New IRS Procedures for Undisclosed Foreign Accounts Demand Immediate Consideration

The Internal Revenue Service is engaged in a large-scale enforcement effort aimed at owners of foreign financial accounts (including bank, securities and other types of financial accounts) who have not reported the accounts to the IRS or who have not included the interest (or other income) from the accounts in taxable income on their U.S. tax returns. Account owners who are in this situation should immediately seek legal counsel.

The IRS has the authority to impose significant civil and criminal penalties on such account owners, but it has announced a new voluntary disclosure initiative under which the account owners or those U.S. persons with the requisite authority over the foreign accounts may be able to reduce the civil penalties substantially and avoid criminal prosecution. Although the program is intended to continue through September 23, 2009, we recommend immediate action. If the IRS receives specific information about the account before a disclosure is made, the account owner or U.S. persons with the requisite authority over the foreign account will not be eligible for the program, and may therefore be subject to considerably harsher penalties.

U.S. Taxpayer Reporting Requirements for Foreign Accounts

The problem starts with owning a foreign account (or having authority over such an account). Some taxpayers operate under the belief that earnings generated in a foreign account are not subject to U.S. taxation. This is not true. The general rule is that U.S. citizens are taxable on their worldwide income. While there is nothing wrong with having a foreign account, the earnings on the account are fully taxable and must be included on federal income tax returns.

Moreover, there are requirements to disclose the existence of the account. First, the individual income tax return (Form 1040, Schedule B) on which interest and dividends are reported asks: "At any time during [the year], did you have an interest in or a signature or other authority over a financial account in a foreign country, such as a bank account, securities account, or other financial account?" This question requires a "yes" or "no" answer and the identification of the country if there is an account. Second, U.S. persons who own or have signatory or other authority over foreign accounts worth more than $10,000 in the aggregate for the year are also required to file an annual Form TD F 90-22.1 Report of Foreign Bank and Financial Accounts (FBAR). In general, these returns are due on June 30 each year and are filed separately from the tax return. However, we understand that the IRS will soon announce that it will not impose penalties for late FBAR filings for the 2008 FBAR due June 30, 2009, if: (1) the taxable income has been properly reported on an income tax return, and (2) the FBAR is filed by September 23, 2009.

The requirement to file an FBAR is imposed on a "U.S. person." For FBARs due through June 30, 2009, a U.S. person is: (a) a citizen or resident of the United States; (b) a domestic partnership (or LLC); (c) a domestic corporation; or (d) a domestic estate or trust. (The instructions to the FBAR due June 30, 2009, would have included any person "in and doing business in the United States," but the IRS withdrew that instruction after receiving numerous complaints. The IRS is currently considering changes in the FBAR instructions for next year.)

There are serious civil and criminal penalties for filing a false income tax return (i.e., a return not reporting foreign income or not disclosing the existence of a foreign account). The penalties for failing to file an FBAR are also serious. The civil penalties alone can be 50 percent of the highest value of the account balance for each year the FBAR is not filed (in the case of a willful violation). Thus, this penalty can exceed the entire account balance after two years.

Voluntary Disclosure Process for Foreign Accounts

To encourage taxpayers to disclose the existence of foreign accounts, and to provide consistency in the handling of disclosures, the IRS adopted a voluntary disclosure process on March 23, 2009, that will apply through September 23, 2009. The voluntary disclosure process has three key elements:

1. Taxpayers need to pay the tax and interest on the omitted income going back six years (taxable years 2003–2008).
2. A penalty (generally 20 percent) will be added to the unpaid tax liability. No reasonable cause exception will be applied.
3. The penalty for failing to file the FBAR will be 20 percent of the highest balance in the account at any time during the last six years (instead of 50 percent for each annual failure to file).

The IRS offer is only available to taxpayers who would qualify under the traditional IRS voluntary disclosure practice. This means that an account owner or U.S. person with the requisite authority over a foreign account may not participate in the program if the IRS has previously given notice of, or initiated, an examination of the taxpayer. It also precludes participation if the IRS already has specific information about the existence of a nondisclosed account.

On May 6, 2009, the IRS released additional details regarding the process. One detail, which surprised most practitioners, is that the IRS is requiring that the disclosure be made to a special agent in its Criminal Investigation Division. Previously, a number of taxpayers had made so-called "quiet disclosures" by mailing to the IRS amended income tax returns and by filing delinquent FBARs. The IRS has now disapproved of this practice, and any taxpayer who previously made such a disclosure must contact a special agent if he wants to participate in the new voluntary disclosure program.

On the other hand, if the taxpayer previously reported and paid tax on all taxable income, such as the interest earned on the foreign account, but simply failed to file the FBAR—a rather common occurrence—the IRS position is that the taxpayer should file the delinquent FBARs with the IRS office in Detroit according to the FBAR instructions and file a copy of those delinquent FBARs with the IRS office in Philadelphia and attach a statement explaining why they are late. The IRS says it will not impose a penalty in this situation.

Owners of Foreign Accounts Should Act Immediately

The IRS is aggressively seeking information relating to foreign accounts through negotiations with, and summonses issued to, financial institutions, as well as treaty negotiations with foreign governments. In addition, as part of the voluntary disclosure process, it has been asking account owners questions designed to identify bankers, accountants or lawyers who may have assisted in establishing foreign accounts, presumably so that the IRS can then investigate and acquire the names of additional account holders from such persons (or for other enforcement purposes). The IRS also has established a Whistleblower Office and is offering rewards for information leading to the assessment of additional taxes.

All of the above suggests that a U.S. person who has failed to pay tax on foreign account income or failed to file an FBAR should act quickly if participation in the voluntary disclosure program is desired. Because of the need in most cases to interface with the IRS Criminal Investigation Division, the retention of legal counsel is recommended.

Although participating in the new IRS program will be expensive, it may be far less expensive in the long term than not participating. Moreover, despite the fact that the IRS cannot formally guarantee that there will be no prosecution (because decisions to prosecute are made by the Department of Justice), as a practical matter taxpayers who make voluntary disclosures generally are immunized from criminal prosecution.