What Happens When Taxpayers Fail To Report Foreign Sources Of Income: FBARS and Form 3520

What Happens When Taxpayers Fail To Report Foreign Sources Of Income: FBARS and Form 3520

Harrington v. Comm’r, T.C. Memo. 2021-95 | July 26, 2021 | Lauber, J. | Dkt. No. 13531-18

Short Summary:  Mr. Harrington is a U.S. citizen; his wife is a dual citizen of the United States and Germany.  Mr. Harrington sold his house after meeting Mr. John Glube, a Canadian attorney for Eastern Wood Harvesters (EHW).  He then provided these proceeds—$350,000—to Mr. Glube, who deposited that amount in a Union Bank of Switzerland (UBS) account under the name of Reed International, Ltd. (the “Reed Account”).  At trial, Mr. Harrington testified that he lent this $350,000 as part of his effort to stabilize EHW, a company in which he became an employee.  Later, EHW went under due to the European Union banning the import of North American softwood products, products that EHW sold.

In 2007, the Reed Account was closed because Reed International was being dissolved.  UBS Bankers advised Mr. Harrington that the funds would be safer in a “stiftung,” a European trustlike vehicle.  Mr. Harrington agreed and the funds were transferred under the name Schroder Stiftung, a newly formed Liechtenstein entity, and were held for the benefit of Mr. Harrington and his family.

In 2009, UBS closed the Schroder Stiftung account.  Also in that year, the U.S. Department of Justice entered into a deferred prosecution agreement with UBS “based on a charge of conspiracy to defraud the United States by impending the IRS in the ascertainment, computation, assessment, and collection of income taxes[.]”  After UBS informed Mr. Harrington that the account would be closed, a UBS banker connected him with a Swiss national who advised Mr. Harrington to contribute the assets from the Schroder Stiftung account to a life insurance policy in Liechtenstein.  Mr. Harrington did so and named his wife and children as the beneficiaries.

In 2013, the life policies were canceled, and Mr. Harrington again moved the assets to an account at LGT Bank, a Liechtenstein entity, under his wife’s name.  He testified that the account needed to be in his wife’s name because “that bank wasn’t accepting U.S. clients.”

Mr. Harrington and his wife prepared and filed joint income tax returns for 2005-2010.  On these returns, they did not report any income attributable to the offshore investment vehicles discussed above.  In 2012, the IRS selected the Harringtons’ 2005-2010 returns for examination.  The IRS did so on the basis of information and documents it received from UBS pursuant to the deferred prosecution agreement.  During the examination, the Harringtons provided the IRS with amended returns for 2005 through 2010 and FBARs.  In addition, the Harringtons provided the IRS with Forms 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts, after the IRS requested these forms.

Using a sampling method analysis, the IRS determined that Mr. Harrington had received, but failed to report, $791,661 in offshore investment income during the years at issue.  The IRS also imposed fraud penalties against the Harringtons under Section 6663 for 2005-2010.

Key Issue:  Whether the IRS’ assessment of tax and fraud penalties was barred by the three-year period of limitations for assessment in Section 6501(a).

Primary Holdings

  • The IRS has established by clear and convincing evidence that the underpayments of tax for 2005, 2006, 2008, and 2009, and a portion of the underpayment for 2007, were attributable to fraud. However, because the IRS has not established by clear and convincing evidence that Petitioner underpaid his tax for 2010, he is not liable for that year’s fraud penalty, and the IRS is barred under Section 6501(a) from assessing any deficiency for that year.

Key Points of Law:

