A Glimmer of Hope for Lower Criminal and Civil FBAR Penalties

It was in 2007 that Igor Olenicoff, a wealthy California real-estate developer, entered a guilty plea to filing a false tax return by failing to disclose a foreign bank account he controlled through a foreign shell corporation. Olenicoff's UBS banker was Bradley Birkenfeld, who helped Olenicoff create the shell corporation for the express purpose of avoiding U.S. income tax. Birkenfeld was arrested in 2008 and entered a guilty plea in June 2008 to conspiring to help Olenicoff evade $7.2 million in federal income taxes. Birkenfeld cooperated with the government and provided a road map of the methods used by UBS Private Bankers to assist U.S. taxpayers in evading U.S. income taxes. On Aug. 21, 2009, Birkenfeld was sentenced to 40 months in prison.

The DOJ, armed with Birkenfeld's information, opened a civil examination and a parallel criminal investigation of UBS. On the civil side, a John Doe summons was issued to UBS demanding the identities of all U.S. taxpayers who had authority over accounts managed through any of UBS's Swiss offices or affiliates from 2002 to 2007 and for whom UBS did not file a required Form 1099, reporting interest income to the IRS. Simultaneously, on the criminal side, the DOJ served UBS with a grand jury subpoena and initiated a treaty request.

In the face of a potentially devastating criminal prosecution, UBS entered into a deferred prosecution agreement under which it turned over to the DOJ the names of approximately 280 account holders, paid a fine of $780 million and agreed to cooperate with the IRS.

Just a few days after the deferred prosecution agreement was announced, the IRS sued UBS in federal district court in Miami, seeking enforcement of the John Doe summons. After much litigation, UBS and the IRS entered into a settlement agreement in August 2009. Under the terms of the settlement agreement, UBS agreed to turn over the names and files of 4,450 U.S. taxpayers who fell within certain guidelines. Subsequently, there was high drama in both Swiss parliament and the Swiss courts as both refused to condone UBS's disclosure of U.S. account information as violative of Swiss law. Ultimately, on June 17, 2010, the Swiss Parliament ratified the settlement agreement and approved the disclosure of U.S. account information to the IRS.

A number of U.S. citizens have been prosecuted based on UBS's initial disclosure of 280 names to the IRS. As the remaining 4,450 names are turned over to the DOJ, thousands of taxpayers who chose not to participate in the OVDP are anxiously awaiting judgment day.

The Offshore Voluntary Disclosure Program

The OVDP, which officially ended in October 2009, provided an opportunity for U.S. taxpayers with previously undisclosed foreign financial accounts to come clean with the government and normalize their tax reporting going forward. When it was first announced, the OVDP seemed to offer opportunities for taxpayers to present the facts concerning their non-compliance, many of which are extremely sympathetic, to prove that such non-compliance was not willful. Nineteen months after the program began, the opportunities for lower penalties have proven elusive for the vast majority of taxpayers who entered the OVDP.

For the most part, the IRS has turned a deaf ear to arguments that, in a normal tax case, would support a finding of non-willfulness. Instead, in the interests of national consistency, the IRS has employed a robotic approach to the OVDP penalty structure and has insisted on uniformly penalizing all taxpayers, regardless of their circumstances. Taxpayers who entered the OVDP are essentially at the mercy of the IRS. If they choose to challenge the penalties imposed under the OVDP, they are faced with an untenable result: they will be removed from the OVDP and all prior assurances will be taken off the table, including the guarantee that there will be no criminal prosecution. In addition, they face the maximum civil penalties allowed under the law. (This is no option at all, since the maximum civil penalties can far exceed the amount of money ever held in the undisclosed foreign bank account, and there is no guarantee that a peal process.)

Most taxpayers are surprised to learn that the most significant penalty under the OVDP is not for failure to report income from foreign accounts on their tax returns. Rather, the most significant penalty is for the failure to file an FBAR. Prior to the inception of the OVDP and the publicity that has ensued from the government's prosecution of and ultimate settlement with UBS, it is fair to say that most U.S. taxpayers were completely unaware of the existence of the FBAR. Indeed, this writer's experience has been that many tax return preparers to this day are unaware of the FBAR filing requirements. Despite this lack of common knowledge about the FBAR, the IRS is not only vigorously pursuing criminal cases against individuals for failure to file FBARS, it is penalizing taxpayers under the OVDP with the presumption that FBAR violations were willful, regardless of the facts.

