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FBAR Preparation and Penalty Defense

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At the tax law firm of Diosdi & Liu, LLP we prepare FinCen Report 114 (“FBAR”) for our clients. We not only prepare FBARs for clients, we defend clients in FBAR audits and against FBAR related penalties.

For decades, many U.S. taxpayers have held interests in financial accounts located in foreign countries. However, few U.S. taxpayers were disclosing these financial accounts or income received from these foreign accounts on FBAR informational returns or their U.S. tax returns. In order to force U.S. taxpayers to properly disclose their foreign financial accounts to the IRS, Congress enacted laws providing for stiff penalties for not timely disclosing foreign accounts to the IRS. In particular, in 2004, as part of the Jobs Creation Act, Congress introduced a new set of penalties aimed at U.S. individuals who fail to properly disclose their interest in foreign bank accounts. The law promulgated by Congress in 2004 distinguished between willful and non-willful failure to timely disclose an interest in a foreign financial account on an FBAR by enacting two separate corresponding penalty structures. In addition the IRS was delegated full administrative, investigative, and enforcement authority in regards to the willful and non-willful FBAR penalties.

The IRS made the enforcement of FBAR violations a top priority. What is still unclear is how the IRS intends to assess the non-willful penalty against individuals who fail to comply with their FBAR filing obligations and whether the current statutory scheme available to assess is even valid.

An Overview of the Relevant Procedural Law Governing FBAR Filing

In 1970, Congress enacted what has commonly become known as the bank Secrecy Act (“BSA”), as part of the Currency and Foreign Transactions Reporting Act. This was codified in Title 31 (“Money and Finance”) of the United States Code. The purpose of the BSA was to prevent money laundering by requiring the filing of reports and the retention of records where doing so would be helpful to the U.S. government in carrying out criminal, civil, tax, and regulatory investigations. One of the most important provisions of the BSA was Title 31 of United States Code Section 5314(a) which provides in relevant part that:

The Secretary of Treasury (“Secretary”) shall require a resident or citizen of the
United States or a person in, and doing business, in the United States, to keep
records, file reports, when the resident, citizen, or person makes a
transaction or maintain a relation for any person with a foreign financial agency.

A careful reading of the statute indicates that it has two distinct requirements: 1) the filing of FBAR informational returns and 2) the keeping and retaining of specific records related to the accounts listed on the FBAR informational return.

First, the statute mandates the following:

Each person subject to the jurisdiction of the United States (except a foreign
subsidiary of a U.S. person) having a financial interest in, or signature or
other authority over, a bank, security or other financial account in a foreign
country shall report such relationship to the [IRS] for each year in which such
relationship exists, and shall provide such information as shall be specified in
a reporting form prescription by the Secretary to be filed by such persons.

Second, the regulations of Section 5314 contain considerable detailed information regarding which financial records should be retained. In particular, the applicable sections of the regulation to Section 5314 state that:

Records of accounts required by to be reported to the [IRS] shall be retained
by each person having a financial interest in or signature or other authority
over any such account. Such records shall contain the name in which each such
account is maintained, the number or other designation of such account, the type
Of such account, and the maximum value of such account during the reporting
Period. Such records shall be retained for a period of five years and shall be kept
At all times for the inspection as authorized by law.

The above clearly demonstrates that not only must a holder of a foreign account report the account on his or her U.S. income tax return, the holder of a foreign account must also keep detailed records for five years after the account was disclosed on a U.S. tax return. Unfortunately, many taxpayers do not realize that they have a duty to disclose their interest in foreign accounts on an FBAR. Even fewer taxpayers realize that they have a record keeping duty if they hold an interest in a foreign bank account. Although failing to properly maintain records can trigger civil penalties, recent IRS enforcement initiatives have focused mainly on failing to timely disclose foreign financial accounts; therefore, this article focuses strictly on this aspect.

Who Has a Legal Obligation to File an FBAR

To fully understand an individual’s legal duty in regards to disclosing a foreign account on an FBAR, it is first necessary to understand the applicable instructions promulgated by the IRS to prepare an FBAR. According to the instructions, an individual must file an FBAR informational return if all of the following conditions are met: 1) a “U.S. person,” 2) had a “financial interest” in, or “signature authority” over, or “other authority” over 3) one or more “financial accounts” 4) located in a “foreign country,” 5) and the aggregate value of such account(s) exceed $10,000, 6) at any time during the calendar year. See U.S. DEPT OF THE TREASURY, TD F 90-22.1, Report of Foreign Bank and Financial Accounts (OMB No. 1545-2038)(January 2012)(General Instructions) /31 C.F.R. Section 103.24. According to the instructions issued by the IRS, a “U.S. person” means a U.S. citizen, U.S. resident (green card holder or an alien residing in the United States), corporations, partnerships, or limited liability companies created or organized in the United States or under the laws of the United States and trust or estates formed under the laws of the United States. Ascertaining whether one has a “financial interest” in or, “signature authority” over, or “other authority” over one or more foreign financial accounts, and if the aggregate value of such accounts exceed $10,000 requires a close review of the FBAR instructions promulgated by the IRS.

Defining Financial Interest in Financial Accounts Located Outside the United States

A U.S. person has a financial interest in a foreign financial account for which he is the owner of record or holder of legal title, regardless of whether the account is maintained for the benefit of the U.S. person or for the benefit of another person. The instructions also state that a U.S. person has a “financial interest” in each account where the titleholder or owner of the account falls into one of the following six categories: 1) the U.S. person’s agent, nominee, or attorney, 2) a corporation whose shares are owned, directly or indirectly, more than 50 percent by the person, 3) a partnership in which the person owns greater than a 50 percent profits interest, 4) a trust of which a U.S. person is the trust grantor and has an ownership interest in the trust for United States tax purposes, 5) a trust from which the person derives in excess of 50 percent of the current income or in which the person has a present beneficial interest in more than 50 percent of the assets, or 6) any other entity in which the U.S. person owns directly or indirectly more than 50 percent of the voting power.

Defining Signature Authority

A person has “signature authority” over an account if the person can control the disposition of assets held in a foreign financial account by direct communication (whether in writing or otherwise) to the bank or other financial institution that maintains the financial account. Certain important exceptions exist for members of the military stationed in military installations outside of the United states and beneficiaries of a foreign trust if the trust or trustee or agent of the trust files an FBAR disclosing the trust’s foreign financial accounts.

Defining Financial Account

The definition of “financial account” located in a “foreign country” can be difficult to understand. According to the FBAR instructions, a financial account includes securities, brokerage, savings, demand, checking, deposit, time deposit, or other accounts maintained with a financial institution. A financial account also includes a commodity future or option account, an insurance policy with a cash value (such as a whole life insurance policy), an annuity policy with a cash value, and shares in a mutual fund or similar pooled fund. For reporting purposes, the term “foreign country” includes all geographical areas except the United States, Guam, Puerto Rico, American Virgin Islands, District of Columbia, Northern Mariana Islands, and Indian lands.

Defining Aggregate Value

The FBAR instructions refer to the “aggregate value” of the accounts “at any time during the calendar year.” The amount for which the IRS is searching is clarified on the FBAR itself, which requires the person to indicate the “maximum value” of each account. Generally, the “maximum value” of an account is the largest amount of cash and nonmonetary assets that appear on any periodic account statement. If periodic statements are not issued for the account, then the “maximum value” is the largest amount of cash and nonmonetary assets in the account at any time during the year. With respect to cash, the FBAR instructions direct a person to convert any foreign currency into U.S. dollars by using the treasury’s financial service rate at the end of the year in question.

Defining Non-Monetary Assets

Regarding non-monetary assets, such as securities, the instructions indicate that their value should be determined based on the fair market value of such assets at the end of the calendar year. If the assets were withdrawn from the account during the year, then their value is based on the fair market value at the time of the withdrawal. If the person is required to file an FBAR with regard to more than one account, then the person must ascertain the “maximum value” for each account separately using the preceding rules.

The instructions above demonstrate that taxpayers must carefully review the FBAR instructions in order to properly complete the FBAR form. The failure to carefully review the instructions to prepare an FBAR informational return or confusion regarding the definition of the words utilized in the FBAR instructions will result in the improper completion of an FBAR.

CIVIL PENALTIES RELATED TO NOT TIMELY FILING AN FBAR

The Jobs Act of 2004 provides that the Secretary (and by extension the IRS pursuant to delegation of authority) “may” impose a civil penalty on any person who violates Section 5314. Under the Jobs Act, a penalty may be imposed under 31 U.S.C. Section 5321(5)(A) and (C) for non-willful and willful violations of the law.

In cases of non-willful violations, the IRS may assess a penalty up to $10,000 per violation. The Jobs Act also enacted a new penalty scheme in cases where willfulness is demonstrated with the failure to timely file an FBAR. In the case of willful violations involving a financial “transaction,” the IRS can impose a penalty of $100,000 or 50 percent of the amount of the financial “transaction,” whichever is greater. See 31 U.S.C. Section 5321(a)(5)(C)(i).

The Jobs Act made three significant changes to the penalty structure for FBAR violations. First, the Jobs Act added a new penalty for cases involving non-willful violations. Second, the Jobs Act changed the burden of proof in regards to the assessment of certain FBAR penalties. Prior to the enactment of the Jobs Act, all FBAR associated penalties required the IRS to demonstrate willfulness. In order to assess any FBAR penalties the IRS had to show by clear and convincing evidence that the individual knew about the FBAR filing and intentionally failed to comply with the law. See 31 U.S.C. Section 5321(a)(5)(A)(2000). The Jobs Act changed the applicable law to allow the IRS to assert a penalty any time an FBAR is not timely or properly filed with the government. Third, the Jobs Act increased the maximum penalty that may be imposed for willful FBAR violations. Prior to the Jobs Act, the penalty for not complying with the FBAR filing requirements ranged from $25,000 to $100,000. The Jobs Act increased these penalties significantly. Under the Jobs Act, the penalty for not timely disclosing an interest in a foreign financial account may now greatly exceed $100,000 per violation.

Statutory Defenses For Section 5321 FBAR Penalties

Under Section 5321, no non-willful penalty shall be imposed if the following two conditions are met: 1) the violation was due to “reasonable case,” and 2) the amount of the “transaction” or the balance in the account at the time of the “transaction” was properly reported. See 31 U.S.C. Section 5321(B)(i). Although the above exceptions appear relatively simple, these terms are poorly defined. At initial glance, the first element of the exception to the non-willful penalty seems relatively straightforward; all an individual has to demonstrate is that there was a “reasonable cause” for not filing an FBAR informational return to satisfy the first prong of the Section 5321 or in any applicable regulation. Although the term “reasonable cause” is not addressed in Section 5321 or any regulations, the concept of “reasonable cause” is referred to in the Internal Revenue Manual.

The Internal Revenue Manual under 4.26.16.4.3.1 (07-01-2008) contains the following statements to this effect:

1. The [non-willful] penalty should not be imposed if the violation was due to
Reasonable cause.

2. If the failure to file the FBAR is due to reasonable cause, and not due to the negligence of the person who had the obligation to file [a penalty should not be assessed].

3. Reasonable Cause and Good Faith Exception to Internal Revenue Code Section 6662 may serve as useful guidance in determining the factors to consider [in assessing FBAR penalties].

4. Although the tax regulations for Section 6662 does not apply to FBARs, the information it contains may still be helpful in determining whether the FBAR violation was due to reasonable cause.

The Internal Revenue Manual indicates that an examiner could consider defenses to the Section 6662 penalty in determining whether a taxpayer should be liable for the non-willful FBAR penalty. The reasonable cause exception in a Section 6662 penalty has been generally interpreted to mean the exercise of ordinary business care and prudence. See United States v. Boyle, 269 U.S. 241, 246 (1985). Where an individual exercises ordinary business care and prudence, the individual will not be liable for the Section 6662 penalty where the understatement results from a mistake of law of fact in good faith and on reasonable grounds. See Scott v. Commissioner, 61 T.C. 654 (1974). Those who represent individuals before the IRS understand that the most common reason taxpayers do not disclose foreign financial accounts on FBAR informational returns is ignorance of the filing requirement.

There are numerous reasons why individuals are not aware of rules governing the FBAR reporting requirements. First, the applicable laws and regulations governing the disclosure of foreign financial accounts invite unintentional mistakes. This is because the rules governing FBAR informational returns can be found in Title 31 of the United States Code and not the Internal Revenue Code, which can be found in Title 26 of the United States Code. As such, a taxpayer can read each and every Internal Revenue Code provision along with each applicable regulation and never discover that he or she has a legal duty to file an FBAR.

Second, the term “foreign financial accounts” for FBAR purposes is confusing and misleading to many individuals. Most individuals mistakenly believe that only foreign bank accounts need to be disclosed on an FBAR informational return. However, as discussed earlier in this article, a taxpayer’s legal duty to disclose on an FBAR encompasses the disclosures far beyond interests in foreign bank accounts. In fact, an individual may have to disclose interests in securities accounts, mutual funds, certificates of deposits, life insurance policies, and more. Taking into consideration the broad definition of the terms “foreign financial accounts,” an individual can easily omit a foreign financial account from an FBAR informational return. Given that many individuals are still honestly ignorant of the FBAR filing requirements, compelling arguments can be made in many cases that taxpayers who failed to timely disclose foreign financial accounts on FBARs acted with “reasonable cause.”

CONCLUSION

If you have not timely reported a foreign financial account on an FBAR, you may not only be subject to significant civil penalties that can easily exceed the value of the unreported foreign financial account, you could also be subject to a number of criminal penalties. The attorneys at Diosdi & Liu, LLP have significant experience defending individuals from civil and criminal FBAR penalties. We have successfully represented individuals that were criminally referred to the United States Attorney for failing to timely disclose foreign financial accounts on an FBAR. We also litigated a number of civil FBAR penalty cases and we may be the only attorneys that successfully challenged an FBAR penalty under the Administrative Procedure Act.

Anthony Diosdi

Written By Anthony Diosdi

Partner

Anthony Diosdi focuses his practice on international inbound and outbound tax planning for high net worth individuals, multinational companies, and a number of Fortune 500 companies.

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