On occasion, taxpayers holding investments in foreign financial assets or with foreign financial institutions may find themselves in the uncomfortable position of realizing that they have failed to report their holdings on their federal income tax returns or have otherwise failed to report these holdings in accordance with federal law. This article provides a summary of options available to such taxpayers to come into compliance with their reporting obligations.
Reporting obligations in general
Under Sec. 6038D, an individual taxpayer is generally required to file a Form 8938, Statement of Specified Foreign Financial Assets, with his or her U.S. tax return if he or she meets three criteria. Briefly, these criteria are as follows:
- The taxpayer is a "specified person." This includes U.S. citizens and resident aliens of the United States and certain nonresident aliens.1
- The taxpayer has an interest in "specified foreign financial assets." These generally include any financial accounts maintained by a foreign financial institution and other foreign financial assets held for investment that are not in an account maintained by a U.S. or foreign financial institution.2
- The aggregate value of the specified foreign financial assets exceeds a certain threshold. For married taxpayers filing joint tax returns and living in the United States, this threshold is (1) $100,000 on the last day of the tax year, or (2) $150,000 at any time during the tax year. For other individuals, the amounts are $50,000 and $75,000 respectively.3
Apart from this information return reporting obligation, a U.S. citizen or resident also must file a FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR), to report a financial interest in financial accounts located outside of the United States if the aggregate value of those accounts exceeds $10,000 at any time during the year.4
This article first discusses the penalties that can be imposed for failure to satisfy these foreign financial asset filing requirements and then explores options available to taxpayers who have neglected to file their FBAR or information return to come into compliance with their reporting obligations.
Penalties associated with the failure to file timely or accurate returns
Broadly speaking, there are a variety of civil penalties that can be imposed in connection with the failure to pay a tax due or timely submit accurate returns. Briefly, these are as follows:
- Accuracy-related penalties: Generally, where there is an underpayment of tax that is due to negligence or disregard of rules and regulations, a penalty may be imposed in an amount equal to 20% of the underpayment.5 The penalty is increased to 40% of the underpayment in the case of an undisclosed foreign financial asset understatement.6
- Delinquency penalties: Generally, where there is a failure to timely file a return, a penalty may be imposed in an amount equal to 5% per month, up to a maximum of five months, of the net amount due.7 In cases where there is a failure to timely file a return, but no amount of tax is due, a minimum penalty may be imposed.
- Fraud penalties: Where there is an underpayment of tax that is due to fraud, a penalty may be imposed in an amount equal to 75% of the underpayment.8 Where there is a failure to timely file a return that is due to fraud, a penalty may be imposed in an amount equal to 15% per month, up to a maximum of 75%, of the net amount due.9 In certain circumstances, criminal penalties may also be assessed in cases of fraud.
- Information return penalties: Where a taxpayer must file a Form 8938, disclosing his or her interest in "specified foreign financial assets," fails to do so for any tax year, the taxpayer is subject to a penalty of $10,000. If the taxpayer does not file the required Form 8938 for more than 90 days after the IRS sends the taxpayer a notice of the failure to file the form, the taxpayer will incur an additional penalty of $10,000 for each 30-day period (or fraction thereof) during which the failure to file continues after the expiration of the 90-day period, up to a total additional penalty of $50,000.10
The reasonable-cause defense
A defense to the accuracy-related penalties and fraud penalties described above may exist if the taxpayer had reasonable cause for his or her underpayment and acted in good faith with respect to it.11 A defense to the delinquency penalties may exist if the taxpayer's delinquent filing was due to reasonable cause and not willful neglect.12 Similarly, a defense to the failure to file an information return disclosing a taxpayer's interest in specified foreign financial assets may exist if the taxpayer's failure to file was due to reasonable cause and not willful neglect.13
"Reasonable cause" generally means that the taxpayer has exercised ordinary business care and prudence. In the context of accuracy-related penalties, this standard will generally be met where the taxpayer has retained a competent tax adviser, supplied the adviser with all relevant information, and relied on the adviser's advice in good faith.14 In the context of delinquency-related penalties, the reasonable-cause standard will generally be satisfied where the taxpayer was unable to file the return within the prescribed time despite the exercise of ordinary business care and prudence.15
Whether reasonable cause exists is highly dependent on the facts and circumstances of the particular case. Factors that may potentially support a reasonable-cause defense, according to the Internal Revenue Manual (IRM), include whether the taxpayer's noncompliance was caused by (1) a death, serious illness, or unavoidable absence; (2) a fire, casualty, or natural disaster; (3) an inability to obtain necessary records despite the exercise of ordinary business care and prudence; or (4) reliance on faulty professional advice.16 In addition, an honest misunderstanding of the law may (but not necessarily will) establish reasonable cause. The ordinary-business-care-and-prudence standard requires that taxpayers make reasonable efforts to determine their tax obligations; however, a taxpayer may be able to establish reasonable cause with a showing of ignorance of the law in conjunction with other facts and circumstances. The taxpayer's ignorance of the law must be reasonable in light of the facts and circumstances, including the taxpayer's experience, knowledge, and education.
