2009 because they did not know of their filing obligation and could not obtain the information necessary to make the deadline.

FBAR Filing Obligations

There are four requirements before an FBAR needs be filed. First, the filer must be a U.S. person. Second, there must be a foreign account. Third, the U.S. person must have a financial interest, or signatory or similar interest, in the foreign account. Finally, any exceptions should not apply (for example, foreign accounts of a U.S. person need not be disclosed if the collective balance remains below $10,000 for the year).

U.S. Person

The FBAR instructions, which were issued in October 2008, state that “the term 'United States Person' means a citizen or resident of the United States or a person in and doing business in the United States.” In response to numerous questions and a high level of confusion about what it means to be “in and doing business in the United States,” on June 5, 2009 the IRS issued Announcement 2009-51, which effectively deferred the introduction of the new definition by one year. For the June 30, 2009 filing, United States person (“U.S. person”) means U.S. citizens, U.S. residents, domestic corporations, domestic partnerships, which would include most U.S. law firms, and domestic trusts or estates.

While this has alleviated some of the concerns for the June 30, 2009 filings, greater clarity is still required for future FBARs, which will be required to comply with the new definition in the instructions.

Financial Account

The second requirement is that there is a “financial account.” The definition of financial account is inclusive, rather than absolute, and specifically includes bank accounts of all sorts, securities accounts, securities derivatives accounts, and other financial instrument accounts. It also includes investments in commingled funds such as mutual funds.

It was not clear until June 2009 that the IRS considers foreign hedge funds and private equity funds, which are generally foreign corporations, to be commingled funds. Many practitioners have assumed that “commingled funds” were meant to be limited to trusts and joint ownership arrangements where the U.S. person has a beneficial interest in the underlying assets. If a corporation can be a commingled fund, the question arises as to what distinguishes a foreign corporation that buys, sells, and sometimes short sells portfolio interests in stocks and bonds, from a foreign corporation carrying on any other type of business.

The instructions do not mention foreign pension accounts, but these would seem to be subject to FBAR disclosure also.

Bonds, notes, and stocks that are directly held (i.e., not held in a brokerage account), should not be considered foreign accounts.

Interest in the Account

The U.S. person must have a financial, or signatory or similar interest, in the account before being required to report it. Where a person owns a foreign account, this is quite clear. However, a greater than 50% interest in a corporation, partnership, or trust can also create such an obligation for the shareholder, partner, or beneficiary, respectively. For example, if there is a foreign account owned by a U.S. corporation, which is owned by the U.S. shareholder, both the U.S. corporation and the U.S. shareholder will have a financial interest in the foreign account.

Similarly, when a U.S. person has signatory authority or other authority to direct where funds in the account are used, the U.S. person will need to report this account. Despite having no financial or beneficial interest in the account, a failure to file could still attract substantial penalties.

Assisting Clients

The IRS has announced a Voluntary Disclosure program, which is scheduled to end on Sept. 23, 2009. Prior to that date, attorneys should bring the FBAR disclosure obligations to the attention of their clients (which most will have done), but then probe their responses to be sure they have not forgotten any accounts or misunderstood what disclosures may be required.

This is especially the case for high-risk clients. Clients who tend to vacation in one part of the world every year, have a holiday house offshore, have family overseas, or who immigrated to the United States often have a financial interest or signatory interest in a foreign bank or securities account. Similarly, significant shareholders and directors of companies that invest abroad are likely to have an obligation to file.

Probing is important because many taxpayers simply do not register that there is a need to file an FBAR, or forget about accounts that are for personal use or are used infrequently. For example, a significant deposit could be made in a bank account in France prior to a family's vacation in Paris. These funds could be used while they are traveling, and the account could be left almost empty and dormant for the rest of the year. Another example is where money is sent to a foreign bank account to fund the purchase of an asset (for personal or business purposes). The funds may be in the account for a matter of days, but that is enough to trigger a filing requirement.

Directors and family members involved with family companies are also high-risk U.S. persons, as they are often given a broad range of authority and so may not remember (or may never have been told) that they have signatory authority over a foreign subsidiary's bank account.

Housekeeping

Meanwhile, law firms and their attorneys need to address their exposure to the FBAR obligations. If the firm has offices outside the United States, it will almost certainly have an offshore bank account. However, it may also have escrow accounts, a pension fund, and a range of other accounts that are potentially subject to the FBAR filing requirements. Where there are foreign accounts and specific partners have signatory authority on behalf of the partnership, the partnership and those partners may be required to disclose this on an FBAR.

Law firms should also assist their attorneys who are involved in cross-border transactions or have foreign clients to monitor and track their exposures to foreign accounts to ensure all director, nominee, and similar arrangements that give an attorney authority over a foreign account are identified. Firms should also ensure that such positions are formerly terminated as soon as the relevant transaction is completed.

The potentially devastating penalties have made the FBAR a priority issue that law firms and their clients cannot afford to overlook or take casually. Attorneys should carefully monitor their exposure, both personally and as a firm, to any interests in foreign accounts. By using knowledge of a client's activities, both in and out of business, attorneys can also be of invaluable assistance to their clients in identifying interests in foreign accounts and dealing with the FBAR.

Ryan Dudley is a director of international tax at Friedman LLP. He advises foreign corporations and individuals investing in the United States ' as well as U.S. multinationals investing offshore ' on commercial structures and financing strategies. His clients come from a wide range of industries including law, technology, pharmaceuticals, manufacturing, real estate, infrastructure, and private equity. The views expressed in this article are the views of the author, not Friedman LLP.