Willfulness, FBAR penalties and the OVDP

This is a scary time for taxpayers who have undisclosed offshore accounts. More and more countries are signing FATCA agreements with the IRS. Swiss banking secrecy is a thing of the past. Taxpayers who have undisclosed accounts are justifiably frightened that the IRS or DOJ will learn about their accounts.

Horror stories about taxpayers facing incredible fines abound, like the story of Mary Estelle Curran. Curran inherited Swiss accounts when her husband passed away in 2000. The accounts were never disclosed to the IRS. The IRS estimated that she evaded around $667,000 in taxes. Her penalty? Over $26 million. 

Stories like Curran’s can cause fear and uncertainty for taxpayers with undisclosed offshore accounts.

As a means for taxpayers to avoid these kinds of penalties, and to avoid potential criminal punishments, the IRS offers the Offshore Voluntary Disclosure Program (OVDP). However, the OVDP is not for everyone. The decision to enter the OVDP should be informed by analyzing the risks involved in not entering the program. What is the risk that the taxpayer, with the taxpayer’s unique facts, will face these kinds of penalties? The lower the risk, the less compelling the OVDP.

The risk of facing these penalties depends on how likely the taxpayer will be found to have “willfully” failed to disclose offshore accounts on FBARs. While “willfully” may seem like a high standard, recent cases show that the IRS and DOJ are adopting a more aggressive posture regarding willfulness and they are winning in court.

The ‘draconian’ FBAR penalty regime

Taxpayers with offshore accounts who did not fulfil the obligation to report income potentially face a host of penalties that include fines, penalties and jail time. However, the failure to report income and pay taxes is generally not the biggest concern for taxpayers; the prime concern is the failure to simply disclose offshore accounts’ existence on FBARs. Despite the magnitude of the penalties for failing to report and pay taxes on offshore income, what really strikes fear into taxpayers is the “draconian” FBAR penalty regime.

The FBAR penalty regime identifies two different types of failures to file FBARs: (1) non willful failures and (2) willful failures. Whether the failure to file was willful or non willful determines the severity of the penalty.

If the failure to file was non willful, there are no criminal penalties and the potential civil penalties are limited to $10,000 per violation. Additionally, if the IRS determines that the failure to file was due to reasonable cause, then the IRS will not impose any penalty. Where things get rough is when the government determines that the failure to file was willful.

The civil penalty for willfully failing to file an FBAR is up to the greater of either $100,000 or 50 percent of the balance of the offshore account, per violation. The criminal penalties can go as high as $500,000 and carry up to 10 years in prison.

Avoiding willful FBAR penalties is one of the prime benefits taxpayers receive by joining the OVDP. The OVDP is the latest in a series of voluntary disclosure initiatives the IRS adopted to encourage taxpayers with undisclosed accounts to become compliant.

Under the OVDP, taxpayers who failed to report offshore income and disclose offshore accounts file eight years of correct tax returns, pay certain tax-related penalties and interest, and file eight years of complete FBARs. The IRS assures taxpayers that by joining the OVDP, taxpayers will gain protection from criminal prosecution. Additionally, in lieu of potentially facing willful civil FBAR penalties and losing 50 percent of undisclosed accounts’ balances per violation, taxpayers entering the OVDP pay a standard penalty that is generally considerably less than 50 percent per account per violation.

However, the benefits of peace of mind and certainty come at a significant cost. Entering the OVDP requires preparing up to eight years of tax returns. These can include foreign tax credits, Controlled Foreign Corporations (CFCs), and Passive Foreign Investment Company valuations (PFICs). All of these can add considerably to the costs of preparing the returns. Then there are the transaction costs of compiling the OVDP submission and shepherding the submission through the various channels at the IRS until finally receiving a closing agreement.

In light of the considerable cost of entering the OVDP, it is clear that the OVDP is not the right option for everyone. It depends on if the benefit, i.e., reducing the risk of jail and very expensive penalties, outweighs the costs, i.e., the transaction costs of preparing the tax returns and entering the OVDP. In general, the more a taxpayer’s situation can be presented as willful, the greater the benefit of entering the OVDP. Conversely, the more a taxpayer’s situation can be presented as non-willful, the smaller the benefit of entering the OVDP.
 

