BY SCOTT H. NOVAK, ESQ.
DECEMBER 2013

CPAs often have clients with an interest in or signature authority over a foreign account. The IRS has emphasized compliance in reporting requirements for U.S. owners of foreign accounts, but many taxpayers may still not know their responsibilities and liabilities. This article outlines these responsibilities and liabilities and describes current enforcement efforts.

DISCLOSURE RESPONSIBILITIES

A taxpayer who has an interest in or signature authority over certain foreign accounts must inform the government of the existence of the account each year by checking the box in Part III, line 7a, on Schedule B, Interest and Ordinary Dividends, of the taxpayer’s Form 1040, U.S. Individual Income Tax Return. The taxpayer must also attach Form 8938, Statement of Specified Foreign Financial Assets, providing details about the foreign accounts if the account balances and the value of other foreign financial assets total more than $50,000 on the last day of the year or more than $75,000 at any time during the year for single filing status. For married taxpayers filing jointly, the threshold amounts are $100,000 and $150,000, respectively. Taxpayers with foreign accounts with an aggregate value of more than $10,000 during the calendar year must also file FinCEN (Financial Crimes Enforcement Network) Form 114 (formerly TD F 90-22.1), Report of Foreign Bank and Financial Accounts (FBAR). This form is filed electronically with the Treasury Department’s BSA (Bank Secrecy Act) E-Filing System (accessible at tinyurl.com/qo9apa) not later than June 30. No extensions are available.

Over the past several years, many taxpayers with foreign accounts have erroneously checked “no” on line 7a of Schedule B, Part III, and have not filed Forms 8938 or FBARs as required. A taxpayer who signs a return without disclosing the existence of a foreign account may well have committed perjury, and hiding assets in an offshore account may constitute tax fraud.

HOW DOES THE IRS FIND FOREIGN ACCOUNT OWNERS?

The U.S. Treasury and Justice departments have become aggressive in going after foreign banks and other facilitators to get information about U.S. account owners. The first major target that they had success with was UBS in Switzerland, which ultimately turned over the names of more than 4,000 U.S. taxpayers with hidden Swiss accounts. UBS also agreed to pay a $780 million fine as a result of an investigation and its guilty plea to helping Americans evade taxes.

Switzerland’s oldest bank, Wegelin & Co., paid $74 million in fines, restitution, and forfeitures and agreed to cease operations as a bank. More banks in Switzerland followed, and the program has been extended to many other countries and areas, including Israel and the Caribbean. As these banks enter into settlements with the U.S. government, they often agree to hand over the names of their U.S. customers.

In August, the United States and Switzerland signed an agreement that provides for fines in exchange for nonprosecution agreements for banks that facilitated American tax evasion. As these banks enter into settlements with the U.S. government, they, too, will hand over the names of their U.S. customers. 

Another recent development was the indictment of Edgar Paltzer, an American-educated Swiss attorney who not only helped many Americans evade taxes through foreign accounts but had control over and access to many European bank vaults holding assets and valuables that were being hidden from the government. He faces up to five years in prison, but the sentence is expected to be less because he is cooperating with authorities. The information Paltzer is providing gives the IRS a better picture of the methods used to evade taxes by transferring cash and assets to foreign accounts and locations.

Sensational stories of high-profile foreign account cases have caused many taxpayers with foreign accounts to step forward under the IRS’s Offshore Voluntary Disclosure Initiative (OVDI). As of December 2012, the IRS had collected more than $5.5 billion in back taxes, interest, and penalties from more than 39,000 taxpayers under the program, the U.S. Government Accountability Office (GAO) reported (GAO Rep’t No. 13-318).

OPTIONS FOR TAXPAYERS WITH UNDISCLOSED FOREIGN ACCOUNTS

Taxpayers who have an unreported foreign account must decide which of three actions to take: do nothing and hope for the best, make a quiet disclosure or a new disclosure, or enter the OVDI.

Do nothing and hope for the best. This is, obviously, a high-risk option. Treasury and Justice continue to hone their skills not only in going after individuals who have foreign accounts but also in securing names of U.S. account holders from foreign banks. Nearly every FBAR matter that is resolved requires the taxpayer to sit down with the IRS to answer questions. To the extent that the Fifth Amendment right against self-incrimination is not invoked, the IRS gets information at each of these meetings that can help it find and prosecute those who helped Americans open foreign accounts and hide income from the government. The facilitators, as part of their own settlements, often turn over the names of U.S. owners of hidden foreign accounts. Considering the increasing likelihood that the IRS will eventually find foreign account owners, stepping forward and doing something is likely preferable.

