Raising the FBAR on Foreign Tax Compliance

Wednesday, March 17, 2010

How would you like to tell your clients that they owe a $350,000 penalty for failing to report the transfer of one million dollars to a foreign trust? And that they’ll also owe $10,000 more for each additional 30 days that the tax return was past due. Or to tell them that they owe a penalty of up to 50% of their account balance (and criminal exposure) because they had failed to report an offshore bank account on their tax return? Or that they owe a penalty for 10% of the amount they transferred to their own foreign company? Do these penalties seem harsh to you? Welcome to International Tax Law.


Penalties like these are typically not as prevalent in other areas of taxation (perhaps, except for Pension Taxation). You see, the problem is that the penalties imposed for failing to comply with International Tax law are not based solely upon the tax from the foreign asset earnings. In certain circumstances, the penalties are based upon the value of the asset itself.




Global tax reporting has recently obtained heightened awareness as the US government has beefed up its efforts in furtherance of prosecuting the Swiss bankers at UBS (and more recently against U.S. clients of indicted financier R. Allen Stanford). It is often explained that this enforcement is rooted in the Patriot Act and is being carried out more harshly now to prevent terrorist financing. However, these laws have been in place for years and there is only one true reason why they are being enforced more vigorously now….the government needs money. And from a policy standpoint it looks bad to raise taxes on working families without first insuring that investment bankers and investors using global tax avoidance structures are paying their fair share.


In turn, the IRS created an initiative[1] to capture the big fish and what they’ve found is that thousands of little fish became scared enough to come forward. We are in a global economy and it is now more common to have offshore accounts, transfers to foreign trusts, the receipt of foreign inheritances and interests in foreign entities. The international tax reporting for each specific area can be complicated, with inflexible deadline requirements and harsh penalties for failure to comply. Advisors who “dabble” in the area face significant exposure[2] when assisting their clients. Particularly if they believe that only foreign bank accounts trigger tax filing obligations.[3]Even worse, they often direct clients to an independent Accountant to submit their disclosure application and fail to secure any Attorney-Client protection at all.


One frequently seen example comes to mind: Many foreign countries impose real estate transfer taxes on US taxpayers who acquire realty within their borders but have exceptions for properties purchased by a foreign entity. In response, US taxpayers create a foreign entity to purchase the real estate and circumvent the additional costs. However, the US taxpayer failed to recognize that in the process, they’ve formed a Controlled-Foreign-Corporation (CFC)[4] with its own tax rules and annual international tax filing requirements. The result: a hefty US tax penalty for noncompliance.





Recently, the IRS had an Offshore Voluntary Compliance & Income Reporting Initiative offering taxpayers a unique opportunity to step forward and address their prior year foreign bank account reporting (FBAR) deficiencies and other foreign reporting shortfalls. The program allowed for a limited look-back (from 2003-2008) and the ability to encapsulate the potential penalties assessed at up to 20% of the highest account value plus back taxes and a 20% accuracy penalty on any income not reported during that period. It ran from March 23 through October 15, 2009 and gave noncompliant taxpayers a path back into the system. The Criminal Investigation Division served as the gatekeeper and directed each application either for prosecution by the Department of Justice or to Civil Agents at the IRS. But the expiration of this program has generated questions about what taxpayers should do if they first realize their problem now. With the program finished, do any options still exist?


Fortunately, the IRS has a voluntary disclosure program which existed before the offshore initiative emerged and it’s still in effect today. However, it does not carry the same certainty in calculating the cost of re-entering the tax system. The price-tag for stepping forward has gone up.Although some have chosen to continue hiding their head in the sand, others have an urgent need to step forward. The foreign bank could have conveyed their intent to inform the US government of their account holdings.[5] Or they might just want repatriate and gain access to their own funds. Most commonly, clients just want to sleep better knowing that they are complying with the requirements of the Federal tax law.


International Tax has become a serious area of enforcement for the Treasury Department. The IRS may now be gentler and friendlier, but remember, an International Tax voluntary disclosure is not the typical run-of-the-mill Offer-in-Compromise or tax negotiation. There is no IRS Taxpayer Advocate looking to hold the client’s hand in the process. On the other side of the table is the Criminal Investigation Division and they are looking to see if they can prosecute your client. In light of the potential stakes involved, clients need to insure that their Attorney is experienced in both Tax Controversy and International Tax matters. It would be foolish to present a voluntary disclosure arguing for a reduction or elimination of a penalty while unknowingly acknowledging other penalties, errors and omissions in the exchange.



Will another compliance initiative be introduced soon? Will the terms be better then? No one knows for sure. However, I am certain of one thing. Whether it happens in one year, five years or maybe ten….at some point all global economic banking activity will be traceable. And by that time, it may be too late for noncompliant taxpayers to step forward. After all, the surest way to minimize the criminal exposure and tax punishment is to approach the IRS before they find you.



Eric L. Morgenthal, Esq., CPA, M.S. (Taxation) maintains his Tax Law practice in Smithtown, NY. He is Co-Chair of the Suffolk County Bar Association Taxation Law Committee, a member of the Nassau County Bar Associations-Tax Law Committee, the NYS Bar Association-Tax Section, the American Institute of CPA's and the IRS Liaison Committee of the American Association of Attorney-CPA's. For more information, visitwww.litaxlaw.com or e-mail Eric Morgenthal at info@litaxlaw.com.


[1] IRS Offshore Income Reporting Initiative.

[2] IRS Circular 230 sets forth additional requirements for Offshore Disclosures, i.e. notification in writing to the client of the costs and risks for failure to comply.

[3] In fact, mere signatory authority can trigger the obligation to file the required tax disclosures.

[4] IRC Sections 957, 951 and 958(b) dictate that a foreign corporation owned greater than 50% (by vote or by value) by five or fewer individuals constitutes a “controlled foreign corporation”.

[5] A Voluntary Disclosure is considered timely only if submitted prior to the IRS being notified of noncompliance by a third-party, audit or criminal enforcement action.