Seemingly simmering just below the surface for several years now, practitioner frustration with how the IRS is implementing exams for foreign bank account reporting may soon reach a boiling point. At the heart of that frustration is an agency that, according to practitioners, is inflexible, heavy-handed with penalties, and presuming willful violations of reporting obligations at nearly every turn.
Take, for example, one client of Jeffrey Neiman of Marcus Neiman & Rashbaum LLP. Originally from another country, she is 75 and has resided and worked in the United States for many years; she also has suffered multiple strokes and is legally blind. Several years ago, her father, who still lived in the foreign country, died. Following his death, she sold her offshore real estate and deposited the money into a local foreign bank and didn’t give the matter much more thought. Her compliance was prompted by her hiring new accountants after her old accountant passed away. She was upfront with her new accountants and was then audited by the IRS — an audit that has dragged on for over a year, with the IRS still contemplating penalties for willfulness.
Neiman’s client would seem to be a far cry from the taxpayers in two of the more notable FBAR cases to date. In United States v. Williams, 489 Fed. Appx. 655 (4th Cir. 2012), the defendant acknowledged a willful failure to report Swiss bank accounts, which were part of a larger tax evasion scheme. And in United States v. McBride, 908 F. Supp. 2d 1186 (D. Utah 2012), the taxpayer looked to reduce income taxes and hired a financial management firm to aid in that effort by moving profits offshore. When investigated, both taxpayers lied to the IRS. Based on a preponderance of the evidence, both taxpayers were found to have willfully violated FBAR reporting rules.
Under a common-sense approach to willfulness, Nieman said, it’s clear that many individuals facing FBAR exams should be considered non-willful. However, nearly every taxpayer coming forward now is being categorized by the IRS as willful, he said.
Mark E. Matthews of Caplin & Drysdale Chtd. noted that while some taxpayers who entered the IRS offshore disclosure programs could be designated as the “classic offshore tax cheat” — a U.S. citizen creating an offshore account to avoid taxes — that is not the case for numerous other taxpayers with offshore reporting issues. That latter group includes recent immigrants or U.S. citizens living abroad, often for most of their lives.
The line between negligence and willfulness to evade taxes seems to have been forgotten, Matthews added. “It would be good for the Service to get some checks and balances here and higher-level approvals prior to asserting willful FBAR penalties,” he said. “Historically, this has gotten out of whack. . . . For years, the penalties were relatively modest.”
According to Matthews, the IRS is increasing FBAR audits and its use of information document requests to seek FBAR information, even for charities with foreign operations. “The institutional message seems to be that if you can just develop an FBAR compliance issue, then you can get the taxpayer on their heels, hostage to a massive penalty, even though unrelated to any tax issue,” he said. “In fact, the FBAR penalties often dwarf any tax issue. They seem to be surfing for these late FBARs, unrelated to tax administration.”
Steven Toscher of Hochman, Salkin, Rettig, Toscher & Perez PC had a slightly more measured response.
“I can’t say the system is totally broken,” Toscher said, arguing that agent exams present a “mixed bag.” Often, agents possess data from treaties or the Justice Department’s Swiss bank program that they are unwilling to share, he said, adding, “There is a presumption by some agents that these taxpayers are going to be subject to the willful penalty.”
‘A Huge Hammer’
FBAR rules require each U.S. person with a financial interest in, or signature authority over, a financial account in a foreign country that exceeds $10,000 to report such interest to the IRS. Penalties for shirking that duty can be severe, can far outstrip the taxes owed, and can vary greatly depending on the nature of the conduct: usually no more than $10,000 for each year of a non-willful violation and the greater of $100,000 or 50 percent of the aggregate balance of the unreported account for willful violations. While legally permissible to impose six years of willful penalties for a total of 300 percent of an account’s value, the IRS issued a memorandum (SBSE-04-0515-0025) in 2015 that capped the total penalty amount for all willful violations at 100 percent of the aggregate balance. Practitioners speculated that the guidance might have been issued to deflect concerns of potential violations of the excessive fines clause under the Eighth Amendment.
But those soft and hard caps on willful violations have not proved successful in completely deflecting practitioner criticism that the IRS is improperly running its FBAR exams and exacting an unwarranted toll on taxpayers.
