International information return penalties are civil penalties assessed by the IRS against a United States person for failing to timely file complete and accurate international information returns required by specific Internal Revenue Code (IRC) sections.  Those information returns cover a broad spectrum of reporting obligations, and include IRS Forms 5471, 5472, 3520, 3520-A, 8938, 926, 8865, 8621, 8858 and others.

U.S. taxpayers are required to report their worldwide income. International information returns require taxpayers to report information relating to foreign assets, interests in various entities, certain transactions, and information relating to foreign-sourced income.

As a general matter, international information returns are required for entities or events that the taxpayer has “control” over or that the taxpayer has the power or authority to administer or that the taxpayer is beneficiary of.  However, the reporting obligations under the Code or substantially more expansive and cover various other reporting matters.

Returns that are filed but that are not substantially complete and accurate are considered “un-filed” and may result in penalty assessments.

Certain international information returns are also considered un-filed if the taxpayer does not provide required information when requested by the IRS, and penalties may be assessed even if the required return has been submitted.

A U.S. person may have several reporting obligations for a particular tax year and thus may have exposure to multiple penalty assessments.  Penalties may apply to each information return that was required to be filed for each year.

Common Terms

U.S. Person—Generally, the term “U.S. person” includes citizens or residents of the United States, domestic corporations, domestic partnerships, U.S. estates, or trusts. Trusts are considered U.S. persons only if they satisfy a two-part test: (1) a court within the U.S. is able to exercise primary supervision over the administration of the trust, and (2) one or more U.S. persons have the authority to control all substantial decisions of the trust. See IRC 7701(a)(30)(E).

Assessable Penalties—Assessable penalties are not subject to the IRC’s deficiency procedures set forth in IRC 6211 through IRC 6215. Assessable penalties are required to be paid upon notice and demand. For assessable penalties, there is no notice requirement prior to assessment. As a general rule, penalties are assessable without deficiency procedures when they are not dependent upon the determination of a deficiency. If a penalty is not dependent upon the determination of a deficiency, then the penalty may not be subject to deficiency procedures. See Smith v. Commissioner, 133 T.C. 424, 429 (2009).

Statute of Limitations—The IRS maintains that penalties that are not considered taxes generally have no statute of limitation for assessment.  As a result, it maintains that the statute of limitations may remain open for such items—in many cases, for an unlimited number of years.   Penalties related to returns, however, are generally treated as taxes and governed by the statute of limitation for assessment.  Section 6501(c)(8) often governs the statute of limitations with respect to international information returns.

Reasonable Cause—Reasonable cause is a defense to most, but not all, of international information return penalties. However, the IRS maintains that taxpayers who conduct business or transactions offshore or in foreign countries have a responsibility to exercise ordinary business care and prudence in determining their filing obligations and other requirements.  The IRS’s position is that it is not reasonable or prudent for taxpayers to have no knowledge of, or to solely rely on others for, the tax treatment of international transactions.

The IRS takes the position that reasonable cause does not apply to penalties assessable after the taxpayer was notified of the requirement to file or was requested to provide specific required information.

The fact that reasonable cause relief was granted to the related income tax return does not automatically provide relief for the failure to timely file the information returns.

The IRS takes the position that reasonable cause should not be granted to a taxpayer merely because of the following:1) A foreign country would impose penalties on them for disclosing the required information,

1. A foreign trustee refuses to provide them information for any other reason, including difficulty in producing the required information or provisions in the trust instrument that prevent the disclosure of required information, or
2. The taxpayer relied on another person to file returns. The IRS believes that it is the taxpayer’s responsibility to ensure that all returns are filed timely and accurately.

Appeal Rights—Appeals currently provides a prepayment, post assessment appeal process for all international penalties.  Appeals also provides for an accelerated process for certain international penalties.

Information Returns—Information returns generally must be attached to the related income tax return. In addition, certain information returns must also be separately filed with the IRS campus site identified in the instructions for such form. Any information return required to be attached to the related income tax return is due on the due date of the income tax return, including extensions. Form 3520, Annual Return to Report Transactions With Foreign Trust and Receipt of Certain Foreign Gifts, and Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner are not required to be attached to an income tax return.

Form 8278—International penalties are assessed on Form 8278, Assessment and Abatement of Miscellaneous Civil Penalties, with a Form 886-A, Explanation of Items, attached to identify what penalty is being assessed, how the penalty was calculated, and why reasonable cause was not applicable.

Penalty Tax Adjustments—Some of the IRC penalty sections include penalty adjustments to income tax or penalties that are based on the amount of income tax. Penalties based on the amount of income tax, income tax deficiency, adjustments to taxable income, tax credits, or income tax computations are return-related penalties and are covered by deficiency procedures. Return-related penalties must be included in an examination report.

Related Statute for Assessment—The IRS takes the position that IRC section 6501(c)(8) extends the statute for assessment on the related income tax return regarding items related to the information required to be reported until 3 years after the information required by IRC 6038, IRC 6038A, IRC 6038B, IRC 6038D, IRC 6046, IRC 6046A, and IRC 6048 is furnished to the IRS. Thus, failing to file information returns may affect the statute for assessment on the related income tax return.

While IRC 6501(c)(8) may apply to extend the limitations period for assessment on the related tax return, there is a reasonable cause exception.

Other Penalties

Criminal penalties may apply to U.S. and foreign taxpayers who willfully fail to file a return (IRC 7203) or file a false or fraudulent return (IRC 7206 and IRC 7207).

IRC 6662(e), Substantial Valuation Misstatement Under Chapter 1, and IRC 6662(h), Increase in Penalty in Case of Gross Valuation Misstatements, may be applicable in the international reporting context.

In addition, the following reporting and filing requirements are subject to failure to deposit penalties and are applicable to Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons.

31 U.S.C. 5321—Report of Foreign Bank and Financial Accounts (FBAR), FinCEN Form 114 (as of September 30, 2013)

Generally, a U.S. person having one or more foreign accounts with aggregate amounts in the accounts of over $10,000 any time during the calendar year is required to maintain records and submit FinCEN Form 114 by the due date in the following year.

Penalties for a failure to file may apply in the following situations:

• Under 31 U.S.C. 5321(a)(5)(B) for any non-willful violation of the recordkeeping and filing requirements under 31 U.S.C. 5314.
• Under 31 U.S.C. 5321(a)(5)(C) for any willful violation of the recordkeeping and filing requirements under 31 U.S.C. 5314.
• Under 31 5321(a)(6)(A) for negligently failing to meet the filing and recordkeeping requirements for financial institutions or non-financial trades or businesses.
• Under 5321(a)(6)(B) for a pattern of negligent violations of any provision of 31 U.S.C. 5311-5332 by financial institutions or non-financial trades or businesses.

See 31 U.S.C. 5321(b) for the statute of limitations on assessment and collection.

Assessment Procedures for Penalties Not Subject to Deficiency Procedures

The IRS maintains that deficiency procedures under Subchapter B of Chapter 63 (relating to deficiency procedures for income, estate, gift, and certain excise taxes) generally do not apply to international information return penalties discussed herein.

Requirement to File—The IRS makes a determination whether an information return was required to be filed. The IRS believes that the following types of information support a presumptive requirement to file an international information return:

• Testimony of the taxpayer or other reliable persons.
• Late filed return.
• A filed return indicating that information returns are due for prior or subsequent periods or for related entities.
• A filed return that does not include all the required information or the required supporting information was not provided when requested.
• Information that the taxpayer has control over, is receiving benefits from, or is receiving distributions or income from an account in the name of a foreign entity.
• Statement in the name of the foreign entity addressed to the taxpayer.
• Information received from promoter investigations that indicates the taxpayer owns or has control over a foreign entity, is controlled by a foreign entity, or meets another filing requirement.

Generally, the information returns or statements are required to be attached to the related income tax return and the due date is the same as the related income tax return (including extensions). Specific exceptions, however, may apply.

Some returns have dual filing requirements and the penalty can apply for failure to file either return.

Notice Letter Provisions—Penalties under IRC 6038, IRC 6038A, IRC 6038D, IRC 6677, and IRC 6679 have “notice letter” provisions and a continuation penalty may apply. The provisions state the following:

• If the required returns are not filed or the required information is not received on or before the 90th day after the notice letter is issued, additional penalties of $10,000 per month (or fraction thereof) may be assessed.
• The penalty continues to increase until the required information is received, or the information returns are filed, or the maximum penalty is assessed.
• The maximum penalty amount for the continuation penalty is different for each IRC section and is referenced in each penalty section.

Reasonable Cause—The IRS takes the position that reasonable cause does not apply to the initial penalty in some relevant IRC sections.

Many of the penalty sections, however, have specific provisions for reasonable cause.

The IRS takes the position that a taxpayer’s repeated failure to file does not support testimony that the taxpayer demonstrated normal business care or prudence for the older, late-filed years.

Continuation Penalties—A continuation penalty is associated with several penalties and can either be assessed at the same time as the initial penalty or at a later date. There are maximum limits to some continuation penalties while others have no limitation on the amount that can be assessed.

Approval—IRC 6751 requires that managers approve penalties prior to assertion. IRS guidance requires that managers approve the case control, sign the notice letters, and approve the penalty by signing Form 8278 prior to closing the penalty case file.

Penalty Assessment–Form 8278, Assessment and Abatement of Miscellaneous Civil Penalties

If a continuation penalty is proposed in conjunction with an initial penalty, a separate Form 8278 is required for each type of penalty, for each tax year, and for each IRC section for which a penalty assessment is made.

IRC 6038—Information Reporting With Respect to Foreign Corporations and Partnerships

IRC 6038(b) provides a monetary penalty for failure to furnish information with respect to certain foreign corporations and partnerships.

The filing requirements apply to both entities which are treated as associations taxable as corporations or as partnerships under Treas. Reg. 301.7701-3.

Reporting and Filing Requirements

Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, and Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships, are used for reporting purposes.

Foreign Corporations—IRC 6038(a) and Treas. Reg. 1.6038-2(a) require a U.S. person to furnish information with respect to certain foreign corporations. The required information includes foreign corporation entity data, stock ownership data, financial statements, and intercompany transactions with related persons. Other provisions that must be considered include the following:

• A taxpayer meets the requirement by providing the required information on a timely filed Form 5471. A Schedule M attached to Form 5471 is used to report related party transactions. The information is for the annual accounting period of the foreign corporation ending with or within the U.S. person’s taxable year. Form 5471 is filed with the U.S. person’s income tax return on or before the date required by law for the filing of that person’s income tax return, including extensions. See Treas. Reg. 1.6038–2(i).
• Regulations provide exceptions for attaching the Form 5471 to the related income tax return when the return is filed by another shareholder. The non-Form-5471-filer must attach a statement to his or her income tax return with the name and TIN of the person filing the Form 5471. If the required return was not filed timely by the other party, the penalty applies. No statement is required to be attached to tax returns for persons claiming the constructive ownership exception. See Treas. Reg. 1.6038-2(j)(2).
• Dormant Corporations. Proc. 92-70 provides for summary reporting of dormant corporations. By using the summary filing procedure, the filer agrees that it will provide any information required within 90 days of being asked to do so on audit. The monetary penalty or the foreign tax credit reduction can be imposed if the information is not provided within the 90 days.

Foreign Partnerships—IRC 6038(a) and Treas. Reg. 1.6038-3(a) require a U.S. person to furnish information with respect to certain foreign partnerships. The required information includes foreign partnership entity data, ownership data, financial statements, and intercompany transactions with related persons. The information is furnished to the IRS as follows:

• A taxpayer meets the requirement by providing the required information on a timely filed Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships.
• Schedule N, attached to Form 8865, is used to report related party transactions. The information is for the annual accounting period of the foreign partnership ending with or within the U.S. person’s taxable year.
• Form 8865 is filed with the U.S. person’s income tax return on or before the date required by law for the filing of that person’s income tax return, including extensions. See Treas. Reg. 1.6038-3(i).

Penalty Computation

Initial Penalty—The initial penalty is $10,000 per failure to timely file complete and accurate information on each Form 5471 or Form 8865. The penalty is assessed for each form (of each foreign corporation or partnership) for each year that was not timely filed with complete and accurate information.

Continuation Penalty—If any failure continues more than 90 days after the day on which the notice of such failure was mailed to the taxpayer (90-day period), additional “continuation” penalties are generally applicable.  The continuation penalty is $10,000 for each 30-day period (or fraction thereof) during which such failure continues after the expiration of the 90-day period. The maximum continuation penalty for IRC 6038(b) is $50,000 per required Form 5471 or Form 8865.

Thus, the maximum total penalty under IRC 6038(b) is $60,000 per Form 5471 or Form 8865 required to be filed per year (an initial penalty maximum of $10,000 plus the continuation penalty maximum of $50,000 per return).

Of course, criminal penalties may also be applicable to U.S. and foreign taxpayers who willfully fail to file a return (IRC 7203) or file a false or fraudulent return (IRC 7206 and IRC 7207).

Reasonable Cause

Initial Penalties—To demonstrate that reasonable cause exists, a taxpayer should make an affirmative showing of the facts that demonstrates reasonable cause.  Taxpayers are strongly encouraged to engage legal counsel both for attorney-client privilege reasons and for purposes of providing a penalty defense submission that complies with IRS procedures and substantive legal requirements.  For a failure to file Form 5471, the written statement must contain a declaration that it is made under the penalties of perjury. Additional information required by IRS regulations is available as set forth below:

1. Form 5471 see Treas. Reg. 1.6038-2(k)(3).
2. Form 8865 see Treas. Reg. 1.6038-3(k)(4).

Continuation Penalty—The IRS maintains that there is no reasonable cause exception for this penalty.  Freeman Law disagrees with this position.

