The recent Tax Court decision in Farhy demonstrates that clever and novel arguments can carry the day in complex tax litigation matters. In that case, the taxpayer stipulated that he: (1) had Form 5471 filing obligations for his 2003 through 2010 tax years; (2) participated in an illegal scheme to reduce the amount of income tax that he owed; and (3) did not have reasonable cause for abatement of the civil penalties assessed against him for his multi-year failure to file Forms 5741. Indeed, the sole contention raised by the taxpayer in Farhy was a statutory interpretation argument: according to the taxpayer, the IRS simply did not have the authority to assess the civil penalties against him in the manner in which they were assessed.
In a division opinion, the Tax Court agreed with the taxpayer’s contention. Although Farhy requires a careful read of various relevant statutory provisions within and outside the Internal Revenue Code of 1986, as amended (the “Code”), the decision is worth a close read. In the meantime, below are some high points from the decision.
Facts In Farhy
The taxpayer in Farhy owned 100% interests in two foreign corporations. Because of these interests, the taxpayer was required to file timely and complete IRS Forms 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations, for his 2003 through 2010 tax years. The taxpayer failed to do so.
Under section 6038(b)(1), the IRS can impose civil penalties against taxpayers who fail to file Forms 5471. Generally, the civil penalties are $10,000 per failure to file; however, these civil penalties may be increased to $50,000 if the IRS notifies the taxpayer of the failure to file, and the taxpayer continues not to file a timely and complete Form 5471 by a prescribed period of time. In this latter case, the IRS may impose increased “continuation penalties” of $50,000 in addition to the initial $10,000 civil penalty.
In the federal income tax world, there are effectively two functions within the Internal Revenue Service (“IRS”). First, the IRS examines tax years and tax returns to determine whether the taxpayer has reported the correct amount of tax liability. In this so-called “assessment phase,” the IRS may propose additional income tax owed beyond the amount reported on the taxpayer’s tax return.
Second, if the taxpayer and the IRS agree on the amount of taxes owed or the taxpayer can no longer challenge the amount of tax, the IRS may engage in actions to collect the federal income taxes that are due and not paid. In this so-called “collection phase,” the IRS may file notices of federal tax lien or propose levies to try to collect the unpaid tax debts.
Congress also recognizes the distinction between the assessment phase and the collection phase in the Internal Revenue Code (the “Code”). With respect to the assessment phase, Congress permits the IRS, as a very general matter, to make an assessment of additional income tax within three years of when the tax return is filed.[i] Barring some exceptions, the IRS may not make an assessment of tax outside this three-year window. With respect to the collection phase, Congress permits the IRS, again as a very general matter, to take collection actions within ten years after an assessment has been made.[ii]
But every general rule has its exceptions, and the assessment phase is no different. Under the governing provisions of section 6501 of the Code, for example, the IRS may make an assessment of additional tax at any time if the taxpayer files a fraudulent tax return.[iii] Similarly, section 6501 provides that the general three-year period to make an assessment does not run at all if the taxpayer has failed to file an income tax return.
Much of the current litigation between taxpayers and the United States has centered on the definition of willfulness or whether the non-willful FBAR penalty should apply on a per year or per account basis. Accordingly, there have been very few cases covering other requirements the United States must show to meet its burden of proof to impose FBAR penalties.
Tax professionals should expect that to change in the future. Indeed, a recent Order from the Southern District of California serves as a reminder that the United States must show various other requirements outside the willful context.[i] In Aroeste, the dispute between the taxpayer and the United States was an ostensibly simple one: whether a tax treaty between the United States and Mexico could serve to abrogate the definition of a “United States person” under the FBAR-reporting rules.