FBAR Penalties Are Significantly Higher When Non-compliance Was Willful

There is a drastic difference between penalties for willful violations of the FBAR filing requirements and penalties for non-willful violations. The penalties for non-willful violations of the FBAR filing requirements are relatively mild: no criminal prosecution and a civil penalty of $10,000 per year for violations occurring in 2005 and later (prior to 2005, no penalty existed for non-willful FBAR violations). See 31 U.S.C. ' 5321(a)(5)(B)(i).

On the other hand, willful violations of the FBAR filing requirements can result not only in criminal prosecution and up to five years in prison, but in crippling civil penalties. For willful violations occurring in 2005 and later, the maximum civil penalty is the greater of: 1) $100,000; or 2) 50% of the balance in the account at the time of the violation. An FBAR penalty can be imposed for each year that a violation occurred. See 31 U.S.C. ' 5321(a)(5)(C). (Prior to its amendment in 2004, 31 U.S.C. ' 5321(b)(1) provided for a maximum penalty of $100,000 for willful violations of the FBAR filing rule set forth in 31 U.S.C. ' 5314.) A taxpayer therefore could end up paying civil FBAR penalties that far exceed the amount of money held in the foreign account. For example, if starting in 2005 and continuing until 2009, a taxpayer failed to report his foreign account on both his tax return and FBAR, and the foreign account had a continuing balance of approximately $1 million in that time period, the FBAR penalty could be as follows: 50% of the account balance for each of tax years 2005, 2006, 2007, 2008 and 2009. The result: an FBAR penalty of $2.5 million, or 2' times the amount held in the foreign account.

FBAR Penalties to Date

In the reported criminal guilty pleas to date, defendants have been required to pay an FBAR penalty of 50% of the highest value of the foreign account in a six-year period, regardless of whether the defendant still has that money. The government has not yet sought an FBAR penalty exceeding the highest value of the account during the relevant time period.

Under the OVDP, taxpayers are required to file amended tax returns and delinquent FBARs going back six years. For taxpayers who applied to the OVDP before Oct. 15, 2009, the IRS has guaranteed that it will impose, at most, a one-time 20% FBAR penalty based upon the highest value of the foreign account in that six-year period. For many taxpayers, this is a very hard pill to swallow. Most foreign account holders experienced a significant dip in their account balances in 2007 and 2008, due to the global economic crisis. Despite the fact that the account no longer has the value it had in earlier years, the IRS is imposing the 20% penalty mechanically.

(There is a second possible penalty, but it is referred to by practitioners as the “holy grail” because it is so rarely applied. That is a 5% penalty for taxpayers who meet the following criteria: 1) The taxpayer did not open any account or cause any account to be opened or entities to be formed; 2) There has been no activity in any account or entity during the period the account/entity was controlled by the taxpayer; and 3) All applicable U.S. taxes have been paid on the funds in the account (where only account/entity earnings have escaped U.S. taxation). Many taxpayers who entered the OVDP believed that they met the above criteria for the 5% penalty. The IRS has applied this penalty in only the rarest of cases, however. It is the IRS's position that any activity in the account, including the forced moving of the account at the demand of UBS, disqualifies the taxpayer from the 5% penalty.)

The IRS has encouraged taxpayers to apply to its regular voluntary disclosure program even after the special off-shore program ended on October 25, 2009. The writer's law firm has handled scores of post-Oct. 15 disclosures. Unfortunately, the IRS has to date failed to inform taxpayers of the FBAR penalty it intends to impose on these later filings. As a result, the IRS has created a situation where taxpayers are reluctant to enter the program because there is no certainty as to the penalty scheme. The IRS therefore has missed a golden opportunity to capitalize on the momentum created by the OVDP's success by attracting more foreign account holders into the regular voluntary disclosure program.

In next month's newsletter we will discuss further the implications of a finding of willfulness to FBAR penalties.

Sharon L. McCarthy is a partner in New York's Kostelanetz & Fink, LLP.

The year 2010 will go down in history as the year the great wall of Swiss bank secrecy officially collapsed. On June 17, 2010, the Swiss Parliament ratified the settlement agreement between the U.S. Department of Justice (DOJ) and UBS AG, and the process of turning over the names and Swiss banking information of approximately 4,450 U.S. taxpayers began. For taxpayers who missed the opportunity to participate in the Internal Revenue Service's special Off-shore Voluntary Disclosure Program (OVDP), which ended in October 2009, the chance of criminal prosecution is high.

