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So You Have Unreported Foreign Bank Accounts & Income, Now What?

With limited exceptions, every American citizen, permanent resident and even residents for tax purposes with direct or indirect ownership or control over a foreign financial account must report those accounts on Treasury Department form TD F 90-22.1, more commonly known as the FBAR [Foreign Bank and Financial Accounts Report].

The form is due June 30 for accounts held in the previous year, and there are absolutely no extensions. Late filing will result in a $10,000 penalty unless the individual can show “reasonable cause” for being late.

Civil penalties for not filing an FBAR, reporting some but not all foreign accounts and failure to keep proper records of the accounts start at $100,000 and can easily exceed the maximum balance in the account during that year.

If the Internal Revenue Service recommends criminal prosecution, the individual can also face additional penalties up to $500,000 and 10 years in prison. Permanent residents ( i.e. green card holders), convicted of tax crimes also risk revocation of their residency. Those hoping to someday become residents for immigration purposes may have their applications denied for failure to comply with tax laws that they may already be subject to.

Those who missed the June 30 deadline for accounts held during 2009, and those with unreported foreign accounts from previous years basically have two choices — file late reports, or have their tax attorney contact the IRS and ask to make a voluntary disclosure. If the unreported accounts generated unreported income or were held by foreign corporations or trusts, amended income tax returns and additional tax filings also are required.

Some taxpayers have legitimate concerns about engaging the IRS and would be content paying a $10,000 penalty in the hopes the problem will just go away. After a certain number of years, this strategy may accomplish just that if the taxpayer’s circumstances do not support a criminal investigation. With some luck, the taxpayer won’t even be audited. The downside is that even though everything might have finally been reported, there is still criminal exposure if the government can prove the taxpayer intentionally failed to report everything as and when required.

Quiet Disclosure

The IRS is required to abate or waive the $10,000 late filing penalty if the taxpayer can show “reasonable cause” for being late. Reasonable cause is determined on a case-by-case basis, taking into account all the relevant circumstances. Generally, the most important factor is the extent to which the taxpayer tried to get it right, taking into account the taxpayer’s experience, knowledge and education.

The IRS Office of Appeals has a special track for FBAR penalty appeals so they may reviewed by FBAR experts, and outcomes can be more consistent nationwide. When the office denies a request for penalty abatement, the next stop is usually the U.S. Tax Court, where the taxpayer can have his case decided by a judge with tax expertise in a relatively informal and inexpensive forum. But the Tax Court lacks jurisdiction over FBAR penalty cases since the filing requirement administered by the IRS is part of the Bank Secrecy Act and not the Tax Code. The only option then is to pay the penalty and sue the U.S. government for a refund — a costly, risky and time-consuming process.

But abatement requests, late filings and amended returns increase the risk of being audited. During an abatement investigation or audit, the IRS will be looking for unreported income and other unfiled returns in connection with foreign companies or trusts typically used to hold foreign accounts.

The usual offshore asset protection trust structure, for example, brings with it several IRS reporting obligations including the FBAR. In any case, the foreign account is likely to have generated taxable income even if no withdrawals were made. Evidence of a purposeful failure to report income could result in a referral to the IRS criminal investigation division, increased civil penalties and a determination of whether a case should be sent to the Justice Department for criminal prosecution.

Voluntary Disclosure

For those whose circumstances are less than ideal or who just want to feel more comfortable about their decision to come clean, the IRS’s voluntary disclosure program is usually the way to go. The reduced penalties offered under last year’s partial amnesty are no longer available, but qualifying for and successfully completing a voluntary disclosure will still virtually eliminate the chance of criminal prosecution. Of course, this program is not available to those involved in other nontax criminal activities or whose funds came from illegal sources.

Qualifying for acceptance into the voluntary disclosure program primarily consists of reporting before being investigated; otherwise, the disclosure won’t be considered voluntary. Time is of the essence because even an internal investigation unknown to the taxpayer can disqualify them. Another important criterion is swearing to fully cooperate with the IRS, so preparing to present the facts in the best possible light and evaluating all the legal ramifications before making the disclosure is critical.

A tax attorney typically will hire an accountant to review the client’s books and records, and calculate the best- and worst case impact of amending several years of tax returns. It’s important to note, however, that there is no federal accountant client privilege in criminal matters. In fact, CPAs can be compelled to testify against their clients, and all their records and e-mails may be subpoenaed as evidence should the government decide to prosecute. A tax attorney can hire the CPA to assist with any voluntary disclosure under a special arrangement where the accountant’s work and confidential communications with the client cannot be later used as evidence against him.

Published as “Failure to file FBAR comes with risk of stiff penalties” by the Daily Business Review, July 26, 2010. Reprinted with permission from Incisive Media.