“The IRS is now using the FBAR as a tool for income tax enforcement, which is not what the FBAR was originally designed to be used for,” Neiman said, arguing that the original purpose of the FBAR was to disclose the highest account balance on a foreign account. “The FBAR has gigantic penalties, and it is a huge hammer. I don’t blame the IRS for trying to take advantage of it, but there needs to be that balance of fairness.”
Scott D. Michel of Caplin & Drysdale agreed, noting that the IRS has myriad other remedies to deal with money hidden in unreported offshore accounts, including prosecution for evasion or filing false returns and imposition of civil fraud penalties. But none of those remedies comes with a 50 percent penalty based on asset size, he said.
“To insert [FBAR penalties] into the tax regime, where Congress has . . . laid out a panoply of remedies for people who have evaded their taxes through offshore structures or accounts, and then to detonate that weapon in the middle of all those other remedies, has produced in some cases wildly incongruous and disproportionate results,” Michel said.
For several decades dating back to the 1980s, the relatively few FBAR cases brought involved “outright, unequivocal tax evasion,” according to Michel. That started to change about a decade ago with the tax-evasion scandal involving Swiss Bank UBS, when more benign actors began to be swept up and the civil FBAR penalty became a “go-to” punishment, he said.
“When you are in the enforcement world, if Congress gives you a toy . . . and you don’t use it, you’ve got to be worried they may take it away,” Matthews said. “It was no accident that they came up suddenly with this 20 percent penalty, which sort of walked, talked, and quacked like an FBAR penalty, but it wasn’t the full 50 percent,” he added, referencing the first version of the OVDP in 2009. The OVDP could have just as easily instituted penalty amounts of triple the tax due, Matthews said, but then it wouldn’t have looked like an FBAR penalty.
In exchange for fixed penalties of 27.5 percent (50 percent when a financial institution has been publicly identified as under investigation) of an account’s value, the OVDP provides taxpayers with freedom from criminal prosecution for failure to file FBARs. If dissatisfied with the proposed penalty amounts, taxpayers are free to opt out of the OVDP and then face a full-scope exam. Streamlined filing compliance procedures, by contrast, offer substantially lower penalties for non-willful violations.
The Taxpayer Advocate Service has faulted the IRS for impeding transparency of the OVDP and FBAR enforcement and making it difficult to recognize when a case falls outside the norm. In its fiscal 2018 objectives report to Congress, the TAS criticized the IRS for failing to disclose Treasury’s summary report of FBAR penalties it compiles for Congress.
Further evidence that FBAR penalties are often too heavy-handed may come from criminal FBAR cases, according to Matthews. In 98 percent of those cases, sentences are being adjusted downward from where sentencing guidelines would place them, he said. Defendants with eight- or nine-figure balances in foreign accounts are receiving sentences of less than a year or even probation, he noted, with more than 50 percent of the defendants receiving the latter. “We think that the judges are being influenced by the incredibly steep FBAR penalties, often 10 times the tax loss to the government,” he hypothesized.
The IRS did not respond to a request for comment.
Eviscerating the Willfulness Standard
FBAR reporting has seen a meteoric rise in the last decade. According to the 2018 TAS report, about 322,000 FBAR disclosures were filed in 2007. In 2015 that number had leapt to over 1.1 million. The report attributes that increase to the enactment of the Foreign Account Tax Compliance Act and increased awareness of reporting obligations.
The government has argued that given the publicity of the voluntary disclosure programs, numerous criminal prosecutions, and increasing assessment and enforcement of large civil penalties, it strains credulity that foreign account holders might still be non-willful because of a lack of awareness of filing requirements.
Williams and McBride are two of the earliest decisions concerning FBAR willfulness since the increase in enforcement and thus carry significant legal weight. The courts held that the willfulness standard for the increased FBAR penalty is not the same as the tax crime willfulness standard (voluntary, intentional violation of a known legal duty) and that the government need only show a reckless violation of the statute to apply the higher FBAR penalty. Further, the courts held that the burden of proof would be the normal preponderance of the evidence standard rather than the heightened clear and convincing evidence standard required for imposition of the tax civil fraud penalty under section 6663.
That precedent “essentially makes a box checked on Schedule B almost a de facto presumption of willfulness,” said Zhanna A. Ziering of Caplin & Drysdale, referencing Line 7a of Form 1040’s Schedule B, which asks a taxpayer if she has a financial interest in a foreign account. Although checking no on Schedule B is not enough to establish willfulness, per the Internal Revenue Manual, Ziering said it is not difficult for the IRS to find other factors to get to willfulness.
