Trends in International Tax Reporting, Failure to File Penalties by Joel G. Young, JD, LLM
Posted on May 02, 2023
U.S. tax law requires taxpayers to annually report many of their cross-border activities, including the existence of foreign bank accounts, interests in foreign companies and large gifts from foreign persons. While most of these reports are merely informational and have no bearing on taxpayers’ actual U.S. tax liabilities, failing to file the appropriate forms or filing late can result in significant penalties assessed by the IRS automatically (and often erroneously.) Not only can the dollar amount of these penalties be very burdensome, but taxpayers often find it challenging to convince the IRS to abate these fines, even when taxpayers can show reasonable cause for the delinquent filing. However, recent court cases addressing late filings of various international information returns have ruled in taxpayers’ favor.
Reports of Foreign Bank and Financial Accounts (FBARs)
The Bank Secrecy Act of 1970 requires U.S. persons to report their interests in foreign bank accounts when the aggregate value of those accounts exceeds $10,000 at any time during the calendar year. To satisfy this requirement, taxpayers must annually file FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR), which reports all the required information for each of the taxpayers’ foreign bank accounts on one form. A willfull failure to file an FBAR carries a penalty equal to the greater of 50 percent of the unreported account balance at the time of the violation or $100,000. By contrast, a $10,000 penalty applies to a non-willful (i.e., unknowing or unintentional) failure to file. It is this failure-to-file penalty and the statutory language behind it that have been the subject of debate for many years.
Tax practitioners have long advocated that the IRS should assess FBAR penalties on a per-form basis (i.e., a different penalty for each unfiled FBAR) due to the statutory language that U.S. persons are required to “file reports” and that the penalty is triggered by “not filing a report.” Conversely, the government has maintained that the $10,000 penalty should be assessed on a per-account basis (i.e., a penalty for each account that goes unreported) because it deems the failure to file willful (i.e., knowingly or intentionally) on a per-account basis, even though that penalty is addressed separately under the statute from non-willful violations. The U.S. Supreme Court recently settled this debate in the matter of Bittner v. United States.
Upon learning that he should have reported his foreign bank accounts, Alexandru Bittner, a dual citizen of Romania and the U.S., filed FBARs covering 272 bank accounts during the years 2007 through 2011. The government fined Bittner $10,000 per unreported account during the five years, which totaled $2.72 million. Bittner challenged the penalty in court on the basis that it should have been assessed on a per-form basis under the plain language of the statute, which would reduce his penalty to $50,000 ($10,000 per report X 5 years.)
Ultimately, a divided Supreme Court sided with Bittner, ruling that the penalty for non-willful violations must be based on the number of reports, not the number of accounts. The Court based its reasoning on a “plain language” interpretation of the statute and added that such interpretation was supported by the legislative history and intent behind the statute and that the government’s interpretation could lead to a situation where a non-willful violation resulted in a more significant penalty than a willful violation. The Bittner ruling is a significant win for taxpayers, and absent a statutory amendment, per-form penalties will be the standard for non-willful FBAR filing violations.
Informational Returns of U.S. Persons with Respect to Certain Foreign Corporations (Form 5471)
While the Bittner ruling limited the penalty amount, the Tax Court ruled in Farhy v. Commissioner that the IRS simply lacked the authority to assess the penalty at issue.
Under Sec. 6038(b) of the Internal Revenue Code (IRC), failing to file Form 5471 results in an initial $10,000 penalty plus an additional $10,000 per month, up to a maximum of $50,000. When Alon Farhy failed to file Form 5471 for tax years 2003 to 2010, the IRS assessed the Sec. 6038 penalties, which Farhy attempted to appeal directly to the IRS. When those efforts failed, he took the matter to the Tax Court, which ultimately ruled in his favor based on a very technical procedural argument.
In short, the Tax Court reasoned that IRC Sec. 6201, which authorizes the IRS to assess taxes, interest, additional amounts, additions to tax and “assessable penalties,” does not automatically apply to all penalties. “Assessable penalties” to which Sec. 6201 applies are specifically identified in subchapter B of Chapter 68 of the IRC, whereas Sec. 6038 pertaining to Form 5471 is found in Chapter 61 and does not contain its own provision authorizing penalty assessment. Consequently, the Tax Court held that the IRS cannot automatically assess the penalty but may be able to collect it through a civil court action.
While this ruling is specific to the Form 5471 penalty, its implications are expansive. Other Chapter 61 penalties the IRS may no longer assess automatically include those for several international returns, including Forms 5472, 8865, 8938, 926, 3520, and 3520-A, all of which carry significant penalties for late filing. The IRS is expected to appeal the Tax Court’s ruling to the Circuit Court. However, if affirmed, a massive change to the way the IRS pursues these penalties will occur.
Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts (Form 3520)
The matter of Wrzesinski v. U.S. dealt with Krzysztof Wrzesinski, a Polish-American citizen and Philadelphia police officer who received large gifts in 2010 and 2011 from his mother after she won the Polish lottery. On multiple occasions, Wrzesinski’s asked his accountant, who is also an IRS enrolled agent, if he needed to report the gifts. Each time the accountant incorrectly advised Wrzesinski that no filing was required. Years later, when Wrzesinski sought to gift some of the funds back to family in Poland, he learned that his accountant was wrong and that he should have reported the foreign gifts to the IRS on Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts.
Wrzesinski subsequently retained a tax attorney and applied for penalty relief through the IRS’s “Delinquent International Information Return Submission Procedures” (“DIIRSP”) program, which allows taxpayers to come into compliance with their reporting obligation when they can demonstrate “reasonable cause” for the untimely filing. Not only did the IRS reject Wrzesinski’s claim that he was entitled to reasonable cause relief because he relied on the advice of his tax accountant, but it also assessed $207,000 of penalties on the basis that ignorance of the law is not an excuse for failing to fulfill a tax obligation. While this is generally true, a long line of case law has found that taxpayers’ reasonable reliance on the advice of an accountant or attorney constitutes reasonable cause for penalty relief. Wrzesinski appealed to the IRS’ Appeals Division, which reduced the penalty to $41,500. With all administrative remedies exhausted, Wrzesinski paid the reduced penalty but filed a lawsuit seeking a refund based on his original claim that he had reasonably relied on his tax advisor’s advice.
Fortunately for Wrzesinski, the IRS conceded the case and agreed to refund the remaining penalties to him. Unfortunately for the tax community at large, no legal precedent has been set addressing the IRS’s ongoing reluctance to grant reasonable cause relief, even when taxpayers have a factual and legal position. Instead, the IRS’s first impulse seems to be to deny abatement. Hopefully, the IRS will reassess its internal policies and procedures with respect to reasonable cause relief so that it does not waste its resources and those of the taxpayers to the correct result in the future.
About the Author: Joel G. Young, JD, LLM, provides tax consulting, income and estate tax planning and compliance services for high-net-worth families and closely held businesses with international operations. He can be reached at the CPA firm’s Boca Raton, Fla., office at (561) 361-2000 or firstname.lastname@example.org.