The IRS maintains that first-time abatement (FTA) penalty relief generally does not apply to event-based filing requirements such as with Form 5471.

IRC 6038(c)—Reduction of Foreign Tax Credit

IRC 6038(c) provides for a reduction in foreign tax credits for a failure to furnish information with respect to a controlled foreign corporation (see IRC 957) or a controlled foreign partnership that is required to be filed under IRC 6038.

The foreign tax credit reduction is limited to the greater of $10,000 or the income of the foreign entity for the applicable accounting period.

Not every controlled foreign entity carries a foreign tax credit to the U.S. income tax return. 

Coordination With IRC 6038(b). The amount of the IRC 6038(c) penalty is reduced by the amount of the dollar penalty imposed by IRC 6038(b).

Penalty Computation

Initial Penalties:

• Application of IRC 901—The amount of taxes paid or deemed paid by the U.S. person is reduced by 10 percent.
• Application of IRC 902 and IRC 960—The amount of taxes paid or deemed paid by each of the U.S. person’s controlled foreign corporations is reduced by 10 percent. The 10 percent reduction is not limited to the taxes paid or deemed paid by the foreign corporation(s) with respect to which there is a failure to file information but applies to the taxes paid or deemed paid by all foreign corporations controlled by that United States person.

Continuation Penalties—If such failure continues for more than 90 days after the day on which the notice of such failure was mailed to the taxpayer (90-day period), an additional reduction of 5 percent of the taxpayer’s foreign tax credit is applied for each 3-month period, or fraction thereof, during which such failure continues after the expiration of the 90-day period.

Limitation—The amount of the foreign tax credit reduction for each failure to furnish information with respect to a foreign entity may not exceed the greater of the following:

• $10,000, or
• The income of the foreign entity for its annual accounting period with respect to which the failure occurs.

Reasonable Cause

Initial Penalties— To demonstrate that reasonable cause exists, a taxpayer should make an affirmative showing of the facts that demonstrates reasonable cause.  Taxpayers are strongly encouraged to engage legal counsel both for attorney-client privilege reasons and for purposes of providing a penalty defense submission that complies with IRS procedures and substantive legal requirements.  For failure to file Form 5471, the written statement must contain a declaration that it is made under the penalties of perjury. Additional information is available for the following:

• Form 5471 see Treas. Reg. 1.6038-2(k)(3).
• Form 8865 see Treas. Reg. 1.6038-3(k)(4).

Continuation Penalty—The IRS maintains that there is no reasonable cause exception for this penalty.

IRC 6038A(d)—Information Reporting for Certain Foreign-Owned Corporations

IRC 6038A provides a penalty for certain foreign-owned domestic corporations that fail to report required information or to maintain records.

Reporting and Filing Requirements

IRC 6038A(a) and Treas. Reg. 1.6038A-2 generally require that a reporting corporation report detailed information regarding each person who is a related party and who had any transaction with the reporting corporation during the taxable year, including, but not limited to the following:

1. Name,
2. Business address,
3. Nature of business,
4. Country in which organized or resident,
5. Name and address of all direct and indirect 25-percent shareholders,
6. Name and address of all related parties with which the reporting corporation had a reportable transaction,
7. Nature of relationship of each related party to the reporting corporation, and
8. Description and value of transactions between the reporting corporation and each foreign person who is a related party.

Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business (Under Sections 6038A and 6038C of the Internal Revenue Code), is required to be filed as an attachment to the taxpayer’s U.S. income tax return by the due date of that return, including extensions. If the reporting corporation’s income tax return is not timely filed, Form 5472 nonetheless must be timely filed at the IRS campus where the return is due.  In such case, when the income tax return is ultimately filed, a copy of Form 5472 is required to be attached.

Note that a separate Form 5472 must be filed with respect to each related party that has a reportable transaction with the reporting corporation.

A taxpayer is also required to maintain relevant records to verify the correct tax treatment of transactions with related parties. See IRC 6038A(a) and Treas. Reg. 1.6038A-3.

Exceptions.  The following exceptions apply:

• A reporting corporation that, along with all related reporting corporations, has less than $10,000,000 in U.S. gross receipts for a taxable year is not subject to the specific record maintenance requirement of Treas. Reg. 1.6038A-3 or the authorization of agent requirement of Treas. Reg. 1.6038A-5 for such taxable year. See Treas. Reg. 1.6038A-1(h).
• If the total value of all gross payments (both made to and received from) foreign related parties (including the value of transactions involving less than full consideration) with respect to related party transactions for a taxable year is not more than $5,000,000 and is less than 10 percent of its U.S. gross income, the reporting corporation is not subject to the record maintenance requirement and the authorization of agent requirement for those transactions. See Treas. Reg. 1.6038A-1(i).

These exceptions apply only to the IRC 6038A record maintenance requirements and the authorization of agent requirement. These exceptions do not apply to the reporting requirements for Form 5472 and the general record maintenance requirements of IRC 6001.

Reporting Corporation—For purposes of IRC 6038A, a reporting corporation is a domestic corporation that is 25 percent (or more) foreign-owned.  A corporation is 25-percent foreign-owned if it has at least one direct or indirect 25-percent foreign shareholder at any time during the taxable year.

In addition, a foreign corporation engaged in a trade or business within the U.S. at any time during a tax year is a reporting corporation.  Reg § 1.6038A-1(c)(1).

25 Percent Foreign-Owned—A corporation is 25 percent foreign-owned if it has, at any time during the taxable year, at least one direct or indirect 25 percent foreign shareholder (a foreign person owning at least 25 percent of the total voting power of all classes of stock of such corporation entitled to vote or the total value of all classes of stock of such corporation). The attribution rules of IRC 318 apply, with modifications. See IRC 6038A(c)(5).

Attribution under section 318. For purposes of determining whether a corporation is 25-percent foreign-owned and whether a person is a related party under section 6038A, the constructive ownership rules of section 318 apply, and the attribution rules of section 267(c) also apply to the extent they attribute ownership to persons to whom section 318 does not attribute ownership. However, “10 percent” is substituted for “50 percent” in section 318(a)(2)(C), and Section 318(a)(3)(A), (B), and (C) is not applied so as to consider a U.S. person as owning stock that is owned by a person who is not a U.S. person. Additionally, section 318(a)(3)(C) and §1.318-1(b) are not applied so as to consider a U.S. corporation as being a reporting corporation if, but for the application of such sections, the U.S. corporation would not be 25-percent foreign owned.

Related Party—The term “related party” means:

• Any direct or indirect 25 percent foreign shareholder of the reporting corporation;
• Any person who is related (within the meaning of IRC 267(b) or IRC 707(b)(1)) to the reporting corporation or to a 25 percent foreign shareholder of the reporting corporation; and
• Any other person who is related within the meaning of IRC 482 to the reporting corporation.

Foreign Person—For purposes of IRC 6038A, the term “foreign person” generally means:

• Any individual who is not a citizen or resident of the United States;
• Any individual who is a citizen of any possession of the United States and who is not otherwise a citizen or resident of the United States;
• Any partnership, association, company, or corporation that is not created or organized in the United States or under the law of the United States or any State thereof;
• Any foreign trust or foreign estate, as defined in IRC 7701(a)(31); or
• Any foreign government (or agency or instrumentality thereof).

Records

Generally, the records that must be maintained pursuant to IRC 6038A are required to be maintained within the U.S. However, a reporting corporation may maintain such records outside the U.S. if such records are not ordinarily maintained in the U.S. and if within 60 days of the request to produce them the reporting corporation makes the records available to the Service, or brings the records to the U.S. and complies with the notice requirements under Treas. Reg. 1.6038A-3(f)(2)(ii).

Satisfying the Records Requirements—Generally, a taxpayer meets the requirement by complying with the IRS’s request for books, records, or documents.

Penalty Computation

Initial Penalty—The initial penalty for a reporting failure is $10,000 for each failure during a taxable year of a reporting corporation to:

• Timely file a separate Form 5472 with respect to each related party with which it had a reportable transaction during such taxable year,
• Maintain the required records relating to a reportable transaction, or
• In the case of records maintained outside the U.S., meet the non-U.S. record maintenance requirements.

Continuation Penalties—If any failure continues more than 90 days after the day on which the IRS mails notice of such failure to the taxpayer (the 90-day period), additional “continuation” penalties may apply. The continuation penalty is $10,000 for each 30-day period (or fraction thereof) during which such failure continues after the expiration of the 90-day period.

Unlike the initial penalty, if both a reporting failure and a maintenance failure continue with respect to the same related party, separate continuing penalties may be asserted by the IRS (i.e., for a total of $20,000 each month).

Under certain circumstances, the IRS may impose an additional penalty for a taxable year if, at a time subsequent to the assessment of the initial penalty, a second failure is determined and the second failure continues after notification. See Treas. Reg. 1.6038A-4(d)(2) and Treas. Reg. 1.6038A-4(f) Example (2).

Reasonable Cause

Initial Penalty— To demonstrate that reasonable cause exists, a taxpayer should make an affirmative showing of the facts that demonstrates reasonable cause.  Taxpayers are strongly encouraged to engage legal counsel both for attorney-client privilege reasons and for purposes of providing a penalty defense submission that complies with IRS procedures and substantive legal requirements.

Treas. Reg. 1.6038A-4(b)(2)(ii) states that reasonable cause should be applied liberally when a small corporation had no knowledge of the IRC 6038A requirements, has limited presence in (and contact with) the U.S., promptly and fully complies with all requests to file Form 5472, and promptly and fully complies with all requests to furnish books and records relevant to the reportable transaction.

A “small corporation” for purposes of this section is defined as a corporation whose gross receipts for a taxable year are $20,000,000 or less.

There is not a small corporation exception for filing Form 5472.  All corporations are subject to filing requirements of Form 5472 (if otherwise applicable).

Continuation Penalty—Generally, if there is reasonable cause for a failure to file or maintain records, the IRS maintains that the latest date that reasonable cause can exist is 90 days from the date of notification of the failure by the Service. See Treas. Reg. 1.6038A-4(b)(1).

IRC 6038A(e)—Noncompliance Penalty for Certain Foreign-owned Corporations

IRC 6038A provides that a foreign related party is required to authorize the reporting corporation to act as its limited agent for purposes of an IRS summons regarding transaction(s) with the related party. IRC 6038A further provides that a reporting corporation is required to substantially comply in a timely manner to an IRS summons for records or testimony relating to a transaction with a related party. The penalty for failure to authorize an agent or for failure to produce records is set forth in IRC 6038A(e)(3).

Reporting and Filing Requirements

A taxpayer meets the requirement by providing an executed “Authorization of Agent” form within 30 days of request by the Service or, in the case of production of records, by complying with the request for books, records, or documents. The penalty will  not be imposed if a taxpayer quashes a summons other than on grounds that the records were not maintained as required by IRC 6038A(a).

Statute of Limitations—The running of any period of limitations under IRC 6501 and IRC 6531 may be suspended as set forth in in IRC 6038A(e)(4)(D) relating to proceedings to quash and for a review of a determination of noncompliance.

Penalty Assertion

The IRS will generally assert a penalty when an examiner determines that:

• A foreign related party, upon request, failed to authorize the reporting corporation to act as its agent for IRS summons purposes pursuant to the requirements set forth in Treas. Reg. 1.6038A-5, or
• The reporting corporation has failed to respond substantially and timely to a proper summons for records.

The noncompliance penalty is subject to deficiency procedures and is reflected on a notice of deficiency.

Penalty Computation

The IRS takes the position that the noncompliance penalty adjustment permits the Service, in its discretion, to adjust the amount of deductions and to adjust the cost of property with respect to the related party transaction(s) based upon information available to the Service. See IRC 6038A(e)(3).

Reasonable Cause

In exceptional circumstances, the IRS may treat a reporting corporation as authorized to act as agent for a related party for IRS summons purposes in the absence of an actual agency appointment by the foreign related party in circumstances where the absence of an appointment is reasonable. See Treas. Reg. 1.6038A-5(f).

IRC 6038B(c)—Failure to Provide Notice of Transfers to Foreign Persons

IRC 6038B(c) provides a penalty for failure to furnish information with respect to certain transfers of property by a U.S. person to certain foreign persons.

Reporting and Filing Requirements

Form 8865 Schedule O, Transfer of Property to a Foreign Partnership (Under section 6038B), and Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation, are utilized and required for reporting purposes.

Foreign Corporations—IRC 6038B(a) and the regulations issued thereunder require that any U.S. person that transfers property to a foreign corporation (including cash, stock, or securities) in an exchange described in IRC 332, IRC 351, IRC 354, IRC 355, IRC 356, IRC 361, IRC 367(d), or IRC 367(e) report certain information concerning the transfer:

• Reg. 1.6038B-1(b) provides the general reporting requirements.
• Reg. 1.6038B-1(b)(1) states that notwithstanding any statement to the contrary on Form 926, the form and attachments must be filed with the transferor’s tax return for the taxable year that includes the date of the transfer.

Form 926 must be complete, accurate, and filed with the taxpayer’s income tax return by the due date of the return (including extensions) at the IRS campus where the taxpayer is required to file in order to meet the requirements outlined in Treas. Reg. 1.6038B-1(b).

Exceptions Relating to Certain Transfers to Foreign Corporations—Under the section 6038B regulations, a Form 926 is not required to be filed, and therefore the penalty does not apply, in certain situations as follows:

• For transfers of stock or securities to a foreign corporation in a transaction described in IRC 6038B(a)(1)(A) in which the requirements of Treas. Reg. 1.6038B-1(b)(2)(i) are satisfied and Form 926 need not be filed.

