Willful or Non-Willful? That Is the Question: IRS Rejects Non-Willful Certification

In Flint v. United States, 2022 WL 3593826 (Fed. Cl. 2022), the court held that the executors of an estate could not recover a six-figure "Title 26 miscellaneous offshore penalty" (MOP) the decedent paid to the Internal Revenue Service (IRS) pursuant to an IRS program for non-willful taxpayers known as the Streamlined Filing Compliance Procedures (Streamlined Program) in lieu of other penalties the IRS may have assessed.

Although the Flint case involved breach of contract and illegal exaction claims, it demonstrates that the IRS is not bound to accept a taxpayer's self-certification of non-willfulness and may open an examination and determine additional tax, civil penalties and even criminal liability.

The Flint case also shows that taxpayers should heed to the IRS's warning that they should consult with professional or legal advisers and consider other IRS remedial programs (including the IRS Criminal Investigation Voluntary Disclosure Practice) when they are concerned their failure to report income, pay tax and submit required information returns was due to willful conduct and who therefore seek assurance that they will not be subject to substantial monetary penalties and/or criminal liability.

Streamlined Program in a Nutshell

On Sept. 1, 2012, the IRS introduced the Streamlined Program for remediating noncompliance targeted to certain nonresident U.S. taxpayers who had not previously filed U.S. income tax returns. The commencement of the Streamlined Program was predicated on the IRS's recognition that there should be a less burdensome administrative program available for taxpayers who were mistaken and not willful in their failure to timely file certain income and information returns. Several updates to the Streamlined Program have been implemented, with the most recent 2014 program extending the Streamlined Program to U.S. taxpayers who meet specific non-residency requirements (Streamlined Foreign Offshore Procedure, or SFOP) and to certain U.S. taxpayers who reside inside the U.S. (Streamlined Domestic Offshore Procedures, or SDOP).

Under both the SFOP and SDOP, non-willful taxpayers who are not already under IRS civil or criminal audit are able to remediate their U.S. tax and reporting noncompliance with reduced filing obligations and favorable tax and penalty terms. With the SFOP, taxpayers are generally required to file three years of U.S. federal income tax and relevant international information returns, pay U.S. federal income tax and interest on any previously unreported income for the same period, and file six years of foreign bank account reports (commonly known as FBARs) to report a financial interest or signature authority over foreign financial accounts. No penalties are imposed. With the SDOP, taxpayers have similar filing requirements and the additional requirement that they pay a Title 26 miscellaneous offshore penalty computed at 5 percent of the aggregate value of foreign financial assets that 1) should have been reported on an FBAR for the prior six-year period; 2) should have been reported on Form 8938 (Statement of Specified Foreign Financial Assets) for the prior three-year period; and/or 3) for which income connected with foreign financial assets was not properly reported for the prior three-year period.

With typical penalties for failing to file information returns at a minimum of $10,000 per violation and willful penalties for failing to file an FBAR at up to 50 percent of the aggregate value of unreported foreign financial accounts, taxpayers would clearly benefit from remediation under the SFOP or SDOP, provided eligibility requirements are met.

Who Is Eligible for the Streamlined Program?

The single most significant eligibility requirement for the SFOP and SDOP is that the taxpayer was non-willful in his or her failure to report all income, pay all tax and submit all required information returns (including the FBAR).

The taxpayer must certify his or her non-willful conduct in a narrative statement signed under penalties of perjury. The statement should include, among other details, the specific facts (good, bad and even ugly) surrounding the non-filings, the taxpayer's personal background, the source of funds in the foreign accounts, the taxpayer's relationship with the foreign country where the foreign financial accounts are located, and the name and contact details for any professional adviser the taxpayer may have relied upon.

Because the Streamlined penalty framework is so favorable, it is not uncommon for taxpayers to gloss over potentially negative facts when speaking with their tax counsel. For this reason, it is critical that tax counsel fully vet the non-willful position, including a review of all relevant facts and supporting documents to ensure the credibility of the taxpayer's statements. In doing so, it is imperative that tax counsel analyze the facts from an IRS perspective, because while a particular fact may be viewed by some as harmless, inadvertent or even negligent, the IRS may view the same fact as willful (e.g., reckless).¹ Tax counsel must carefully evaluate and professionally assess a taxpayer's eligibility for the Streamlined Program, then draft a narrative statement in a manner that complies with the Streamlined Program requirements.

If a taxpayer fails to provide a complete and detailed narrative statement, the IRS may reject the taxpayer's Streamlined submission. And worse, if the taxpayer provides false or fraudulent information in the narrative statement, the taxpayer could potentially face criminal prosecution.

