Tax Notes Quotes 3 Caplin Tax Controversy Attorneys on the IRS's Aggressive FBAR Enforcement

Practitioner frustration with how the IRS is implementing exams for foreign bank account reporting may soon reach a boiling point. At the heart of that frustration is an agency that, according to practitioners, is inflexible, heavy-handed with penalties, and presuming willful violations of reporting obligations at nearly every turn. Members of Caplin & Drysdale’s Tax Controversies Team – Mark E. Matthews and Scott D. Michel from the firm’s Washington, D.C., office and Zhanna A. Ziering in the firm’s New York office – offer their analysis of and solutions to this important issue.

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Mark Matthews [] noted that while some taxpayers who entered the IRS offshore disclosure programs could be designated as the “classic offshore tax cheat” — a U.S. citizen creating an offshore account to avoid taxes — that is not the case for numerous other taxpayers with offshore reporting issues. That latter group includes recent immigrants or U.S. citizens living abroad, often for most of their lives.

The line between negligence and willfulness to evade taxes seems to have been forgotten, Matthews added. “It would be good for the Service to get some checks and balances here and higher-level approvals prior to asserting willful FBAR penalties,” he said. “Historically, this has gotten out of whack. . . . For years, the penalties were relatively modest.”

According to Matthews, the IRS is increasing FBAR audits and its use of information document requests to seek FBAR information, even for charities with foreign operations. “The institutional message seems to be that if you can just develop an FBAR compliance issue, then you can get the taxpayer on their heels, hostage to a massive penalty, even though unrelated to any tax issue,” he said. “In fact, the FBAR penalties often dwarf any tax issue. They seem to be surfing for these late FBARs, unrelated to tax administration.”

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A Huge Hammer

Scott Michel [] agreed, noting that the IRS has myriad other remedies to deal with money hidden in unreported offshore accounts, including prosecution for evasion or filing false returns and imposition of civil fraud penalties. But none of those remedies comes with a 50 percent penalty based on asset size, he said.

“To insert [FBAR penalties] into the tax regime, where Congress has . . . laid out a panoply of remedies for people who have evaded their taxes through offshore structures or accounts, and then to detonate that weapon in the middle of all those other remedies, has produced in some cases wildly incongruous and disproportionate results,” Michel said.

For several decades dating back to the 1980s, the relatively few FBAR cases brought involved “outright, unequivocal tax evasion,” according to Michel. That started to change about a decade ago with the tax-evasion scandal involving Swiss Bank UBS, when more benign actors began to be swept up and the civil FBAR penalty became a “go-to” punishment, he said.

“When you are in the enforcement world, if Congress gives you a toy . . . and you don’t use it, you’ve got to be worried they may take it away,” Matthews said. “It was no accident that they came up suddenly with this 20 percent penalty, which sort of walked, talked, and quacked like an FBAR penalty, but it wasn’t the full 50 percent,” he added, referencing the first version of the OVDP in 2009. The OVDP could have just as easily instituted penalty amounts of triple the tax due, Matthews said, but then it wouldn’t have looked like an FBAR penalty.

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Further evidence that FBAR penalties are often too heavy-handed may come from criminal FBAR cases, according to Matthews. In 98 percent of those cases, sentences are being adjusted downward from where sentencing guidelines would place them, he said. Defendants with eight- or nine-figure balances in foreign accounts are receiving sentences of less than a year or even probation, he noted, with more than 50 percent of the defendants receiving the latter. “We think that the judges are being influenced by the incredibly steep FBAR penalties, often 10 times the tax loss to the government,” he hypothesized.

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Eviscerating the Willfulness Standard

That precedent “essentially makes a box checked on Schedule B almost a de facto presumption of willfulness,” said Zhanna A. Ziering of Caplin & Drysdale, referencing Line 7a of Form 1040’s Schedule B, which asks a taxpayer if she has a financial interest in a foreign account. Although checking no on Schedule B is not enough to establish willfulness, per the Internal Revenue Manual, Ziering said it is not difficult for the IRS to find other factors to get to willfulness.

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Ziering said she believes that agents are following a checklist in order to assert willfulness, while other taxpayer-favorable circumstances, such as an account generating very low interest, are being ignored by agents and Appeals.