The Meaning of “United States Person”
Only “United States persons” have obligations to file FBARs. Of course, this includes those born in the United States who have not taken effective actions to expatriate. This also includes, however, “a resident of the United States,” which is defined further in the Title 31 regulations as “an individual who is a resident alien under 26 U.S.C. § 7701(b) and the regulations thereunder but using the definition of ‘United States’ provided in 31 C.F.R. § 1010.100(hhh) rather than the definition of ‘United States’ in 26 C.F.R. § 301.7701(b)-1(c)(2)((ii).”[ii]
The interplay between section 7701(b) (located in Title 26 of the Code) and 31 C.F.R. § 1010.350(b) (located in Title 31 of the Code) is somewhat complex. Under section 7701(b), a non-U.S. citizen is treated as a “resident alien” if he or she is a “lawful permanent resident of the United States at any time” during a calendar year.[iii] Moreover, an individual is a “lawful permanent resident” if he or she has been “lawfully accorded the privilege of residing permanently in the United States as an immigrant in accordance with immigration laws” and if “such status has not been revoked (and has not been administratively or judicially determined to have been abandoned).”[iv] In common parlance, a “lawful permanent resident” is often referred to as having a “green card.”
However, section 7701 confirms that so-called “green card” status can terminate—at least for federal tax purposes—if an individual “commences to be treated as a resident of a foreign country under provisions of a tax treaty between the United States and the foreign country, the individual does not waive the benefits of such treaty applicable to residents of the foreign country, and the individual notifies the Secretary of the commencement of such treatment.[v]
The Discovery Dispute in Aroeste
Recently, there seems to be some confusion regarding section 643(b) of the Internal Revenue Code of 1986, as amended (the “Code”), and its application to trusts. Indeed, that provision—particularly to those not well-versed in federal trust taxation—can confound many. This article seeks to dispel some of the complexity surrounding section 643(b).
The Taxation of Trusts Generally
The federal income taxation of trusts and beneficiaries puzzles even tax professionals. Does the trust pay tax? What about the beneficiaries? What is the difference between a grantor trust and a complex trust? The questions can become endless.
I don’t seek to answer all those here. But I will try to provide some background on certain trust concepts so that you are more familiar with them. First, let’s start off with general concepts associated with the taxation of trusts. In Subchapter J of the Code (which addresses the taxation of trusts), it states in the very first provision: “[t]he tax imposed by section 1(e) shall apply to the taxable income of . . . any kind of property held in trust[.]”[i] That same provision further clarifies that this income includes: (i) income accumulated in trust (even contingent income or income for the benefit of unascertainable persons); (ii) income that a trustee is required distribute to the beneficiaries; and (iii) income that the trustee has discretion to retain in trust.[ii] Accordingly, as a general rule, a trust pays income tax on its activities.
Trusts come in many variations, rendering them often difficult for non-attorneys to follow and comprehend. Indeed, this variation can often be seen in the nomenclature used for trust arrangements, which includes terms such as grantor and non-grantor, simple and complex, revocable and irrevocable, and discretionary or non-discretionary. In many instances, trusts may also have provisions designed to protect the trust principal from third-party creditors—such as spendthrift clauses—making trusts even more difficult for a layman to understand.
Of course, the many variations of trusts also give rise to income tax reporting complexity. Although the IRS has readily recognized that there is nothing unlawful in establishing a trust, it has also actively communicated that it will police trust arrangements to ensure that trusts and trust beneficiaries are complying with the federal income tax and reporting laws. Accordingly, taxpayers establishing trusts—and particularly those where the drafter intends to charge a large fee—should have the trust agreement carefully scrutinized by a tax professional to make sure that the trust complies with these tax laws.
The Bank Secrecy Act (“BSA”) requires a person to file a Report of Foreign Bank and Financial Accounts (“FBAR”), Financial Crimes Enforcement Network (“FinCEN”) Report 114, when that person has a financial interest in, or signature or other authority over, at least one foreign financial account and the aggregate value of all foreign financial accounts exceeds $10,000. While often mistaken for a “tax” form, the FBAR is not technically a tax form. Although the FBAR filing requirement has been around since the 1970s, the Federal Government has significantly stepped up enforcement—and penalty assessment—in more recent years.
FinCEN requires a FBAR filing when the aggregate balance amount of a person’s foreign financial account(s) totals more than $10,000 at any point during the year. A person must list the maximum amount in each account for the year when filing the FBAR. It is irrelevant whether a person has one or ten foreign financial accounts. If the aggregate balance in those accounts exceeds $10,000 at any point during the year, if only for one day, then a FBAR must be filed the following year. The due date for the FBAR for 2016 is April 15, 2017. For years prior to 2016, the due date was June 30 of the following year.