Penalties associated with the failure to file FBARs
The penalties that arise from the failure to timely file FBARs largely turn on whether the failure to file was willful or nonwillful. Willfulness consists of a "voluntary, intentional violation of a known legal duty."17 When a person has knowledge that the FBAR reporting requirement exists, the willfulness standard is satisfied when the person makes a conscious choice not to file the FBAR. Under the concept of "willful blindness," willfulness may be attributed to a taxpayer who has made a conscious effort to avoid learning about the FBAR reporting and recordkeeping requirements.18
In situations where the failure to file an FBAR was not willful, a penalty of not more than $10,000 per violation (as adjusted for inflation) may be imposed. The penalty should not be imposed if the violation was due to reasonable cause and the taxpayer files any delinquent FBARs and properly reports the previously unreported account. In many cases, the IRS will recommend that one penalty, limited to $10,000 per year, be imposed for each year a violation occurred, regardless of the number of unreported foreign accounts. However, depending on the facts and circumstances, the IRS may determine either that (1) assessing a penalty for each year a violation occurred is not warranted, or (2) assessing a separate penalty for each unreported foreign financial account, and for each year, is warranted.19
In situations where the failure to file an FBAR was willful, a penalty of not more than (1) $100,000 (as adjusted for inflation) or (2) 50% of the balance in the account at the time of the violation may be imposed.20 For cases involving willful violations over multiple years, the IRS may recommend a penalty for each year in which the violation was willful. In many cases of multiple violations, the IRS has limited the total penalty amount for all years under consideration to 50% of the highest aggregate balance of all unreported foreign financial accounts during the years under examination.21 However, depending on the facts and circumstances, the IRS may recommend a penalty which is higher or lower than this 50% benchmark, provided that in no event may the total penalty amount exceed 100% of the highest aggregate balance of all unreported foreign financial accounts during the years under examination.22 In addition to civil penalties, a criminal penalty of not more than $250,000, or imprisonment for not more than five years, or both, may be imposed for willful violations.23
The actual amount of the FBAR penalty is left to the discretion of the IRS examiner presiding over the case. If certain conditions are met, the taxpayer may be subject to less than the maximum penalty. The IRM lists the following conditions:
- The taxpayer has no history of criminal tax or Bank Secrecy Act convictions for the preceding 10 years, as well as no history of past FBAR penalty assessments;
- No money passing through any of the foreign accounts associated with the taxpayer was from an illegal source or used for a criminal purpose;
- The taxpayer cooperated during the examination; and
- The IRS did not sustain a civil fraud penalty against the taxpayer for the year in question due to the failure to report income related to any amount in a foreign account.24
Options for coming into compliance
There are several ways by which a taxpayer who has failed to report foreign financial assets and pay all taxes due in respect of those assets may voluntarily come into compliance, including (1) the Voluntary Disclosure Practice (VDP); (2) the streamlined filing compliance procedures (SFCP); and (3) the delinquent FBAR and information return submission procedures. Each is briefly discussed below.