Under Treas. Reg. 1.6038B-1(b)(3), for transfers of cash in a transfer described in IRC 6038B(a)(1)(A), Form 926 is only required to be filed in the following situations:

1) When immediately after the transfer, such person holds directly, indirectly, or by attribution (determined under the rules of IRC 318(a), as modified by IRC 6038(e)(2)) at least 10 percent of the total voting power or the total value of the foreign corporation; or

2) When the amount of cash transferred by such person or any related person (determined under IRC 267(b)(1) through (3) and (10) through (12)) to such foreign corporation during the 12-month period ending on the date of the transfer exceeds $100,000.

Transfers to Foreign Partnerships—IRC 6038B(a) and (b) as well as Treas. Reg. 1.6038B-2 require, in certain circumstances, a U.S. person that transfers property to a foreign partnership in a contribution described in IRC 721 to report certain information concerning the transfer.  In addition, note the following:

• Reporting is required under these rules if:
  • i) Immediately after the transfer, the U.S. person owns, directly, indirectly, or by attribution, at least a 10% interest in the partnership, as defined in section 6038(e)(3)(C) and the regulations thereunder; or
  • ii) The value of the property transferred by the U.S. person, when added to the value of any other property transferred in a section 721 contribution by the person (or any related person) to the partnership during the 12-month period ending on the date of the transfer, exceeds $100,000. See Treas. Reg. 1.6038B-2(a)(1).

Note: The value of any property transferred is the fair market value at the time of its transfer.

If a domestic partnership transfers property to a foreign partnership in a section 751 contribution, the domestic partnership’s partners are considered to have transferred a proportionate share of the contributed property to the foreign partnership. However, if the domestic partnership files Form 8865 and properly reports all the required information with respect to the contribution, its partners are not required to report the transfer. See Treas. Reg. 1.6038B-2(a)(2).

Taxpayers meet the reporting requirements by filing Form 8865 Schedule O with their federal income tax return by the due date of the return (including extensions) at the campus where they are required to file.

Description of Transfer to Foreign Corporations—A transfer described in IRC 367(a) occurs if a U.S. person transfers property to a foreign person in connection with an exchange described in IRC 332, IRC 351, IRC 354, IRC 355, IRC 356, or IRC 361, provided an exception in IRC 367(a) is not applicable.

Note: A transfer described in IRC 367(d) occurs if a U.S. person transfers intangible property to a foreign corporation in an exchange described in IRC 351 or IRC 361.

Description of Transfer to Foreign Partnerships—A transfer described in IRC 721 occurs if a U.S. person transfers property to a foreign partnership in exchange for an interest in the partnership.

Statute of Limitations—The IRS takes the position that the HIRE Act amendments to IRC 6501(c)(8), as well as the additional amendments in the Education Jobs and Medicaid Assistance Act, Public Law No. 111-226, provide that the IRC 6501(c)(8) period applies to the entire return, not just those items associated with the failure to file under IRC 6038B, unless the taxpayer can show reasonable cause. In the case of a taxpayer who demonstrates reasonable cause, only those items related to the failure under IRC 6038B are subject to the longer period under IRC 6501(c)(8).

Penalty Assertion

A penalty is asserted on Form 8278 when the IRS believes that the taxpayer:

• Is a U.S. person and has made a transfer to a foreign corporation or a foreign partnership as described above;
• Has failed to timely file Form 926 and attachments, or Form 8865 Schedule O, Transfer of Property to a Foreign Partnership (Under section 6038B), as specified in IRC 6038B and the regulations thereunder, and
• Has not shown that such failure to comply was due to reasonable cause.

The penalty under IRC 6038B(c) is not subject to deficiency procedures. However, the income tax adjustment for gain recognition is subject to deficiency procedures.

Penalty Computation

If a U.S. person fails to furnish information in accordance with IRC 6038B regarding some or all of the property transferred and the reasonable cause exception does not apply, then:

• With respect to transfers of property to a foreign corporation, the property is not considered to have been transferred for use in the active conduct of a trade or business outside the U.S. for purposes of IRC 367(a) and the regulations thereunder. See Treas. Reg. 1.6038B-1(f);
• With respect to transfers of property to a foreign partnership, the U.S. person must recognize gain on the property. See Treas. Reg. 1.6038B-2(h); and
• The U.S. person must pay a penalty equal to 10% of the fair market value of the property on the date of transfer, not to exceed $100,000, unless the failure was due to intentional disregard. See Treas. Reg. 1.6038B-1(f) and Treas. Reg. 1.6038B-2(h).

The period for limitations on assessment of tax on the transfer of such property does not begin to run until the date on which the U.S. person complies with the reporting requirements.

Note: IRC 6501(c)(8) applies to the income tax deficiency from items required to be reported under IRC 6038B.

Reasonable Cause

The IRS maintains that no reasonable cause should be considered until the taxpayer has filed applicable forms for all open years (not on extension).

IRC 6038B(c)(2) provides that no penalty shall apply to any failure if the U.S. person demonstrates that such failure is due to reasonable cause and not to willful neglect.

IRC 6038C—Information With Respect to Foreign Corporations Engaged in U.S. Business

Generally, a foreign corporation engaged in a trade or business within the United States at any time during the taxable year is a “reporting corporation.” See IRC 6038C and Treas. Reg. 1.6038A-1(c)(1).

Reporting and Filing Requirements

Generally, each reporting corporation as defined in Treas. Reg. 1.6038A-1(c) shall make a separate annual information return on Form 5472 with respect to each related party as described in Treas. Reg. 1.6038A-1(d) with which the reporting corporation has had any “reportable transaction.” See Treas. Reg. 1.6038A-2(a)(2) and Treas. Reg. 1.6038A-2(a)(1).

Generally, a reporting corporation must keep the permanent books of account or records as required by IRC 6001 that are sufficient to establish the correctness of the federal income tax return of the corporation, including information, documents, or records to the extent they may be relevant to determine the correct U.S. tax treatment of transactions with related parties. Such records must be permanent, accurate, and complete, and must clearly establish income, deductions, and credits. See Treas. Reg. 1.6038A-3(a)(1).

Penalty Assertion

An initial penalty is asserted on IRS Form 8278  when the IRS determines a penalty under Treas. Reg. 1.6038A-4(a).

Penalty Computation

Initial Penalty—Generally, if a reporting corporation fails to furnish the information described in Treas. Reg. 1.6038A-2 within the time and manner prescribed by Treas. Reg. 1.6038A-2(d) and (e), fails to maintain or cause another to maintain records as required by Treas. Reg. 1.6038A-3, or (in the case of records maintained outside the United States) fails to meet the non-U.S. record maintenance requirements, within the applicable time prescribed in Treas. Reg. 1.6038A-3(f), the IRS will assess a penalty of $10,000 for each taxable year with respect to which such failure occurs. See Treas. Reg. 1.6038A-4(a)(1).

Continuation Penalty—Generally, if any such failure continues for more than 90 days after the day on which the Service mails notice the failure to the reporting corporation, the IRS will assess against the reporting corporation an additional penalty of $10,000 with respect to each related party for which a failure occurs for each 30-day period during which the failure continues after the expiration of the 90-day period. Any uncompleted fraction of a 30-day period shall count as a 30-day period for this purpose. See Treas. Reg. 1.6038A-4(d)(1).

Reasonable Cause

Generally, certain failures may be excused for reasonable cause, including not timely filing Form 5472, not maintaining or causing another to maintain records as required by Treas. Reg. 1.6038A-3, and not complying with the non-U.S. maintenance requirements described in Treas. Reg. 1.6038A-3(f). See Treas. Reg. 1.6038A-4(b)(1).

Generally, if there is reasonable cause for a failure, the beginning of the 90-day period after mailing of a notice by the Service of a failure shall be treated as not earlier than the last day on which reasonable cause existed. See Treas. Reg. 1.6038A-4(b)(1).

IRC 6038C(d)—Noncompliance Penalty for Certain Foreign Corporations Engaged in U.S. Business

IRC 6038C(d) requires that a foreign related party authorize the reporting corporation to act as its limited agent for summons purposes and requires that the reporting corporation maintain and produce records regarding transactions with the foreign related party.

Reporting and Filing Requirements

The requirement is the same as that of IRC 6038A(e).

Penalty Assertion

Generally, a penalty is asserted when:

• For purposes of determining the amount of the reporting corporation’s liability for tax, the IRS issues a summons to the reporting corporation to produce (either directly or as an agent for a related party who is a foreign person) any records or testimony,
• Such summons is not quashed in a judicial proceeding described in IRC 6038(d)(4) and is not determined to be invalid in a proceeding begun under IRC 7604(b) to enforce such summons, and
• The reporting corporation does not substantially comply in a timely manner with such summons and the IRS has sent by certified or registered mail a notice to such reporting corporation that such reporting corporation has not so substantially complied.

The noncompliance penalty follows deficiency procedures and is reflected in the notice of deficiency.

Penalty Computation

The noncompliance penalty adjustment permits the IRS to deny deductions and adjust cost of goods sold with respect to the related party transaction(s) based upon information available to the Service. See IRC 6038(d)(3).

Reasonable Cause

The IRS maintains that there is no reasonable cause exception for this penalty.

IRC 6039F(c)—Large Gifts From Foreign Persons

IRC 6039F provides reporting requirements for U.S. persons who receive large gifts from foreign persons.

Reporting and Filing Requirements

U.S. persons who receive gifts from a foreign individual or foreign estate during the taxable year that in the aggregate exceed $10,000 must file Form 3520, Annual Return to Report Transactions With Foreign Trust and Receipt of Certain Foreign Gifts, and fill out Part IV of Form 3520. These gifts are reportable under IRC 6039F(a). See Notice 97-34.[1]

The threshold for gifts (or bequests) received from nonresident alien individuals and foreign estates is statutorily $10,000, but the amount was raised to $100,000 under Notice 97-34. Once that threshold is reached, reporting is only required with respect to each such gift that is in excess of $5,000. The threshold for gifts (or bequests) received from a foreign corporation or a foreign partnership was statutorily $10,000, but the amount is adjusted each year for inflation. The instructions for Form 3520 for any year will have the applicable dollar threshold for the filing requirement for that year. Failure to report gifts (or bequests) above the applicable dollar threshold for the relevant year is subject to penalties under IRC 6039F. Gifts from foreign trusts are reportable as distributions from a foreign trust under IRC 6048(c) and failure to report such distributions on Part III of the Form 3520 is subject to penalties under IRC 6677.

Section 6048(a) generally provides that any U.S. person who directly or indirectly transfers money or other property to a foreign trust (including a transfer by reason of death) must report such transfer at the time and in the manner prescribed by the Secretary. Section 6048(a)(2). Transfers to foreign trusts described in sections 402(b), 404(a)(4), or 404A, or trusts determined by the Secretary to be described in section 501(c)(3) are not reportable under these requirements. Section 6048(a)(3)(B)(ii). Transfers involving fair market value sales are also not reportable. Section 6048(a)(3)(B)(i). The Secretary may exempt other types of transfers from being reported if the United States does not have a significant interest in obtaining the required information. Section 6048(d)(4). A person who fails to comply with the reporting requirements of section 6048(a) with respect to a transfer occurring after August 20, 1996, will be subject to a 35 percent penalty on the gross value of the property transferred. Section 6677(a).

One of the purposes of the reporting requirements in section 6048(a) is to ensure that U.S. transferors comply with section 679. Section 679 generally treats a U.S. person as the owner of a foreign trust if the U.S. person transfers property to the foreign trust and the trust could benefit a U.S. person. However, a U.S. person will not be treated as the owner of the trust under section 679 if, in exchange for the property transferred to the trust, the U.S. person receives property whose value is at least equal to the fair market value of the property transferred. Section 679(a)(2)(B).

Certain transfers of property by U.S. persons to foreign trusts may be described in section 1491 as well as section 6048(a). Section 1491 generally provides that a U.S. person who transfers property to a foreign trust is subject to a 35 percent excise tax on any unrecognized gain in the transferred property. Section 1494 generally provides that transfers described in section 1491 to certain foreign entities (including foreign trusts) must be reported. Notice 97-18, 1997-10 I.R.B. 35, provided that in the case of transfers to foreign trusts, reporting obligations under section 1494 may be satisfied if the U.S. transferor complies with its reporting obligations under section 6048(a) and the U.S. transferor does not owe excise tax under section 1491.

Note: Form 3520 has four different parts that relate to different filing requirements for filing a Form 3520. The obligation to file a Form 3520 to report the receipt of a large gift (or bequest) from a foreign person by a U.S. person is reportable on Part IV of the form.

Form 3520 is required to be filed separately from the U.S. person’s income tax return with the Ogden Campus. The due date for filing is the same as the due date for filing a U.S. person’s income tax return, including extensions. In the case of a Form 3520 filed with respect to a U.S. decedent, Form 3520 is due on the date that Form 706, United States Estate (and Generation-Skipping) Tax Return, is due, including extensions, or would be due if the estate were required to file a return. A Form 3520 is filed once a year for all reportable gifts (and bequests) within the year with respect to each U.S. person.

Penalty Assertion

The penalty is asserted on Form 8278  when the examiner determines the following:

• A U.S. person received a reportable gift (or bequest) from a foreign person.
• Has failed to timely file Form 3520.
• Has not shown that failure to file was due to reasonable cause.

Penalty Tax Adjustment—IRC 6039F(c)(1)(A) states that the Secretary will determine the tax consequence of the receipt of such gift (or bequest) if the information is not filed timely. This adjustment is subject to deficiency procedures.

Penalty Computation

The penalty for failure to report a large gift (or bequest) from a foreign person on a timely, complete, and accurate Form 3520 is 5 percent of the amount of such foreign gift (or bequest) for each month for which the failure continues after the due date of the reporting U.S. person’s income tax return (not to exceed 25% of such amount in the aggregate).

Reasonable Cause

IRC 6039F(c)(2) provides that no penalty shall apply for failure to furnish the required information if the U.S. person shows that the failure is due to reasonable cause and not to willful neglect.

IRC 6039G—Expatriation Reporting Requirements

IRC 6039G (originally designated as IRC 6039F) was added by the Health Insurance Portability and Accountability Act in 1996, P.L. 104-191.

The American Jobs Creation Act of 2004 (AJCA), P.L. 108-357, made significant amendments to IRC 6039G for individuals who expatriated after June 3, 2004 and before June 17, 2008. Individuals who relinquished their United States citizenship or lost their U.S. long-term resident status were required to file Form 8854, Initial and Annual Expatriation Information Statement, in order to complete their tax expatriation. Otherwise these individuals are still taxed as U.S. persons until they file the Form 8854.

The Heroes Earnings Assistance and Relief Tax Act of 2008 (HEART Act) made additional amendments to IRC 6039G to reflect the enactment of IRC 877A (see below) which applies to individuals who relinquish their U.S. citizenship or lose their long-term resident status on or after June 17, 2008.

Reporting and Filing Requirements

Pre-AJCA—For individuals who expatriated prior to June 4, 2004, a Form 8854 was due on the date of expatriation (for U.S. citizens) or the due date of the individual’s U.S. income tax return (for long-term residents). There was no annual requirement to file a Form 8854 after the initial form was filed.

Post-AJCA—For individuals who expatriated after June 3, 2004, and before June 17, 2008, there was no due date for the initial Form 8854. But their expatriation will not be recognized for tax purposes until a complete initial Form 8854 is filed with the IRS. If the expatriate was subject to the alternate expatriation tax regime (under IRC 877(b)) on the date of expatriation, an annual Form 8854 is then required for each of 10 tax years after the date of expatriation.

IRC 877A—This section generally provides that all property of a “covered expatriate” (defined below) is treated as sold on the day before the individual’s expatriation date. Gain or loss from the deemed sale must be taken into account at that time (subject to an exclusion amount that is indexed for inflation annually).

Note:  Exclusion amount are provided in the Form 8854 instructions.

The following information is required on the Form 8854 by the individual who expatriates:

1. Taxpayer’s TIN
2. Mailing address of such individual’s principal foreign residence
3. Foreign country in which the individual resides
4. Foreign country of which the individual is a citizen
5. Information detailing the income, assets, and liabilities of such individual
6. Number of days the individual was physically present in the U.S. during the taxable year
7. Such other information the Secretary shall prescribe

Post-HEART Act-U.S. citizens and long-term residents who expatriate on or after June 17, 2008 must file Form 8854 by the due date of the income tax return (including extensions) for the year that includes their expatriation date. Under certain circumstances, such expatriates must file Form 8854 for subsequent years.

Form W-8CE—”Covered expatriates” who had an interest in a deferred compensation plan, a specified tax-deferred account (which includes an IRA), or a non-grantor trust on the day before their date of expatriation must file a Form W-8CE with each payer of these interests. The purpose of the Form W-8CE is to notify each payer that the individual is a “covered expatriate” and is subject to special rules with regard to these interests. Form W-8CE is filed with each payer on the earlier of (a) the day before the first distribution on or after the expatriation date, or (b) 30 days after the expatriation date for each item of deferred compensation, specified tax deferred account or interest in a non-grantor trust.

“Covered Expatriate” —An individual is a “covered expatriate” if the individual is either a former citizen or former long-term resident and:

• The individual’s average annual net income tax for the five years ending before the date of expatriation or termination of residency is more than a specified amount that is adjusted for inflation as provided in the Form 8854 instructions,
• The individual’s net worth is $2 million or more on the date of expatriation, or
• The individual fails to certify on Form 8854 that he or she has complied with all U.S. federal tax obligations for the five years preceding the date of the individual’s expatriation.

Former Long-Term Resident—A former long-term-resident is any individual who was a lawful permanent resident of the United States for all or any part of 8 of the last 15 years preceding the date of expatriation.

Treatment of Deferred Compensation Plans, Specified Tax-Deferred Accounts, and Non-Grantor Trusts—The “mark-to-market” rules (of IRC 877A(a)) do not apply to a covered expatriate’s interest in a deferred compensation plan, a specified tax-deferred account nor a non-grantor trust.

Deferral of “Mark-to-Market” Tax—Covered expatriates may elect to defer the payment of all or part of the amount of the “mark-to-market” tax to which they are subject. This election is not available for tax due with respect to a covered expatriate’s interest in a deferred compensation plan, a specified tax-deferred account, or a non-grantor trust in which the covered expatriate held an interest on the day before expatriation. See Notice 2009-85 and the Form 8854 instructions for more information.

Penalty Assertion

IRC 6039G(c) imposes a $10,000 penalty for a failure to timely file a complete and accurate Form 8854, unless it is shown such failure is due to reasonable cause and not to willful neglect.

The penalty is applied as follows:

• Pre-AJCA—For individuals who expatriated prior to June 4, 2004, if the individual has failed to file a complete, accurate and timely initial Form 8854, the penalty for failure to file the initial Form 8854 is asserted.
• Post-AJCA—For individuals who expatriate after June 3, 2004 but before June 17, 2008, the penalty applies for failure to file a required annual Form 8854.
• Post-HEART Act—For individuals who expatriate after June 16, 2008, if the individual has failed to file a complete, accurate and timely initial Form 8854, the penalty for failure to file the initial Form 8854 is asserted.

Note:  Certain expatriates may only be required to file an initial Form 8854 and have no continued obligation to file Form 8854 annually.

Penalty Computation

The penalty computation under IRC 6039G depends on the date an individual expatriates as follows:

• Pre-AJCA—For individuals who expatriated prior to June 4, 2004, if the individual failed to file a complete, accurate and timely initial Form 8854, the penalty is the greater of 5% of the tax required to be paid under IRC 877 or $1,000 for each taxable year that the 8854 was not filed.
• Post-AJCA—For individuals who expatriated after June 3, 2004, and before June 17, 2008, the penalty for failure to file an annual 8854 is $10,000 per required annual form.
• Post-HEART Act—For individuals who expatriate after June 16, 2008, the penalty for each failure to file a required Form 8854 is $10,000.

Reasonable Cause

The penalty is improper if the failure to provide the required statement and information was due to reasonable cause and not to willful neglect.

The IRS may, however, refuse to recognize the existence of reasonable cause until the taxpayer has filed the required information for all open years (not on extension).

IRC 6652(f)—Foreign Persons Holding U.S. Real Property Investments

IRC 6652(f) provides a penalty for a  failure to meet reporting requirements under IRC 6039C.

Reporting and Filing Requirements

IRC 6039C states that, to the extent provided in regulations, any foreign person holding a direct investment in U.S. real property interests for a calendar year must file a return. The requirement is met by providing information such as name and address, a description of all U.S. real property interests, etc.

However, until such time as the regulations under IRC 6039C are issued, these provisions are not operative. Note, however, that there are other reporting requirements under the Foreign Investment in Real Property Tax Act (FIRPTA) that must still be satisfied.  See, e.g., IRC secs. 897 and IRC 1445.

Penalty Computation

IRC 6652(f)(2) provides that the amount of penalty with respect to any failure shall be $25 for each day during which such failure continues.

IRC 6652(f)(3) limits the amount of the penalty determined to the lesser of the following:

• $25,000, or
• 5 percent of the aggregate of the fair market value of the United States real property interests owned by such person at any time during such year.

Reasonable Cause

IRC 6652(f)(1) provides for a defense to penalties if the failure to report is due to reasonable cause and not to willful neglect.

IRC 6677(a)—Failure to File Information with Respect to Certain Foreign Trusts—Form 3520

IRC 6677 provides that U.S. persons, who have an IRC 6048 filing obligation because they engaged in certain transactions with a foreign trust or are treated as owning a foreign trust, who fail to file a complete and accurate Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, or fail to ensure that a foreign trust has filed a Form 3520-A, Annual Return of Foreign Trust With a U.S. Owner, may be assessed penalties for such failures unless it is shown that such failure was due to reasonable cause and not to willful neglect.

Notice 97-34 provides additional guidance on the filing requirements and penalties.

Reporting and Filing Requirements

Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, is required to be filed by a U.S. person for the following:

• Report the creation of a foreign trust by a U.S. person during the tax year,
• Report certain transfers of money or other property to a foreign trust by a U.S. person,
• Identify U.S. persons who are treated as owners of a foreign trust during all or part of the tax year,
• Provide information about distributions received by a U.S. person from a foreign trust,
• Report the receipt of a loan from a foreign trust during the tax year,
• Report the receipt of uncompensated use of trust property from a foreign trust (applicable only after March 18, 2010), or
• Provide information about certain gifts or bequests received from foreign persons (penalties related to the failure to report the receipt of such gifts or bequests from foreign persons are imposed under IRC 6039F).

Form 3520 must be timely, complete and accurate to be considered filed.

U.S. Owners: Creation or Transfer—IRC 6048(a) generally provides that any U.S. person who creates a foreign trust and directly or indirectly transfers money or other property to a foreign trust (including a transfer by reason of death) must report such transfer. This reporting is performed on Part I of Form 3520.

Generally, a U.S. person who transfers property to a foreign trust is considered the owner of that portion of the foreign trust unless there is no possibility now or in the future of the trust having a U.S. beneficiary. IRC 679 and the regulations thereunder more specifically describe individuals who are considered owners of foreign trusts and describe exceptions to the general rule.

Other things to consider are as follows:

• S. persons who make transfers to Canadian Registered Retirement Savings Plans (RRSPs) or Registered Retirement Income Funds (RRIFs) are not required to report such transfers on Form 3520. See Notice 2003-75 and the instructions to Form 8891, U.S. Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans.
• Generally, foreign trusts described in IRC 402(b), IRC 404(a)(4), IRC 404A, or IRC 501(c)(3) are not reportable under these requirements. See IRC 6048(a)(3)(B)(ii) and Notice 97-34.
• Transfers involving fair market value sales are also not reportable. See IRC 6048(a)(3)(B)(i), Notice 97-34, IRC 679, and the regulations thereunder for additional information.

IRC 6048(b) provides that if at any time during the taxable year a U.S. person is treated as the owner of any portion of a foreign trust under the grantor trust rules (IRC 671 through IRC 679), such person must submit certain information and must ensure that the trust files certain information. The U.S. person must report ownership of the trust for the current tax year on Part II of Form 3520 and, if available, must attach a copy of the owner’s statement (from Form 3520-A) to Form 3520.

Even if the U.S. owner is not required to complete and file the other parts of Form 3520 in a particular year, the U.S. owner must nevertheless complete and file Part II of Form 3520. In addition, the U.S. owner must ensure that the foreign trust files Form 3520-A annually. If the foreign trust fails to file Form 3520-A, the U.S. owner must complete and attach a substitute Form 3520-A to his or her Form 3520.

Distributions: U.S. Beneficiaries—IRC 6048(c) generally requires a U.S. person who receives a distribution or is treated as receiving a distribution, directly or indirectly, from a foreign trust, to report on Form 3520 the name of the trust, the aggregate amount of distributions received from the trust during the taxable year and such other information as the Secretary may prescribe.

Some examples of distributions to U.S. persons from a foreign trust that are reportable or nonreportable are as follows:

Form 3520 is required to be filed separately from the U.S. person’s income tax return and must not be attached to the related income tax return. In addition:

• Form 3520 is filed once a year with respect to each U.S. person and each foreign trust. A separate Form 3520 is required for each foreign trust.
• Form 3520, filed by a U.S. owner, is required to have a copy of the owner’s statement from Form 3520-A attached to the Form 3520.
• Form 3520 is required to be filed by the due date of the income tax return of a U.S. person, including extensions.
• A separate Form 3520 must be filed by each U.S. person. However, married individuals who file married filing joint may file one Form 3520.

Penalty Letters, Notice Letters, and Notices

Letter 3804—This is an opening notice letter issued under the provisions of IRC 6677(a).

Letter 3943—This is the closing acceptance letter utilized after the IRS determines that no penalties will be asserted.

Letter 3944—This is the closing no response letter is issued when a taxpayer either fails to respond to notice letter (Letter 3804) or when a taxpayer does not provide a statement of reasonable cause for failing to file such returns.

Letter 3946—This is the closing reasonable cause rejected letter that is issued after the IRS determines that penalties will be asserted.

Penalty Computation

Gross Reportable Amount—The gross reportable amount is defined in IRC 6677(c) as follows:

• Contributions to the foreign trust: The gross value of the property involved in the event (determined as of the date of the event) in the case of a failure relating to IRC 6048(a),
• The gross value of the portion of the trust’s assets at the close of the year treated as owned by the U.S. person in the case of a failure relating to IRC 6048(b)(1), and
• Distributions from the foreign trust: The gross amount of the distributions in the case of a failure relating to IRC 6048(c).

Inaccurate reporting: The penalty applies only to the extent that the transaction is not reported or is reported inaccurately. Thus, if a U.S. person transfers property worth $1,000,000 to a foreign trust, but reports only $400,000 of that amount, penalties may be imposed only on the unreported $600,000.

Also, if the return is not filed and the Service assesses a penalty based on available information, additional assessments can be made if additional information is received.

Initial Penalty—Prior to 2010 under IRC 6677, the initial penalty for failure to timely file a complete and accurate Form 3520 was calculated based on the respective percentages below of the gross reportable amount. There was no minimum penalty. Beginning with 2010, a minimum threshold was added and the initial penalty is equal to the greater of $10,000 or the following:

• 35 percent of the gross reportable amount of any property transferred to a foreign trust for failure by a U.S. transferor to report the creation of, or transfer to, a foreign trust;
• 35 percent of the gross reportable amount of the distributions received from a foreign trust for failure by a U.S. person to report receipt of the distribution; or
• 5 percent of the gross reportable amount of the portion of the trust’s assets treated as owned by a U.S. person for failure by the U.S. person to report the U.S. owner information (this penalty is imposed under IRC 6677(b).

In the case of a U.S. person treated as the owner of a foreign trust, penalties are assessed in the case of a failure to report such ownership pursuant to IRC 6048(b) on a Form 3520-A rather than on the Form 3520.

Continuation Penalty—If any failure continues more than 90 days after the day on which the notice of such failure was mailed to the taxpayer (90-day period), additional penalties will apply. The continuation penalty is $10,000 for each 30-day period (or fraction thereof) during which such failure continues after the expiration of the 90-day period.

The maximum penalty (both initial penalty and continuation penalty) for each failure to file Form 3520 is the gross reportable amount each year.

Non-Compliance Tax Adjustment—IRC 6048(c)(2) provides that any distribution from a foreign trust, whether from income or corpus, to a U.S. beneficiary will be treated as an accumulation distribution includible in the gross income of that U.S. beneficiary if adequate records are not provided to the Secretary to determine the proper treatment of the distribution. The interest charge under IRC 668 shall apply to the distribution treated as an accumulation distribution. In determining the interest amount under IRC 668, the applicable number of years will be equal to one half of the number of years that the trust has been in existence. This adjustment is subject to deficiency procedures.

Interest—The interest charge will be determined using the normal interest rate and method as described in IRC 6621, unless the period is prior to 1996, when a simple interest rate of 6% will be used. This interest is not deductible.

Reasonable Cause

No reasonable cause should be considered until the taxpayer has filed the complete and accurate information required for all open years (not on extension).

IRC 6677 provides specific exclusions with respect to the initial penalty for reasonable cause and Notice 97-34 provides additional information:

• A taxpayer will not have reasonable cause merely because a foreign country would impose a civil or criminal penalty on the taxpayer (or other person) for disclosing the required information. See IRC 6677(d).
• Refusal on the part of a foreign trustee to provide information for any other reason, including difficulty in producing the required information or provisions in the trust instrument that prevent the disclosure of required information, will not be considered reasonable cause.

The fact that the trustee did not provide the taxpayer with a copy of the owner’s statement of Form 3520-A is not reasonable cause. The taxpayer owner is also the person responsible for ensuring that the Form 3520-A is filed and that he or she receives a copy of the owner’s statement.

IRC 6677(a) and (b)—Foreign Trusts With U.S. Owners—Form 3520-A

The penalties for failure to file Form 3520-A are similar to the penalties for failure to file Form 3520 except that IRC 6677(b) changes the amount of the initial penalty to the greater of $10,000 or 5 percent of the gross reportable amount. The gross reportable amount is defined in IRC 6677(c)(2) as the gross value of the portion of the trust’s assets at the close of the year treated as owned by the U.S. person.

If a foreign trust fails to file Form 3520-A, the penalties are imposed on the U.S. person who is treated as the owner of the foreign trust. The grantor trust rules are in IRC 671 through 679. The U.S. owner may be able to avoid penalties by attaching a substitute Form 3520-A to a timely filed Form 3520.

Reporting and Filing Requirements

Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner, is due by the 15th day of the third month after the end of the trust’s tax year. Each U.S. person treated as an owner of a foreign trust under IRC 671 through IRC 679 is responsible for ensuring that the foreign trust files an annual return setting forth a full and complete accounting of all trust activities, trust operations, and other relevant information as the Secretary prescribes. See IRC 6048(b)(1). In addition, the U.S. owner is responsible for ensuring that the trust annually furnishes such information as the Secretary prescribes to U.S. owners and U.S. beneficiaries of the trust. See IRC 6048(b)(1)(B), Treas. Reg. 404.6048-1, and Notice 97-34.

IRC 6048 authorizes the Secretary to prescribe the information required to be reported. The instructions to Form 3520-A include all information required to be provided.

U.S. persons who are treated as owners of Canadian RRSPs or RRIFs do not need to ensure that the RRSP or RRIF files a Form 3520-A and do not need to file a substitute Form 3520-A.

Form 3520-A includes an owner’s statement (Foreign Grantor Trust Owner Statement) for each U.S. person considered to be an owner of a portion of the foreign trust. The owner’s statement is required to be provided to each U.S. owner of the foreign trust.

Form 3520-A includes a beneficiary’s statement (Foreign Grantor Trust Beneficiary Statement) for any distributions made to U.S. persons. The beneficiary’s statement is required to be provided to each U.S. beneficiary.

U.S. Agent—A copy of the authorization of agent must be attached to the Form 3520-A and must be substantially identical to the format shown in the instructions. The U.S. agent has a binding contract with the foreign trust to act as the foreign trust’s limited agent for purposes of applying IRC 7602, IRC 7603, and IRC 7604 with respect to a request by the IRS to examine records, produce testimony, or respond to a summons by the IRS for such records or testimony.

Trusts without U.S. agents must have the following attached to the Form 3520-A to be considered complete:

• A summary of the terms of the trust including a summary of any oral or written agreements or understandings that the U.S. owner(s) has with the trustee whether or not legally enforceable.
• Copy of any of the following that have not been previously provided:
  • All trust documents and instruments,
  • Any amendments to the trust agreement,
  • All letters of wishes prepared by the settlor,
  • Memorandum of wishes by trustee summarizing the settlor’s wishes, and
  • Any other similar documents.

Penalty Letters, Notice Letters, and Notices

Letter 3804—This is an opening notice letter issued under the provisions of IRC 6677(a).

Letter 3943—This is the closing acceptance letter utilized after the IRS determines that no penalties will be asserted.

Letter 3944—This is the closing no response letter is issued when a taxpayer either fails to respond to notice letter (Letter 3804) or when a taxpayer does not provide a statement of reasonable cause for failing to file such returns.

Letter 3946—This is the closing reasonable cause rejected letter that is issued after the IRS determines that penalties will be asserted.

Penalty Assertion

Form 3520-A is considered incomplete in the following situations:

• The U.S. owner or beneficiary is not timely provided with the required statements.
• A foreign trust without a U.S. agent does not provide all the required attachments, e.g., summary of the terms of the trust, copies of trust documents or amendments to trust documents, and other required information (See IRM 20.1.9.14.1(7)).
• The U.S. agent does not provide information with respect to the trust after a request in writing as required by the terms of the U.S. agent agreement. Reasonable cause does not apply to the penalty in situations relating to a failure to provide information when requested.
• Form 3520-A does not contain substantially all of the required information on the return, e.g., amount of contributions and distributions, amount deemed as owned by each U.S. person, and balance sheet and income statement information.

Penalty Computation

Initial Penalty—Prior to 2010, the initial penalty for failure to timely file a complete and accurate Form 3520-A was 5 percent of the gross reportable amount. There was no minimum penalty. Beginning with 2010, a minimum threshold was added and the initial penalty is the greater of $10,000 or 5 percent of the gross reportable amount at the close of the year treated as owned by the U.S. person. See IRC 6677(b) for the penalty and IRC 6677(c) for the meaning of “gross reportable amount.” In addition:

• The initial penalty is computed for failure to provide information or inaccurate reporting. The penalty applies only to the extent that the transaction is not reported or is reported inaccurately. Thus, if a U.S. person reports the value of the account as worth $400,000, but the correct value is $1,000,000, penalties may be imposed on the unreported $600,000. See Notice 97-34.
• If the return is not filed and the Service assesses a penalty based on available information, adjustments or additional assessments can be made if additional information is received.

Continuation Penalty—If any failure continues more than 90 days after the day on which the notice of such failure was mailed to the taxpayer (90-day period), additional penalties will apply. The continuation penalty is $10,000 for each 30-day period (or fraction thereof) during which such failure continues after the expiration of the 90-day period.

Reasonable Cause

IRC 6677(d) provides specific exceptions with respect to the penalty for reasonable cause and Notice 97-34 provides additional information. In addition:

• The U.S. owner is responsible for ensuring that Form 3520-A is filed timely and includes all required information. The failure of the trustee or agent to timely file complete and accurate returns or provide information when requested is not reasonable cause for this penalty.
• A taxpayer will not have reasonable cause merely because a foreign country would impose a civil or criminal penalty on the taxpayer (or other person) for disclosing the required information. See IRC 6677(d).
• Refusal on the part of a foreign trustee to provide information for any other reason, including difficulty in producing the required information or provisions in the trust instrument that prevent the disclosure of required information, will not be considered reasonable cause.

IRC 6679—Return of U.S. Persons With Respect to Certain Foreign Corporations and Partnerships

IRC 6679 provides a penalty for failure to furnish information and timely file a return required under IRC 6046 or IRC 6046A.

Reporting and Filing Requirement

For tax years that began before January 1, 2005, IRC 6679 provided a penalty for failure to furnish information and timely file a return required under IRC 6035. IRC 6035 required a U.S. citizen or resident who was an officer, director, or 10 percent shareholder of a foreign personal holding company to file Form 5471 Schedule N by the due date of the taxpayer’s income tax return, including extensions.

Note:  Foreign personal holding company provisions have been repealed effective for tax years of foreign corporations beginning after December 31, 2004, and to tax years of U.S. shareholders with or within which such tax year of the foreign corporation ends. Therefore, there is no Form 5471 Schedule N filing requirement for periods after the rules have been repealed.

IRC 6046 requires Form 5471 Schedule O to be filed by the due date of the taxpayer’s income tax return, including extensions and must be filed by the following:

• A U.S. citizen or resident who is an officer or director of a foreign corporation in which a U.S. person has acquired:
  • Stock which meets the 10% stock ownership requirement with respect to the foreign corporation, or
  • An additional 10% or more of the outstanding stock of the foreign corporation.
• A U.S. person who acquires stock in a foreign corporation which, when added to any stock owned on the date of acquisition, meets the 10% stock ownership requirement with respect to the foreign corporation.
• A U.S. person who acquires stock in a foreign corporation which, without regard to stock already owned on the date of acquisition, meets the 10% stock ownership requirement with respect to the foreign corporation.
• Each person who is treated as a U.S. shareholder under IRC 953(c) with respect to the foreign corporation.
• Each person who becomes a U.S. person while meeting the 10% stock ownership requirement with respect to the foreign corporation.
• A U.S. person who disposes of sufficient stock in the foreign corporation to reduce his or her interest to less than the stock ownership requirement.

IRC 6046A requires Form 8865 Schedule P, to be filed by the due date of the taxpayer’s income tax return, including extensions. The form must be filed by any U.S. person who:

• Acquires an interest in a foreign partnership,
• Disposes of an interest in a foreign partnership, or
• Whose proportional interest in a foreign partnership changes substantially.

Penalty Computation

Initial Penalty—The penalty is $10,000 per failure.

Note: For tax years beginning prior to January 1, 2005, the penalty for failure to file Form 5471 Schedule N, Return of Officers, Directors, and 10% or More Shareholders of a Foreign Personal Holding Company, was $1,000 per failure and was assessed with PRN 614.

Continuation Penalty—If any failure continues more than 90 days after the day on which the notice of such failure was mailed to the taxpayer (90-day period), additional penalties of $10,000 for each 30-day period (or fraction thereof) during which such failure continues after the expiration of the 90-day period will apply. The maximum continuation penalty is limited to $50,000 per failure.

Reasonable Cause

IRC 6679(a)(1) provides a reasonable cause exception to the initial penalty.

The IRS maintaines that a reasonable cause defense does not apply to the continuation penalty.  Freeman Law disagrees with this position.

IRC 6686—Information Returns for IC-DISCs

IRC 6686 was added by P.L. 92-178 for Domestic International Sales Corporations (DISC) or former Foreign Sales Corporations (FSC).

The provisions for FSCs were repealed by P.L. 106-519 effective generally for transactions after September 30, 2000.

Although the FSC provisions were repealed, the Interest Charge Domestic International Sales Corporations (IC-DISC) provisions remain in effect.

Reporting and Filing Requirements

An IC-DISC is a domestic corporation that has elected to be an IC-DISC on Form 4876-A, Election To Be Treated as an Interest Charge DISC, and its election is still in effect.

An IC-DISC must file an annual U.S. tax return even though it pays no U.S. income taxes. See IRC 6011(c)(2) and Treas. Reg. 1.991-1.

Penalty Computation

The penalty under IRC 6686 is $100 for each failure to supply information (but the total amount imposed for all such failures during any calendar year shall not exceed $25,000) and $1,000 for each failure to file a Form 1120-IC-DISC.

Reasonable Cause

IRC 6686 provides for such penalties unless it is shown that such failure to file or supply information is due to reasonable cause.

To be considered for reasonable cause, the taxpayer must make an affirmative showing of reasonable cause in a written statement containing a declaration that it was made under the penalties of perjury.

IRC 6688—Reporting for Residents of U.S. Possessions (U.S. Territories)

IRC 6688 applies to any person described in IRC 7654(a) who is required to furnish information and who fails to comply with such requirement unless it is shown that such failure is due to reasonable cause and not to willful neglect.

Reporting and Filing Requirements

IRC 6688 provides a penalty for individuals with total worldwide gross income of more than $75,000 who take the position that, for U.S. income tax reporting purposes (see IRC 937(c)), they became or ceased to be bona fide residents of a U.S. possession (U.S. territory) and fail to meet the requirements under IRC 937 by filing Form 8898, Statement for Individuals Who Begin or End Bona Fide Residence in a U.S. Possession.

Note that:

• The instructions to Form 8898 currently specify that the form only needs to be filed by such individuals if they have more than $75,000 in worldwide gross income in the taxable year that they take the position that they became or ceased to be a bona fide resident of a U.S. possession.
• S. Possessions—Guam, American Samoa, the Commonwealth of the Northern Mariana Islands (CNMI), the Commonwealth of Puerto Rico, and the U.S. Virgin Islands are U.S. possessions, as that term is used in the IRC. These jurisdictions are more commonly referred to as U.S. territories..
• Form 8898 is filed separately with the Philadelphia Campus (or campus identified in future instructions), not with the individual’s tax return.

The penalty also applies to individuals who have adjusted gross income of $50,000 and gross income of $5,000 from sources within Guam or CNMI and who fail to file Form 5074, Allocation of Individual Income Tax to Guam or the Commonwealth of the Northern Mariana Islands (CNMI), as required under Treas. Reg. 301.7654-1(d) for individuals who file U.S. income tax returns.

Subsequent to 2005, Form 8898 must be filed by the due date (including extensions) for filing Form 1040, U.S. Individual Income Tax Return, or Form 1040NR, U.S. Nonresident Alien Income Tax Return.

Penalty Computation

For tax years ending after October 22, 2004, the penalty is $1,000 for failure to file the respective Form 8898, Form 5074, Form 8689, or for filing incorrect or incomplete information.

For tax years ending before October 23, 2004, the penalty is $100.

Reasonable Cause

IRC 6688 provides for such penalties unless it is shown that such failure is due to reasonable cause and not to willful neglect.

IRC 6689—Failure to File Notice of Foreign Tax Redetermination 

IRC 6689 provides a penalty for failure to notify the Service of a foreign tax redetermination with respect to the following:

• The amount of foreign taxes paid, accrued, or deemed paid by the taxpayer for which a notice is required under IRC 905(c), or
• The amount of adjustment to the deduction for certain foreign deferred compensation plans under IRC 404A(g).

Reporting and Filing Requirements

A taxpayer is required to notify the Service of any foreign tax redetermination that may affect U.S. tax liability. If a taxpayer has a reduction in the amount of foreign tax liability, the taxpayer must provide notification by filing Form 1040X, Amended U.S. Individual Income Tax Return, or Form 1120X, Amended U.S. Corporation Income Tax Return, and Form 1116, Foreign Tax Credit, or Form 1118, Foreign Tax Credit—Corporations, by the due date (with extensions) of the original return for the taxpayer’s taxable year in which the foreign tax redetermination occurred. See former Treas. Reg. 1.905-4T(b)(1)(ii).

In addition:

• If a foreign tax redetermination results in an additional assessment of foreign tax, the taxpayer has the 10-year period provided by IRC 6511(d)(3)(A) to file a claim for refund based on additional foreign tax credits. See former Treas. Reg. 1.905-4T(b)(1)(iii).
• When a foreign tax redetermination affects the indirect or deemed paid credit under IRC 902, the taxpayer must provide notification by reflecting the adjustments to the foreign corporation’s pools of post-1986 undistributed earnings and post-1986 foreign income taxes on a Form 1118 for the taxpayer’s first taxable year with respect to which the redetermination affects the computation of foreign taxes deemed paid.

Redetermination of IRC 404A Deduction—A taxpayer is required to notify the Service, in the time and manner specified in the regulations under IRC 905, if the foreign tax deduction for deferred compensation expense is adjusted. See IRC 404A(g)(2)(B).

Foreign Tax Redetermination—Former Treas. Reg. 1.905-3T(c) defines a foreign tax redetermination as a change in the foreign tax liability that may affect a U.S. taxpayer’s foreign tax credit and includes the following:

• Accrued taxes that when paid differ from the amounts added to post-1986 foreign income taxes or claimed as credits by the taxpayer,
• Accrued taxes that are not paid before the date two years after the close of the taxable year to which such taxes relate, or
• Any tax paid that is refunded in whole or in part, and
• For taxes taken into account when accrued but translated into dollars on the date of payment, the difference between the dollar value of the accrued foreign tax and the dollar value of the foreign tax actually paid attributable to fluctuations in the value of the foreign currency relative to the dollar between the date of accrual and the date of payment.

Statute of Limitations—IRC 6501(c)(5) independently suspends the normal statute of limitations for additions to tax resulting from a redetermination of foreign tax. IRC 905(c) contains special rules for such changes.

Penalty Computation

The examiner determines the deficiency attributable to the foreign tax redetermination and to this deficiency is added a penalty computed as follows:

• 5 percent of the deficiency if the failure to file a notice of foreign tax redetermination is for not for more than 1 month;
• An additional 5 percent of the deficiency for each month (or fraction thereof) during which the failure continues, but not to exceed in the aggregate 25 percent of the deficiency; and
• If this penalty applies, then the penalty under IRC 6662(a) and IRC 6662(b)(1), relating to the failure to pay by reason of negligent or intentional disregard of rules and regulations, shall not apply.

Reasonable Cause

The IRS maintains that reasonable cause should only be considered if the taxpayer has filed amended returns for all affected years for which the particular foreign tax redetermination results in a U.S. tax deficiency and for which amended returns are required under former temporary Treas. Reg. 1.905-4T.

IRC 6689(a) provides for such a penalty unless it is shown that such failure is due to reasonable cause and not due to willful neglect.

IRC 6712—Failure to Disclose Treaty-Based Return Position

IRC 6712 provides a penalty for failure to disclose a treaty-based return position as required by IRC 6114.

Reporting and Filing Requirements

IRC 6114 generally requires that if a taxpayer takes a position that any treaty of the U.S. overrules or modifies any provision of the Code, the taxpayer must disclose the position. A taxpayer meets the disclosure requirement by attaching Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b), or appropriate successor form to his or her timely filed tax return (including extensions).

Note:  A taxpayer may be able to treat payments or income items of the same type (e.g., interest items) received from the same ultimate payor (e.g., the obligor of a note) as a single separate payment or income item. See Treas. Reg. 301.6114-1(d)(3)(ii) for guidance on rules for single separate payment or income item.

If an individual would not otherwise be required to file a tax return, the individual must file Form 8833 at the IRS campus where he or she would normally file a return to make the treaty-based return position disclosure under IRC 6114. See Treas. Reg. 301.6114-1(a)(1)(ii) or Treas. Reg. 301.7701(b)-7.

Penalty Computation

Individuals—For an individual, the penalty is $1,000 for each separate treaty-based return position taken and not properly disclosed.

Corporations—For a C corporation, the penalty is $10,000 for each separate failure to disclose a treaty-based return position.

Reasonable Cause

IRC 6712(b) provides that the Secretary may waive all or any part of the penalty on a showing by the taxpayer that there was reasonable cause for the failure and that the taxpayer acted in good faith.

Waiver Criteria—Treas. Reg. 301.6712-1(b) provides the authority to waive, in whole or in part, the penalty imposed under IRC 6712 if the taxpayer’s failure to disclose the required information is not due to willful neglect. An affirmative showing of lack of willful neglect must be made by the taxpayer in the form of a written statement setting forth all the facts alleged to show lack of willful neglect and must contain a declaration by the taxpayer that the statement is made under penalties of perjury.

IRC 6039E—Failure to Provide Information Concerning Resident Status (Passports and Immigration)

IRC 6039E provides a penalty for failure to provide information concerning resident status.

Reporting and Filing Requirements

Passports—IRC 6039E generally requires that any individual, who applies for a United States (U.S.) passport, must include with such application the taxpayer’s TIN (if the individual has one), any foreign country in which such individual is residing, and any other information as the Secretary may prescribe.

Immigration—IRC 6039E generally requires that any individual, who applies to be lawfully accorded the privilege of residing permanently in the U.S. as an immigrant in accordance with the immigration laws, must include with such application the taxpayer’s TIN (if the individual has one), information with respect to whether such individual is required to file a return of the tax imposed by Chapter 1 for such individual’s most recent 3 taxable years, and any other information as the Secretary may prescribe.

Penalty Letters, Notice Letters, and Notices

Letter 4318, IRC 6039E Initial (Passport), and attachment Form 13997, Validating Your TIN and Reasonable Cause, are used by the IRS to propose a penalty.

Letter 4319, IRC 6039E No Penalty (Passport), is used by the IRS to notify the taxpayer that no penalty will be asserted.

Letter 4320, IRC 6039E Penalty (Passport), is used by the IRS to notify the taxpayer that it found that he or she did not have reasonable cause and that the proposed penalty will be asserted.

Penalty Computation

The penalty is $500 for such failure.

Only one $500 penalty may be asserted per application.

Reasonable Cause

IRC 6039E provides for such penalties unless it is shown that such failure is due to reasonable cause and not to willful neglect.

IRC 6038D—Information With Respect to Specified Foreign Financial Assets

IRC 6038D was added by P.L. 111-147, the Hiring Incentives to Restore Employment (HIRE) Act, for any individual failing to disclose information with respect to specified foreign financial assets during any taxable year beginning after March 18, 2010.

Reporting and Filing Requirements

A complete and accurate Form 8938, Statement of Specified Foreign Financial Assets, attached to a timely filed tax return fulfills the reporting requirements.

The required information for such specified foreign financial assets include the following:

• For all accounts and assets:
  • The maximum value of each account or asset during the year, and
  • The foreign currency in which the account or asset is designated, the exchange rate used to convert the account or asset value into U.S. dollars, and the source of the exchange rate if other than the U.S. Treasury Financial Management Service.
• In the case of any foreign deposit or custodial account:
  • The account type, including account number, and account opening and closing dates, and
  • The name and address of the financial institution in which the account is maintained.
• In the case of any stock of, or interest in, a foreign entity:
  • A description of the stock or interest in the entity, including any identifying number, and acquisition and disposition dates, and
  • The name, address, and type of foreign entity.
• In the case of all other specified foreign financial assets:
  • A description of the asset, including any identifying number, and
  • The names and addresses of all issuers and counter-parties with respect to the asset.

Penalty Computation

Initial Penalty—The initial penalty is $10,000 for each taxable year with respect to which such failure occurs.

Continuation Penalty—If any failure continues more than 90 days after the day on which the notice of such failure was mailed to the taxpayer (90-day period), additional penalties will apply. The continuation penalty is $10,000 for each 30-day period (or fraction thereof) during which such failure continues after the expiration of the 90-day period. The maximum continuation penalty is limited to $50,000 per failure.

Reasonable Cause

IRC 6038D(g) provides that no penalty shall apply if the individual shows that the failure is due to reasonable cause and not to willful neglect.

An individual will not have reasonable cause merely because a foreign jurisdiction would impose a civil or criminal penalty on any person for disclosing the required information.

Quick Reference Guide to International Penalties

Reference Guide to Forms

Quick Guide for Penalty Reference Numbers For International Penalty Assessments

International Penalties Subject to or Not Subject to Deficiency Proceeding

Reasonable Cause Relief Summary (The IRS’s Position on Relief Availability)

[1] Notice 97-34 provided guidance regarding the new foreign trust and foreign gift reporting provisions contained in the Small Business Job Protection Act of 1996 (the “Act”). The Act expands information reporting requirements under section 6048 of the Internal Revenue Code (the “Code”) for U.S. persons who make transfers to foreign trusts and for U.S. owners of foreign trusts. In addition, the Act adds new reporting requirements for U.S. beneficiaries of foreign trusts, extensively revises the civil penalties for failure to file information with respect to foreign trusts, and adds civil penalties for failure to report certain transfers to foreign entities. See sections 6048(c), 6677, and 1494(c). The Act also adds section 6039F 1 to the Code, creating reporting requirements for U.S. persons who receive large gifts from foreign persons.

International and Offshore Tax Compliance Attorneys 

Need help with tax issues? Contact us as soon as possible to discuss your rights and the ways we can assist in your defense. We handle all types of cases, including complex international & offshore tax compliance. Schedule a consultation or call (214) 984-3000 to discuss your international tax concerns or questions. 

Texas Legislative Update, 88th Legislature, Regular Session | Qualified Projects Under Texas Tax Code Chapter 351, Subchapter C

Summary: The Texas Legislature enacted four bills that 1) expand the list of cities that can build qualified projects (i.e., hotel and convention center projects subject to certain specifications) under Texas Tax Code Chapter 351, Subchapter C; 2) establish a claw back mechanism if state tax revenue generated by a qualified project does not meet certain metrics, 3) require a biennial report from the Texas Comptroller of Public Accounts regarding qualified projects, and 4) clarify that the provisions in Subchapter C do not provide any additional mechanism for taking property for public purposes or economic development.

Bills Enacted:

• HB 5012, 88th Leg., R.S. (2023) (effective September 1, 2023)
• SB 627, 88th Leg., R.S. (2023) (effective immediately)
• HB 3727, 88th Leg., R.S. (2023) (effective immediately)
• SB 1420, 88th Leg., R.S. (2023) (effective immediately)

Background: Texas Tax Code Chapter 351, Subchapter C entitles certain cities to receive rebates of state taxes if the cities use their municipal hotel occupancy tax revenue in connection with a “qualified project.”^[1] (Note that Texas Tax Code Chapter 351 also envisions qualified projects that are not governed by Subchapter C. For the sake of clarity, I’ll refer to the projects in this post as Subchapter C qualified projects.)

A Subchapter C qualified project is a project to acquire, construct, repair, remodel, expand, or equip a qualified convention center facility, a qualified hotel, and/or certain restaurants bars, retail establishments, spas, and parking areas or structures within a certain proximity to the qualified convention center facility or qualified hotel.^[2]

A “qualified convention center facility” means a facility that:

• is primarily used to host conventions or meetings;
• is wholly owned by a municipality;
• is connected to or has an exterior wall that is located not more than 1,000 feet from the nearest exterior wall of a qualified hotel;
• is not located in a hotel, sports stadium, or other structure;
• has at least 10,000 square feet of continuous meeting space; and
• is configurable to simultaneously accommodate multiple events of different sizes and types.^[3]

A “qualified hotel” means a hotel that is designated by a qualifying city as the hotel that is part of a Subchapter C qualified project.^[4]  A qualified hotel generally:

• must be located on land owned by the designating municipality (there are exceptions discussed below); and
• must be connected to a qualified convention center facility or have an exterior wall that is located not more than 1,000 feet from the nearest exterior wall of the qualified convention center facility.[5]

If a city pledges or commits a portion of its municipal hotel occupancy tax revenue collected by the qualified hotel for the payment of bonds and certain other obligations issued or incurred for the Subchapter C qualified project, the city generally will be entitled to receive certain state tax revenue derived from the project for a period of 10 years after the qualified hotel opens for initial occupancy.^[6] These state taxes include sales and use tax and hotel occupancy tax generated by the qualified hotel, and each restaurant, bar, and retail establishment located in or connected to the qualified hotel or qualified convention center facility.^[7] If a political subdivision that is entitled to receive tax revenue from the project agrees in writing, the city also is entitled to receive the sales and use tax imposed by political subdivision, the hotel occupancy tax imposed by the subdivision, and the mixed beverage tax to which the political subdivision is entitled.^[8]

A certain subset of cities also may be entitled to additional rebates from qualified establishments located within 1,000 feet from the nearest exterior wall of a qualified hotel or qualified convention center facility.^[9]

Prior to this legislative session the following cities were entitled to build a Subchapter C qualified project:

• Corpus Christi^[10]
• Nacogdoches^[11]
• El Paso^[12]
• Arlington^[13]
• San Antonio^[14]
• Grand Prairie^[15]
• Irving^[16]
• Amarillo^[17]
• Tyler^[18]
• Round Rock^[19]
• Odessa^[20]
• Abilene and Midland^[21]
• Prosper^[22]
• Lubbock^[23]
• Frisco and Lewisville^[24]
• Cedar Hill^[25]
• Roanoke^[26]
• Rowlett^[27]
• League City^[28]
• Kemah^[29]
• Sugar Land^[30]
• Katy^[31]
• Port Aransas^[32]
• Pearland^[33]
• Seabrook^[34]
• Alvin^[35]
• Baytown^[36]
• Webster^[37]
• Fredericksburg^[38]
• Hutto^[39]
• Cedar Park^[40]
• Kerrville^[41]
• Conroe^[42]
• San Benito^[43]
• Weatherford^[44]
• Richmond^[45]
• Commerce^[46]
• Celina^[47]
• Rio Grande City^[48]
• Presidio^[49]
• The Colony^[50]
• Kyle^[51]
• Victoria^[52]
• Leander^[53]
• Missouri City^[54]

(Note that Texas Constitution Article III, Section 56 (Prohibited Local and Special Laws) generally prohibits the enactment of local or special laws to the extent that a general law can be used. Thus, the cities above and those listed in the description of legislative changes below are not mentioned by name in the statute. Instead, they are identified by what are called “brackets.” In this context, a “bracket” is a general description that in theory can apply to any number of cities but really only applies to one or maybe two cities. I’ve included the brackets in the footnotes. Check them out for some Texas trivia and/or to get sense of how confusing they can be. I’ve relied on the fiscal notes from the Legislative Budget Board to identify these cities. Please be aware that I’ve not been able to independently verify all the brackets, so some may be misidentified.)

Legislative Changes: The biggest changes in the area of Subchapter C qualified projects this session was the addition of more cities to the list that can build such projects and creating a mechanism for the Texas Comptroller to claw back state tax rebates if these projects fail to meet certain tax revenue goals.

HB 5012 expands the list of cities eligible to build Subchapter C qualified project to include:

• Allen^[55]
• Brownsville^[56]
• Seguin^[57]
• Mansfield^[58]
• Beaumont^[59]
• Bastrop^[60]
• Waco^[61]
• Little Elm^[62]
• Denton^[63]
• Grapevine^[64]
• Mesquite^[65]
• Terrell^[66]
• McKinney^[67]
• Kauffman^[68]
• Temple^[69]
• Austin^[70]
• Carthage^[71]
• Rosenberg^[72]
• Eagle Pass^[73]

HB 5012 also adds Texas Tax Code, Section 351.161, which requires the Comptroller to recapture state tax revenue rebated to cities that build Subchapter C qualified projects if, after twenty years of a project’s operation, the state tax rebates paid by the Comptroller to the city during the first ten years of operation (i.e., the period that cities building such projects generally are entitled to receive such rebates) exceeds the state tax revenue generated by the project during the second ten years of operation.^[74]  This claw back provision only applies to Subchapter C qualified projects that are commenced on or after January 1, 2024, or January 1, 2027, if the project was authorized before January 1, 2023, by a municipality with a population of 175,000 or more.^[75] The claw back provision does not apply to a Subchapter C qualified project that is the subject of an economic development agreement under Local Government Code Chapter 380 that was entered into on or before January 1, 2022.^[76]

SB 627 applies primarily to San Antonio. The bill adds San Antonio to the list of cities that do not have to wholly own a qualified convention center facility or own the land on which qualified hotel is located in order to have Subchapter C qualified project (currently, only Grand Prairie and Fredericksburg qualify for this exception)^[77] The bill also adds San Antonio to the list of cities that may be entitled to additional rebates from qualified establishments and provides that nonprofit corporation can own the land on which the qualified establishments are located.^[78] Finally, SB 627 includes a claw provision substantially similar to the one found in HB 5102, except that it has not limitations on which cities are covered by the provision.^[79]

In connection with Subchapter C qualified projects, HB 3727 adds Waco to the list of cities that can build such a project (HB 5012 also added Waco) and includes a claw back provision substantially similar to the one found in HB 5102.^[80] The bill also adds a provision to Subchapter C clarifying that the subchapter does not authorize the taxing of private property for economic development purposes in a manner inconsistent with the requirements of Texas Constitution Article I, Section 17 (Taking of Property for Public Use; Special Privileges and Immunities; Control of Privileges and Franchises) or Government Code Section 2206.001 (Limitation on Eminent Domain for Private Parties or Economic Development Purposes).^[81] Finally, HB 3727 requires the Comptroller to prepare a biennial report on the status of each qualified project.^[82]

SB 1420 has substantially the same provisions with respect to takings, claw back, and a biennial report as HB 3727.^[83]

State and Local Tax Services

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At Freeman Law, our experienced attorneys regularly guide our clients through complex state and local tax issues—issues that are frequently changing as states seek to keep pace with technology and the evolution of business. Staying ahead requires sophisticated legal counsel dedicated to understanding the complex state tax issues that confront businesses and individuals. Schedule a consultation or call (214) 984-3000 to discuss your local & state tax concerns and questions. 

[1] See Tex. Tax Code §§ 351.152 (Applicability), 351.155 (Pledge of Commitment of Certain Tax Revenue for Qualified Project), 351.156 (Entitlement to Certain Tax Revenue), 351.157 (Additional Entitlement for Certain Municipalities).

[2] Id. § 351.151(4) (Definitions).

[3] Id. § 351.151(2).

[4] Id. § 351.151(3).

[5] Id.

[6] Id. §§ 351.155(e), 351.158 (Period of Entitlement).

[7] Tex. Tax Code §§ 351.156.

[8] See Id. §§ 183.051 (Mixed Beverage Tax Clearance Fund), 351.156(3).

[9] Id. § 351.157.

[10] “[A] municipality with a population of 250,000 or more that:

(i)  is located wholly or partly on a barrier island that borders the Gulf of Mexico;

(ii)  is located in a county with a population of 300,000 or more; and

• has adopted a capital improvement plan to expand an existing convention center facility . . . .”

See Tex. Tax Code §§ 351.001(7)(B), 351.152(1); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[11] “[A] municipality with a population of less than 50,000 that contains a general academic teaching institution that is not a component institution of a university system . . . .” See Tex. Tax Code §§ 351.001(7)(D), 351.152(2); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[12] “[A] municipality with a population of 640,000 or more that:

(i)  is located on an international border; and

(ii)  has adopted a capital improvement plan for the construction or expansion of a convention center facility.”

See Tex. Tax Code §§ 351.001(7)(E), 351.152(3); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[13] “[A] municipality with a population of 350,000 or more but less than 450,000 in which two professional sports stadiums are located, each of which:

(A)  has a seating capacity of at least 40,000 people; and

(B)  was approved by the voters of the municipality as a sports and community venue project under Chapter 334, Local Government Code . . . .”

See Tex. Tax Code §§ 351.102(e)(3), 351.152(4); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[14] “[A] municipality that contains more than 75 percent of the population of a county with a population of 1.5 million or more . . . .” See Tex. Tax Code § 351.152(5) (as amended by HB 5012, 88th Leg., R.S. (2023)); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[15] “[A] municipality with a population of 175,000 or more but less than 200,000 that is partially located in at least one county with a population of 125,000 or more . . . .” See Tex. Tax Code § 351.152(6) (as amended by HB 5012, 88th Leg., R.S. (2023)); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[16] “[A] municipality with a population of 250,000 or more but less than one million that is located in one county with a population of 2.5 million or more . . . .” See Tex. Tax Code § 351.152(7) (as amended by HB 5012, 88th Leg., R.S. (2023)); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[17] “[A] municipality with a population of 180,000 or more that:

(A)  is located in two counties, each with a population of 100,000 or more; and

(B)  contains an American Quarter Horse Hall of Fame and Museum . . . .”

See Tex. Tax Code § 351.152(8); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[18] “[A] municipality with a population of 96,000 or more that is located in a county that borders Lake Palestine . . . .” See Tex. Tax Code § 351.152(9); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[19] “[A] municipality with a population of 96,000 or more that is located in a county that contains the headwaters of the San Gabriel River . . . .” See Tex. Tax Code § 351.152(10); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[20] “[A] municipality with a population of at least 95,000 000 that is located in a county that is bisected by United States Highway 385 and has a population of 170,000 or more . . . .” See Tex. Tax Code § 351.152(11) (as amended by HB 5012, 88th Leg., R.S. (2023)); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[21] “[A] municipality with a population of 110,000 or more but less than 135,000 at least part of which is located in a county with a population of less than 135,000 . . . .” See Tex. Tax Code § 351.152(12); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[22] “[A] municipality with a population of 28,000 or more but less than 31,000 that is located in two counties, each of which has a population of 900,000 or more and a southern border with a county with a population of 2.5 million or more . . . .” See Tex. Tax Code § 351.152(13) (as amended by HB 5012, 88th Leg., R.S. (2023)); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[23] “[A] municipality with a population of 200,000 or more but less than 300,000 that contains a component institution of the Texas Tech University System . . . .” See Tex. Tax Code § 351.152(14); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[24] “[A] municipality with a population of 95,000 or more that:

(A)  is located in more than one county; and

(B)  borders Lake Lewisville . . . .”

See Tex. Tax Code § 351.152(15); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[25] “[A] municipality with a population of 45,000 or more that:

(A)  contains a portion of Cedar Hill State Park;

(B)  is located in two counties, one of which has a population of 2.5 million or more and one of which has a population of 190,000 or more; and

(C)  has adopted a capital improvement plan for the construction or expansion of a convention center facility . . . .”

See Tex. Tax Code § 351.152(16) (as amended by HB 5012, 88th Leg., R.S. (2023)); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[26] “[A] municipality with a population of less than 10,000 that:

(A)  is almost wholly located in a county with a population of 900,000 or more that is adjacent to a county with a population of 2.5 million or more;

(B)  is partially located in a county with a population of 2.1 million or more that is adjacent to a county with a population of 2.5 million or more;

(C)  has a visitor center and museum located in a 19th-century rock building in the municipality’s downtown; and

(D)  has a waterpark open to the public . . . .”

See Tex. Tax Code § 351.152(17) (as amended by HB 5012, 88th Leg., R.S. (2023)); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[27] “[A] municipality with a population of 60,000 or more that:

(A)  borders Lake Ray Hubbard; and

(B)  is located in two counties, one of which has a population of less than 110,000 . . . .”

See Tex. Tax Code § 351.152(18) (as amended by HB 5012, 88th Leg., R.S. (2023)); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[28] “[A] municipality with a population of 60,000 or more that:

(A)  borders Clear Lake; and

(B)  is primarily located in a county with a population of less than 355,000 . . . .”

See Tex. Tax Code § 351.152(19) (as amended by HB 5012, 88th Leg., R.S. (2023)); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[29] “[A] municipality with a population of less than 2,000 that:

(A)  is located adjacent to a bay connected to the Gulf of Mexico;

(B)  is located in a county with a population of 290,000 or more that is adjacent to a county with a population of four million or more; and

(C)  has a boardwalk on the bay . . . .”

See Tex. Tax Code § 351.152(20); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[30] “[A] municipality with a population of 75,000 or more that:

(A)  is located wholly in one county with a population of 800,000 or more that is adjacent to a county with a population of four million or more; and

(B)  has adopted a capital improvement plan for the construction or expansion of a convention center facility . . . .”

See Tex. Tax Code § 351.152(21) (as amended by HB 5012, 88th Leg., R.S. (2023)); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[31] “[A] municipality with a population of less than 70,000 that is located in three counties, at least one of which has a population of four million or more . . . .” See Tex. Tax Code § 351.152(22) (as amended by HB 5012, 88th Leg., R.S. (2023)); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[32] “[A]n eligible coastal municipality with a population of 2,9000 or more but less than 5,000 . . . .” See Tex. Tax Code §§ 351.152(23) (as amended by HB 5012, 88th Leg., R.S. (2023)), 351.001(3) (defining “eligible coastal municipality” as “a home-rule municipality that borders on the Gulf of Mexico and has a population of less than 80,000”); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[33] “[A] municipality with a population of 90,000 or more but less than 150,000 that:

(A)  is located in three counties; and

(B)  contains a branch campus of a component institution of the University of Houston System . . . .”

See Tex. Tax Code § 351.152(24); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[34] “[A] municipality that is:

(A)  primarily located in a county with a population of four million or more; and

(B)  connected by a bridge to [Kemah] . . . .”

See Tex. Tax Code § 351.152(25); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[35] “[A] municipality with a population of 25,000 or more but less than 30,000 that:

(A)  contains a portion of Mustang Bayou; and

(B)  is wholly located in a county with a population of less than 500,000 . . . .”

See Tex. Tax Code § 351.152(26) (as amended by HB 5012, 88th Leg., R.S. (2023)); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[36] “[A] municipality with a population of 70,000 or more but less than 90,000 that is located in two counties, one of which has a population of four million or more and the other of which has a population of less than 50,000 . . . .” See Tex. Tax Code § 351.152(27); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[37] “[A] municipality with a population of 10,000 or more that:

(A)  is wholly located in a county with a population of four million or more; and

(B)  has a city hall located less than three miles from a space center operated by an agency of the federal government . . . .”

See Tex. Tax Code § 351.152(28); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[38] “[A] municipality that is the county seat of a county:

(A)  through which the Pedernales River flows; and

(B)  in which the birthplace of a president of the United States is located . . . .”

See Tex. Tax Code § 351.152(29); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[39] “[A] municipality that contains a portion of U.S. Highway 79 and State Highway 130 . . . .” See Tex. Tax Code § 351.152(30); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[40] “[A] municipality with a population of 70,000 or more but less than 115,000 that is located in two counties, one of which has a population of 1.1 million or more but less than 1.9 million . . . .” See Tex. Tax Code § 351.152(31) (as amended by HB 5012, 88th Leg., R.S. (2023)); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[41] “[A] municipality with a population of less than 25,000 that contains a museum of Western American art . . . .” See Tex. Tax Code § 351.152(32); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[42] “[A] municipality with a population of 50,000 or more that is the county seat of a county that contains a portion of the Sam Houston National Forest . . . .” See Tex. Tax Code § 351.152(33); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[43] “[A] municipality with a population of less than 25,000 that:

(A)  contains a cultural heritage museum; and

(B)  is located in a county that borders the United Mexican States and the Gulf of Mexico . . . .”

See Tex. Tax Code § 351.152(34); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[44] “[A] municipality that is the county seat of a county that:

(A)  has a population of 115,000 or more;

(B)  is adjacent to a county with a population of 2.1 million or more; and

(C)  hosts an annual peach festival . . . .”

See Tex. Tax Code § 351.152(35) (as amended by HB 5012, 88th Leg., R.S. (2023)); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[45] “[A] municipality that is the county seat of a county that:

(A)  has a population of 800,000 or more; and

(B)  is adjacent to a county with a population of four million or more . . . .”

See Tex. Tax Code § 351.152(36); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[46] “[A] municipality with a population of less than 10,000 that:

(A)  contains a component university of The Texas A&M University System; and

(B)  is located in a county adjacent to a county that borders Oklahoma . . . .”

See Tex. Tax Code § 351.152(37); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[47] “[A] municipality with a population of less than 17,000 that:

(A)  is located in two counties, each of which has a population of 900,000 or more but less than two million; and

(B)  hosts an annual Cajun Festival . . . .”

See Tex. Tax Code § 351.152(38) (as amended by HB 5012, 88th Leg., R.S. (2023)); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[48] “[A] municipality with a population of 13,000 or more that:

(A)  is located on an international border; and

(B)  is located in a county:

(i)  with a population of less than 400,000; and

(ii)  in which at least one World Birding Center site is located . . . .”

See Tex. Tax Code § 351.152(39); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[49] “[A] municipality with a population of 3,200 or more that:

(A)  is located on an international border; and

(B)  is located not more than five miles from a state historic site that serves as a visitor center for a state park that contains 300,000 or more acres of land . . . .”

See Tex. Tax Code § 351.152(40); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[50] “[A] municipality with a population of 36,000 or more that is adjacent to at least two municipalities [with a population of 95,000 or more that are located in more than one county and that border Lake Lewisville] . . . .” See Tex. Tax Code § 351.152(41); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[51] “[A] municipality with a population of 28,000 or more that is located in a county with a population of 240,000 or more that contains a portion of the Blanco River and in which is located a historic railroad depot and heritage center . . . .” See Tex. Tax Code § 351.152(42) (as amended by HB 5012, 88th Leg., R.S. (2023)); Legislative Budget Board, Fiscal Note for HB 4347, 86th Leg., R.S. (May 21, 2019).

[52] “[A] municipality located in a county that has a population of not more than 300,000 and in which a component university of the University of Houston System is located . . . .” See Tex. Tax Code § 351.152(43); Legislative Budget Board, Fiscal Note for HB 4103, 87th Leg., R.S. (May 27, 2021).

[53] “[A] municipality with a population of less than 500,000 that is:

(A)  located in two counties; and

(B)  adjacent to [Cedar Park] . . . .”

See Tex. Tax Code § 351.152(44); Legislative Budget Board, Fiscal Note for HB 4103, 87th Leg., R.S. (May 27, 2021).

[54] “[A]municipality that:

(A)  has a population of more than 67,000; and

(B)  is located in two counties with 90 percent of the municipality’s territory located in a county with a population of at least 800,000, and the remaining territory located in a county with a population of at least four million.”

See Tex. Tax Code § 351.152(45) (as amended by HB 5012, 88th Leg., R.S. (2023)); Legislative Budget Board, Fiscal Note for HB 4103, 87th Leg., R.S. (May 27, 2021).

[55] “[A] a municipality that:

• has a population of 100,000 or more; and
• is wholly located in, but is not the county seat of, a county with a population of one million or more:
• in which all or part of a municipality

with a population of one million or more is located; and

• that is adjacent to a county with a

population of 2.5 million or more . . . .”

See HB 5012, 88th Leg., R.S. (2023) (adding Tex. Tax Code § 351.152(46)); Legislative Budget Board, Fiscal Note for HB 5012, 88th Leg., R.S. (May 25, 2023).

[56] “[A] municipality that is the county seat of a county bordering the Gulf of Mexico and the United Mexican States . . . .” See HB 5012, 88th Leg., R.S. (2023) (adding Tex. Tax Code § 351.152(47)); Legislative Budget Board, Fiscal Note for HB 5012, 88th Leg., R.S. (May 25, 2023). 

[57] “[A] municipality that is bisected by the Guadalupe River and is the county seat of a county with a population of

170,000 or more . . . .” See HB 5012, 88th Leg., R.S. (2023) (adding Tex. Tax Code § 351.152(48)); Legislative Budget Board, Fiscal Note for HB 5012, 88th Leg., R.S. (May 25, 2023). 

[58] “[A] municipality with a population of 70,000 or more but less than 150,000 that borders Joe Pool Lake . . . .“ See HB 5012, 88th Leg., R.S. (2023) (adding Tex. Tax Code § 351.152(49)); Legislative Budget Board, Fiscal Note for HB 5012, 88th Leg., R.S. (May 25, 2023).

[59] “[A] municipality with a population of 115,000 or more that borders the Neches River . . . .” See HB 5012, 88th Leg., R.S. (2023) (adding Tex. Tax Code § 351.152(50)); Legislative Budget Board, Fiscal Note for HB 5012, 88th Leg., R.S. (May 25, 2023).

[60] “[A] municipality described by Section 351.101(k) . . . .”  Texas Tax Code Section 351.101(k) describes “a municipality that is intersected by both State Highways 71 and 95 . . . .”

See HB 5012, 88th Leg., R.S. (2023) (adding Tex. Tax Code § 351.152(51)); Legislative Budget Board, Fiscal Note for HB 5012, 88th Leg., R.S. (May 25, 2023).

[61] “[A] municipality that is the county seat of a county:

• through which the Brazos River flows; and
• in which a national monument is located . . . .”

See HB 5012, 88th Leg., R.S. (2023) (adding Tex. Tax Code § 351.152(52)); Legislative Budget Board, Fiscal Note for HB 5012, 88th Leg., R.S. (May 25, 2023).

[62] “[A] municipality with a population of 45,000 or more that:

• is not the county seat of a county;
• is located in a single county; and
• contains a portion of Lake Lewisville . . . .”

See HB 5012, 88th Leg., R.S. (2023) (adding Tex. Tax Code § 351.152(53)); Legislative Budget Board, Fiscal Note for HB 5012, 88th Leg., R.S. (May 25, 2023).

[63] “[A] municipality that is the county seat of a county with a population of more than 900,000 that is adjacent to two counties, each of which has a population of more than 1.8 million . . . .” See HB 5012, 88th Leg., R.S. (2023) (adding Tex. Tax Code § 351.152(54)); Legislative Budget Board, Fiscal Note for HB 5012, 88th Leg., R.S. (May 25, 2023).

[64] “[A] municipality that hosts an annual wine festival and is located in three counties, each of which has a population of more than 900,000 . . . .” See HB 5012, 88th Leg., R.S. (2023) (adding Tex. Tax Code § 351.152(55)); Legislative Budget Board, Fiscal Note for HB 5012, 88th Leg., R.S. (May 25, 2023).

[65] “[A] municipality that has a population of at least 150,000 but less than 1,300,000 and is partially located in a county that contains a portion of Cedar Creek Reservoir . . . .” See HB 5012, 88th Leg., R.S. (2023) (adding Tex. Tax Code § 351.152(56)); Legislative Budget Board, Fiscal Note for HB 5012, 88th Leg., R.S. (May 25, 2023).

[66] “[A] municipality that is located in a county that contains a portion of Cedar Creek Reservoir and in which a private college is located . . . .” See HB 5012, 88th Leg., R.S. (2023) (adding Tex. Tax Code § 351.152(57));

Legislative Budget Board, Fiscal Note for HB 5012, 88th Leg., R.S. (May 25, 2023).

[67] “[A] municipality that is the county seat of a county:

• with a population of one million or more;
• in which all or part of a municipality with a population of one million or more is located; and
• that is located adjacent to a county with a population of 2.5 million or more . . . .”

See HB 5012, 88th Leg., R.S. (2023) (adding Tex. Tax Code § 351.152(58)); Legislative Budget Board, Fiscal Note for HB 5012, 88th Leg., R.S. (May 25, 2023).

[68] “[A] municipality that is the county seat of a county that contains a portion of Cedar Creek Reservoir and borders a county with a population of more than 240,000 . . . .” See HB 5012, 88th Leg., R.S. (2023) (adding Tex. Tax Code § 351.152(59)); Legislative Budget Board, Fiscal Note for HB 5012, 88th Leg., R.S. (May 25, 2023).

[69] “[A] municipality with a population of more than 80,000 but less than 150,000 that is located in a county with a population of more than 369,000 but less than 864,000 that contains part of an active duty United States Army installation . . . .” See HB 5012, 88th Leg., R.S. (2023) (adding Tex. Tax Code § 351.152(60)); Legislative Budget Board, Fiscal Note for HB 5012, 88th Leg., R.S. (May 25, 2023).

[70] “[A] municipality with a population of 750,000 or more that is located in a county with a population of 1.5 million or less . . . .” See HB 5012, 88th Leg., R.S. (2023) (adding Tex. Tax Code § 351.152(61)); Legislative Budget Board, Fiscal Note for HB 5012, 88th Leg., R.S. (May 25, 2023).

[71] “[A] municipality with a population of less than 7,000 that contains a country music hall of fame . . . .” See HB 5012, 88th Leg., R.S. (2023) (adding Tex. Tax Code § 351.152(62)); Legislative Budget Board, Fiscal Note for HB 5012, 88th Leg., R.S. (May 25, 2023).

[72] “[A] municipality with a population of 35,000 or more that contains a railroad museum and is located in a county that:

• has a population of 800,000 or more; and
• is adjacent to a county with a population of four million or more . . . .”

See HB 5012, 88th Leg., R.S. (2023) (adding Tex. Tax Code § 351.152(63)); Legislative Budget Board, Fiscal Note for HB 5012, 88th Leg., R.S. (May 25, 2023).

[73] “[A] municipality:

(A) that is the county seat of a county:

(i) with a population of 60,000 or less; and

(ii) that borders the Rio Grande; and

• in which is located a United States military for listed in the National Register of Historic Places.”

See HB 5012, 88th Leg., R.S. (2023) (adding Tex. Tax Code § 351.152(64)); Legislative Budget Board, Fiscal Note for HB 5012, 88th Leg., R.S. (May 25, 2023).

[74] See HB 5012, 88th Leg., R.S. (2023) (adding Tex. Tax Code § 351.161).

[75] Id.

[76] Id.

[77] See SB 627, 88th Leg., R.S. (2023) (amending Tex. Tax Code § 351.153)); Tex. Tax Code §§ 351.151(2)(B), (3)(A), 351.152(6), (29).

[78] SB 627, 88th Leg., R.S. (2023) (amending Tex. Tax Code § 351.157).

[79] See SB 627, 88th Leg., R.S. (2023) (adding Tex. Tax Code § 351.161); HB 5012, 88th Leg., R.S. (2023) (adding Tex. Tax Code § 351.161).

[80] See HB 3727, 88th Leg., R.S. (2023) (adding Tex. Tax Code §§ 351.152(46) and 351.162); HB 5012, 88th Leg., R.S. (2023) (adding Tex. Tax Code §§ 351.152(52), 351.161).

[81] HB 3727, 88th Leg., R.S. (2023) (adding Tex. Tax Code §§ 351.161).

[82] HB 3727, 88th Leg., R.S. (2023) (adding Tex. Tax Code §§ 351.163).

[83] See HB 3727, 88th Leg., R.S. (2023) (adding Tex. Tax Code §§ 351.161, 351.162, an 351.163); HB 5012, 88th Leg., R.S. (2023) (adding Tex. