Unreported Foreign Income – High IRS Fines & Penalties | Case Study
Unreported Foreign Income – High IRS Fines & Penalties: It is important that taxpayers are aware of the fact that once a person is required to file a US tax return, they are required to report all of their U.S. and Foreign Income.
Unreported Foreign Income
Just because a person believes that his or her foreign income might be “minimal,” and the process of obtaining the information may be burdensome, that does not mean the income is exempt from reporting.
Moreover, if the person knows he or she has a reporting requirement but intentionally fails to file, it may lead to extensive IRS fine, penalties, and a possible criminal investigation.
“Minimal” is Relative
For example, a person with $5 million in a foreign bank account may believe that the $30,000 a year he or she earns in foreign income is negligible – whereas a person with $50,000 in an overseas foreign account earning $1,000 a year in interest would think that $30,000 a year in interest is a lot of money.
In other words, the Internal Revenue Service does not care what a person believes is considered minimal interest or minimal income – if a person earned foreign income (and is otherwise required to file a tax return), then the taxpater is required to file a tax return and disclose all of their U.S. and Foreign income.
Failure to Disclosure – Willful vs. Non-Willful
Another important issue to contend with is whether your failure to report the income was willful or non-willful. Other websites and scholars can wax poetic all day about what the definition of willful vs. non-willful means, but in reality it boils down to one key issue – Did a person knowingly or intentionally fail to disclose foreign income on a US tax return.
Foreign Bank Account Penalties
We have prepared a case study example for individuals in this type of situation, so they can better understand the scenario and how it may result in fines & penalties.
It Doesn’t Need to be a Massive Fraud
A person does not need to have “Manafort & Gates” sized accounts to find themselves subject to the same type of criminal tax investigation as these two individuals have found themselves in.
While there is definitely a Gray Area when it comes to whether a person is willful or non-willful, a common problem is that there are inexperienced attorneys taking people “Streamlined,” even when the individual is willful because they convince the client (agains the client’s better judgment, when they are in a state of panic) that because the amount of unreported income is low, it necessarily reduces the IRS Audit Risk — it doesn’t, and this is terrible advice.
All it will do is put you in harm’s way.
**This is why if you are willful, you should never submit to the Streamlined Program, under any circumstance.
For a comprehensive case on the dangers of going Streamline when you are willful, please click here.
People are Understandably Scared
In the last year alone, we have had a number of clients contact us after speaking with other (less experienced) attorneys who are telling them that just because they have a low amount of unreported income, they will qualify for the Streamlined Program since they will not be audited.
This is bad advice for the simple reason that a person does not have to be audited under the Streamlined Program specifically in order for their Streamlined Application to be audited.
There is a distinction between two potential types of audit situations:
1) The IRS Auditing an Applicant’s Streamlined Program Application for willfulness (not as common but still occurs)
2) The IRS Auditing the Applicant for non-foreign income-related issues, but the statute of limitations (usually 6 years) for the Streamlined Application has not yet expired and the IRS will examine them on the Streamline-related issues as well (a more common occurrence)
Typically, the Statute of Limitations for IRS audits is 3 years. But, if a person has more than $5,000 of unreported foreign income, the Statute of Limitations jumps to 6 years.
That means for the 3 prior years that your tax returned were not amended with your Streamlined Program application, a person may become subject to penalties on un-filed forms 8938, 5471, and other forms that were not filed in the 3 years prior to the submission of the Streamlined Application — since the 3 prior years were not amended under the Streamlined Program.
**If a person was clearly non-willful, the IRS Streamlined Program may be an excellent alternative; for anyone else who was “willful or acted with reckless disregard,” going streamlined or submitting a reasonable cause application is a terrible strategic move.
Case Study – Brian
Brian is a U.S. citizen. He was naturalized back in 2010 and originally is from Taiwan. Besides being a hard worker who earns significant income, Brian comes from a wealthy family. Over the years, his net worth has increased significantly.