FBAR-Compliance

Determining willfulness in the FBAR context

Willfulness is a measure of someone’s state of mind, and, as such, it is a notoriously difficult metric to determine and apply. In the criminal tax context of Title 26, the Supreme Court has developed a line of jurisprudence directly addressing the question of willfulness. Historically, the court understood that willfulness incorporated an element of mens rea. At least as far back as 1933 the court included “bad faith or evil intent” in tax willfulness. Thus, in order for the government to convict a taxpayer of a willful violation, the government had to meet the high burden of proving that the taxpayer had bad faith or evil intent. In Bishop, the court explained that including the mens rea element in the government’s burden of proving willfulness implements Congress’ desire to punish the “purposeful tax violator.”

Despite this cogent justification for including a mens rea element, the court’s jurisprudence took a radical turn in 1976 in Pomponio and the mens rea element was essentially removed from tax willfulness. This made it easier for the government to show willfulness. The court currently understands tax willfulness as an “intentional violation of a known legal duty.” This same definition of willfulness in criminal tax cases also applies to criminal FBAR cases. Even though tax cases are in Title 26 and the FBAR statutes are in Title 31 in the Bank Secrecy Act (BSA) laws, the court in Ratzlaff affirmed that the definition of willfulness in the BSA is the same as it is in Title 26, i.e., an “intentional violation of a known legal duty.”

Even without a mens rea element, the bar for establishing willfulness seems to remain high. In order to prove willfulness, the government still has to prove two elements: (1) the defendant knew about the law, and (2) the defendant knew that the law applied in her case.

A high bar for establishing willfulness diminishes the risk that a taxpayer will be found willful and, in turn, diminishes the benefit of joining the OVDP. However, willfulness may not be that hard for the government to show and there is good reason for offshore account holders to be concerned with willful FBAR penalties.

Willful doesn’t always mean knowing; it can even mean reckless

Taxpayers with offshore accounts should not rely too much on the high willfulness standard for FBAR violations. Taxpayers are ill-advised to cavalierly avoid the OVDP by assuming that their conduct will not be found willful. In the criminal context, willful does not mean knowingly. A taxpayer who acts with “willful blindness,” even though it was not knowingly, is considered to have acted willfully. Courts have justified lowering the willful standard to be more inclusive by arguing that “deliberate ignorance and positive knowledge are equally culpable.” Courts also understand that the purpose of including willfulness in tax crimes is simply to protect taxpayers who “exercise reasonable care” and to punish those who did not. Indeed, the First Circuit even stated that the standard for criminal willfulness is actually lower than willful blindness.

In Aversa, the court stated held that the standard for criminal willfulness is “violation of a known legal duty or in consequence of a defendant’s reckless disregard of such a duty.”  Thus, even taxpayers who are reasonably confident that their conduct does not amount to “knowing” may be subject to criminal FBAR penalties. In light of this, the OVDP can be an attractive option.

The OVDP becomes even more attractive when considering the recent civil FBAR cases. In the civil context, the state of mind that qualifies as willful is fairly easy to identify, if not apply. It is clear that a taxpayer is willful for civil FBAR penalties if she acts with at least “reckless disregard,” even though she did not act knowingly, or even with willful blindness. This is a relatively low standard. Thus, taxpayers whose conducts rise above merely “inadvertently ignoring” the FBAR requirement are in danger of facing willful civil FBAR penalties of 50 percent of the accounts’ value per violation. For these taxpayers, the OVDP can be a highly attractive option despite its expense.

Proving willfulness

Regardless of whether the willfulness standard is understood to mean knowingly, willful blindness or recklessness, the question of willfulness often boils down to the taxpayer’s specific facts and how they are presented. Of course, each situation is unique and while the court has compiled an impressive list of conduct that evidences willfulness, there are no hard and fast rules. However, there is one pernicious fact that features regularly in the FBAR context – Question 7 on Schedule B.