Voluntary Disclosure Practice
The VDP, as described in IRM Section 18.104.22.168, is an option for taxpayers whose failure to report foreign financial assets and pay all taxes due in respect of those assets exposes them to criminal liability. Such liability generally arises where the taxpayer's conduct was fraudulent or willful. The VDP is not recommended for nonwillful violations of the law and is not available to taxpayers with illegal-source income.
Participation in the VDP creates no substantive rights for the taxpayer, nor does it guarantee immunity from prosecution, but it may result in criminal prosecution not being recommended. Taxpayers cannot rely on the fact that other similarly situated taxpayers may not have been recommended for criminal prosecution. A voluntary disclosure occurs when the disclosure is truthful, timely, and complete and when the taxpayer (1) shows a willingness to cooperate (and does in fact cooperate) with the IRS in determining his or her correct tax liability, and (2) makes good-faith arrangements to pay in full the tax, interest, and any penalties determined by the IRS to apply.
The IRS considers a disclosure to be timely only if it is received before (1) the IRS has initiated a civil or criminal investigation of the taxpayer (or has advised the taxpayer that it intends to do so); (2) the IRS has received information from a third party with respect to the taxpayer's noncompliance; (3) the IRS has initiated a civil or criminal investigation directly related to the specific liability of the taxpayer; or (4) the IRS has acquired information directly related to the specific liability of the taxpayer from a criminal enforcement action.
According to an IRS internal memorandum that updated the VDP,25 a taxpayer who has qualified to participate in the VDP will generally undergo an examination by the IRS for the most recent six tax years. Taxpayers will be required to submit all tax returns and reports for this period, and IRS examiners will determine applicable taxes, interest, and penalties under existing laws and procedures for this period. Generally, the civil penalty for fraud or fraudulent failure to file tax returns will apply to the one tax year with the highest tax liability. However, the IRS may apply these civil fraud penalties for more than this one year, based on the facts and circumstances, and may even apply these civil fraud penalties beyond the six-year period under examination if the taxpayer fails to cooperate and resolve the examination by agreement. Willful FBAR penalties are assessed in accordance with the guidelines set forth in the IRM, discussed above. While a taxpayer is not precluded from requesting the imposition of accuracy-related penalties instead of civil fraud penalties or nonwillful FBAR penalties, the granting of requests for lesser penalties is exceptional. Penalties for the failure to file information returns are not automatically imposed.
Streamlined filing compliance procedures
The SFCP are generally intended for taxpayers whose failure to report foreign financial assets and pay all taxes due in respect of those assets was not willful and who therefore have no exposure to criminal liability. Taxpayers using the SFCP must certify that the failure to report all income, pay all tax, and submit all required information returns (including the FBAR) was due to nonwillful conduct. A taxpayer is not eligible to use the SFCP if (1) the IRS has initiated a civil examination of the taxpayer's returns for any tax year, regardless of whether the examination relates to undisclosed foreign financial assets; (2) the taxpayer is under criminal investigation by the IRS; or (3) the taxpayer has made a voluntary disclosure under the VDP.
In addition to meeting the general eligibility criteria, a taxpayer seeking to use the domestic version of the SFCP — the Streamlined Domestic Offshore Procedures (SDOP) — must (1) fail to meet applicable nonresidency criteria; (2) have previously filed a U.S. tax return (if required) for each of the past three tax years for which the U.S. tax return due date has passed; (3) have failed to report gross income from a foreign financial asset and pay required tax (and may have failed to file an FBAR or an information return with respect to the foreign financial asset) as a result of nonwillful conduct. The IRS says nonwillful conduct is 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."26
A taxpayer who is eligible to use the SDOP must (1) file amended tax returns and all required information returns for the most recent three tax years for which the U.S. tax return due date has passed (the "covered tax return period"); (2) file any delinquent FBARs for the most recent six tax years for which the FBAR due date has passed (the "covered FBAR period"); and (3) pay a Title 26 miscellaneous offshore penalty and pay the tax due reflected on the tax returns and all applicable statutory interest with respect to each of the late-payment amounts. The tax, interest, and miscellaneous offshore penalty amounts should be remitted with the amended tax returns.