Brian is 34 years old and has about $3 million (USD) in Taiwan. The money is split over various different investments, but the majority of the investments do not issue dividends, interest, or capital gains. As a result, Brian earns around $6,000 of income from foreign accounts in Taiwan.
Taiwan does not tax this type of income for Brian, since the Taiwanese Foreign Financial Institutions (FFIs) still believe Brian resides at his Taiwanese address. As a result, there are no taxes being paid in Taiwan on the earnings.
Brian Uses a CPA
In most years, Brian’s tax returns are relatively simple. He owns property in the United States, he also has one rental house, and earns around $600,000 a year in income. He is not married and has learned that paying high tax is just a part of becoming a US citizen – and he’s okay with it.
Brian uses a CPA firm is not a “Big 4” but still a relatively prestigious CPA firm. In the early years (pre-FATCA), there were no questionnaires and the CPA firm never asked Brian about his foreign accounts. It wasn’t intentional; FATCA was not yet in effect (before FATCA was in effect, most firms did not care much about the FBAR – in fact, many of them never knew about it).
Since Brian speaks perfect English and does not speak with any accent, Brian’s tax preparer just simply did not think to ask Brian about foreign accounts.
CPA Firm Begins Using a Questionnaire
In recent years, after the introduction of FATCA and a few close calls that almost resulted in the CPA firm being sued, Brian is sent a detailed written questionnaire. The CPA who emailed Brian the questionnaire explains to him that it is around 30-40 pages long and to do his best to answer the questions.
Brian had several months to answer the questionnaire, but he is busy. He launched his own consulting firm, and that is where all of his time and focus is directed towards.
Therefore, he skims through the questionnaire, signing his initials on each page (as requested by the CPA). On the bottom of the last page of the questionnaire where it asked Brian to confirm that nothing has changed in his tax situation regarding the information within the questionnaire, Brian confirms, under penalty of perjury, that his tax situation is still the same.
Brian’s CPA Prepares the Return for Brian
Brian’s CPA prepares the tax return for Brian and emails it to him for review. Brian takes a look through the return, noting that for the first time there is a schedule B included.
This is because Brian had invested in some US stock that issued dividends in the amount of $4000. In reviewing the return, Brian notices question seven on the schedule B, which is marked “No” — confirming that Brian does not have foreign accounts.
Brian knows he has foreign accounts, and he knows that he earns around $6,000 of income from abroad. Moreover, Brian’s CPA likes Brian and always tells him that if he has any questions to contact him so they can discuss it.
Instead of contacting the CPA, and against his better judgment — Brian confirms the information in the return and authorizes his CPA to file the return.
At this moment in time Brian’s intent is not to defraud the U.S. government; but that is not the standard. Brian is in the process of building his business, and he has important meetings scheduled for the rest of the week. The idea of sitting down with his CPA to discuss his tax liability is not a priority.
The problem is, from an IRS standpoint, this is a pivotal moment. Brian is aware that the IRS and his CPA wanted to know if Brian has any foreign accounts or foreign income. Brian answered No, even though he knows that is false. He understood the questionnaire from his CPA, and understood Question 7 on Schedule B.
As a result, while Brian won’t be doing a twenty-year stint in prison, if he is audited, he may be questioned about his foreign accounts.
Brian is Audited…
Brian is audited for a number of different reasons – none of them having to do with his foreign income. Rather, when Brian moved from an employee to a consultant and launched his own company, he made an incorrect late election for his S corporation (his CPA is not well-versed in corporate law).
Moreover, Brian misinterpreted section 83(b) and did not file a timely election within 30 days. Also, the IRS is questioning him about some of his deductions.
The IDR Asks About Unreported Income
An IDR is an Information Document Request and it is status quo during an audit. The individual will receive the IDR (or multiple IDRs) prior to the actual date of the audit. The purpose is so Brian can compile the necessary documents needed for the IRS agent to have the information beforehand, in preparation of the audit.
