NTA Blog: Foreign Information Penalties: Part Three: Keeping a Watchful Eye on the FBAR Guard Dog
May 1, 2023 -This is part 3 of my blog series addressing international reporting requirements. Part 1 addressed the U.S. Tax Court’s decision in Farhy v. Commissioner and the need to make Chapter 61 international information return penalties subject to deficiency procedures.
NTA Blog: Chapter 61 Foreign Information Penalties: Part Three: The Bittner Decision and TAS Legislative Recommendations: Keeping a Watchful Eye on the FBAR Guard Dog
This is part 3 of my blog series addressing international reporting requirements. Part 1 addressed the U.S. Tax Court’s decision in Farhy v. Commissioner and the need to make Chapter 61 international information return penalties subject to deficiency procedures. In Part 2, I urged Congress to take steps to ensure that Chapter 61, Subchapter A, Part III, Subpart A penalties are governed by the statute of limitations of IRC § 6501, specifically that articulated in IRC § 6501(c)(8). In part 3, I turn my attention to the Supreme Court’s decision in Bittner v. United States and my longstanding recommendation that “willfulness” be proven by clear and convincing evidence.
For decades, the U.S. government has had concerns about accounts and other financial relationships held abroad. The fear is these resources could be simultaneously difficult to monitor and readily available for illicit uses, such as in terrorism, drug trafficking, or tax evasion. As a result, Congress, Treasury, and the IRS have collectively exercised their statutory and regulatory might to obtain information about money potentially flowing into and out of the United States. From time to time, however, enforcement regimes should be reexamined and adjusted to protect those who are governed from needless hardship and disproportionate harm.
In 1970, Congress passed the Bank Secrecy Act, which, along with its implementing regulations, generally requires U.S. persons to report to Treasury any bank, securities, or other financial account in a foreign country when the aggregate balance of those accounts exceeds $10,000 at any point in the calendar year. The form on which these reports must be made is known as the Report of Foreign Bank and Financial Accounts (FBAR). Even a small mistake on the form can result in up to a $10,000 penalty (adjusted for inflation), and penalties are substantially higher for willful violations.
The FBAR reporting requirement addresses real abuses and serves an important function. However, it is important that this regime not become the watchdog that indiscriminately gobbles all who come into its neighborhood. Taxpayers and practitioners are not always familiar with the FBAR reporting requirement, and a penalty of $10,000 or more can be inappropriate in many cases. Prior to the Bittner decision, the IRS assessed penalties on a per-account basis. This led to situations where even nonwillful violations of the statute generated significant penalties. For example, a U.S. citizen who lives and works abroad and who has a checking and savings account in the country of residence could, in the eyes of the IRS, face up to $20,000 in penalties for nonwillful violations of the FBAR requirement – $10,000 for each account, irrespective of whether the accounts generated any income.
The Supreme Court recently took an important step toward checking IRS excesses in Bittner v. United States. Bittner involved a U.S. taxpayer who held numerous foreign accounts and failed to file correct FBARs for five years. Although the IRS considered these violations to be nonwillful, it assessed 272 penalties totaling $2.72 million. The Court disagreed with this interpretation of the FBAR requirement and associated penalty, holding instead that the penalty for nonwillful violations should be applied once per report, not as “a cascade of such penalties calculated on a per-account basis.” The $2.72 million in penalties thus was reduced to $50,000, or a single $10,000 penalty for each of the five years in question. In this way, the Supreme Court preserved the integrity of the FBAR regime while protecting taxpayers with nonwillful violations from potentially life-altering penalties.
Nevertheless, taxpayers face an additional source of uncertainty and significant liability that still must be addressed. Because of the Bittner decision, taxpayers whose failure to report is deemed nonwillful face penalties that are daunting, but at least circumscribed.