The Title 26 miscellaneous penalty is equal to 5% of the highest aggregate balance/value of the taxpayer's foreign financial assets that are subject to the penalty during years in the covered tax return period and the covered FBAR period. The highest aggregate balance/value is the highest yearly aggregate balance in the covered periods. The taxpayer determines the aggregate balance/value for each year by aggregating the year-end account balances and asset values of all the foreign financial assets subject to the penalty for each of the years.
A foreign financial asset is subject to the penalty in a given year in the covered FBAR period if the asset should have been, but was not, reported on an FBAR for that year. A foreign financial asset is subject to the penalty in a given year in the covered tax return period if (1) the asset should have been, but was not, reported on a Form 8938 for that year, or (2) the asset was properly reported for that year, but gross income in respect of the asset was not reported in that year.
Delinquent information return and FBAR submission procedures
Taxpayers who have not filed one or more required international information returns, but who do not need to use the VDP or the SFCP to file delinquent or amended tax returns to report and pay additional tax, may file the delinquent information returns with a statement of all facts establishing reasonable cause for the failure to file. In order to use this procedure, the taxpayer must (1) have reasonable cause for not timely filing the information returns; (2) not be under a civil or criminal investigation by the IRS; and (3) not have been contacted by the IRS about the delinquent information returns. A reasonable-cause statement should be attached to each delinquent information return filed for which reasonable cause is being claimed.
Similarly, taxpayers who have not filed required FBARs, but who do not need to use the VDP or the SFCP to file delinquent or amended tax returns to report and pay additional tax, may file delinquent FBARs according to the FBAR instructions. In order to use this procedure, the taxpayer must not (1) be under a civil or criminal investigation by the IRS or (2) have been contacted by the IRS about the delinquent FBARs. The FBARs should be filed electronically through the Financial Crimes Enforcement Network's Bank Secrecy Act E-Filing System, and a statement should be provided explaining why the FBARs are being filed late. The IRS will not impose a penalty for failure to file the delinquent FBARs if the taxpayer (1) has properly reported on his or her U.S. tax return, and paid all tax on, the income from the foreign financial accounts reported on the delinquent FBARs, and (2) has not been previously contacted regarding an income tax examination or a request for delinquent returns for the years for which the delinquent FBARs are submitted.
Mitigating the damage
A taxpayer's realization that he or she has failed to timely file federal income tax information returns or FBARs can be distressing. Significant financial penalties, and perhaps even criminal penalties, may be imposed. Choosing the best pathway to come into compliance with these reporting obligations can be a daunting task. Under certain circumstances, relief may be available under a treaty or IRS pronouncement. Care should be taken to consult with a qualified tax adviser to analyze options and mitigate exposure.
1Regs. Sec. 1.6038D-1.
2Regs. Sec. 1.6038D-3.
3Regs. Sec. 1.6038D-2(a)(2).
431 U.S.C. §5314.
14Regs. Sec. 1.6664-4(c).
15Regs. Sec. 301.6651-1(c)(1).
16See IRM §22.214.171.124.2.
17Cheek, 498 U.S. 192, 201 (1991).
18Williams, 489 Fed. Appx. 655 (4th Cir. 2012).
19The Ninth Circuit recently held that the penalty cannot be imposed per account, but only per year (Boyd, No. 19-55585 (9th Cir. 3/24/21)).
2031 U.S.C. §5321(a)(5)(C).
21IRS Memorandum SBSE-04-0515-0025, "Interim Guidance for Report of Foreign Bank and Financial Accounts (FBAR) Penalties" (May 13, 2015).
2331 U.S.C. §5322.
26IRS, Streamlined Filing Compliance Procedures.
|James W. Standard Jr., J.D., LL.M., MBA, M. Fin., is a partner at Taylor English in Atlanta. For more information about this article, contact firstname.lastname@example.org.