Can the IRS Automatically Assess a Penalty against a U.S. Taxpayer who Innocently or Mistakenly Failed to Disclose a Foreign Bank Account?
What happens in cases where a U.S. taxpayer innocently or mistakenly failed to disclose a foreign account and mistakenly failed to report foreign source income? Is such a taxpayer doomed to pay the 25 percent OVDI penalty? And if this taxpayer does not participate in the OVDI and notwithstanding potential criminal matters, is this taxpayer subject to a willful failure to report a foreign account penalty? The willful failure to disclose a foreign account penalty provides that a taxpayer could be penalized for 50 percent of the value of the undisclosed foreign account per year of omission. The statute of limitations on this penalty is six years. This means that the IRS could in theory assess a penalty that is three times the value of the foreign account or accounts against a U.S. taxpayer.
Before we begin our discussion on this matter, it is important for all our readers to understand that the 50 percent penalty for willfully failing to disclose a foreign account is not automatic. If a U.S. taxpayer innocently or mistakenly failed to properly disclose a foreign account, the maximum penalty is $10,000 per year starting in 2005, and there is a reasonable cause exception to remove or abate this penalty.
If a U.S. taxpayer deliberately established a foreign account to evade U.S. taxes, he or she could be subject to the 50 percent willful penalty or year. In order to avoid this draconian penalty, the taxpayer should elect to participate in the 2011 OVDI immediately. In other cases, whether a taxpayer chooses to apply for the OVDI may depend on whether there has been a willful violation of the law with respect to the non-filing of FBARS or failure to disclose and pay taxes on the foreign income. The decision on whether a taxpayer should or should not participate in the OVDI should be predicated for the most part on whether the failure to disclose the foreign account or accounts can be classified as willful.
Willful is a legal concept, one which requires an affirmative act to evade or avoid a known legal requirement. Inadvertence negligence is not willfulness. In a recent case, United States v. Williams, 2010 Dist (ED VA 2010), a taxpayer sent $7.0 million to a Swiss bank account, checked the box “no” on Schedule B of Form 1040 stating that he did not have an interest in a foreign bank account. The taxpayer pled guilty to one count of tax fraud. The IRS claimed the taxpayer willfully violated the FBAR filing requirement and attempted to assess the 50 percent penalty. The court disagreed.
The court stated the willfulness meant a knowing or reckless violation of a standard, not just a couple instances of inadvertent neglect. The lesson to be learned from Williams is the failure to report a foreign account does not necessarily mean a taxpayer will be subject to the 50 willful penalty even if the taxpayer specifically checked a box on a tax return denying the existence of a foreign account. The decision in Williams represents an important first step toward imposing discipline to a government seeking to wrongful extract money from hardworking U.S. citizens who established or inherited foreign accounts and did not know of the requirements to disclose the account. Williams offers important protections for these individuals. Now since the IRS can no longer simply assess a 50 percent penalty against taxpayers for merely not disclosing a foreign bank account, in certain cases it may not make much sense to participate in the OVDI.
The decision as to whether an individual should participate in the OVDI is difficult. The individual should seek the assistance of a qualified attorney who can assist the individual in this process. In any case, whether or not the individual decides to enroll in the 2011 OVDI, the individual must amend his or her tax returns and report any previously undisclosed income. The returns should not merely be filed with the IRS, but in cases where the individual decides against participating in the program, this individual should request a traditional voluntary disclosure through a local IRS criminal investigation division. The disclosure should report all foreign source income that was previously omitted and a detailed written statement as to why all applicable FBAR or offshore penalties should not be assessed. Finally, the U.S. taxpayer making such a disclosure should be prepared to immediately satisfy all tax, interest, and penalties from the failure to disclose foreign source income. Remember, the Williams case offers a compelling defense against penalties associated with not disclosing a foreign account. However, Williams does not excuse a U.S. taxpayer from disclosing foreign source income that is required to be disclosed and paying all applicable tax on the previously undisclosed income.
For more information, contact Moskowitz LLP.