Minimizing Penalties for Unreported Foreign Bank Accounts

So what can taxpayers with unreported foreign bank accounts expect from the IRS? A taxpayer who fails to report the existence of a foreign bank account and/or income from a foreign bank account can be subject to several different civil and criminal penalties. Oddly enough, the most severe penalties are not the penalties for failing to report the income from the account but, instead, are the penalties for failure to file an information return disclosing the existence of the account, known as the Report of Foreign Bank and Financial Accounts, Form TD F 90-22.1, commonly called an FBAR.

An FBAR must be filed by United States persons to disclose ownership and signatory or other authority over a foreign bank, security or financial account. A person who willfully fails to file an FBAR, or who willfully files a false FBAR, is subject to a criminal penalty of up to five years in prison and/or a criminal fine of $250,000. In addition, beginning with FBARs due in 2005, Congress significantly increased the civil penalty that can be imposed on any person who willfully fails to file an FBAR, or who willfully files a false FBAR. The civil penalty is up to 50% of the balance in the account for each year that the violation continues. Thus, even if a taxpayer avoids criminal prosecution, he or she can be subject to crippling civil penalties that easily could be several times the size of the unreported foreign account.

Ramping It Up

In the past, the FBAR reporting requirements were rarely enforced, and very few penalties were ever imposed. Indeed, a Treasury study found that, in 2001, only 20% of taxpayers with foreign bank accounts were actually filing the required reports. More recently, however, the IRS has made clear that it intends to ramp up FBAR enforcement. Taxpayers who voluntarily disclose their previously unreported foreign bank accounts can avoid criminal prosecution but can expect to pay significant FBAR penalties. Taxpayers who are caught red-handed with an unreported foreign account will face a potential criminal prosecution for failure to file the FBAR and, even if the government declines to prosecute, the civil FBAR penalties that are asserted will be far greater than if the taxpayer had come forward voluntarily.

It is important to understand, however, that these oppressive civil and criminal FBAR penalties apply only when the government can prove that the violation of the FBAR reporting obligations was willful. The penalties for non-willful violations are relatively mild: there can be no criminal prosecution, and the civil penalties are only $10,000 per year for 2005 and later (prior to 2005, no penalty existed for non-willful violations). Thus, willfulness is the key issue in the context of an FBAR violation. A taxpayer who is confident that the government cannot prove willfulness will have much greater leverage in negotiating a potential penalty.

Unfortunately, there is a dearth of authority on how willfulness is defined in the FBAR context. The main sources of guidance are some provisions in the Internal Revenue Manuel (IRM), a memorandum written by the IRS Office of Chief Counsel to its field agents (the “OCC Memo”), some Supreme Court cases discussing willfulness in other contexts, and one appellate decision that specifically addresses a criminal prosecution for failure to report a number of foreign bank accounts, United States v. Sturman, 951 F.2d 1466 (6th Cir. 1991).

Supreme Court Cases

Supreme Court cases have defined willfulness for purposes of income tax prosecutions as “an intentional violation of a known legal duty.” In the IRM and the OCC Memo, the IRS recognized that this definition applies for both the civil and criminal FBAR penalties. The IRM and the OCC Memo also agree that, for purposes of the civil FBAR penalty, the IRS must prove willfulness by clear and convincing evidence, and that a criminal prosecution would require proof of willfulness beyond a reasonable doubt. The first step in proving that a taxpayer willfully failed to file the FBAR is to prove that he or she knew of the FBAR filing requirement. This is no easy task given the lack of FBAR enforcement over the past 30 years. Most taxpayers and accountants were completely unaware of the FBAR filing requirements until recently. Indeed, it is likely that most IRS agents themselves were not aware of the FBAR filing requirements until a few years ago when the FBAR form began to receive more attention from the IRS.

So how does the IRS go about proving that a taxpayer knew of the FBAR filing requirement? The only direct evidence of what a person knew or did not know is a confession. Absent a confession of knowledge, the only way to prove a person's state of mind is through indirect or circumstantial evidence from which a finder of fact can infer what the person must have known.

