Time to Act for U.S. Taxpayers in Violation of Offshore Tax Compliance Requirements
United States persons are responsible for filing tax returns and reporting their worldwide income, including income associated with foreign accounts, and there are numerous informational returns that U.S. persons may be required to file. The penalties associated with the failure to properly report income and/or the failure to file these informational returns are significant. However, in March 2009, the Internal Revenue Service (IRS) announced a six-month settlement initiative through which taxpayers with offshore noncompliance could come forward to resolve their issues. The IRS settlement offer terminates on September 23, 2009, so it is imperative for any taxpayer interested in benefiting from the settlement terms to contact their advisors immediately.
The settlement has been widely covered by the national media, but generally in the context of taxpayers who have unreported accounts with UBS AG, the Swiss financial services firm that admitted to helping U.S. taxpayers hide accounts from the IRS. It is important to understand that the IRS settlement is not limited to individuals with unreported accounts at UBS, or unreported accounts at any other financial institution.
We will discuss here some of the most commonly overlooked informational filings by U.S. taxpayers (Forms 3520, 3520-A, 5471, and TDF 90-22.1), and the penalties for failing to file. We will also look at the IRS settlement initiative in detail.
Do you have a foreign bank account you own either individually or jointly? Do you have a foreign investment account you own either individually or jointly? Do you have a debit or credit card that is tied to a foreign account even if not yours? Do you own a foreign mutual fund? Are you trustee of a trust with foreign investments? Do you hold a power of attorney for someone who owns foreign investments? If you can answer yes to any of these questions, you likely have an FBAR (Report of Foreign Bank and Financial Accounts) filing requirement.
All U.S. persons must file Treasury Department Form 90-22.1 (the FBAR) to report the existence of a financial interest, signature authority or other authority over foreign financial accounts if in the aggregate at any time during the preceding calendar year the balance of all such accounts equals or exceeds $10,000. The FBAR is not a tax filing; rather, it is an informational return that must be received by the IRS on June 30. (Mailing it on the 30th is insufficient.)
The form is filed with the Detroit Service Center of the IRS and is considered late if not filed at such time; extensions are not granted. The duty to file the FBAR is independent of the obligation to file an income tax return, even though the FBAR is cross-referenced on Form 1040, Schedule B, Part III. A foreign account that meets the FBAR filing requirements must be reported even if the account does not generate taxable income. Thus, if a taxpayer fails to file an FBAR because the account that meets the FBAR requirements generates no taxable income, the taxpayer will be subject to penalty – and the penalties for failure to comply with the FBAR requirements are punitive. It should be noted that because each of the respective terms is defined quite broadly and multiple persons can have a filing obligation to report the existence of the same accounts, it is easy for taxpayers to be noncompliant.
There are questions on multiple tax returns (such as Forms 1040, 1041, 1065 and 1120) that seek information related to the existence of foreign accounts. Even if the taxpayer has no interest or dividends (which would otherwise be reported in Question 7, Part III of Form 1040, Schedule B; Line 3, Schedule G of Form 1041; Line 9 of Schedule B of Form 1065; or Line 6a of Schedule N of Form 1120), the requisite Schedule must be completed to report the existence of the foreign account. If a taxpayer fails to report the account on his or her tax return, it may be considered an incomplete return – and the statute of limitations would remain open indefinitely for the underlying income tax. Of much greater importance, however, is Section 12.08(6)(g) of the Department of Justice Criminal Tax Manual, which provides that responding “no” on the Form 1040 can be the basis for a tax evasion prosecution. Although it is doubtful a taxpayer would be criminally prosecuted for failing to properly answer the question on a tax return regarding the existence of a foreign account, especially if the taxpayer properly reported the income associated with the foreign account, all bets are off if the income was omitted from the U.S. return.