Question 7 on Schedule B asks taxpayers a simple, but important question. During the taxable year, did you have an interest in, or another specified relationship with, a foreign account? Question 7 also directs taxpayers to see the instructions regarding FBAR requirements that are included with the instructions for Schedule B. (In 2011, the IRS modified question 7 to specifically ask if the taxpayer is required to file an FBAR.)

Question 7 potentially effects taxpayers risk analyses in two ways. First, Question 7 and the instructions to Schedule B clearly reference the existence of the FBAR requirements. Thus, is a taxpayer who was ignorant of the FBAR requirement because she failed to read Question 7 willfully blind or at least reckless?

Question 7’s second impact stems from the declaration that taxpayers make when signing their Forms 1040: “Under penalties of perjury, I declare that I have examined this return and accompanying schedules and statements.” Thus, a taxpayer who signed her returns has declared, under penalties of perjury, that she examined Schedule B. Does this mean that she has actual knowledge of the FBAR requirement?

The IRS seemed incline to side with taxpayers in both of these questions. In Internal Revenue Manual (IRM) Section 4.26.16.4.5.3 the IRS indicates that signing tax returns alone does not mean that the taxpayer has knowledge of the FBAR requirement. The IRS also states there that even if the taxpayer knew about Schedule B, mere failure to disclose the existence of accounts on Question 7 alone does not even constitute willful blindness.

However, the IRM is not binding law and recent FBAR cases have shown that this IRM Section provides scant relief to taxpayers with offshore accounts. In Williams, the Fourth Circuit held that a taxpayer’s signature on the return “is prima facie evidence that he knew the contents of the return . . . and at a minimum line 7a’s directions to ‘[s]ee instructions for exceptions and filing requirements for Form TD F 90–22.1’ puts [taxpayers] on inquiry notice of the FBAR requirement.” The court held that failure to further ascertain if there is an FBAR requirement constitutes at least willful blindness.

The court in McBride went even further. There, the court held that “[a] taxpayer’s signature on a return is sufficient proof of a taxpayer’s knowledge of the instructions contained in the tax return form and in other contexts.”

The court acknowledged the existence of case law holding that signing a return does not impute knowledge of the returns contents to the taxpayer. However, the court understood that those cases refuse to impute knowledge of the numbers and information supplied by the taxpayer and the return preparer. However, knowledge of the questions and instructions contained on the forms themselves is imputed to the taxpayer who signed the return.

Taxpayers conducting their risk analyses may be tempted to dismiss these FBAR cases as having particularly bad facts that do not apply to them. It is true that these cases did involve facts unfavorable to the taxpayer. However, the IRS and DOJ have consistently taken a tough line on taxpayers who did not enter the OVDP.

The latest sign of the government’s hard line is a case that was tried in May 2014, United States v. Zwerner. In this case, the government assessed four willful civil FBAR penalties against Mr. Zwerner, for ’04, ’05, ’06 and ’07. This seemed to be a radically aggressive move to the tax community. Previously, the general assumption was that the “worst case” scenario was only one civil FBAR penalty of 50 percent. However, that assumption is now wrong. Taxpayers may face willful FBAR penalties for multiple years. Indeed, on May 28, 2014, the jury verdict found Zwerner willful for three years, essentially upholding the IRS’s application of three civil FBAR penalties. After Zwerner, the “worst case” in taxpayers’ risk analysis became considerably worse. Additionally, Zwerner lacked many of the bad facts that the other FBAR cases had. Taxpayers, therefore, should not dismiss the IRS and DOJ enforcement action lightly.

Conclusion

Ultimately, the decision to enter the OVDP or not depends not on risk, but on risk tolerance. A taxpayer with facts that almost certainly are not willful, but who is completely risk averse will find the certainty offered by the OVDP well worth the cost. However, in order for taxpayers to accurately assess what the OVDP offers to them personally, they need to be informed of the risks of not entering the program. The risks of FBAR violations, both criminal and willful, are subject to7 the willfulness standard. However, as recent cases show, willfulness may be easier for the government to show than taxpayers think.
 

 

Regulation-swiss_flag_mug_dollar