Quiet disclosures and new disclosures. With a quiet disclosure, the taxpayer files amended income tax returns and FBARs going back as far as the statute of limitation requires, generally three or six years. The benefit of a quiet disclosure is that the taxpayer is not coming forward under the OVDI, thereby avoiding even the reduced penalties imposed under the program. In such a case, the taxpayer merely amends his or her returns to bring them into compliance with the law and completes the necessary FBARs. This may have worked for many people over the last several years, but it is becoming a high-risk tactic, too. Taxpayers who reported the income on a foreign account but failed to file FBARs are likely to fare better from a penalty perspective than those who did neither.

The GAO report cited above suggests that quiet disclosures have been rampant. It determined that from 2003 to 2008, 10,595 taxpayers made quiet disclosures. Of those, 3,386 taxpayers made late or amended filings for multiple tax years—94 of them for all six years. The IRS is also aware of the problem, though it had estimated a much smaller number of quiet disclosures. The GAO recommended that the IRS begin to look for these amended returns to better detect quiet disclosures and impose penalties where warranted.

Among other things, the GAO said the IRS should explore options to more effectively detect and pursue quiet disclosures and analyze first-time offshore account reporting trends to catch people trying to avoid paying what they owe.

First-time offshore account reporting, or a “new disclosure,” is another tactic taxpayers have used. The taxpayer simply makes the disclosure on a current return and hopes not to be discovered for prior years. This has worked for some, in much the same way that quiet disclosures have worked for others. The GAO noted that the number of taxpayers checking the box on Schedule B that indicates the existence of a foreign account has more than doubled from 2003 to 2010, to 515,635. Strikingly, the number of FBARs filed more than tripled to 618,134 from 2003 to 2011 and more than doubled between 2009 and 2010.

The IRS will likely begin to take a closer look at first-time FBAR filers and at returns where line 7a of Schedule B is checked for the first time. In addition, a much higher level of audit activity can be expected where amended returns are filed that indicate the existence of a foreign account.

The IRS OVDI. The IRS has had three iterations of the OVDI. The first iteration offered the lowest level of penalty (20%). The current version sets the penalty at 27.5%. Under the program, the account owner must also agree to be taxed on the prior eight years of income in the account rather than three or six.

Why would owners of foreign accounts step forward under the voluntary program when they are virtually assured that in addition to eight years of federal income tax on the account earnings, they will be required to pay a 20% accuracy penalty on the amount of income tax due, interest, and 27.5% of the highest account value as an additional penalty? Under the voluntary program, the potential for criminal prosecution is removed. In addition, outside the voluntary program, the penalties can be far higher, as much as the greater of $100,000 or 50% of the highest account value for each violation. In most cases, this larger penalty has been applied to the highest account value over the last three or six years, depending on which statute of limitation applies (see Internal Revenue Manual (IRM) Section 4.26.16.4.7(4)). But see Zwerner, No. 1:13-cv-22082-CMA (S.D. Fla., complaint filed 6/11/13), for a case where the government is attempting to collect multiple-year maximum civil penalties in an FBAR matter.

The first step when a client desires to enter the voluntary program is to write to the IRS Criminal Investigation Division (CID) to get the client precleared to enter the program. A client whose bank has already provided the IRS with the client’s information is not likely to receive clearance. If the client is precleared to enter the program, the next step is to amend the last eight years of income tax returns to include any previously unreported income from the foreign account.

These items must be submitted when disclosing a foreign account, generally within 45 days after receiving a preclearance letter:

• Copies of original returns (and amendments) filed for the years covered by the voluntary disclosure.
• Amended returns and certain tax return schedules for the years covered by the voluntary disclosure.
• A signed offshore voluntary disclosure letter with the necessary attachment.
• A check for the tax, interest, and penalty computed on the account.
• A completed foreign account or asset statement if the information on the statement was not already disclosed on the offshore voluntary disclosure letter.
• Completed penalty computation worksheet.
• Signed extension of time to assess tax (including penalties and FBAR penalties).
• Completed FBARs.
• For applicants disclosing offshore financial accounts with an aggregate highest account balance in any year of $500,000 or more, financial account statements showing all account activity during the voluntary disclosure period. For applicants disclosing offshore financial accounts with an aggregate highest account balance in any year of less than $500,000, copies of offshore financial account statements reflecting all account activity for each of the tax years covered by the voluntary disclosure must be available upon request.

It should be noted that in most instances, the taxpayer will be required to sit down with the IRS agent assigned to the taxpayer’s case in a meeting that might also include a supervisor and an attorney from the IRS District Counsel’s office.

FBAR VIOLATIONS OUTSIDE THE OVDI

If the IRS has already obtained a taxpayer’s foreign account information from a foreign institution, he or she will likely be barred from the voluntary program. In addition, there could be strategic reasons not to enter the program.

The IRS will seek to determine whether the foreign account violations were willful and, if so, whether the case is worthy of criminal prosecution.

Willful vs. nonwillful violations. This determination is critical for the assessment of civil penalties. Willful penalties, as described above, can be as high as the greater of $100,000 or 50% of the account value. This is in addition to back taxes, interest, and an accuracy penalty that is 20% (or in some cases 40%) of the back taxes owed. A nonwillful violation generally calls for a penalty of up to $10,000 per year of violation for the years that remain open under the statute of limitation. In some cases, the IRS may agree to waive penalties altogether, though this appears to be rare. So what separates a willful violation from a nonwillful violation?

The test for willfulness is whether there was a voluntary, intentional violation of a known legal duty (IRM §4.26.16.4.5.3.1). The IRS has the burden of establishing willfulness (IRM §4.26.16.4.5.3.3). Willfulness is shown by the person’s knowledge of the reporting requirements and conscious choice not to comply. In an FBAR situation, the only thing that a person needs to know is that he or she has a reporting requirement. If a person has that knowledge, the only intent needed to constitute a willful violation of the requirement is a conscious choice not to file the FBAR (IRM §4.26.16.4.5.3.5). Several examples of what the IRS considers to be a willful violation can be found in IRM Section 4.26.16.4.5.3.8.

While the standard of proof the IRS must meet to prove that an FBAR violation is willful formerly appeared to be one of clear and convincing evidence (see IRS Chief Counsel Advice (CCA) 200603026), the less strict preponderance-of-the-evidence standard was applied by the court inMcBride, No. 2:09-cv-378 (D. Utah 2012).

Willful violations are perhaps more likely to be found where the account owner put the funds in the account, used the funds in some manner, and actively participated in keeping the account hidden from the authorities. Nonwillful violations may more likely be found where the taxpayer did not put the funds in the account, exercised no control over the funds, did not use any of the funds, and was unaware of reporting requirements. Clearly, a large spectrum of behavior between these two extremes comes down to the facts and circumstances of a particular situation. Defending a client against the higher penalties associated with willfulness calls upon the practitioner’s skills and abilities.

Can a taxpayer avoid the finding of a willful violation by claiming that he or she did not know about the foreign account filing requirements? For a time, it looked as if one district court was going in this direction (see Williams, No. 1:09-cv-437 (E.D. Va. 9/1/10)). On the government’s appeal, however, the Fourth Circuit held (Williams, 489 Fed. Appx. 655 (4th Cir. 2012)) that the district court had clearly erred in finding that Williams did not willfully violate 31 U.S.C. Section 5314, the federal law that requires individuals to report to the IRS annually any financial interests they have in any bank, securities, or other financial accounts in a foreign country.

In Williams, the taxpayer, Bryan Williams, checked “no” on Schedule B, Section III, line 7a, and filed no FBARs. He claimed that he was unaware of the filing requirements and never read the actual words on his return. The Fourth Circuit found that the taxpayer made a conscious effort to avoid learning about the reporting requirements. The court found that signing his 2000 federal income tax return was prima facie evidence that the taxpayer knew the return’s contents. Williams’s false answers on both the tax organizer he filled out for his tax preparer and his income tax return further indicated conduct that was meant to conceal or mislead on sources of income or other financial information, the court found. In such a situation, “willful blindness” may be inferred, the court said, where “a defendant was subjectively aware of a high probability of the existence of a tax liability, and purposely avoided learning the facts” (quoting Poole, 640 F.3d 114, 122 (4th Cir. 2011)).

According to the court, at a minimum, Williams’s actions established reckless conduct, which satisfied the preponderance-of-the-evidence burden of proof requirement for the civil FBAR penalty for willfulness.

McBride similarly dealt with willfulness in the context of FBARs. The taxpayer, Jon McBride, had a company that was operating overseas. He retained the services of a firm that designed strategies to allow its clients to avoid reporting income and their ownership in assets by having its clients’ assets held by nominees holding legal title of shell corporations and foreign bank accounts. McBride accessed the funds through sham lines of credit. The district court found that McBride had an interest in foreign accounts and that he willfully failed to report his interest in them.

