By Stephen J. Dunn
There are two reasons for a taxpayer to enter the IRS’ Offshore Voluntary Disclosure Program (“OVDP”). First, to avoid a criminal prosecution. Second, to avoid the draconian civil penalty under the Bank Secrecy Act.
The two principal tax crimes are 26 USC §§ 7201 and 7206(1). To convict under § 7201, the government must persuade the trier of fact beyond a reasonable doubt (1) an understatement of tax; (2) willfulness; and (3) at least one affirmative act of evasion. An affirmative act of evasion is any act intended to defraud or deceive the government, such as making a false statement in a tax return or to a federal agent, keeping two sets of books, or dealing only in cash. Conviction under § 7201 is punishable by fine of up to $100,000, imprisonment of up to five years, or both.
To convict under § 7206(1), the government must persuade the trier of fact beyond a reasonable doubt that (1) the taxpayer (1) willfully (2) made and subscribed a tax return under oath, (3) which he did not believe to be true and correct in every material matter. Conviction under § 7206(1) is punishable by fine of up to $100,000, imprisonment of up to three years, or both.
Criminal tax prosecutions are expensive. The government tends to bring them only to redress a scheme perpetrated for several years, which has evaded a substantial amount of tax. In the case of foreign accounts, the amount of tax evaded is not the balance in the accounts, but the much smaller amount of tax on unreported income (interest, dividends, net capital gains) from the accounts.
The Bank Secrecy Act, 31 USC § 5311 et seq., requires a person with more than $10,000 in foreign financial accounts as of December 31 to report the accounts on FinCEN Form 114, Report of Foreign Financial Accounts, (“FRAR”) by the ensuing June 30. Failure to file an FBAR that is due is subject to civil penalty and criminal prosecution. The civil penalty is the greater of $100,000 or 50% of the balance of the account. The civil penalty is only $10,000 if the account owner did not “willfully” fail to file an FBAR. But if there is reasonable cause for failing to file an FBAR, there is no penalty at all. 31 USC § 5321(a)(5).
Under 31 USC § 5322(a), a person convicted willfully failing to file an FBAR is subject to a fine of up to $100,000, or imprisonment for up to five years, or both.
The OVDP incorporates a long-standing Treasury policy of not prosecuting an offense reported to it before the government has learned of it. Under the OVDP, the taxpayer discloses the account(s) and the taxpayer’s identity to the IRS Criminal Investigation Division. IRS CID reviews its data base and, if it finds nothing concerning the taxpayer, sends the taxpayer a letter accepting the taxpayer into the OVDP. The letter says that the taxpayer will not be prosecuted concerning the account(s), provided the taxpayer complies with the terms of the OVDP.
The principal terms of the OVDP are that the taxpayer:
- Consent to waive the assessment statute of limitations, and file Forms 1040X, Amended U.S. Individual Income Tax Return, for the last eight years reporting income on the foreign account(s), and pay the tax due on the Forms 1040X, along with an accuracy-related penalty equal to 20% of the tax.
- File FBARs for the last eight years.
- Pay a civil penalty, in lieu of the 31 USC § 5321(a)(5) penalty, equal to 25% of the highest balance in the account over the last eight years.
Willfulness is a key factor in deciding whether a taxpayer should enter the OVDP. A taxpayer who did not willfully fail to report income from a foreign account would not be subject to criminal tax prosecution concerning the account. And a taxpayer who did not willfully fail to file an FBAR for a foreign account is not subject to the draconian penalty of 31 USC § 5321(a)(5) concerning the account.
“Willfulness” is a voluntary, intentional violation of a known legal duty. A good-faith misunderstanding of the law, whether or not objectively reasonable, negates willfulness. Cheek v. United States, 498 U.S. 192, 200-202, 112 L. Ed. 2d 617, 11 S. Ct. 604 (1991); United States v. Bishop, 412 U.S. 346, 360, 36 L. Ed. 2d 941, 93 S. Ct. 2009 (1973); United States v. Pensyl, 387 F.3d 456, 458-60 (6th Cir. 2004). In United States v. Bishop, the Supreme Court observed:
In our complex tax system, uncertainty often arises even among taxpayers who earnestly wish to follow the law. . . . “It is not the purpose of the law to penalize frank difference of opinion or innocent errors made despite the exercise of reasonable care.”