Foreign Income & Account Questions are Standard
Ever since the introduction of FATCA, it has become commonplace for the IRS to ask questions regarding foreign accounts and foreign income-even in situations in which it is not the heart of the audit. The IDR also asks Brian to provide copies of any questionnaires or other documents received from the CPA; this is also status quo.
Brian contacts his CPA to discuss the issue.
The CPA is Understandably Upset
Nobody wants to be in a situation in which they had a client who not provide them the full information regarding any type of tax matter. It puts the CPA in a tough spot because the CPA signs the return with Brian.
Therefore, the CPA cannot prevent (and would have no motivation to prevent) Brian from providing a copy of the questionnaire to the auditor. Why? Because the CPA doesn’t want to look like the CPA colluded with the client to commit some type of tax fraud.
In fact, the CPA wants Brian to provide the document, because it puts the CPA in a positive light.
What are the Penalties?
In this type of situation, where it is clear that Brian understood the questionnaire provided by the CPA and understood the questions in Schedule B, but still answered No regarding foreign income and foreign accounts – the IRS is presumably going to penalize Brian.
Moreover, since there is $6,000 of annual unreported foreign income, the audit can go back at least 6 years. If the IRS suspects fraud, there is no statute of limitations.
Streamlined and Willful
When someone enters the streamlined program when they are willful with facts such as these and an IRS agent realizes what’s going on during the audit, the person may be subject to a 100% penalty.
That is because while the willful penalty is 50% value of the account, or $100,000, whichever is greater — in a multi-year audit, the 50% can easily turn into 100% penalty. It used to be 300%, but the IRS capped it at 100%.
If you knowingly filed a Tax Return that you reviewed in which you were aware you were supposed to report your foreign accounts and did not do so, you should be very cautious entering the streamlined program. It will be nearly impossible to show that you are not at least reckless or made a willful omission.
Learn Your Options Before Acting Hastily
Before making any decision to proactively make a statement to the IRS, please be sure to speak with an experienced offshore voluntary disclosure lawyer first.
If you are found to be willful and intentionally misrepresented your case to the IRS, you may be subject to extremely high fines and penalties beyond what you may have already paid.
The following is a summary of penalties as published by the IRS on their own website:
A penalty for failing to file FBARs. United States citizens, residents and certain other persons must annually report their direct or indirect financial interest in, or signature authority (or other authority that is comparable to signature authority) over, a financial account that is maintained with a financial institution located in a foreign country if, for any calendar year, the aggregate value of all foreign financial accounts exceeded $10,000 at any time during the year. The civil penalty for willfully failing to file an FBAR can be as high as the greater of $100,000 or 50 percent of the total balance of the foreign financial account per violation. See 31 U.S.C. § 5321(a)(5). Non-willful violations that the IRS determines were not due to reasonable cause are subject to a $10,000 penalty per violation.
Beginning with the 2011 tax year, a penalty for failing to file Form 8938 reporting the taxpayer’s interest in certain foreign financial assets, including financial accounts, certain foreign securities, and interests in foreign entities, as required by IRC § 6038D. The penalty for failing to file each one of these information returns is $10,000, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return.
A penalty for failing to file Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts. Taxpayers must also report various transactions involving foreign trusts, including creation of a foreign trust by a United States person, transfers of property from a United States person to a foreign trust and receipt of distributions from foreign trusts under IRC § 6048. This return also reports the receipt of gifts from foreign entities under IRC § 6039F. The penalty for failing to file each one of these information returns, or for filing an incomplete return, is the greater of $10,000 or 35 percent of the gross reportable amount, except for returns reporting gifts, where the penalty is five percent of the gift per month, up to a maximum penalty of 25 percent of the gift.