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Money Chase

“The enforcement efforts are extremely aggressive and appear to the taxpayers like searches for revenue by the IRS, not an effort to administer the tax laws fairly,” said Matthews. “It is causing bad habits for an agent class who are prohibited by law from being motivated or evaluated by revenue results.”

As an example, Matthews described a case of his in which the IRS is considering a multi-million-dollar penalty on an FBAR that was filed three months late, even though the related audit revealed a tax refund was due.

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According to Ziering and Michel, civil fraud penalties are also being implemented in tandem with FBAR penalties, and often in inappropriate circumstances. Failure-to-file penalties for foreign information returns have increased in frequency as well, and reasonable cause statements that would usually excuse such failures are receiving greater IRS scrutiny, they said.

“If the IRS feels any hesitation or pushback on the FBAR penalty where it uncharacteristically develops a level of doubt to go on a willful basis, they’ll sort of make up for it,” Michel said. “They’ll say . . . if you’re not going to agree on the FBAR penalty, maybe instead of doing that where we’ve got to send it to the Department of Justice, we’ll impose a series of cascading 5 percent or 25 percent or 35 percent penalties in connection with your foreign trust. Or if you have a dozen [controlled foreign corporations], we’ll hit you with $10,000 a year for each one back to the beginning of time.”

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Wizards Behind the Curtain

Several practitioners identified the IRS’s use of technical advisers as a primary source of their audit strife. Michel acknowledged a need for national consistency in how the FBAR penalty is applied, but he argued that the role of technical advisers is seemingly to implement a “secret body of law” into which practitioners have little insight.

Matthews agreed. “The line agents frequently come back with harsher positions and point to the technical advisers as the reason,” he said. “Out of thousands of matters, we’ve never encountered an agent coming back with a lower penalty and saying the technical adviser had suggested that was more appropriate.”

Matthews said the technical advisers comprise eight to 10 individuals who have established themselves as FBAR experts.

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Matthews wondered whether better training for technical advisers and managers, including limits on when penalties are implemented, would be useful, adding that the technical advisers might benefit from further IRS supervision at the national level. If there is to be an FBAR program at the IRS, it needs to be grounded in the history and purposes of the FBAR form, which were as much about anti-money-laundering and terrorist financing as tax administration.

Michel theorized that “institutional inertia” might also encourage the IRS to avoid making hard decisions on willfulness. Because collecting the FBAR penalty involves the DOJ filing a civil suit, Michel believes the IRS may choose what it sees as a “safer” course of deciding to assess a willful FBAR penalty, figuring the DOJ will make the ultimate call on whether to file suit or settle.

Matthews concurred. “On FBAR penalties outside OVDP, the IRS attitude seems to be to impose the penalty and then let DOJ sort it out and determine whether to pursue the matter as a willful penalty or cut a deal,” he said.

What’s the Solution?

“If you overuse that toy, if you become more aggressive and even tend toward abusive penalties, Congress will eventually take it from you or restrict it,” Matthews said about the possibility of the FBAR penalty pendulum swinging back.

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Adding a proportionality requirement, a finding of a substantial interest in tax administration, or other specific enforcement objectives before assessing willful FBAR penalties could also go a long way toward addressing practitioner concerns, Michel said. Those measures could lead to a more rigorous examination of facts, he argued, and limit imposition of the willful FBAR penalty to narrower circumstances that might warrant such an extreme and punitive sanction.

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Michel said he hoped Bedrosian might serve as a wake-up call to the IRS, pointing to the court’s decision to directly contrast its taxpayer to the taxpayers in McBride and Williams. The government presumably strategized to litigate those other cases first precisely because they presented unsympathetic taxpayers and could establish law favorable to the IRS, according to Michel and Matthews.

“What [Bedrosian] did, in finding the absence of willfulness in part because the facts were not as bad as in McBride and Williams, turns this classic regulatory enforcement strategy on its head. The IRS runs the risk that one or two other judges will start to make the same analysis and the case law begins to lean toward more mitigating factors,” Michel said. There is “great irony” in that, he said.

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Excerpt taken from the article “News Analysis: Is the IRS Turning the Screws on Taxpayers in FBAR Exams?” by Andrew Velarde for Tax Notes.