The IRS has six years within which to assess a civil penalty related to an FBAR violation. However, it is unclear whether the statute will toll if the FBAR is not filed. 31 U.S.C. § 5321(b)(1). A taxpayer who fails to file an FBAR may be subject to both civil and criminal penalties. The same violation may be punishable by both a civil and criminal penalty. 31 U.S.C. § 5321(d)
FBAR Civil Penalties. The penalty for a non-willful failure to file the FBAR can be up to $10,000. 31 U.S.C. § 5321(a)(5)(B)(i). However, if the amount of the transaction or the balance of the foreign account is reported on the taxpayer’s Form 1040, the penalty may be eliminated as a result of the reasonable cause exception. 31 U.S.C. § 5321(a)(5)(B)(ii). Note, however, that Form 1040, Schedule B, Part III instructs a taxpayer who indicates that he has a financial account in a foreign country to review the FBAR.
To satisfy the reporting necessitated for the reasonable cause exception, the taxpayer must be certain to include on the Form 1040 any income generated by the foreign account and to the extent possible a detailed explanation of the transaction. For a willful violation of the FBAR reporting requirement, the penalty is the greater of $100,000 or 50 percent of the amount of the transaction or of the balance of the account at the time of the offense. 31 U.S.C. § 5321(a)(5)(C). Violations that are deemed to be willful are not subject to the reasonable cause exception. 31 U.S.C. § 5321(a)(5)(C)(ii).
FBAR Criminal Penalties. If the failure to file the FBAR is deemed to be a criminal violation, the penalty can include a fine of up to $250,000, imprisonment for up to five years, or both. 31 U.S.C. § 5322(a). If the failure to file is deemed to be part of a criminal activity, (i.e., it occurs during the violation of another law or is part of an illegal activity involving more than $100,000 in a 12-month period), the maximum fine increases to $500,000 and the possibility of imprisonment increases to up to 10 years. 31 U.S.C. § 5322(b). There is, of course, a possibility that both the $500,000 penalty and 10-year jail term will be subject to the applicable sentencing guidelines. Id.
To establish willfulness, the government must prove that the taxpayer had knowledge of the reporting requirement and in spite of such knowledge chose to ignore the requirement. See, e.g., United States v. Eisenstein, 731 F.2d 1540 (11th Cir. 1984). However, some courts have held that the government may prove willfulness by demonstrating that the taxpayer consciously or recklessly disregarded the law. See, e.g., United States v. London, 66 F.3d 1227 (1st Cir. 1995). FBAR penalties are particularly draconian and the IRS is engaged in active enforcement.
Growing FBAR Filing Requirements and Enforcement
Taxpayers should also be aware that the IRS has increased enforcement of the FBAR, and the filing requirements are expanding. For example, on September 30, 2008, and with no pronouncement, the IRS posted a revised FBAR form on its website, which is to be used for all filings subsequent to December 31, 2008. The revised FBAR also included a significant change to the definition of “U.S. person,” which has since been tolled by the IRS. The persons required to file an FBAR previously included United States citizens, residents, domestic partnerships, domestic corporations, domestic trusts and domestic estates. The revised FBAR expanded the definition to include “a citizen or resident of the United States, or a person in and doing business in the United States.” The IRS introduced insufficient guidance as to who would be classified as being “in and doing business in the United States.” Consequently, on June 5, 2009, the IRS issued Announcement 2009-51, which suspends the requirement for persons who are not citizens, residents or domestic entities to file an FBAR for the 2008 tax year. Nonresident aliens should pay close to attention to future guidance, however, as it is likely they will be required to file FBARs in 2010 if they were “in and doing business in the United States.”
The definition for a financial account in the prior instructions included “any bank, securities, securities derivatives or other financial instruments accounts. Such accounts generally also encompass any accounts in which the assets are held in a commingled fund, and the account owner holds an equity interest in the fund. The term also means any savings, demand, checking, deposit, time deposit or any other account maintained with a financial institution or other person engaged in the business of a financial institution.” The revised FBAR expanded the definition to make clear that it also encompasses the use of a debit card or credit card.
