Hunter Biden is alleged to have received millions of dollars in income from sources in Russia, the Ukraine, and China; to have failed to report some or all of the income on a U.S. income tax return; and to have received the income through foreign shell corporations used to mask his identity. Mr. Biden has announced that his income tax returns are under investigation, and that he is having the tax returns reviewed for the purpose of making any amendments needed to them. This article reviews United States laws concerning the reporting of foreign income, financial accounts, and entities, and the penalties for noncompliance with those laws.
There are two relevant statutory schemes. The United States Internal Revenue Code imposes an income tax to finance operation of the federal government. The United States Bank Secrecy Act supports the Internal Revenue Code by requiring the reporting of foreign financial accounts which might otherwise be used to evade the Federal income tax.
Internal Revenue Code
The Internal Revenue Code imposes an income tax on U.S. citizens or residents’ worldwide income. A credit is available against the tax for income tax paid or accrued to foreign governments. Tax not timely paid accrues interest.
A taxpayer who fails to timely file an income tax return is subject to a penalty of 5 percent of tax reportable on the tax return for each month of the delinquency, up to a maximum penalty of 25 percent of the tax.
A taxpayer who fails to pay tax reported on an income tax return is subject to a penalty of .5 percent of the tax for each month of the delinquency, up to a maximum penalty of 25 percent of the tax. This penalty is in addition to interest that accrues on the tax.
If an income tax return underreports tax, the taxpayer is subject to an “accuracy-related” (negligence) penalty equal to 20 percent of the unreported tax.
The Internal Revenue Service will grant relief from the above penalties the first time the taxpayer incurs them. The IRS will also grant penalty relief for delinquencies resulting from reasonable cause and not willful neglect.
If an income tax return underreports tax due to fraud (i.e., willfulness), the taxpayer is subject to a penalty of 75 percent of the omitted tax. A civil fraud penalty can only be sustained by clear and convincing evidence. This is a higher standard than the preponderance of evidence standard that usually obtains in civil cases.
An individual who willfully fails to file a tax return or pay tax that is due is subject to prosecution for a misdemeanor under Internal Revenue Code (IRC) § 7203. Conviction is punishable by fine of up to $25,000 or imprisonment of up to one year or both.
An individual who files an income tax return which materially, willfully underreports tax is subject to criminal prosecution for felony tax evasion under IRC § 7201. Conviction is punishable by fine of up to $100,000 or imprisonment for up to five years or both.
Affirmative acts of evasion evince willfulness, i.e., a knowing, deliberate failure to follow the law. Affirmative acts of evasion, which may be present in Mr. Biden’s case, include the receipt of income through foreign shell corporations, and the failure to report material amounts of gross income, in more than one year. In Paul Manafort’s case, the failure to answer questions about foreign income and accounts on his accountant’s organizer was found to be an affirmative act of evasion. There is no accountant-client privilege in a federal criminal tax prosecution.
Receiving income through a foreign shell corporation avails a taxpayer of nothing. The income passes through to the shareholder under Internal Revenue Code Section 951(a) (“subpart F income”). More fundamentally, the identity of the corporate intermediary can be disregarded as a sham, and the income deemed realized directly by the shareholder, on an alter ego theory.
The Internal Revenue Code also requires the filing of information returns with respect to foreign financial accounts and foreign entities. An individual beneficially owning foreign financial accounts with an aggregate balance above the applicable threshold must report the accounts on Form 8938, Statement of Foreign Financial Assets. For married taxpayers filing a joint income tax return, the Form 8938 filing threshold is foreign financial accounts with an aggregate balance of $150,000 at any time during the year, or with an aggregate balance of $100,000 on the last day of the year.
An individual owning more than 50 percent of the outstanding capital stock, by vote or value, of a foreign corporation at any time during the year must file Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations, reporting the corporation.
If the foreign financial accounts are held in a trust for the taxpayer’s benefit at any time during the year, then the taxpayer report must them not on Form 8938, but on Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, and on Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner.
A taxpayer owning foreign mutual funds at any time during the year must report them on Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund. The Regulations provide a de minimis exception.
Failure to file an information return is subject to a $10,000 penalty. The IRS will grant relief from the penalty where the failure results from reasonable cause and not willful neglect.
The income tax assessment statute of limitations is three years, but it does not begin to run until the taxpayer files an income tax return for the year in question. The assessment statute of limitations is six years with respect to a tax return that understates gross income by more than 25 percent. There is no assessment statute of limitations on an income tax return beset by fraud.
Moreover, failure to file an information return tolls (suspends) the assessment statute of limitations on the taxpayer’s Federal income tax return for that year, until the information return is filed. But if there is reasonable cause for the failure to file the information return, the tolling of the assessment the statute of limitations applies not to the entire income tax return but only as to civil penalties for failure to timely file the information return.
Bank Secrecy Act
The Bank Secrecy Act requires a U.S. citizen or resident who has a financial interest in, or signature authority over, one or more foreign financial accounts with an aggregate balance of $10,000 or more at any time during a calendar year to file FinCEN Form 114, Report of Foreign Bank or Financial Accounts, (FBAR) reporting foreign financial accounts for that year. For this purpose, an individual is deemed to have a financial interest in a foreign financial account titled to a corporation of which he owns more than 50 percent of the outstanding capital stock, by vote or value.
Failure to file an FBAR is subject to a civil penalty of $10,000. If the failure was willful, the penalty is the greater of $100,000 of 50 percent of the taxpayer’s high aggregate balance of foreign financial accounts for the year (this is sometimes called the “draconian penalty”). There is no penalty if the failure was due to reasonable cause and not willful neglect. If the taxpayer files delinquent or amended FBARs as needed before the U.S. Treasury discovers the delinquency and brings it to the taxpayer’s attention, U.S. Treasury will refrain from assessing a penalty. This is why a taxpayer who needs to file delinquent or amended FBARs should file them soon as possible.
The statute of limitations on assessment of a civil penalty with respect to an FBAR is six years. It begins to run on the due date of the FBAR, whether it is filed or not.
A willful failure to file an FBAR can be the subject of a criminal prosecution. The unfortunate Mr. Manafort is one of a very few persons I know of convicted of such an offence.
Compliance: Better Late Than Never
Amending income tax returns is wise. It can undermine willfulness necessary for criminal prosecutions or severe civil penalties. Amending income tax returns also enables a taxpayer to cast the facts in a light favorable him, and to resolve doubts in his favor.
If Mr. Biden is not in full compliance with the law, he should file any amended or delinquent income tax returns or FBARs needed for him to comply with the law, and let the chips fall where they may. If the U.S. Treasury proposes any penalties against him, he will be afforded due process to contest them.
Stephen J. Dunn is a tax attorney in Troy, Michigan. He is the author of the treatise Foreign Accounts Compliance (Thomson Reuters 2017) and Foreign Accounts Compliance Blog. He is also an adjunct professor at Michigan State University College of Law.
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