FBAR penalty procedures under Title 31 are similar to federal tax penalty procedures under Title 26. Under both Title 31 and Title 26, the IRS must make a timely assessment of the penalty prior to initiating collection action. However, the two procedures diverge somewhat with respect to collection remedies available to the government. This article discusses FBAR penalty collection procedures and provides some insights on issues that tax professionals should consider when representing taxpayers who have FBAR penalty assessments.
FBAR Collection Procedures
Prior to beginning a discussion of the FBAR collection procedures, it is important to remember that the IRS has six (6) years to make a timely FBAR assessment. This six-year period begins on the date in which the FBAR should have been filed and runs regardless of whether an FBAR has been filed at all.
Because FBAR penalties are located in Title 31, provisions therein govern collection. Under Title 31, the government may collect FBAR penalty assessments through various means including: (i) administrative (or tax refund) offset (collectively, “administrative offset”); (ii) wage garnishment; and/or (iii) litigation.[i]
Enacted as part of the CARES Act in 2020, the Employee Retention Credit (ERC) provided much-needed relief to employers during the COVID-19 pandemic, particularly those who were on the fence as to whether they would maintain their payroll. However, with the COVID-19 pandemic largely behind us now, the IRS has taken steps to begin to identify whether employers who claimed the ERC on prior year employment tax returns were actually entitled to the credit and, if so, whether they properly reduced their wage expense deductions for the employment periods in which the credit was claimed.
More recently, the IRS has indicated that it is now aware of third-party ERC promoters who may have nudged employers to claim the ERC even when those employers did not qualify for the credit. On October 19, 2022, the IRS issued an announcement in the Internal Revenue Bulletin, warning employers of these schemes. To the extent the IRS identifies an employer who improperly claimed the ERC when it otherwise did not qualify, the IRS has indicated that it intends to reclaim the credits with penalties and interest. In addition, given the warning shot fired at third-party promoters of ERC schemes, such promoters are now on notice that the IRS may attempt to impose civil penalties or criminal sanctions against them as well under various federal statutes that prohibit unscrupulous promoter and tax-return preparation activities. See, e.g., I.R.C. § 6694 (understatement penalty for unreasonable position or willful or reckless conduct); § 6700 (promoting abusive tax shelters); § 6701 (aiding and abetting an understatement of tax liability).
What 2022 Has Taught Us About FBAR Willfulness
The Bank Secrecy Act requires certain taxpayers to submit timely FBARs to the United States reporting their interests in foreign accounts. If a taxpayer has an FBAR filing requirement and misses it, the taxpayer can be liable for civil penalties of up to 50% of the account balances or $100,000, if the taxpayer is willful. On the other hand, if a taxpayer misses the FBAR filing deadline due to non-willfulness, the civil penalties are limited to $10,000 per violation, subject to reasonable cause.
What is the difference between willfulness and non-willfulness? Good question. Because the concept of willfulness can include recklessness—and the scope of non-willfulness includes negligence and inadvertence—the line between willful and non-willful is not an easy one to define. Accordingly, federal courts have been left to grapple with the distinction.
So far in 2022, federal courts have issued five important cases on willfulness. Each of these is discussed more below.
Taxpayers routinely ask me if they can go to jail for not paying their federal income taxes. Admittedly, the bar is not that high for felony tax evasion—the government must only prove three elements: (i) willfulness; (ii) the existence of a tax deficiency; and (iii) an affirmative act constituting evasion or attempted evasion of tax.[i] Because the existence of a tax deficiency is generally not a big issue in non-payment cases, the government is left focusing on the remaining two elements: the taxpayer’s state of mind and evidence of affirmative acts.
Although the bar for federal tax evasion is low, the government does not have the resources nor the will to go after all evasion non-payment cases. Instead, the government carefully picks and chooses the cases it believes to have the best chances for obtaining criminal convictions. Predictably, this is where the types and quantities of affirmative acts come into play. Because the recent Sixth Circuit decision in Pieron[ii] shows this well, that decision is the topic of this article.