This article addresses the potential penalties facing taxpayers with undisclosed foreign accounts and focuses in particular on the draconian penalties being issued across the board for failure to file Form TDF 90-22.1, Report of Foreign Bank and Financial Accounts ' commonly referred to as an “FBAR.” And we also discuss a recent decision out of the Eastern District of Virginia, which provides some small hope that the government will begin to exhibit a bit of flexibility in its approach to FBAR penalties.

The UBS Prosecution and Settlement Agreement

It was in 2007 that Igor Olenicoff, a wealthy California real-estate developer, entered a guilty plea to filing a false tax return by failing to disclose a foreign bank account he controlled through a foreign shell corporation. Olenicoff's UBS banker was Bradley Birkenfeld, who helped Olenicoff create the shell corporation for the express purpose of avoiding U.S. income tax. Birkenfeld was arrested in 2008 and entered a guilty plea in June 2008 to conspiring to help Olenicoff evade $7.2 million in federal income taxes. Birkenfeld cooperated with the government and provided a road map of the methods used by UBS Private Bankers to assist U.S. taxpayers in evading U.S. income taxes. On Aug. 21, 2009, Birkenfeld was sentenced to 40 months in prison.

The DOJ, armed with Birkenfeld's information, opened a civil examination and a parallel criminal investigation of UBS. On the civil side, a John Doe summons was issued to UBS demanding the identities of all U.S. taxpayers who had authority over accounts managed through any of UBS's Swiss offices or affiliates from 2002 to 2007 and for whom UBS did not file a required Form 1099, reporting interest income to the IRS. Simultaneously, on the criminal side, the DOJ served UBS with a grand jury subpoena and initiated a treaty request.

In the face of a potentially devastating criminal prosecution, UBS entered into a deferred prosecution agreement under which it turned over to the DOJ the names of approximately 280 account holders, paid a fine of $780 million and agreed to cooperate with the IRS.

Just a few days after the deferred prosecution agreement was announced, the IRS sued UBS in federal district court in Miami, seeking enforcement of the John Doe summons. After much litigation, UBS and the IRS entered into a settlement agreement in August 2009. Under the terms of the settlement agreement, UBS agreed to turn over the names and files of 4,450 U.S. taxpayers who fell within certain guidelines. Subsequently, there was high drama in both Swiss parliament and the Swiss courts as both refused to condone UBS's disclosure of U.S. account information as violative of Swiss law. Ultimately, on June 17, 2010, the Swiss Parliament ratified the settlement agreement and approved the disclosure of U.S. account information to the IRS.

A number of U.S. citizens have been prosecuted based on UBS's initial disclosure of 280 names to the IRS. As the remaining 4,450 names are turned over to the DOJ, thousands of taxpayers who chose not to participate in the OVDP are anxiously awaiting judgment day.

The Offshore Voluntary Disclosure Program

The OVDP, which officially ended in October 2009, provided an opportunity for U.S. taxpayers with previously undisclosed foreign financial accounts to come clean with the government and normalize their tax reporting going forward. When it was first announced, the OVDP seemed to offer opportunities for taxpayers to present the facts concerning their non-compliance, many of which are extremely sympathetic, to prove that such non-compliance was not willful. Nineteen months after the program began, the opportunities for lower penalties have proven elusive for the vast majority of taxpayers who entered the OVDP.

For the most part, the IRS has turned a deaf ear to arguments that, in a normal tax case, would support a finding of non-willfulness. Instead, in the interests of national consistency, the IRS has employed a robotic approach to the OVDP penalty structure and has insisted on uniformly penalizing all taxpayers, regardless of their circumstances. Taxpayers who entered the OVDP are essentially at the mercy of the IRS. If they choose to challenge the penalties imposed under the OVDP, they are faced with an untenable result: they will be removed from the OVDP and all prior assurances will be taken off the table, including the guarantee that there will be no criminal prosecution. In addition, they face the maximum civil penalties allowed under the law. (This is no option at all, since the maximum civil penalties can far exceed the amount of money ever held in the undisclosed foreign bank account, and there is no guarantee that a peal process.)