By signing his returns, McBride was said to have imputed knowledge of the requirement to file FBARs, since the tax returns contained a plain instruction informing individuals that they have the duty to report their interest in any foreign financial or bank accounts held during the tax year. The court acknowledged that willful blindness satisfies a willfulness standard in both civil and criminal contexts. In McBride, the court also reasoned that the willfulness standard can be satisfied through the taxpayer’s reckless disregard of a statutory duty. Simply not knowing about the foreign account reporting requirements is not enough to defeat a finding of willfulness.

The court noted in McBride that subjective knowledge was not required for the taxpayer to have willfully failed to comply with the FBAR requirements, because the taxpayer acted in reckless disregard of the known or obvious risks created by his involvement with foreign accounts. Drawing an analogy with the trust fund recovery penalty standards under Sec. 6672, the court stated that “a responsible person is reckless if he knew or should have known of a risk that the taxes were not being paid, had a reasonable opportunity to discover and remedy the problem, and yet failed to undertake reasonable efforts to ensure payment” (quoting Jenkins, 101 Fed. Cl. 122, 134 (2011)).

In the Williams and McBride cases, the courts noted that both taxpayers failed to discuss their financial strategies involving millions of dollars with their accountants. This was viewed by the court as significant evidence of willfulness or at least recklessness and willful blindness.

OPTING OUT OF THE OVDI

There might be good reason to opt out of the OVDI. To see some examples that the IRS believes to be appropriate opt-out opportunities, see Offshore Voluntary Disclosure Program Frequently Asked Questions and Answers, Question 51.1, available at tinyurl.com/9oolgde. Opting out is at the sole discretion of the taxpayer and is an irrevocable election. Examiners are advised that taxpayers should not be treated in a negative fashion merely because they choose to opt out.

Once an opt-out is elected, the taxpayer can expect a full audit. The IRS will remind the taxpayer in writing of the continuing responsibility to cooperate under Criminal Investigation’s Voluntary Disclosure Practice and will instruct the taxpayer to provide a written statement setting forth the facts of the case, a recommendation of the penalties that should apply, and the rationale for the penalty recommendations within 20 days of receiving the letter from the IRS. (See IRS memorandum, “Guidance for Opt Out and Removal of Taxpayers from the Civil Settlement Structure of the 2009 Offshore Voluntary Disclosure Program (2009 OVDP) and the 2011 Offshore Voluntary Disclosure Initiative (2011 OVDI)” (June 1, 2011).)

FBAR VIOLATION MEETINGS WITH THE IRS

Meetings with the IRS concerning FBAR violations create a quandary for the practitioner. The IRS will generally not settle FBAR cases without having a face-to-face meeting with the taxpayer. A taxpayer who refuses is deemed to be uncooperative, and this may have an impact on penalties (see IRM Exhibit 4.26.16-2 (7/1/08)). On the other hand, if the attorney advises the client to attend the meeting and speak freely, will a bad result raise a potential malpractice issue? If the client is advised to not agree to the meeting, the IRS will move to compel the meeting. While the IRS can ultimately force the client to meet, it cannot force him or her to speak.

Now a choice must be made. One alternative is for the client to plead the Fifth Amendment right against self-incrimination at such a meeting, though doing so will almost certainly lead to greater IRS scrutiny. If the client has a good story to tell, this is likely the time to tell the story if there is a good chance that, based on the facts, the practitioner thinks that nonwillful penalties are likely to apply. If the client is going to speak at this meeting, he or she must be candid and truthful.

This is yet another area where the practitioner’s experience and judgment play a large role. This may be a good time for the client to engage an attorney if he or she has not done so already. In any event, the client must make the ultimate decision about whether to have the meeting. All communications with the client on this topic should be in writing, for the practitioner’s protection (see the sidebar, “Checklist for Foreign Accounts,” for a step-by-step framework for assessing the client’s circumstances and recommending a course of action).
Making a Clear Assessment of the Facts

Where a taxpayer was clearly willful or reckless, the voluntary program may be the best option if the IRS has not found the taxpayer before he or she attempts to enter the program. This tack will limit penalties and likely help the client avoid criminal prosecution. But where willfulness and recklessness do not appear to be the cause of the reporting failures, careful consideration should be given to opting out of the voluntary program.

The IRS can determine that no penalty is warranted and issue a warning letter, though again, it rarely does. Rather, it will look to determine if there was some level of negligence in a particular matter. Negligence can be inferred in some instances by the sophistication or education level of the taxpayer. With a large account, $10,000 per year for each year that the FBAR statute of limitation is open may be far more palatable than the penalty that would be paid under the voluntary program. Another consideration is that the FBAR examiner has a certain amount of discretion. The IRS has developed penalty mitigation guidelines to ensure some level of consistency in the treatment of similarly situated taxpayers.