The IRM identifies several types of evidence that could support an inference that a taxpayer knew of the requirement to file an FBAR yet nevertheless failed to file it. Such evidence includes failure to report income from the foreign bank account on the taxpayer's tax return, failure to check the box on Schedule B asking whether the taxpayer has a foreign account, or falsely checking the box “No,” discussions between the taxpayer and an accountant regarding the foreign bank account, and false statements to an IRS agent who inquires about the existence of a foreign bank account.

Many IRS agents and some government attorneys believe that evidence that a taxpayer failed to report income from the foreign account and failed to disclose the account in answer to the question on Schedule B clearly demonstrate that the taxpayer is a tax cheat and liar who must have known about the FBAR filing requirements, yet willfully failed to comply.

Nothing could be further from the truth. Many taxpayers inherit the foreign accounts and believe that income earned in a foreign country is not reportable in the United States until it's brought into the country. The tax code is so complicated and riddled with exceptions regarding the reporting of off-shore earnings that such a belief is very understandable. Further, Form 1040 is sufficiently complex that many taxpayers simply signed their tax returns without reviewing every line, including the line at the bottom of Schedule B asking whether the taxpayer had a foreign bank account. Most accountants never discuss this aspect of the return with their clients and simply check the box no without further inquiry.

In Sturman, the only reported decision that discusses the imposition of a criminal FBAR penalty, the taxpayer clearly intended to evade taxes by creating hundreds of shell corporations to skim income from his adult publishing business and diverting it to a series of undisclosed foreign bank accounts. In addition, Sturman admitted that he knew that he was supposed to check the “Yes” box on Schedule B disclosing the foreign accounts, but failed to do so. Thus, the Sturman case had particularly strong indicia of willfulness and cannot be used to support the imposition of civil or criminal FBAR penalties on typical taxpayers, such as those who inherited a foreign bank account and simply failed to report it to the IRS.

Opposite Cases

Not all taxpayers who fail to report income from and the existence of a foreign account on a tax return are trying to hide it from the IRS. In Cheek v. United States, 498 U.S. 192 (1991), the Supreme Court held that an honest but mistaken belief regarding the requirements of the tax law is a complete defense to a criminal tax prosecution, no matter how unreasonable the taxpayer's belief may be. Because the definition of willfulness is the same for both civil and criminal FBAR penalties, the same principle applies.

Conclusion

Taxpayers may be able to avoid imposition of FBAR penalties if they can convince the IRS that it will not be possible to prove that the taxpayer knew about the FBAR filing requirement yet intentionally failed to comply ' i.e., willfulness. To prevail, taxpayers must have a good explanation of why they did not report the income from the foreign account nor check the box “Yes” on Schedule B of their tax return. Also, it is important to establish that the taxpayer did nothing to hide the existence of the account from the return preparer or the auditing agent. These factors, combined with sympathetic background facts regarding the taxpayer's age, health, family background, level of sophistication and reason for holding a foreign account, must be developed and forcefully presented to the IRS. In the end, some of these cases will go to trial, and courts will find that many taxpayers should not be subject to crippling FBAR penalties.

Bryan C. Skarlatos (bskarlatos@kf law.com) is a partner at Kostelanetz & Fink, LLP, New York, where his practice focuses on civil and criminal tax controversies. Michael Sardar is an associate at the firm.

Taxpayers with unreported foreign bank accounts are sweating bullets these days. The IRS is in the midst of an unprecedented crackdown on foreign bank accounts. The primary example is the criminal prosecution of UBS (f/k/a Union Bank of Switzerland). In February 2009, the criminal case was resolved by a deferred-prosecution agreement pursuant to which UBS agreed to pay a huge fine, cooperate with the IRS, and turn over the names of approximately 285 U.S. taxpayers with accounts at the bank. Shortly thereafter, UBS settled a civil summons proceeding with the IRS and agreed to provide the identities of another 4,450 U.S. taxpayers with accounts at the bank. These developments caused a surge of 15,000 taxpayers with foreign bank accounts to disclose voluntarily their previously unreported accounts to the IRS.