A penalty for failing to file Form 3520-A, Information Return of Foreign Trust With a U.S. Owner. Taxpayers must also report ownership interests in foreign trusts, by United States persons with various interests in and powers over those trusts under IRC § 6048(b). The penalty for failing to file each one of these information returns or for filing an incomplete return, is the greater of $10,000 or 5 percent of the gross value of trust assets determined to be owned by the United States person.
A penalty for failing to file Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations. Certain United States persons who are officers, directors or shareholders in certain foreign corporations (including International Business Corporations) are required to report information under IRC §§ 6035, 6038 and 6046. The penalty for failing to file each one of these information returns is $10,000, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return.
A penalty for failing to file Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business. Taxpayers may be required to report transactions between a 25 percent foreign-owned domestic corporation or a foreign corporation engaged in a trade or business in the United States and a related party as required by IRC §§ 6038A and 6038C. The penalty for failing to file each one of these information returns, or to keep certain records regarding reportable transactions, is $10,000, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency.
A penalty for failing to file Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation. Taxpayers are required to report transfers of property to foreign corporations and other information under IRC § 6038B. The penalty for failing to file each one of these information returns is ten percent of the value of the property transferred, up to a maximum of $100,000 per return, with no limit if the failure to report the transfer was intentional.
A penalty for failing to file Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships. United States persons with certain interests in foreign partnerships use this form to report interests in and transactions of the foreign partnerships, transfers of property to the foreign partnerships, and acquisitions, dispositions and changes in foreign partnership interests under IRC §§ 6038, 6038B, and 6046A. Penalties include $10,000 for failure to file each return, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return, and ten percent of the value of any transferred property that is not reported, subject to a $100,000 limit.
Underpayment & Fraud Penalties
Fraud penalties imposed under IRC §§ 6651(f) or 6663. Where an underpayment of tax, or a failure to file a tax return, is due to fraud, the taxpayer is liable for penalties that, although calculated differently, essentially amount to 75 percent of the unpaid tax.
A penalty for failing to file a tax return imposed under IRC § 6651(a)(1). Generally, taxpayers are required to file income tax returns. If a taxpayer fails to do so, a penalty of 5 percent of the balance due, plus an additional 5 percent for each month or fraction thereof during which the failure continues may be imposed. The penalty shall not exceed 25 percent.
A penalty for failing to pay the amount of tax shown on the return under IRC § 6651(a)(2). If a taxpayer fails to pay the amount of tax shown on the return, he or she may be liable for a penalty of .5 percent of the amount of tax shown on the return, plus an additional .5 percent for each additional month or fraction thereof that the amount remains unpaid, not exceeding 25 percent.
An accuracy-related penalty on underpayments imposed under IRC § 6662. Depending upon which component of the accuracy-related penalty is applicable, a taxpayer may be liable for a 20 percent or 40 percent penalty.
Even Criminal Charges are Possible…
Possible criminal charges related to tax matters include tax evasion (IRC § 7201), filing a false return (IRC § 7206(1)) and failure to file an income tax return (IRC § 7203). Willfully failing to file an FBAR and willfully filing a false FBAR are both violations that are subject to criminal penalties under 31 U.S.C. § 5322. Additional possible criminal charges include conspiracy to defraud the government with respect to claims (18 U.S.C. § 286) and conspiracy to commit offense or to defraud the United States (18 U.S.C. § 371).
A person convicted of tax evasion is subject to a prison term of up to five years and a fine of up to $250,000. Filing a false return subjects a person to a prison term of up to three years and a fine of up to $250,000. A person who fails to file a tax return is subject to a prison term of up to one year and a fine of up to $100,000. Failing to file an FBAR subjects a person to a prison term of up to ten years and criminal penalties of up to $500,000. A person convicted of conspiracy to defraud the government with respect to claims is subject to a prison term of up to not more than 10 years or a fine of up to $250,000. A person convicted of conspiracy to commit offense or to defraud the United States is subject to a prison term of not more than five years and a fine of up to $250,000.