IRM 184.108.40.206.5.1 defines a willful FBAR violation as a voluntary, intentional violation. Willfulness can be imputed under willfulness blindness, when a person avoids learning about FBAR reporting requirements. The IRM also states that “the government may base a determination of willfulness on inference from conduct meant to conceal sources of income or other financial information.”
Ziering said she believes that agents are following a checklist in order to assert willfulness, while other taxpayer-favorable circumstances, such as an account generating very low interest, are being ignored by agents and Appeals.
In its 2016 midyear report to Congress, the TAS argued that “the government is eviscerating the statutory requirement for it to prove willfulness” before imposing FBAR penalties. While acknowledging Williams and McBride, the report advocates a clear and convincing evidence standard for the government to establish willfulness. The report indicts the government for arguing for a preponderance of the evidence standard, which it says is made all the easier to establish through circumstantial evidence that is nearly always available with Schedule B reference to the FBAR requirement. The only reason to lower the burden of proof is to win cases, the report argues.
“If the clear and convincing standard is eliminated and the government is still allowed to rely on circumstantial evidence, nearly any FBAR violation will be subject to what amounts to a draconian strict liability penalty that is misleadingly characterized as a penalty reserved for willful violations,” the TAS said.
The IRS’s move toward presumed willfulness has permeated every type of audit, Neiman said, including standard audits, OVDP opt-outs, and streamlined filing. He added that in the last seven years he has been in private practice, non-willful determinations have been made, but they are rare.
“The enforcement efforts are extremely aggressive and appear to the taxpayers like searches for revenue by the IRS, not an effort to administer the tax laws fairly,” said Matthews. “It is causing bad habits for an agent class who are prohibited by law from being motivated or evaluated by revenue results.”
As an example, Matthews described a case of his in which the IRS is considering a multi-million-dollar penalty on an FBAR that was filed three months late, even though the related audit revealed a tax refund was due.
Toscher also took issue with examiners never seeming to use discretion in imposing the amount of the penalty — allowed to be up to 50 percent of the account value — possibly because the agency is not used to giving agents discretion in determining the amount of penalties. He contrasted the FBAR penalty with penalties more frequently administered by IRS agents under title 26 that do not allow for discretion: the accuracy-related penalty of 20 percent of tax owed and the civil fraud penalty of 75 percent.
According to Ziering and Michel, civil fraud penalties are also being implemented in tandem with FBAR penalties, and often in inappropriate circumstances. Failure-to-file penalties for foreign information returns have increased in frequency as well, and reasonable cause statements that would usually excuse such failures are receiving greater IRS scrutiny, they said.
“If the IRS feels any hesitation or pushback on the FBAR penalty where it uncharacteristically develops a level of doubt to go on a willful basis, they’ll sort of make up for it,” Michel said. “They’ll say . . . if you’re not going to agree on the FBAR penalty, maybe instead of doing that where we’ve got to send it to the Department of Justice, we’ll impose a series of cascading 5 percent or 25 percent or 35 percent penalties in connection with your foreign trust. Or if you have a dozen [controlled foreign corporations], we’ll hit you with $10,000 a year for each one back to the beginning of time.”
Toscher said he had similar experiences with penalties associated with Form 5471, “Information Return of U.S. Persons With Respect to Certain Foreign Corporations,” and Form 3520, “Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts.” He said that contrary to his experience seven or eight years ago, there is an increasing aggressiveness with those penalties, which can be asserted for many years because there is no statute of limitations if the form has not been filed.
“Some assertions border on the ridiculous and reflect that the IRS sometimes forgets the purpose of tax penalties — to foster voluntary compliance, not to bankrupt a taxpayer,” Toscher said.
‘Wizards Behind the Curtain’
Several practitioners identified the IRS’s use of technical advisers as a primary source of their audit strife. Michel acknowledged a need for national consistency in how the FBAR penalty is applied, but he argued that the role of technical advisers is seemingly to implement a “secret body of law” into which practitioners have little insight.
Matthews agreed. “The line agents frequently come back with harsher positions and point to the technical advisers as the reason,” he said. “Out of thousands of matters, we’ve never encountered an agent coming back with a lower penalty and saying the technical adviser had suggested that was more appropriate.”
Matthews said the technical advisers comprise eight to 10 individuals who have established themselves as FBAR experts.
The IRS has stripped the revenue agents of any discretion and has transferred decision-making power to “the wizards behind the curtain who don’t meet the taxpayers, who don’t hear firsthand from the advocates, and who live in an alternate universe in which everybody is willful,” Neiman said.
Toscher said he has met face-to-face with technical advisers, but such meetings are not common. “A basic part of due process is the right to be heard. . . . If someone is going to be weighing in and making these judgments, they should be willing to meet with representatives so there can be a full and complete discussion of the parties’ positions,” he said.
And unfortunately for taxpayers, the IRS Office of Appeals has not offered much relief.
“Appeals officers can walk away from [Form] 5471 penalties and can sometimes walk away from [Form] 3520 penalties. But their discretion again has been taken away from them with regard to FBAR penalties,” Neiman argued. That’s because Appeals agents are deferring to technical advisers who refuse to budge on FBAR penalty determinations, jeopardizing Appeals’ status as an independent arbiter, he said.
Matthews wondered whether better training for technical advisers and managers, including limits on when penalties are implemented, would be useful, adding that the technical advisers might benefit from further IRS supervision at the national level. If there is to be an FBAR program at the IRS, it needs to be grounded in the history and purposes of the FBAR form, which were as much about anti-money-laundering and terrorist financing as tax administration.
Michel theorized that “institutional inertia” might also encourage the IRS to avoid making hard decisions on willfulness. Because collecting the FBAR penalty involves the DOJ filing a civil suit, Michel believes the IRS may choose what it sees as a “safer” course of deciding to assess a willful FBAR penalty, figuring the DOJ will make the ultimate call on whether to file suit or settle.
Matthews concurred. “On FBAR penalties outside OVDP, the IRS attitude seems to be to impose the penalty and then let DOJ sort it out and determine whether to pursue the matter as a willful penalty or cut a deal,” he said.
What’s the Solution?
“If you overuse that toy, if you become more aggressive and even tend toward abusive penalties, Congress will eventually take it from you or restrict it,” Matthews said about the possibility of the FBAR penalty pendulum swinging back.
Neiman agreed that it might take an act of Congress to better define willfulness. The IRS has consistently declined to offer more definitiveness to what constitutes willfulness under title 31, even though both the American Institute of CPAs and the the American Bar Association Section of Taxation requested such action from the agency. They both suggest that age, education, health, language barriers, mental capacity, communication with advisers, ties to the country with the account, compliance history, source of funds, and involvement with the account will all be considered when determining whether a taxpayer is non-willful and eligible for streamlined filing procedures.
Adding a proportionality requirement, a finding of a substantial interest in tax administration, or other specific enforcement objectives before assessing willful FBAR penalties could also go a long way toward addressing practitioner concerns, Michel said. Those measures could lead to a more rigorous examination of facts, he argued, and limit imposition of the willful FBAR penalty to narrower circumstances that might warrant such an extreme and punitive sanction.
As for the courts, Neiman isn’t sure whether the decisions in McBride and Williams will have long-term significance. “McBride and Williams are very government-friendly in their interpretation of willfulness,” Neiman said, but he added that more cases are needed to develop a more thorough body of law. “I bet you in 10 years we look back at this, and McBride and Williams will end up being outliers,” he said.
There is one sign that things might be starting to change. In September, in Bedrosian v. United States, No. 2:15-cv-05853 (E.D. Pa. 2017), a district court once again held the burden of proof for a willful FBAR penalty is preponderance of the evidence and that only recklessness is necessary to prove willfulness. But the court held in favor of the taxpayer, finding that his failure to disclose UBS accounts was, at most, negligent. In Bedrosian, the court was careful to point out that the taxpayer cooperated with the IRS investigation.
Michel said he hoped Bedrosian might serve as a wake-up call to the IRS, pointing to the court’s decision to directly contrast its taxpayer to the taxpayers in McBride and Williams. The government presumably strategized to litigate those other cases first precisely because they presented unsympathetic taxpayers and could establish law favorable to the IRS, according to Michel and Matthews.
“What [Bedrosian] did, in finding the absence of willfulness in part because the facts were not as bad as in McBride and Williams, turns this classic regulatory enforcement strategy on its head. The IRS runs the risk that one or two other judges will start to make the same analysis and the case law begins to lean toward more mitigating factors,” Michel said. There is “great irony” in that, he said.