If the IRS deems the FBAR reporting violations willful, however, penalties expand exponentially, growing to the greater of $100,000 (adjusted for inflation) or 50 percent of the account balance at the time of the violation. These can be imposed on an annual basis. With manager approval, examiners are free to propose penalties of up to 100 percent of the highest aggregate balance of all unreported foreign accounts for each year under examination, if they believe the case is “egregious.” This can lead to breathtakingly disproportionate results. For example, a taxpayer whose failure to report a maximum aggregate balance of $25,000 is deemed willful can owe up to $100,000 in FBAR penalties, even if that taxpayer only lived and worked outside the U.S. for less than a year and the account did not generate any income. While the Internal Revenue Manual (IRM) discusses this scenario and advises examiners not to propose penalties exceeding the high aggregate balance of a taxpayer’s accounts, the IRM is not legally binding on the IRS, and the IRS is legally free to take a more aggressive position.
Willful Standard
The rules for FBAR willfulness should be the same as in a standard tax fraud case. That is, to establish willfulness, the burden of proof is on the government by clear and convincing evidence. Additionally, proof of willfulness should show an intentional violation of a known legal duty. Currently, the government and the courts are harming taxpayers by using (1) a lower standard for the definition of willfulness; and (2) a lower burden of proof for establishing willfulness.
The key determination involves distinguishing between willful and nonwillful violations. In the classic civil tax fraud inquiry, the burden of proof is on the government to show by clear and convincing evidence an intentional wrongdoing, on the part of a taxpayer, with the specific purpose of evading a tax known or believing to be owing. Thus, taxpayers generally will not be held liable for fraud simply due to a mistake or inaction based on ignorance.
Willfulness, in FBAR and other civil contexts, is generally defined as covering “not only knowing violations of a standard, but reckless ones as well” or exhibits willful blindness. When it comes to proving willfulness with respect to FBAR penalties, IRS Counsel predicted in a nonprecedential 2006 memorandum that the courts would apply the same standard of “clear and convincing evidence” as was adopted for civil tax fraud. Over time, however, the IRS has taken a more aggressive approach and persuaded the courts that the proper burden of proof for FBAR violations is “the preponderance of the evidence.” As a result, the IRS sometimes asserts willfulness where willfulness is only inferred rather than affirmatively evidenced.
For instance, the IRS has taken the position that willfulness may be demonstrated when a taxpayer failed to check “yes” on the foreign account question on Schedule B and also failed to file an FBAR for that year. This failure and the circumstances surrounding it can be used by the government as it alleges “willful blindness” on the part of the taxpayer and attempts to meet its burden of proof. Judicial precedent is unsettled regarding what constitutes willfulness for purposes of the FBAR penalty. Some courts have held that the failure to check the foreign account question box on Schedule B indicates a willful violation, whereas others have held that willfulness cannot be established under those facts where reasonable reliance on a tax preparer was present. The IRS approach, if adopted, would in essence represent a strict liability test for failure to check the box on Schedule B.
The way to limit this confusion and guard against draconian outcomes while still retaining the deterrent effect of FBAR penalties is to require the same heightened burden of proof for willfulness as is required in the case of civil tax fraud (i.e., by clear and convincing evidence). Failure to report, absent some additional evidence, such as an affirmative act, should not be construed as willful. The IRS should not be permitted to establish willfulness by relying simply on the Schedule B. Although not a complete remedy for the IRS’s aggressive reading of “willfulness,” my proposed change would free many unwitting taxpayers from heavy-handed penalties while still accomplishing the intended goal of the Bank Secrecy Act: namely, obtaining information about foreign accounts held by U.S. taxpayers.
Conclusion
I have proposed legislation to Congress in my 2023 Purple Book of legislative recommendations that would require the government to establish willfulness in the FBAR context by clear and convincing evidence. Additionally, I have recommended narrowing the maximum civil penalty for willful violations to 50 percent of the balance in the account at the time of the violation and eliminating the potential $100,000 penalty where that is greater. This change would protect taxpayers with low balance accounts and prevent the surreal scenario, currently possible, in which maximum FBAR penalties can exceed the amount of an underlying account balance. Together with the clarifying decision in Bittner, this combination of reforms would help perpetuate an FBAR penalty that is fair, measured, and effective for taxpayers and tax administration.
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