Most taxpayers are surprised to learn that the most significant penalty under the OVDP is not for failure to report income from foreign accounts on their tax returns. Rather, the most significant penalty is for the failure to file an FBAR. Prior to the inception of the OVDP and the publicity that has ensued from the government's prosecution of and ultimate settlement with UBS, it is fair to say that most U.S. taxpayers were completely unaware of the existence of the FBAR. Indeed, this writer's experience has been that many tax return preparers to this day are unaware of the FBAR filing requirements. Despite this lack of common knowledge about the FBAR, the IRS is not only vigorously pursuing criminal cases against individuals for failure to file FBARS, it is penalizing taxpayers under the OVDP with the presumption that FBAR violations were willful, regardless of the facts.

FBAR Penalties Are Significantly Higher When Non-compliance Was Willful

There is a drastic difference between penalties for willful violations of the FBAR filing requirements and penalties for non-willful violations. The penalties for non-willful violations of the FBAR filing requirements are relatively mild: no criminal prosecution and a civil penalty of $10,000 per year for violations occurring in 2005 and later (prior to 2005, no penalty existed for non-willful FBAR violations). See 31 U.S.C. ' 5321(a)(5)(B)(i).

On the other hand, willful violations of the FBAR filing requirements can result not only in criminal prosecution and up to five years in prison, but in crippling civil penalties. For willful violations occurring in 2005 and later, the maximum civil penalty is the greater of: 1) $100,000; or 2) 50% of the balance in the account at the time of the violation. An FBAR penalty can be imposed for each year that a violation occurred. See 31 U.S.C. ' 5321(a)(5)(C). (Prior to its amendment in 2004, 31 U.S.C. ' 5321(b)(1) provided for a maximum penalty of $100,000 for willful violations of the FBAR filing rule set forth in 31 U.S.C. ' 5314.) A taxpayer therefore could end up paying civil FBAR penalties that far exceed the amount of money held in the foreign account. For example, if starting in 2005 and continuing until 2009, a taxpayer failed to report his foreign account on both his tax return and FBAR, and the foreign account had a continuing balance of approximately $1 million in that time period, the FBAR penalty could be as follows: 50% of the account balance for each of tax years 2005, 2006, 2007, 2008 and 2009. The result: an FBAR penalty of $2.5 million, or 2' times the amount held in the foreign account.

FBAR Penalties to Date

In the reported criminal guilty pleas to date, defendants have been required to pay an FBAR penalty of 50% of the highest value of the foreign account in a six-year period, regardless of whether the defendant still has that money. The government has not yet sought an FBAR penalty exceeding the highest value of the account during the relevant time period.

Under the OVDP, taxpayers are required to file amended tax returns and delinquent FBARs going back six years. For taxpayers who applied to the OVDP before Oct. 15, 2009, the IRS has guaranteed that it will impose, at most, a one-time 20% FBAR penalty based upon the highest value of the foreign account in that six-year period. For many taxpayers, this is a very hard pill to swallow. Most foreign account holders experienced a significant dip in their account balances in 2007 and 2008, due to the global economic crisis. Despite the fact that the account no longer has the value it had in earlier years, the IRS is imposing the 20% penalty mechanically.

(There is a second possible penalty, but it is referred to by practitioners as the “holy grail” because it is so rarely applied. That is a 5% penalty for taxpayers who meet the following criteria: 1) The taxpayer did not open any account or cause any account to be opened or entities to be formed; 2) There has been no activity in any account or entity during the period the account/entity was controlled by the taxpayer; and 3) All applicable U.S. taxes have been paid on the funds in the account (where only account/entity earnings have escaped U.S. taxation). Many taxpayers who entered the OVDP believed that they met the above criteria for the 5% penalty. The IRS has applied this penalty in only the rarest of cases, however. It is the IRS's position that any activity in the account, including the forced moving of the account at the demand of UBS, disqualifies the taxpayer from the 5% penalty.)

The IRS has encouraged taxpayers to apply to its regular voluntary disclosure program even after the special off-shore program ended on October 25, 2009. The writer's law firm has handled scores of post-Oct. 15 disclosures. Unfortunately, the IRS has to date failed to inform taxpayers of the FBAR penalty it intends to impose on these later filings. As a result, the IRS has created a situation where taxpayers are reluctant to enter the program because there is no certainty as to the penalty scheme. The IRS therefore has missed a golden opportunity to capitalize on the momentum created by the OVDP's success by attracting more foreign account holders into the regular voluntary disclosure program.

In next month's newsletter we will discuss further the implications of a finding of willfulness to FBAR penalties.

Sharon L. McCarthy is a partner in New York's Kostelanetz & Fink, LLP.