Flint v. United States

In the Flint case, the plaintiffs – executors of the estate of Margaret J. Jones – sought the return of the $156,795.26 MOP that Mrs. Jones paid to the IRS pursuant to the terms of the SDOP. The relevant facts are as follows:²

Jeffrey L. Jones, Mrs. Jones' late husband, was born in New Zealand in 1919 and lived there for the first 30 years of his life. Mrs. Jones was born in Canada in 1928 and lived there for the first 26 years of her life. The Joneses met and were married in Canada and moved to California in 1954. In 1969, the Joneses became U.S. citizens. Mr. Jones and Mrs. Jones died in 2013 and 2021, respectively.

During their lifetimes, Mr. and Mrs. Jones owned interests (both individually and jointly) in 11 foreign bank accounts in New Zealand and Canada. The Joneses failed to report income from the foreign accounts on their jointly filed Forms 1040, U.S. Individual Income Tax Return (Form 1040), for the 2011 and 2012 tax years. Accordingly, on July 7, 2014, more than a year after her husband's death, Mrs. Jones filed Forms 1040-X, Amended U.S. Individual Income Tax Return (Form 1040X), for the 2011 and 2012 tax years, reporting approximately $250,000 in additional foreign interest income for each year and checking the "yes" box on the Schedule B, Interest and Ordinary Dividends (Schedule B) attached to Form 1040 acknowledging the ownership of foreign accounts. On April 15, 2014, Mrs. Jones filed a joint Form 1040 for the 2013 tax year.

On March 16, 2015, Mrs. Jones, solely in her individual capacity and not jointly with her late husband's estate, made the SDOP submission, which included 1) the most recent three years of joint income tax returns (i.e., the previously filed Forms 1040X for the 2011 and 2012 tax years and previously filed Form 1040 for the 2013 tax year); 2) outstanding FBARs for the 2008 through 2013 calendar years; 3) a certificate of non-willfulness; and 4) the $156,795.26 MOP calculated based on 5 percent of the highest account balance of the foreign accounts in which Mrs. Jones had an interest (either individually or jointly).

In her certificate of non-willfulness, Mrs. Jones certified, under penalties of perjury, that she only recently became aware of her husband's New Zealand accounts and was added as a joint owner before his death. Mrs. Jones further certified that neither she nor her husband used or spent funds in such accounts, as they understood they would be subject to U.S. taxation (in addition to New Zealand taxation) if those assets were brought to the U.S. Mrs. Jones also certified that she separately established savings accounts in Canada when she was living in Canada.

In failing to report income from the foreign accounts, Mrs. Jones' certificate of non-willfulness focused on her transparent and open communication with foreign financial and legal advisers regarding investments and reinvestments; her lack of training or background in tax, finance or related accounting matters (although she considered herself an educated and knowledgeable woman); good faith misunderstanding of U.S. income taxation; and reliance on their U.S. Certified Public Accountant (CPA), who knew Mr. Jones and Mrs. Jones were from New Zealand and Canada, respectively, but never asked them about interests in foreign assets or accounts and never advised about requirements to file FBARs or foreign income reporting.

In 2016, the IRS selected Mrs. Jones' 2013 Form 1040 for examination. The IRS interviewed Mrs. Jones and the Joneses' historic U.S. CPA. In 2018, the IRS initiated an examination of the Joneses' failure to report foreign bank accounts before ultimately issuing assessment letters, with each accompanied by a Form 886-A, Explanation of Items (Form 886-A), setting forth facts and analysis in support of willful FBAR penalties.³ Mrs. Jones' Form 886-A included several potential indicators of willfulness, including:

• Despite certifying that neither she nor Mr. Jones ever spent or withdrew funds from the foreign bank accounts, certain Canadian account statements showed payment of expenses incurred in Canada and cash withdrawals.
• Mrs. Jones' certification that the Joneses' failure to report foreign interest income based on an erroneous misunderstanding of how the U.S. tax laws apply to foreign income was contradicted by the agent's finding that Canada, New Zealand and U.S. residents must all pay taxes on worldwide income and that the sources of such misunderstanding are unknown as the misunderstanding did not come from their U.S. CPA nor any other U.S. tax professional.
• Although Mrs. Jones certified that she was "transparent and openly communicated with the foreign financial and legal advisors regarding the ongoing investments and reinvestments," the agent found she was "clearly NOT transparent or open in her communications with her US CPA." In this regard, Mrs. Jones stated in her interview with the agent that she did not disclose the foreign accounts to the U.S. CPA because it was "none of his business."
• Mrs. Jones opened individual and joint investment accounts in New Zealand in 1973, decades before her late husband's death, and emailed certain approvals and/or directed investment activities as early as 2008.
• When asked why she checked the "no" box regarding foreign accounts in Schedule B, Mrs. Jones replied she "must have lied."
• Mrs. Jones' failure to inform her U.S. CPA or any other qualified U.S. tax professional about the foreign accounts did not demonstrate she made any "good faith" effort to understand U.S. tax laws.