412 U.S. at 360-61, quoting Spies v. United States, 317 U.S. 492, 496, 87 L. Ed 418, 63 S. Ct. 364 (1943). Willfulness must include an evil motive and want of justification in view of all the circumstances. James v. United States, 366 U.S. 213, 221, 6 L. Ed. 2d 246, 81 S. Ct. 1052 (1961).
Misunderstanding or lack of knowledge of the law or facts militates against a finding of willfulness. Complicating the willfulness analysis for taxpayers is Form 1040, U.S. Individual Income Tax Return, Schedule B, Income and Dividends, Part III, which provides:
“7a At any time during [the taxable year], did you have a financial interest in or signature authority over a financial account (such as a bank account, securities account, or brokerage account) located in a foreign country? See instructions.
If “Yes,” are you required to file FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR), formerly TD F 90-22.1, to report that financial interest or signature authority? See FinCEN Form 114 and its instructions for filing requirements and exceptions to those requirements.
b If you are required to file FinCEN Form 114, enter the name of the foreign country where the financial account is located ▶
8 During [the taxable year], did you receive a distribution from, or were you the grantor of, or transferor to, a foreign trust? If “Yes,” you may have to file Form 3520. See instructions on back.”
Before 2011, Schedule B, Part III read as follows:
“7a At any time during [the taxable year], did you have a financial interest in or signature authority over a financial account in a foreign country, such as a bank account, securities account, or other financial account? See instructions exceptions on back for exceptions and filing requirements for Form TD F 90-22.1.
b If “Yes,” enter the name of the foreign country ▶
8 During 2013, did you receive a distribution from, or were you the grantor of, or transferor to, a foreign trust? If “Yes,” you may have to file Form 3520. See instructions on back.”
It is difficult for a taxpayer to claim that he did not know of the requirement to report foreign accounts if the taxpayer has filed tax returns with “No” checked in the boxes in Schedule B, Line 7a, especially given that the taxpayer must sign the tax return under penalty of perjury. The taxpayer is less likely to be found willful if the tax return was prepared by a third party expert, such as a CPA.
Some examples from my recent practice will illustrate the above principles.
Example 1. Taxpayers are retired physicians. Husband, a German native, inherited an apartment located in Germany. In 2007, taxpayers established an account in Germany with a view to dividing their retirement time between the United States and Germany. They properly reported all income from the account on their U.S. income tax returns. Since 2011 they have properly reported the account on Schedule b, Part III. Their CPA prepared all of their income tax returns. The taxpayers were not willful, and they will not enter the OVDP. Moreover, the taxpayers have reasonable cause for not filing FBARs, as they made full disclosure to their CPA, completely relied upon him, and he did not advise them to file FBARs.
Example 2. Father was a commodities merchant, and frequently traveled to Europe. Two years after Father’s death, Son learns that he has inherited a Swiss bank account from father. Son is advised that he owns the account. In the two years since Father’s death, Son has failed to report income from the account on his federal income tax returns, or report the account on an FBAR. Son was not willful. Nonetheless, out of an abundance of caution, Son enters the OVDP, and is granted the 5% non-willfulness penalty for failure to timely file an FBAR.
Example 3. Son’s parents established an account in Israel and funded it with Holocaust reparation payments. Son inherited half of the account upon the death of his father in 1972, and the balance of the account upon the death of his mother in 1998. Son augmented the account with his earnings in Israel before he immigrated to the United States, and income from rental of an apartment in Israel which he inherited from his parents. Son has entered the OVDP, and advisedly so.
Example 4. Taxpayer had a time deposit account in his native United Kingdom upon emigrating to the United States in 2000. Since then the account had matured several times, each time the taxpayer reinvesting it. Taxpayer filed Schedule B with his U.S. federal income tax return each year, always checking the “No” boxes in Part III. Taxpayer has always prepared his own U.S. income tax return. Taxpayer has entered the OVDP, and advisedly so.