According to IRM Section 4.26.16.4.6.1, to qualify for mitigation, a person must meet four criteria:

1. The person has no history of criminal tax or BSA convictions for the preceding 10 years, as well as no history of past FBAR penalty assessments.
2. No money passing through any of the foreign accounts associated with the person was from an illegal source or used to further a criminal purpose.
3. The person cooperated during the examination.
4. The IRS did not determine a civil fraud penalty against the person for an underpayment of income tax for the year in question due to the failure to report income related to any amount in a foreign account.

There is a risk of criminal prosecution when a taxpayer has a hidden offshore account. This is another reason to consider engaging an attorney early in the process. In terms of criminal prosecution and incarceration in offshore cases, it appears that judges are handing down shorter sentences than recommended under federal guidelines, with the average sentence being about half as long as in some other types of tax cases.

Since Treasury and Justice began their heightened scrutiny of offshore account activity roughly four years ago, they have charged at least 71 taxpayers criminally. The average sentence handed down in offshore cases has been less than 15 months. In contrast, the average sentence in tax-shelter schemes has been 30 months over the past three years. Three-quarters of taxpayers charged in offshore account cases have pleaded guilty. Prison sentences have been handed down about half the time (see “Leniency for Offshore Cheats,” Wall Street Journal, May 5, 2013).

AN EVER-WIDER NET

The IRS will continue to develop its capabilities in finding and prosecuting foreign account cases. The new agreement with the Swiss and the fact that the IRS insists on interviewing taxpayers indicates that there is a high risk that foreign banks and taxpayers will name others involved in foreign account facilitation, thus allowing Treasury and Justice to cast an ever-wider net. An adviser must look at the facts of each case and determine which path to suggest to a client, because doing nothing is no longer a viable option.

Checklist for Foreign Accounts

Initial inquiry:

• Does the client have a foreign account?
• If yes, is it the type of account that is covered by 31 U.S.C. Section 5314?
• If applicable, has the client properly completed Form 1040, Schedule B, Interest and Ordinary Dividends, Part III, Line 7a?
• Has the client annually reported the income from the account?
• Has the client filed FinCEN Form 114 (formerly TD F 90-22.1), Report of Foreign Bank and Financial Accounts (FBAR)?
• Has the client filed Form 8938, Statement of Specified Foreign Financial Assets, with his or her federal income tax return?
• Has the IRS already contacted the client about the foreign account?

For a client with an unreported foreign account who has not been contacted by the IRS:

• How long has the client had the account?
• What was the source of the funds?
• Was the account inherited?
• Did the client use funds in the account or actively manage it?
• Is the client a nominal or beneficial owner of the account?
• Does an entity own the account? If yes, what is the client’s ownership of or involvement in the entity?
• Upon your analysis, does it appear reasonably likely that the IRS could sustain a successful criminal prosecution against the client?
• Upon your analysis, does it make sense to enter the Offshore Voluntary Disclosure Initiative (OVDI)?
• Despite the risk, is there logic in considering a quiet disclosure rather than entering the OVDI?
• Is there a reason to opt out of the OVDI?
• Are there other issues on the client’s federal income tax return that would not stand up to an IRS audit?

Additional considerations when the client has been contacted by the IRS or is denied access to the OVDI:

• Has the client disclosed the account to his or her accountant or tax preparer?
• Does it appear that the IRS could sustain a willfulness penalty against the client?
• Do the facts support a negligence penalty?
• Do the mitigation guidelines apply?

EXECUTIVE SUMMARY

Taxpayers with an interest in or signature authority over foreign accounts generally must disclose them on their annual tax returns and file FinCEN Form 114 (formerly TD F 90-22.1), Report of Foreign Bank and Financial Accounts (FBAR), with the Treasury Department annually by June 30.

The IRS is increasingly likely to detect noncompliance as it gains greater cooperation from foreign financial institutions and analyzes returns for new and “quiet” disclosures. Qualifying taxpayers wishing to limit their exposure may enter the IRS’s Offshore Voluntary Disclosure Initiative (OVDI).

If taxes on income from undisclosed foreign accounts is unpaid, taxpayers in the OVDI will likely pay eight prior years’ back taxes on the income, plus a 20% accuracy penalty, and an additional penalty of 27.5% of the highest account value. In return, they will not be subject to criminal prosecution or liable for the potentially much greater penalties that could be imposed, especially if the noncompliance is willful.

However, some clients may be best advised to opt out of the OVDI if, for instance, they have unreported foreign account income but no tax deficiency, and in some instances, for nonwillful failure to file FBARs.