The Willfulness Standard: A Moving Target

The Flint case demonstrates the importance of making a determination of whether the taxpayer's U.S. tax and reporting noncompliance was the result of willful or non-willful conduct. Sometimes, that determination can be a close call – a difficult analysis that has been magnified by court decisions that have eroded traditional notions of willfulness.

Taxpayers and practitioners have long operated under the impression that willfulness is determined by the standard articulated more than three decades ago by the U.S. Supreme Court in United States v. Cheek.⁴ The high court held that "the standard for the statutory willfulness requirement is the voluntary, intentional violation of a known legal duty."⁵ Stated another way, to be willful in the tax context, a taxpayer needed to have knowledge of the requirement for which a violation was asserted.

As discussed above, the Streamlined procedure is restricted to those taxpayers who were non-willful in their tax compliance shortfalls. The IRS has maintained that willfulness for purposes of participating in its remediation programs should be determined in the FBAR context. The IRS describes non-willfulness for purposes of participating in the Streamlined Filing Compliance Procedures as "conduct that is due to negligence, inadvertence, or mistake or conduct that is the result of a good faith misunderstanding of the requirements of the law."⁶ Nevertheless, recent case law has weakened the willfulness standard. By using non-tax legal precedent, courts have adopted a watered-down definition of willfulness to the point where recklessness suffices to establish willfulness. No longer is actual knowledge required, but rather, recklessness can be found where a taxpayer has engaged in conduct that entails an unjustifiably high risk of harm that is so obvious that it should be known. A complete recitation of conduct satisfying this standard is beyond the scope of this alert. However, some examples of seemingly innocuous conduct on which courts have based conclusions of recklessness include electing to not receive statements, failing to inform tax return preparers of the existence of foreign accounts (whether or not those return preparers inquired as to foreign accounts) and answering "no" on the Form 1040, Schedule B question asking whether or not the taxpayer maintains foreign accounts.⁷

Determining whether a taxpayer's noncompliance was due to willful conduct is a highly fact-specific evaluation that requires a nuanced analysis by tax counsel with significant experience in this evolving area. It is no longer enough for a non-legal professional to believe willfulness is not at issue (or not present) simply because the taxpayer's situation lacks the traditional signs of willfulness. The IRS, with assistance from numerous courts, has created a moving target with respect to the willfulness standard. Accuracy in the willfulness evaluation is crucial. Remediating tax and reporting noncompliance is not "one-size-fits-all." Taxpayers need to be represented by legal counsel experienced in crafting the most appropriate solution based on each taxpayer's specific sets of facts and circumstances. The IRS has indicated the Streamlined Program can end at any time. Taxpayers with U.S. tax and reporting noncompliance should act with urgency and avoid procrastinating, especially considering the Streamlined Program is already 10 years old and its future is uncertain.

Notes

¹ For example, when a taxpayer's foreign accounts are held via foreign trusts or corporations; the taxpayer has opened foreign accounts with a non-U.S. passport or in jurisdictions that have no clear tie to the taxpayer's countries of citizenship or residency; or, the taxpayer only transacts from the account via cash or the use of a debit or credit card, tax counsel may want to dig a little deeper into the facts.

² Certain facts are based on allegations from the parties' respective court filings and exhibits thereto. References to which facts are alleged have been omitted to limit redundancy.

³ The IRS ultimately assessed two separate willful FBAR penalties against the estate of Mr. Jones and Mrs. Jones totaling approximately $3.4 million. Mrs. Jones partially paid each assessment and subsequently filed two claims in the U.S. District Court for the Central District of California against the U.S. for illegal exaction. The U.S. defended the assessments and counterclaimed, seeking judgment on the unpaid portion of the assessed FBAR penalties. The U.S. subsequently filed its own complaint seeking to bring to judgment the willful FBAR penalties assessed against Mr. and Mrs. Jones. After consolidation, Mrs. Jones settled all three cases regarding the Joneses' FBAR liabilities for $1.3 million.

⁴ 498 U.S. 192 (1991).

⁵ Id. At 201.

⁶ https://www.irs.gov/individuals/international-taxpayers/us-taxpayers-residing-outside-the-united-states

⁷ Form 1040, Schedule B, Part III, Line 7a ("At any time during [year], did you have a financial interest in or signature authority over a financial account (such as a bank account, securities account, or brokerage account) located in a foreign county?"

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the authors of this publication, your Holland & Knight representative or other competent legal counsel.