The collapse of Swiss bank secrecy, the IRS settlement with UBS, the criminal investigation of HSBC and the related IRS voluntary disclosure program all have put foreign bank accounts in the spotlight. Tens of thousands, if not hundreds of thousands, of U.S. taxpayers have foreign bank accounts. Some of those taxpayers opened their foreign bank account in order to hide money or the earnings in the account from the IRS.
However, the majority of taxpayers with foreign bank accounts never intended to hide their foreign accounts from the IRS. Some just inherited the foreign account from a relative who lived abroad at some point in their lives. Other taxpayers lived abroad themselves and opened a bank account in a foreign country as a matter of convenience or necessity. Still other U.S. taxpayers with foreign accounts never even lived in the United States but are U.S. citizens, and therefore are subject to U.S. reporting requirements, simply because one or both of their parents were U.S. citizens.
Regardless of why the foreign account was created or acquired, any U.S. person with an interest in, or signatory authority over, a foreign financial account must file a Report of Foreign Bank Accounts (FBAR) with the United States Treasury Department. The IRS recently has stepped up enforcement against taxpayers who fail to file FBARs. The basic penalty for a simple, non-willful failure to file a FBAR is $10,000 per year for 2005 and later years. (Prior to 2005, there was no penalty at all for non-willful violations.) However, if the IRS can prove that the taxpayer willfully failed to file a FBAR, or willfully filed a false FBAR, the penalties are much higher. The taxpayer can be subject to criminal prosecution and, for 2005 and later years, the IRS can impose crippling civil penalties of up to 50% of the highest balance in the foreign account for each year that the violation continues. (Prior to 2005, the penalty for a willful violation was capped at $100,000 per year.)
If the IRS catches a taxpayer who failed to file a FBAR, the IRS will either refer the case for prosecution or attempt to assert a penalty based on some percentage of the highest balance in the foreign account. In fact, even taxpayers who approach the IRS and voluntarily disclose the existence of their foreign account will be charged a penalty based on a percentage of the highest balance in the foreign account. Taxpayers who voluntarily disclosed their foreign account prior to October 15, 2009 are being charged a 20% penalty. Taxpayers who make a voluntary disclosure after October 15, 2009 are still being accepted into the voluntary disclosure program, but they will be charged a penalty of at least 20%, and probably more, of the highest balance in the foreign account.
Any penalty that is based on a percentage of the balance in the foreign account is premised on the idea that the FBAR violation was willful, and therefore, the IRS could take up to 50% of the balance in the account for each year of the violation. However, if the FBAR violation was not willful, then the penalty would be limited to $10,000 per year, and it would not be possible to charge a penalty based on a percentage of the balance in the account. Even taxpayers who have entered the voluntary disclosure program can opt out of the program and contest the willfulness penalty that is imposed as part of the program. Thus, when advising a client regarding his or her exposure to FBAR penalties, it is essential to determine whether the failure to file the FBAR was willful.
Willfulness is defined as "an intentional violation of a known legal duty." The government has the burden of proving willfulness. To prove willfulness, the government must establish that (1) the taxpayer was required to file a FBAR; (2) the taxpayer knew that he or she had to file a FBAR; and (3) the taxpayer intentionally failed to file, or falsely filed, the FBAR. It is very difficult for the government to prove that a taxpayer knew that he or she had to file a FBAR. This is particularly so, given the complete lack of FBAR enforcement over the past 30 years. Very few taxpayers and tax return preparers had ever heard of a FBAR until recently. Indeed, most IRS agents themselves were completely unaware of the FBAR filing requirements until a few years ago when FBARs began to receive more attention from the IRS.
So, how does the IRS go about proving that a taxpayer knew that he or she had to file a FBAR? The Internal Revenue Manual identifies several types of evidence that could support an inference that a taxpayer knew of the requirement to file a FBAR yet nevertheless failed to file it. Such evidence includes, but is not limited to, (1) failure to report income from the foreign bank account on the taxpayer's tax return; (2) failure to check the box on Schedule B asking whether the taxpayer has a foreign account, or falsely checking the box "No"; (3) discussions between the taxpayer and an accountant regarding the foreign bank account; and (4) false statements to an IRS agent who inquires about the existence of a foreign bank account.
Many IRS agents believe any taxpayer who failed to report income from a foreign account and failed to disclose the account in response to the question on Schedule B is a tax cheat and liar who must have known about the FBAR filing requirements yet intentionally failed to comply. Nothing could be further from the truth.
As described above, many taxpayers created or inherited a foreign account for completely legitimate, non-tax-related reasons and believed 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 discussed this aspect of the return with their clients and simply checked the box "no," or left it blank, with no further inquiry.
Tax professionals with clients who are being threatened with crippling FBAR penalties should carefully evaluate whether the IRS can prove that the FBAR violation was willful. A taxpayer should consider contesting imposition of any FBAR penalty that is based on a percentage of the foreign account if he or she has a good explanation for why the foreign account was created, why the income earned in the account was not properly reported, and why the box on schedule B was not checked "yes." Also, it is important to establish that nothing was done to hide the existence of the account from the return preparer or the IRS. These factors, combined with sympathetic background facts regarding the taxpayer's age, health, family background and level of sophistication must be developed and forcefully presented to the IRS. In the end, taxpayers who truly did not know of the FBAR filing requirements should not be forced to pay crippling penalties for the failure to file a FBAR.
Bryan C. Skarlatos is a partner at Kostelanetz & Fink, LLP in New York, NY.