Notwithstanding, on June 12, 2009, an IRS representative stated on a telephone conference call sponsored by the American Institute of Certified Public Accountants and the ABA Sections of International Law Committee on International Taxation and Section of Real Property Trust & Estate Law that an FBAR was required to be filed for the following U.S. persons: those with an investment in a foreign hedge fund, a foreign private equity fund or a foreign partnership – if those investments were operated similar to a mutual fund, whereby funds were commingled, regardless of the ownership percentage the U.S. person held in the investment (“foreign commingled funds”). This marked the first time the IRS had publicly stated that the definition for a foreign account reached such investments.
On August 7, 2009, the IRS in Notice 2009-62 suspended the need for taxpayers to report their investment in a foreign commingled fund until June 30, 2010. The IRS intends to introduce further guidance explaining the types of foreign commingled funds that must be reported on an FBAR. This 10-month extension follows the relief provided on June 24, 2009; there the IRS said taxpayers who had recently learned of their need to file an FBAR with regard to their investment in a foreign commingled fund could file the form by September 23, 2009.
Have you ever set up a foreign trust? Have you ever contributed funds or property to a foreign trust set up by someone else? Have you ever received gifts from foreign persons? Have you ever received an inheritance from a foreign person? Have you ever received funds from a foreign corporation or partnership in which you do not have an ownership interest? Have you ever loaned funds to a foreign trust? Have you ever received a distribution from a foreign trust? Do you have a debit or credit card that is tied to a foreign trust? Do you own real estate in Mexico? If you answer yes to any of these questions you may have a Form 3520 filing requirement.
Sections 6039F and 6048 mandate the filing of a Form 3520. U.S. persons must file Form 3520 to report their (i) creation of a foreign trust; (ii) transfer of money or property to a foreign trust including by reason of death; (iii) receipt of distributions from a foreign trust; and (iv) receipt of certain gifts from foreign persons. For purposes of the filing, “distributions” include direct distributions (i.e., a distribution directly to the “U.S. beneficiary”), as well as indirect distributions (i.e., a U.S. person writes a check that will be satisfied from a foreign trust or uses a credit card that takes funds out of a foreign trust). If a U.S. person is subject to these reporting rules, the form is due on the date that such person’s income tax return is due, including extensions. The form must be filed in duplicate, one copy attached to the U.S. person’s income tax return and the second sent separately to the IRS Service Center in Philadelphia.
The penalty for failure to file Form 3520 to report the transfer of funds to a foreign trust is currently “35 percent of the gross value of any property transferred to a foreign trust” and “35 percent of the gross value of distributions received from a foreign trust” for the failure to report the receipt of a distribution from a foreign trust. If the Form 3520 is incomplete, in addition to penalties, the entire trust distribution will be deemed an accumulation distribution and taxed as ordinary income. Section 6048(c)(2)(A).
It should be noted that if the Form 3520 is delinquent more than 90 days after receiving notification from the IRS of such delinquency, an additional penalty of $10,000 is permitted for every 30 days (or fraction thereof).
Section 6039F(a) requires U.S. persons to disclose the receipt of large gifts or bequests from foreign persons. The disclosure requirement is tied to the identity of the donor and there are different thresholds based upon the donor. For example, there are higher thresholds for gifts received from nonresident alien individuals and foreign estates than there are for gifts from foreign partnerships and foreign corporations. Consequently, a U.S. person is required to report the receipt of gifts from a nonresident alien or foreign estate only if the total amount of gifts from that nonresident alien or foreign estate is more than $100,000 during the tax year. Once the $100,000 threshold has been met, the U.S. person must separately identify each gift that is more than $5,000, but doesn’t have to identify the donor.