  • Section 61 provides that gross income “means all income from whatever source derived,” including gains derived from dealings in property, interest, and dividends. 61(a)(3), (4), (7).  In cases of unreported income, the IRS must establish “a minimal evidentiary foundation” connecting the taxpayer with the income-producing activity.  See U.S. v. McMullin, 948 F.2d 1188, 1192 (10th Cir. 1991).  Once the IRS has established some evidentiary foundation, the burden shifts to the taxpayer to prove by a preponderance of the evidence that the IRS’ determinations are arbitrary or erroneous.  See Erickson v. Comm’r, 937 F.2d 1548, 1551-52 (10th Cir. 1991), aff’g, T.C. Memo. 1989-552.
  • Section 6501(a) generally requires the IRS to assess a tax within 3 years after the return was filed. The period of limitations is extended to 6 years when the taxpayer omits from gross income an amount “in excess of 25% of the amount of gross income stated in the return.”  6501(e)(1)(A)(i).
  • Section 6501(c)(1) provides that, where a taxpayer has filed “a false or fraudulent return with the intent to evade tax,” there is no period of limitations and the tax “may be assessed . . . at any time.” “The determination of fraud for purposes of the period of limitations on assessment under Section 6501(c)(1) is the same as the determination of fraud for purposes of the penalty under Section 6663.”  Neely v. Comm’r, 116 T.C. 79, 85 (2001).
  • Section 6751(b)(1) provides that “[n]o penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination.” As a threshold matter, the IRS must show that it complied with Section 6751(b)(1).  See Chai v. Comm’r, 851 F.3d 190, 221 (2d Cir. 2017).  In Belair Woods, LLC v. Comm’r, the Tax Court explained that the initial determination of a penalty assessment is typically embodied in a letter by which the IRS formally notifies the taxpayer that the Examination Division has completed its work and has made a definite decision to assert penalties.  Once the IRS introduces sufficient evidence to show supervisory approval, the burden shifts to the taxpayer to show that the approval was untimely, e., that there was a formal communication of the penalty to the taxpayer before the proferred approval was secured.  Frost v. Comm’r, 154 T.C. 23, 35 (2020).
  • If any part of any underpayment of tax required to be shown on a return is due to fraud, section 6663(a) imposes a penalty of 75% of the portion of the underpayment attributable to fraud. The IRS has the burden of proving fraud, and the IRS must prove it by clear and convincing evidence.  7454(a); Rule 142(b).  To sustain this burden, the IRS must establish two elements:  (1) that there was an underpayment of tax for each year at issue; and (2) that at least some portion of the underpayment for each year was due to fraud.  Hebrank v. Comm’r, 81 T.C. 640, 642 (1983).
  • If the IRS asserts fraud for multiple tax years, the IRS must prove fraud “applies separately for each of the years.” Vanover v. Comm’r, T.C. Memo. 2012-79.  If the IRS proves that some portion of an underpayment for a particular year was attributable to fraud, then “the entire underpayment shall be treated as attributable to fraud” unless the taxpayer shows, by a preponderance of the evidence, that the balance was not so attributable.  6663(b).
  • An amended return may constitute an admission of substantial underpayment for purposes of a penalty determination. Badaracco v. Comm’r, 464 U.S. 386, 399 (1984); see also Lare v. Comm’r, 62 T.C. 739, 750 (1974) (statements made in a tax return may be treated as admissions).
  • Fraud is intentional wrongdoing designed to evade tax believed to be owing. Neely, 116 T.C. at 86.  The existence of fraud is a question of fact to be resolved upon consideration of the entire record.  Estate of Pittard v. Comm’r, 69 T.C. 391, 400 (1977).  Fraud is not to be presumed or based upon mere suspicion.  Petzoldt, 92 T.C. at 699-700.  But because direct proof of a taxpayer’s intent is rarely available, fraudulent intent may be established by circumstantial evidence.  at 699.  The taxpayer’s entire course of conduct may be examined to establish the requisite intent, and an intent to mislead may be inferred from a pattern of conduct.  Webb v. Comm’r, 394 F.2d 366, 379 (5th Cir. 1968).
  • Circumstances that may indicate fraudulent intent, often called “badges of fraud,” include but are not limited to: (1) understating income; (2) keeping inadequate records; (3) giving implausible or inconsistent explanations of behavior; (4) concealing income or assets; (5) failing to cooperate with tax authorities; (6) engaging in illegal activities; (7) supplying incomplete or misleading information to a tax return preparer; (8) providing testimony that lacks credibility; (9) filing false documents (including false tax returns); 10) failing to file tax returns; and (11) dealing in cash.  Schiff v. U.S., 919 F.2d 830, 833 (2d Cir. 1990).  No single factor is dispositive, but the existence of several factors “is persuasive circumstantial evidence of fraud.”  Vanover, 103 T.C.M. (CCH) at 1420-21.
  • A pattern of substantially understating income for multiple years is strong evidence of fraud, particularly if the understatements are not satisfactorily explained. See Vanover, 103 T.C.M. (CCH) at 1421.
  • A willful attempt to evade tax may be inferred from a taxpayer’s concealment of income or assets. Spies v. U.S., 317 U.S. 492 (1943).
  • The section 6663 penalty does not apply to any portion of an underpayment “if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to . . . [it].” 6664(c)(1).  The decision as to whether the taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances.  Sec. 1.664-4(b)(1).  Circumstances that may signal reasonable cause and good faith “include an honest misunderstanding of fact or law that is reasonable in light of all of the facts and circumstances, including the experience, knowledge, and education of the taxpayer.”  Id.

Insight:  As shown in Harrington, issues of fraud can arise when taxpayers fail to report income from foreign sources and file appropriate informational returns (e.g., FBARs, Forms 3520, etc.).  If the IRS can successful show fraud, it is permitted to open up those tax years for additional assessments, provided it can demonstrate fraud by clear and convincing evidence.

Have a question? Contact Jason Freeman, Freeman Law, Texas.

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Mr. Freeman is the founding and managing member of Freeman Law, PLLC. He is a dual-credentialed attorney-CPA, author, law professor, and trial attorney. Mr. Freeman has been recognized multiple times by D Magazine, a D Magazine Partner service, as one of the Best Lawyers in Dallas, and as a Super Lawyer by Super Lawyers, a Thomson Reuters service.
He was honored by the American Bar Association, receiving its “On the Rise – Top 40 Young Lawyers” in America award, and recognized as a Top 100 Up-And-Coming Attorney in Texas. He was also named the “Leading Tax Controversy Litigation Attorney of the Year” for the State of Texas” by AI.

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