Although recent court decisions in Switzerland have ruled that it is illegal for UBS to turn over identifying information about its customers, both UBS and the IRS have announced that they intend to find a way around these court decisions and continue with the exchange of information so that they can avoid further litigation. Against this backdrop, the news media have reported that other Swiss bank employees are negotiating to sell stolen customer information to various taxing authorities around the world. The writing is on the wall: the veil of bank secrecy is being torn away, and secret foreign bank accounts are quickly becoming a thing of the past.

Filing an FBAR

So what can taxpayers with unreported foreign bank accounts expect from the IRS? A taxpayer who fails to report the existence of a foreign bank account and/or income from a foreign bank account can be subject to several different civil and criminal penalties. Oddly enough, the most severe penalties are not the penalties for failing to report the income from the account but, instead, are the penalties for failure to file an information return disclosing the existence of the account, known as the Report of Foreign Bank and Financial Accounts, Form TD F 90-22.1, commonly called an FBAR.

An FBAR must be filed by United States persons to disclose ownership and signatory or other authority over a foreign bank, security or financial account. A person who willfully fails to file an FBAR, or who willfully files a false FBAR, is subject to a criminal penalty of up to five years in prison and/or a criminal fine of $250,000. In addition, beginning with FBARs due in 2005, Congress significantly increased the civil penalty that can be imposed on any person who willfully fails to file an FBAR, or who willfully files a false FBAR. The civil penalty is up to 50% of the balance in the account for each year that the violation continues. Thus, even if a taxpayer avoids criminal prosecution, he or she can be subject to crippling civil penalties that easily could be several times the size of the unreported foreign account.

Ramping It Up

In the past, the FBAR reporting requirements were rarely enforced, and very few penalties were ever imposed. Indeed, a Treasury study found that, in 2001, only 20% of taxpayers with foreign bank accounts were actually filing the required reports. More recently, however, the IRS has made clear that it intends to ramp up FBAR enforcement. Taxpayers who voluntarily disclose their previously unreported foreign bank accounts can avoid criminal prosecution but can expect to pay significant FBAR penalties. Taxpayers who are caught red-handed with an unreported foreign account will face a potential criminal prosecution for failure to file the FBAR and, even if the government declines to prosecute, the civil FBAR penalties that are asserted will be far greater than if the taxpayer had come forward voluntarily.

It is important to understand, however, that these oppressive civil and criminal FBAR penalties apply only when the government can prove that the violation of the FBAR reporting obligations was willful. The penalties for non-willful violations are relatively mild: there can be no criminal prosecution, and the civil penalties are only $10,000 per year for 2005 and later (prior to 2005, no penalty existed for non-willful violations). Thus, willfulness is the key issue in the context of an FBAR violation. A taxpayer who is confident that the government cannot prove willfulness will have much greater leverage in negotiating a potential penalty.

Unfortunately, there is a dearth of authority on how willfulness is defined in the FBAR context. The main sources of guidance are some provisions in the Internal Revenue Manuel (IRM), a memorandum written by the IRS Office of Chief Counsel to its field agents (the “OCC Memo”), some Supreme Court cases discussing willfulness in other contexts, and one appellate decision that specifically addresses a criminal prosecution for failure to report a number of foreign bank accounts, United States v. Sturman , 951 F.2d 1466 (6th Cir. 1991).

Supreme Court Cases

Supreme Court cases have defined willfulness for purposes of income tax prosecutions as “an intentional violation of a known legal duty.” In the IRM and the OCC Memo, the IRS recognized that this definition applies for both the civil and criminal FBAR penalties. The IRM and the OCC Memo also agree that, for purposes of the civil FBAR penalty, the IRS must prove willfulness by clear and convincing evidence, and that a criminal prosecution would require proof of willfulness beyond a reasonable doubt. The first step in proving that a taxpayer willfully failed to file the FBAR is to prove that he or she knew of the FBAR filing requirement. This is no easy task given the lack of FBAR enforcement over the past 30 years. Most taxpayers and accountants were completely unaware of the FBAR filing requirements until recently. Indeed, it is likely that most IRS agents themselves were not aware of the FBAR filing requirements until a few years ago when the FBAR form began to receive more attention from the IRS.

