The first thing a taxpayer should do who is out of compliance with United States laws concerning foreign financial accounts is immediately file delinquent FinCEN Forms 114, Report of Foreign Bank and Financial Accounts, (“FBARs”), or amended FBARs for the preceding six years.
The statute of limitations on assessment of penalties for failure to file an FBAR is six years, and it begins to run when the FBAR is due, whether or not it is filed.
Under the Internal Revenue Service’s Delinquent FBAR Submission Procedures, a taxpayer who has failed to file one or more FBARs over the preceding six years, but who has not failed to report U.S income tax, may file the delinquent FBARs without penalty.
Once compliant with filing FBARs, the taxpayer should turn to voluntary disclosure programs available from the Internal Revenue Service. Those include the Streamlined Compliance Procedures, for residents or nonresidents of the U.S.; the Delinquent International Information Return Submission Procedures; and the Voluntary Disclosure Practice.
Streamlined Compliance Procedures
The Streamlined Compliance Procedures remain an advantageous means of complying with United States laws concerning foreign financial accounts. Under the Streamlined Procedures for Residents or Nonresidents of the U.S., the taxpayer must file delinquent or amended FBARs as needed for the preceding six years. In addition, under the Streamlined Procedures for Residents of the U.S., the taxpayer must file amended U.S. income tax returns, including international information returns, for the last three years; pay tax due on the amended income tax returns and interest on the tax; and pay a miscellaneous Title 26 penalty equal to five percent of the taxpayer’s high aggregate year-end balance of foreign financial accounts over the preceding three years. Under the Streamlined Procedures for Nonresidents of the U.S., the taxpayer must file amended or original U.S. income tax returns, including international information returns, for the preceding three years; and pay tax due on the amended original income tax returns; but there is no penalty.
The Streamlined Procedures are limited to taxpayers whose noncompliance was non-willful. A willful taxpayer is one who knows what U.S. law requires of him, and deliberately fails to comply with the law. The classic willfulness profile is a U.S. person who opens an account overseas, ideally in a country lacking a tax treaty with the U.S., and transfers funds from the U.S. to the account, for the purpose of evading Federal income tax on income generated by the funds.
Most taxpayers are non-willful. Many taxpayers move to the U.S. leaving financial accounts in their prior country(ies), and do not learn what U.S. laws require of them concerning their foreign accounts until they have been living in the U.S. for years. Some U.S. persons open financial accounts overseas for business or personal use, and are unaware of their reporting obligations under U.S. law concerning the foreign accounts.
Delinquent International Information Return Submission Procedures
A taxpayer who has not failed to report income tax, but who has failed to file one or more international information returns, may file them under the IRS’ Delinquent International Information Return Submission Procedures. International information returns include Form 8938, Statement of Foreign Financial Assets, Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, and Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner.
The penalty for failure to file an international information return is $10,000. If the taxpayer fails to file an international information return within five months after the IRS asks for it, there is an additional penalty of $10,000 for each month or part thereof the information return remains unfiled, up to a total additional penalty of $50,000.
When a taxpayer fails to file an international information return, there is no assessment statute of limitations, not only as to penalties for failure to file the information return, but as to the taxpayer’s entire income tax return for that year. Therefore, a taxpayer must file all international information returns which the taxpayer has failed to file. I have seen the IRS assert delinquent international information return penalties going back more than 20 years.
Voluntary Disclosure Practice (VDP)
A willfully noncompliant taxpayer, i.e., one who is subject to criminal prosecution for income tax evasion or for willful failure to file an FBAR, may come into compliance with the law, and potentially avoid criminal prosecution, by means of the IRS’ Voluntary Disclosure Practice (VDP).
A voluntary disclosure occurs when the communication is truthful, timely, complete, and when: (1) a taxpayer shows a willingness to cooperate (and does in fact cooperate) with the IRS in determining his/her correct tax liability; and (2) the taxpayer makes good faith arrangements with the IRS to pay in full tax, interest, and any penalties determined by the IRS to be applicable.
A disclosure is timely if it is received before: (1) the IRS has initiated a civil examination or criminal investigation of the taxpayer, or has notified the taxpayer that it intends to communicate such an examination or investigation; (2) the IRS has received information from a third party (e.g., informant, other governmental agency, or the media) alerting the IRS to the specific taxpayer’s noncompliance (3) the IRS has initiated a civil examination or criminal investigation which is 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 (e.g., search warrant, grant jury subpoena).
A voluntary disclosure may not be used to disclose illegal source income.
A VDP case begins with the taxpayer filing a Form 14457, Voluntary Disclosure Practice Preclearance Request and Application, with the IRS Criminal Investigation Division (“CI”). Upon receipt of a Form 14457, CI queries IRS databases to ascertain whether a civil examination or a criminal prosecution is underway concerning the taxpayer, or whether the IRS has otherwise learned of the taxpayer’s compliance.
If the taxpayer clears the IRS’ database check, CI will conditionally accept the taxpayer into the voluntary disclosure program. Such acceptance is subject to revocation if the taxpayer fails to cooperate in the ensuing audit. The taxpayer must promptly submit to CI all required voluntary disclosure documents, including delinquent or amended FBARs, Federal income tax returns, and information returns for the six-year disclosure period.
Upon audit the IRS examiner will determine applicable taxes, interest, and penalties under existing law and procedures. Penalties will include a fraud penalty under Internal Revenue Code (“IRC”) § 6663, equal to 75 percent of the underreported tax, or a penalty under IRC § 6651(f) for failure to file a tax return, equal to 20 percent of the underreported tax. Such penalty will apply to one tax year with the highest underreported tax liability. The taxpayer may argue for an IRC § 6662 “accuracy-related” (negligence) penalty equal to 20 percent or the underreported tax instead of a fraud penalty.
Penalties will also include a willful FRAR penalty equal to 50 percent of the high aggregate balance of the taxpayer’s foreign financial accounts during the six-year disclosure period, or $100,000, whichever is greater. A taxpayer may request a non-willful FBAR penalty instead of a willful FBAR penalty. The non-willful penalty for failure to file an FBAR is $10,000. For example, a taxpayer who has failed to file FBARS for six years, and whose noncompliance is non-willful, is subject to an FBAR penalties of $10,000 per year for six years, totaling $60,000.
Penalties for failure to file information returns will not be automatically imposed in a VDP case. The examiner is directed to take into account other penalties, such as the civil fraud penalty and the willful FBAR penalty) and to resolve the examination by agreement. The taxpayer retains the right to request review of the case by the IRS Appeals Office.
What about a taxpayer whose preclearance request has been denied? Such a taxpayer should file delinquent or amended FBARs and Federal income tax returns, including international information returns, as needed, and pay or arrange to pay tax and interest due, as soon as possible, and let the chips fall where they may. Bona fide effort to comply mitigates willfulness, and generally is favorably received by the IRS. Remaining noncompliant is never advisable.
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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