Taxpayers holding investments in foreign financial assets or with foreign financial institutions may find themselves in the uncomfortable position of realizing that they have failed to report their holdings on their federal income tax returns or have otherwise failed to report these holdings in accordance with federal law. Several options are potentially available to such taxpayers to come into compliance with their reporting obligations. The most beneficial option will depend upon the taxpayer’s specific factual scenario.
An individual taxpayer is generally required to file a Statement of Specified Foreign Financial Assets (Form 8938) with his or her U.S. tax return if he or she meets certain criteria. Briefly, this criteria is as follows:
- The taxpayer is a “specified person.” This includes U.S. citizens and resident aliens of the U.S.
- The taxpayer has an interest in “specified foreign financial assets.” These generally include any financial accounts maintained by a foreign financial institution and other foreign financial assets held for investment that are not in an account maintained by a U.S. or foreign financial institution.
- The aggregate value of the specified foreign financial assets exceeds a certain threshold. For married taxpayers filing joint tax returns and living in the U.S., this threshold is (a) $100,000 on the last day of the tax year or (b) $150,000 at any time during the tax year.
Apart from this information return reporting obligation, a U.S. citizen or resident also must file a Report of Foreign Bank and Financial Accounts (FBAR) on FinCEN Form 114 to report a financial interest in financial accounts located outside or the U.S. if the aggregate value of those accounts exceed $10,000 at any time during the year.
Significant civil penalties, and even potential criminal liability, may result from the failure to pay a tax due or timely submit accurate returns. These may include accuracy-related penalties, delinquency penalties, fraud penalties, and information return penalties. A “reasonable cause” defense may or may not be available as a defense to these penalties depending on the facts and circumstances of the particular case. In addition, penalties may arise from the failure to timely file FBARs. The nature and severity of these penalties largely depend on whether the failure to file was willful on non-willful. In criminal cases willfulness must be proven by beyond a “reasonable doubt” with evidence that the taxpayer made a “voluntary, intentional violation of a known legal duty.” However, the standard of proof is easier for the government in civil FBAR penalty cases wherein willfulness can be shown with a “preponderance of evidence” that the taxpayer acted “knowingly or recklessly” or with “willful blindness.” Under the concept of “willful blindness,” willfulness may be attributed to a taxpayer who made a conscious effort to avoid learning about the FBAR reporting and record-keeping requirements.
There are several ways by which a taxpayer who has failed to report foreign financial assets and pay all taxes dues in respect of those assets to voluntarily may come into compliance. The IRS’s Voluntary Disclosure Program (VDP) may be a viable option for taxpayers whose failure to report foreign financial assets and pay all taxes dues in respect of those assets potentially exposes them to criminal liability. As stated previously, exposure to criminal liability generally arises in situations where the taxpayer knew of an obligation to file and intentionally failed to satisfy that obligation. Participation in the VDP creates no substantive rights for the taxpayer nor does it guarantee immunity from prosecution, but it may avoid criminal prosecution. A voluntary disclosure occurs when the disclosure is truthful, timely, and complete, and when the taxpayer (a) shows a willingness to cooperate (and does in fact cooperate) with the IRS in determining his or her correct tax liability and (b) makes good faith arrangements to pay in full the tax, interest, and any penalties determined by the IRS to apply. A disclosure is timely only if it is received before (1) the IRS has initiated a civil or criminal investigation of the taxpayer (or has advised the taxpayer that it intends to do so), (2) the IRS has received information from a third party with respect to the taxpayer’s noncompliance, (3) the IRS has initiated a civil or criminal investigation 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.
A taxpayer who has qualified to participate in the VDP will generally undergo an examination by the IRS for the most recent six tax years. Taxpayers will be required to submit all tax returns and reports for this period, and IRS examiners will determine applicable taxes, interest, and penalties under existing law and procedures for this period. Generally, the civil penalty for fraud or fraudulent failure to file tax returns will apply to the one tax year with the highest tax liability. However, the IRS may apply these civil fraud penalties for more than this one year based on the facts and circumstances, and may even apply these civil fraud penalties beyond the six year period under examination if the taxpayer fails to cooperate and resolve the examination by agreement.
The IRS’s Streamlined Filing Compliance Procedures (SFCP) are generally intended for taxpayers whose failure to report foreign financial assets and pay all taxes dues in respect of those assets was not willful, and who therefore have no exposure to criminal liability. Taxpayers using the SCFP must certify — under penalty of perjury — that the failure to report all income, pay all tax, and submit all required information returns (including the FBAR) was due to non-willful conduct. A taxpayer is not eligible to use the SCFP if (a) the IRS has initiated a civil examination of the taxpayer’s returns for any tax year, regardless of whether the examination relates to undisclosed foreign financial assets, (b) the taxpayer is under criminal investigation by the IRS, or (c) the taxpayer has made a voluntary disclosure under the VDP. In addition to meeting this general eligibility criteria, a taxpayer seeking to use the domestic version of the SCFP — the Streamlined Domestic Offshore Procedures (SDOP) — must (1) fail to meet applicable non-residency criteria, (2) have previously filed a U.S. tax return (if required) for each of the past three tax years for which the U.S. tax return due date has passed, and (3) have failed to report gross income from a foreign financial asset and pay required tax (and may have failed to file an FBAR or an information return with respect to the foreign financial asset) as a result of non-willful conduct. Non-willful conduct is conduct which is due to “negligence, inadvertence, or mistake or conduct that is the result of a good faith misunderstanding of the requirements of the law.”
A taxpayer who is eligible to use the SDOP must (a) file amended tax returns and all required information returns for the most recent three tax years for which the U.S. tax return due date has passed (the “covered return period”), (b) file any delinquent FBARs for the most recent six tax years for which the FBAR due date has passed (the “covered FBAR period”), and (c) pay a Title 26 miscellaneous offshore penalty. The full amount of the tax, interest, and miscellaneous offshore penalty should be remitted with the amended tax returns. The Title 26 miscellaneous penalty is equal to 5% of the highest aggregate balance/value of the taxpayer’s foreign financial assets that are subject to the penalty during years in the covered tax return period and the covered FBAR period.
Taxpayers who have not filed one or more required international information returns, but who do not need to use the VDP or the SFCP to file delinquent or amended tax returns to report and pay additional tax, may file the delinquent information returns with a statement of all facts establishing reasonable cause for the failure to file. In order to use this procedure, the taxpayer must (a) have reasonable cause for not timely filing the information returns, (b) not be under a civil or criminal investigation by the IRS, and (c) not have been contacted by the IRS about the delinquent information returns. A reasonable cause statement should be attached to each delinquent information return filed for which reasonable cause is being requested.
Similarly, taxpayers who have not filed required FBARs, but who do not need to use the VDP or the SFCP to file delinquent or amended tax returns to report and pay additional tax, may file delinquent FBARs according to the FBAR instructions. In order to use this procedure, the taxpayer must not (a) be under a civil or criminal investigation by the IRS or (b) have been contacted by the IRS about the delinquent FBARs. The FBARs should be filed electronically at FinCEN, and a statement should be provided as to why the FBARs are being filed late.
A taxpayer’s realization that he or she has failed to timely file federal income tax information returns or FBARs can be distressing. Significant financial penalties, and perhaps even criminal penalties, may be imposed. Care should be taken to consult with a qualified tax advisor to analyze options and mitigate exposure.