The penalty for failure to file a Form 3520 reporting the receipt of a large foreign gift is less than that for filing the Form 3520 reporting the receipt of distributions from the foreign trust. The penalty for failing to timely report the receipt of a foreign gift is imposed by Section 6039F, as opposed to Section 6677, and is 5 percent per month. The penalty increases each month that the Form 3520 is delinquent and continues up to a total of 25 percent. The penalty is due upon notice and demand. Section 6039F(c)(1)(B).
Have you ever created a foreign trust? If you have recently become a U.S. taxpayer, did you create a foreign trust within five years of becoming a U.S. taxpayer? Be sure not to answer too quickly: the Internal Revenue Code and Treasury regulations can re-characterize a transaction such that indirect transfers are included within the reach of Section 679.
If a taxpayer transfers assets to his or her parents who are not U.S. taxpayers and who then settle a foreign trust, the trust will likely be deemed created by the U.S. taxpayer. Treas. Reg. Section 1.679-3(c) provides that “a transfer to a foreign trust by a person to whom a US person transfers property is treated as an indirect transfer by a US person to the foreign trust if such transfer is made pursuant to a plan one of the principal purposes of which is the avoidance of United States tax.” The principal purpose of a transfer will be deemed to be tax avoidance if: (i) the U.S. person is related to a beneficiary of the foreign trust, and (ii) the U.S. person cannot demonstrate to the satisfaction of the IRS that there was no other basis for creating the trust to benefit such person.
Additionally, even if a foreign trust appears to have no U.S. beneficiaries, the Internal Revenue Code can override the determination and treat the trust as having a U.S. beneficiary regardless of what is provided in the trust document itself. For example, according to Section 679(c)(1) a trust will be deemed to have a U.S. beneficiary unless (i) under the terms of the trust no part of the income or corpus could be paid or accumulated for the benefit of a U.S. person, and (ii) if the trust terminated during the tax year, no part of the income or corpus could be paid to a U.S. person. Furthermore, Treas. Reg. Section 1.679-2(a)(4)(ii)(A) provides that if the trust documentation can be amended to benefit a U.S. person, then it will be classified as if there were such a U.S. beneficiary. Similarly, Treas. Reg. Section 1.679-2(b)(1) provides that if a beneficiary of the trust is a controlled foreign corporation or a foreign partnership in which the taxpayer is a partner, the trust will similarly be classified as having a U.S. beneficiary.
The consequence of having settled a foreign trust, which is classified as having a US beneficiary, is that the taxpayer will be deemed to own the trust under the grantor trust rules. Consequently, the taxpayer will be liable for paying the income tax on the trust’s income. Additionally, the taxpayer will be required to file Form 3520-A. The form must be filed by March 15, but a six-month extension may be received by filing Form 7004. The penalty for failure to file Form 3520-A is 5 percent of the December 31 value of the portion of the trust’s assets treated as owned by the taxpayer.
Do you own a foreign corporation? Are you a director or officer of a foreign corporation? If the answer to either of these questions is yes, you may have an obligation to file Form 5471.
Certain U.S. citizens and residents who are officers, directors or shareholders of foreign corporations must file Form 5471. While there are several categories of persons who must file the form, if a U.S. officer or director acquires stock to meet the 10 percent ownership requirement, or if a U.S. person had control of a foreign corporation for an uninterrupted period of at least 30 days during the annual accounting period of the foreign corporation, such person would also have a filing obligation. A person is in control of a foreign corporation if (i) the person owns stock possessing more than 50 percent of the total combined voting power of all classes of stock entitled to vote, or (ii) the person owns more than 50 percent of the total value of shares of all classes of stock of a corporation. The form is due at the same time as the U.S. person’s individual income tax return. There is a $10,000 penalty for each annual accounting period for which the failure to file a Form 5471 exists.
