The IRS has been asserting foreign bank account (FBAR) and other international compliance penalties (i.e. Forms 5471, 8938, 3520, etc.) outside the Offshore Voluntary Disclosure Initiative (OVDI). At the present time, the OVDI is an indefinite program subject to the advertised terms and conditions. However, not all taxpayers with foreign assets participate in the OVDI and some elect to opt-out of the OVDI after submitting their materials to the IRS through the OVDI process. This article will focus on recent developments when the IRS and the taxpayer disagree on the proposed FBAR penalty, and other international related penalties.
Applicable Penalties Under The Internal Revenue Code
The IRS has the authority to assert international penalties under Internal Revenue Code (IRC) Sections 6038, 6677, and 6679. In addition, IRC Section 6662(j) was recently added to increase the accuracy related penalty from 20% to 40% in those cases where the understatement of tax relates to an “undisclosed foreign financial asset.” This new increased IRC Section 6662(j) penalty applies to those returns filed after March 18, 2010. Some examples of penalties applicable to international compliance requirements are: (this list is not inclusive of all required forms but is a representation of the most common international forms required to be filed by the IRS)
• Form 114a (FBAR) – Report of Foreign Bank Account. There is a $10,000 penalty per non-willful violation. For willful violations the penalty is the greater of $100,000 or 50% of the amount in the account (aggregate total) at the time of the violation. There may be several violations per year depending on the number of accounts, and several years may be subject to the penalty depending on the Statute of Limitations. The IRS issued guidance to limit excessive penalties but this practice is not being followed by all IRS agents.
• Form 5471 - Information Return of U.S. Persons With Respect to Certain Foreign Corporations. There is a $10,000 initial penalty plus an additional $10,000 penalty per 30-day period or fraction thereof, after the IRS has mailed a notice of failure to file such form capped at a total of $50,000. There may be additional penalties if the failure to file was intentional.
• Form 8865 - Return of U.S. Persons With Respect to Certain Foreign Partnerships. There is a $10,000 initial penalty, plus an additional $10,000 penalty per 30-day period or fraction thereof after the IRS has mailed a notice of failure to file such form capped at a total of $50,000. There may be additional penalties if the failure to file was intentional.
• Form 926 - Filing Requirement for U.S. Transferors of Property to a Foreign Corporation (US persons acquiring more than 10% ownership in foreign corporation or transfer of more than $100,000 to a foreign corporation during the tax year). The penalty for failure to file this form is 10% of the fair market value of the property at the time of the exchange/transfer, capped at $100,000 unless the failure was due to intentional disregard. • Form 3520 - Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts. There are a number of penalties that may apply including a penalty of 5% of the amount of a large foreign gift for each month for which the failure continues after the due date capped at 25%, and/or the greater of $10,000 or 35% of the gross reportable amount of any property transferred to a foreign trust or distribution received from a foreign trust. These penalties all continue higher if not cured within a specific time frame.
• Form 3520-A - Annual Information Return of Foreign Trust With a U.S. Owner. The penalty for failing to file this form may be 5% of the gross value of the portion of the trust’s assets treated as owned by the US person, and if the failure continues for more than 90 days after the IRS notifies the taxpayer of his or her failure, the penalty is increased by an additional $10,000 for each 30 day period.
• Form 8938 - Statement of Specified Foreign Financial Assets. There is a $10,000 initial penalty, plus an additional $10,000 penalty per 30-day period or fraction thereof that begins 90 days after the IRS has mailed a notice of failure to file such form capped at a total of $50,000. There may be additional penalties if the failure to file was intentional.
Extension of Statute of Limitations
It is important to note that the Statute of Limitations on assessment under IRC Section 6501(c)(8) is suspended on all items of the taxpayer’s tax return while the above forms go unfiled unless the taxpayer can demonstrate that his or her failure to file is due to reasonable cause. If the taxpayer can demonstrate reasonable cause then the Statute of Limitations is suspended only with respect to items related to the international form.
Disputing International Penalties
As stated in the IRS’s Internal Revenue Manual, most international penalties have post assessment pre-payment appeal rights. These international penalties are not subject to typical deficiency procedures and cannot be litigated in US Tax Court. While it may be possible to pay the penalty and bring a claim for refund, it is more common for the United States to bring a claim against the taxpayer for collection of the penalty and litigate its merits during that process in the US District Court.
The best defense to any assertion of an international penalty is to demonstrate that the taxpayer had “reasonable cause” for his or her failure to file the information return and pay the tax, where applicable. Reasonable cause applies to most of the international penalties – but not all of them. For example, reasonable cause does not apply to penalties after the taxpayer was notified of the requirement to file by the IRS. In no event are examiners instructed to consider reasonable cause until all forms have been filed and the taxpayer is in full compliance.
As of the date of this writing, the author is aware of in excess of 30 cases that have been or are currently being litigated in the courts related to the proposed assessment of international penalties.
Adam Fayne is an attorney with the law firm of Arnstein & Lehr LLP. Prior to private practice, he was an attorney with the Internal Revenue Service Office of Chief Counsel. He has represented many taxpayers nationally and internationally with IRS examinations, IRS appeals, Tax Court, criminal defense, and foreign compliance matters. He may be reached at 312-876-7883 or
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