Offshore Banking & IRS Penalties – FATCA, FBAR & DOJ Enforcement
Offshore Banking & IRS Penalties – FATCA, FBAR & DOJ Enforcement
Offshore banking in and of itself, is legal. For example, if an individual determines that they want to invest in foreign mutual funds, there is nothing wrong investing in foreign mutual funds – it is not illegal.
Moreover, if a person wants to shift assets offshore, because it generates a higher rate of return or return on investment, that is also perfectly legal.
The problem with offshore banking arises when a person wants to increase their income without paying tax or without reporting that income in the United States.
Alternatively, if a person knowingly or with reckless disregard fails to report the accounts or investments properly to the IRS, that can also result in serious consequences.
That is a form of offshore evasion or offshore tax fraud that could lead to significant fines and penalties.
Common Offshore Banking Examples
We represent people on all ends of the offshore banking spectrum, from individuals who are legitimately investing offshore, to other individuals whose investments might not be kosher.
Offshore Bank Account
When it comes to offshore bank accounts, Internal Revenue Service (IRS), Department of Treasury (DOT), and Department of Justice (DOJ) as a whole have increased enforcement of offshore reporting and offshore income reporting.
From an IRS perspective, to the average person there are two main concerns when it involves offshore bank accounts
Reporting the Offshore Bank Account
For most individuals, if they meet the threshold requirement under IRS Rules and Regulations, they may have to report their bank accounts on multiple forms each year. The two most important and most common forms are the FBAR (Report of Foreign Bank and Financial Accounts) and FATCA (Foreign Account Tax Compliance Act) form 8938.
If a person does not properly report their offshore bank accounts on these forms, the IRS can hit them with excessive fines and penalties. Even if a person was considered non-willful they could get hit with a $10,000 per account, per your penalty.
Alternatively, if the person was considered willful (a.k.a. knowledgeable or acted with reckless disregard), the penalty can be upwards of 50% value of each account per year. And, in a multiyear audit — that could quickly result in a 100% penalty.
Offshore Income Earned on the Account
Many offshore bank accounts will generate some type of interest income. Moreover, depending on whether it is a bank account, or an investment account (or hybrid), it may also generate other types of additional passive income, such as dividends and capital gains.
The reason why the IRS is coming down so hard on individuals with offshore accounts is because often times these offshore accounts do not issue a 1099. Moreover, the account may not be directly in the name of the individual. As a result, the person may be receiving income that is not being taxed.
Therefore, if a person is using offshore bank accounts and generating income (even if it is considered tax-free in the outside jurisdiction), it still must be reported on a US tax return. If for any reason it is also exempt from U.S. tax, it still needs to be included on the US tax return but then identified as tax-free income (and will usually also include reference to the Treaty section that authorizes the exclusion of the income for tax purposes).
What comes to offshore banking, a major perceived benefit our tax loopholes, but in actuality most of these loopholes do not work (or at least not necessarily in the way the investment is “sold” to the U.S. Person”)
In many countries passive income such as interest income, dividends or capital gains is not taxed. Therefore, feasibly if a non-U.S. person lives in Hong Kong and earns interest income in Hong Kong, they do not have to pay tax on it. But, if the person is a U.S. person (which includes individuals who have legal permanent residency status in the U.S. or meet the Substantial Presence Test) then they have to report their worldwide income. This includes any income that might have been earned in a otherwise tax-free jurisdiction such as passive income in Hong Kong.
A foreign trust is a bit more complex. What is important to understand is that most foreign trusts are grantor trusts, and a foreign trust that is a grantor trust is taxed to the grantor.
Foreign Trust Assignment of Income Example
David is the grantor of a foreign trust. He is a successful dude, and he makes a lot of money. David is also very close with his nephews, and his nephews are getting ready to launch their own business. David decides create a foreign trust and direct the income to his nephews, the beneficiaries.
David’s nephews are the Trust’s only beneficiaries, and likewise would be taxed at a reduced tax rate (e.g., they are not in the same tax bracket as Dave). The IRS disallows David from indirectly assigning his income byway of forming a foreign trust in order to reduce the tax rate on the income; rather, David as the grantor is taxed on the income received by the Beneficiaries..
**Having David taxed on the income can come times be seen as a benefit (aka Intentionally Defective Grantor Trust) when David doesn’t want the beneficiaries have any tax issue regarding income. But, in this type of situation wherein David wants to assign the full income to his nephews (and have them receive the income and pay tax), it’s not going to work.
Tax Havens Such as the Cayman Islands, Bahamas, Panama, etc.
In recent years, the Internal Revenue Service, Department of Treasury an Department of Justice have all made offshore tax evasion a key enforcement priority. In addition, with the introduction enforcement of FATCA (Foreign Account Tax Compliance Act), more than 100 countries and 300,000 Foreign Financial Institutions have agreed to report US account holder information to the IRS.
Thus, while offshore banking in these particular countries might have been beneficial many years ago, under most circumstances it no longer is (at least is the purpose is financial secrecy). Even if you are receiving a better rate of investment on certain investments in these countries, you will be under the microscope of the IRS, which is no fun.
In addition, there amplified reporting requirements, which if you do not meet those requirements can lead to excessive fines and penalties.
IRS Offshore Penalties
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.