The IRS Settlement Initiative
On March 23, 2009, the IRS announced the creation of new voluntary disclosure program for undeclared foreign accounts. The IRS Offshore Income Reporting Initiative (the Initiative) is only available for six months, or until September 23, 2009, and provides that those taxpayers who qualify will not be subject to criminal penalties or the civil fraud penalty. Taxpayers will have to file six years of tax returns, depending upon the circumstances, either amended or delinquent, and pay all taxes and interest due. Taxpayers will also incur an accuracy related penalty or a delinquency penalty, as well as a penalty of up to 20 percent on the highest aggregate balance held in the account during the six-year period. Certain taxpayers may qualify for a reduced penalty of 5 percent on the highest aggregate balance in the foreign account.
The 5 percent penalty will only apply if the taxpayer: (i) did not open or create the foreign account, (ii) has never withdrawn money from the foreign account or added money to the foreign account, and (iii) all U.S. taxes have been paid on the funds which were deposited into the account. Thus, the only noncompliance that may exist on the part of the taxpayer is not reporting the income earned on the foreign account. Of course the third requirement may be the most difficult to satisfy, as it only applies to persons who either inherited a foreign account or received a foreign account as a gift. If a taxpayer inherited the account from a foreign relative, it is likely no U.S. taxes would have been paid, and possible that the taxpayer failed to report the receipt of the foreign gift on a Form 3520. If a taxpayer inherited the account from a U.S. relative, it may be unclear as to whether taxes were paid on the funds contributed to the account.
The IRS has released a series of questions and answers on its website related to the Initiative, the most important of which provide a procedure for taxpayers to file delinquent informational returns without penalty provided there was no omission of income on the taxpayer’s U.S. tax return.
Although the penalties under the Initiative may cause some financial difficulties, taxpayers should not lose sight of what they avoid by submitting a disclosure consistent with the Initiative. While not a complete summary of potential penalties, the following are some of the most common:
- criminal prosecution
- civil fraud penalties under IRC 6651(f) and 6663, which can amount to penalties of 75 percent of the unpaid tax
- failure to pay penalties under IRC 6651 (a)(2) and (a)(3)
- failure to file penalties under IRC 6651
- penalties for failure to file foreign corporation information returns (Form 5471 and or Form 5472), which begin at $10,000 and can run as high as $50,000 per return
- penalties for failure to report transfers of property to a foreign corporation (Form 926), which begin at 10 percent of the value of the property transferred to the corporation and which can reach a maximum of $100,000 per return
- penalties for failure to file a Form 3520 reporting the transfer of funds to a foreign trust or receipt of a distribution from a foreign trust, which begins at 35 percent of the amount transferred to or received from the foreign trust
- penalties for failure to file a Form 3520 to report the receipt of a gift or inheritance from a foreign person or estate, or a gift received from a foreign corporation or partnership, which begins at 5 percent of the value of the gift and can reach as high as 25 percent of the value
- penalties for failure to file Form 3520-A reflecting ownership of a foreign trust under the grantor trust rules, which consists of a penalty of 5 percent of trust assets
- penalties for failure to file foreign partnership information returns (Form 8865), which start at $10,000 and can reach a maximum of $50,000 per return, plus up to $100,000 of the value of property transferred to the foreign partnership
- penalties for failure to file FBARs, which can reach as high as 50 percent of the account balance, and in certain situations may include a jail sentence
Tough Words From the IRS Commissioner
If avoiding the imposition of the above penalties is not a significant enough carrot, taxpayers should understand that the situation will not get any better. IRS agents have been instructed by IRS Commissioner Shulman that if the taxpayer did not self-report through a voluntary disclosure, they are “to fully develop these cases, pursuing both civil and criminal avenues, and consider all available penalties including the maximum penalty for the willful failure to file the FBAR report and the fraud penalty.”
Important to Act Before September 23, 2009
Taxpayers with offshore noncompliance – regardless of whether it involves unreported foreign accounts, failure to properly account for subpart F income, or failure to file an informational return – should take advantage of the IRS Initiative that terminates on September 23, 2009. Although the financial penalties may appear to be severe, criminal prosecution and imposition of the civil fraud penalty can be avoided. The time to act is now.