So how does the IRS go about proving that a taxpayer knew of the FBAR filing requirement? The only direct evidence of what a person knew or did not know is a confession. Absent a confession of knowledge, the only way to prove a person's state of mind is through indirect or circumstantial evidence from which a finder of fact can infer what the person must have known.

The IRM identifies several types of evidence that could support an inference that a taxpayer knew of the requirement to file an FBAR yet nevertheless failed to file it. Such evidence includes failure to report income from the foreign bank account on the taxpayer's tax return, failure to check the box on Schedule B asking whether the taxpayer has a foreign account, or falsely checking the box “No,” discussions between the taxpayer and an accountant regarding the foreign bank account, and false statements to an IRS agent who inquires about the existence of a foreign bank account.

Many IRS agents and some government attorneys believe that evidence that a taxpayer failed to report income from the foreign account and failed to disclose the account in answer to the question on Schedule B clearly demonstrate that the taxpayer is a tax cheat and liar who must have known about the FBAR filing requirements, yet willfully failed to comply.

Nothing could be further from the truth. Many taxpayers inherit the foreign accounts and believe that income earned in a foreign country is not reportable in the United States until it's brought into the country. The tax code is so complicated and riddled with exceptions regarding the reporting of off-shore earnings that such a belief is very understandable. Further, Form 1040 is sufficiently complex that many taxpayers simply signed their tax returns without reviewing every line, including the line at the bottom of Schedule B asking whether the taxpayer had a foreign bank account. Most accountants never discuss this aspect of the return with their clients and simply check the box no without further inquiry.

In Sturman, the only reported decision that discusses the imposition of a criminal FBAR penalty, the taxpayer clearly intended to evade taxes by creating hundreds of shell corporations to skim income from his adult publishing business and diverting it to a series of undisclosed foreign bank accounts. In addition, Sturman admitted that he knew that he was supposed to check the “Yes” box on Schedule B disclosing the foreign accounts, but failed to do so. Thus, the Sturman case had particularly strong indicia of willfulness and cannot be used to support the imposition of civil or criminal FBAR penalties on typical taxpayers, such as those who inherited a foreign bank account and simply failed to report it to the IRS.

Opposite Cases

Not all taxpayers who fail to report income from and the existence of a foreign account on a tax return are trying to hide it from the IRS. In Cheek v. United States , 498 U.S. 192 (1991), the Supreme Court held that an honest but mistaken belief regarding the requirements of the tax law is a complete defense to a criminal tax prosecution, no matter how unreasonable the taxpayer's belief may be. Because the definition of willfulness is the same for both civil and criminal FBAR penalties, the same principle applies.

Conclusion

Taxpayers may be able to avoid imposition of FBAR penalties if they can convince the IRS that it will not be possible to prove that the taxpayer knew about the FBAR filing requirement yet intentionally failed to comply ' i.e., willfulness. To prevail, taxpayers must have a good explanation of why they did not report the income from the foreign account nor check the box “Yes” on Schedule B of their tax return. Also, it is important to establish that the taxpayer did nothing to hide the existence of the account from the return preparer or the auditing agent. These factors, combined with sympathetic background facts regarding the taxpayer's age, health, family background, level of sophistication and reason for holding a foreign account, must be developed and forcefully presented to the IRS. In the end, some of these cases will go to trial, and courts will find that many taxpayers should not be subject to crippling FBAR penalties.

Bryan C. Skarlatos (bskarlatos@kf law.com) is a partner at Kostelanetz & Fink, LLP, New York, where his practice focuses on civil and criminal tax controversies. Michael Sardar is an associate at the firm.