With all of the focus on FBAR penalties when it comes to foreign asset reporting, it’s easy to overlook the others, some of which can be just as onerous as the FBAR penalty itself. What other pestilent civil penalties are lying in wait for the unwary taxpayer who decides not to participate in one of the IRS’s voluntary disclosure programs and is subsequently audited?
I. Failure to File a Tax Return Penalty
The civil penalty applicable for failure to timely file returns is section 6651(a)(1). This penalty applies both inside and outside of the OVDP regime. The elements of this penalty are the same as the elements of the section 7203 failure-to-file offense. Indeed, the taxpayer must have a duty to file and must have failed timely to file.
In general, the section 6651(a)(1) penalty is 5 percent per month, plus an additional 5 percent for each month – or fraction thereof – during which the failure continues. The penalty shall not exceed 25 percent.
What is the penalty base? Very simply, it is the tax required to be shown on the return. However, that base is reduced by the tax that has been paid by the due date of the return. For example, by withholding or estimated taxes.
One important point to remember is that if the failure to file is fraudulent, the penalty rate becomes 15% per month, with a maximum of 75% (see the discussion of the civil fraud penalty below).
Can a taxpayer use the statute of limitations as a defense to the failure to file penalty? Unfortunately, such a defense is doomed to failure. In general, the IRS must assess any tax, or issue a notice of deficiency, with respect to a tax year within three years of (1) when the return for the year was filed or (2) when the return was due to be filed, whichever is later. For example, if John filed his return on March 15, the statute of limitations would begin to run on April 15.
On the other hand, if the return is filed after the original due date, the statute of limitations begins running the day the return was actually filed, regardless of whether an extension was granted. For example, if John was granted an extension to July 1 to file his return, but actually filed it on June 1, the statute of limitations begins to run on June 1.
However, many conditions can extend or suspend the running of this limitations period. One such condition is the failure to file a tax return. The statute of limitations for the IRS to assess and collect any outstanding balances does not begin until a return has been filed. In other words, the IRS has until time immemorial to assess and collect tax when no return has been filed.
II. Accuracy-related Penalty
Under Section 6662(a), the accuracy-related penalty is 20% of the underpayment. It applies both inside and outside of the OVDP regime. The penalty applies whenever any one of five conditions is present. The two most common are: (1) negligent or intentional disregard of tax rules and (2) substantial understatement of income tax.
Here’s how the accuracy-related penalty is calculated. Assuming a tax deficiency of $ 500, including interest, the accuracy-related penalty would be $ 100 (.20 x $ 500).
III. The Penalty for Failing to File Form 8938
On March 18, 2010, the “Hiring Incentives to Restore Employment Act” or “HIRE Act” was signed into law. The HIRE Act contains several modifications to the foreign tax reporting rules, tax penalty structure, as well as the statute of limitations.
1. Foreign Financial Account Disclosure (§ 6038D) – “FBAR Plus”
Section 511 of the HIRE Act created I.R.C. § 6038D. This section requires specified individual taxpayers with an interest in “specified foreign financial assets” to file Form 8938 if the aggregate value of those assets exceeds the applicable reporting threshold.
Let’s break down the elements of this rule. First, who is a specified individual? A specified individual is any one of the following:
i. A U.S. citizen;
ii. A resident alien of the United States for any part of the tax year (but
see Reporting Period);
iii. A nonresident alien who makes an election to be treated as a resident
alien for purposes of filing a joint income tax return;
iv. A nonresident alien who is a bona fide resident of American Samoa or
Puerto Rico. See Pub. 570, Tax Guide for Individuals With Income From U.S.
Possessions, for a definition of bona fide resident.
Second, what are “specified foreign financial assets?” Specified foreign financial assets include financial accounts maintained by a foreign financial institution. The term, “financial account” has a very broad definition. It includes any depository or custodial account maintained by a foreign financial institution as well as any equity or debt interest in a foreign financial institution (other than interests that are regularly traded on an established securities market).
Specified foreign financial assets also include the following, provided they are held for investment and not held in an account maintained by a financial institution:
i. Stock or securities issued by someone that is not a U.S. person;
ii. Any interest in a foreign entity; and
iii. Any financial instrument or contract that has an issuer or counterparty that is not a U.S. person.
A mistake that many taxpayers make is in believing that IRAs and other retirement plans are included in the definition of “specified foreign financial assets.” However, to the extent that such an interest represents a social security, social insurance, or other similar program of a foreign government, that is incorrect. Indeed, such accounts are not specified foreign financial assets and thus are exempt from the Form 8938 reporting requirements. This is an easy mistake to make in light of the fact that “specified foreign financial assets” has such a broad definition.
It is critical for taxpayers to understand that they have an interest in specified foreign financial asset even if there are no income, gains, losses, deductions, credits, gross proceeds, or distributions from holding or disposing of the asset included on the tax return for the tax year.
Third, how are specified foreign financial assets valued? The value of a specified foreign financial asset is the asset’s fair market value on the last day of the tax year. For purposes of figuring the total value of specified foreign financial assets, the value of a specified foreign financial asset denominated in a foreign currency must first be determined in the foreign currency and then converted to U.S. dollars.
Fourth, what is the reporting threshold? The reporting threshold depends on two main variables: first, whether the taxpayer lives in the United States or outside of the United States and second, whether the taxpayer is single or married. Assuming the taxpayer is married, the reporting threshold varies depending on whether the taxpayer is filing a joint income tax return with his or her spouse or a separate income tax return.
For example, an unmarried taxpayer living in the United States satisfies the reporting threshold if the total value of his specified foreign financial assets is (1) greater than $50,000 (USD) on the last day of the tax year or (2) greater than $75,000 (USD) at any time during the tax year.
However, if that same taxpayer lived outside the United States as opposed to in the United States, he would only satisfy the reporting threshold if the total value of his specified foreign financial assets was (1) greater than $ 200,000 (USD) on the last day of the tax year or (2) greater than $ 300,000 (USD) at any time during the tax year.
Again, I don’t mean to beat a dead horse, but this comes up with enough frequency in my private practice that it cannot be emphasized enough: specified foreign financial assets must be reported even if none of the assets affects the taxpayer’s tax liability for the tax year.
Now we get down to brass tax. What are the consequences of failing to file Form 8938? Under I.R.C. § 6038D(d), the penalty for failing to file Form 8938 is $ 10,000. If the IRS notifies the individual regarding his failure to make the required disclosures, and the failure continues for more than 90 days after the mailing of the notification, there is an additional $ 10,000 penalty for each 30-day period that passes, up to a maximum of $ 50,000 per return. § 6038D(d)(2).
This penalty went into effect beginning with the 2011 tax year.
2. Undisclosed Foreign Financial Asset Understatement Penalty
Subsection (b)(7) of section 6662 provides a 20% penalty for “any undisclosed foreign financial asset understatement.” Subsection (j) of section 6662 provides the following definitions:
(j) UNDISCLOSED FOREIGN FINANCIAL ASSET UNDERSTATEMENT
(1) IN GENERAL.–For purposes of this section, the term “undisclosed foreign financial asset understatement” means, for any taxably year, the portion of the understatement for such taxable year which is attributable to any transaction involving an undisclosed foreign financial asset.
(2) UNDISCLOSED FOREIGN FINANCIAL ASSET.–For purposes of this subsection, the term “undisclosed foreign financial asset” means, with respect to any taxable year, any asset with respect to which information was required to be provided under section 6038, 6038B, 6038D, 6046A, or 6048 for such taxable year but was not provided by the taxpayer as required under the provisions of those sections.
There is also a newly enhanced penalty for any “undisclosed foreign asset understatement.” § 6662(j)(3).
This penalty is effective for taxable years beginning after March 18, 2010, the date of enactment. HIRE Act, § 512(b).
IV. A potential civil fraud penalty imposed under IRC §§ 6651(f)
Where an underpayment of tax, or a failure to file a tax return, is due to fraud, the taxpayer is liable for the civil fraud penalty. The civil fraud penalty is the 800-pound gorilla of civil penalties because it is the largest civil penalty in dollar magnitude. It applies not only to cases where the taxpayer files a false return but also to cases where the taxpayer refrains from filing a return at all. The former applies only to filed returns and is penalized under section 6663. The latter includes both a failure to file and a late filing. It is penalized under section 6651.
Section 6663(a) imposes a penalty equal to 75% of the portion of the underpayment which is attributable to fraud. Under section 6651(a)(1), the normal delinquency penalty is five percent per month (or part of a month) capped at 25%. However, when the failure to file is due to fraud, section 6651(f) raises the delinquency penalty to 15% per month (or part of a month) capped at 75%.
The IRS bears the burden of proving civil fraud by clear and convincing evidence, which is a higher standard than that for other civil penalties but a lower standard than the “beyond a reasonable doubt” quantum required for a criminal conviction. Civil fraud is defined as follows:
The intentional commission of an act or acts for the specific purpose of evading a tax believed to be owing. Fraud implies bad faith, intentional wrongdoing, and a sinister motive. It is never imputed or presumed. Whether fraud has been committed is a question of fact to be determined from the entire record.
Since direct proof of fraudulent intent is seldomly available, this element is typically inferred from objective facts (i.e., the existence of one or more of the so-called “badges of fraud”). They include, among others:
• A multi-year pattern of understating income;
• Failing to maintain adequate books and records;
• Failing to file returns;
• Concealing assets;
• Lying to or failing to cooperate with IRS agents;
• Receiving illegal source income;
• Giving implausible or inconsistent explanations;
• Dealing in cash;
• Consistently and substantially overstating deductions;
• Keeping multiple sets of books;
• Creating false documents or entries;
• Destroying information; and
• Deceptively structuring transactions.
There are two very important things to keep in mind regarding the civil fraud penalty. First, reasonable cause is a defense. And second, when fraud is established, there is no statute of limitations impediment to the assessment of civil liabilities.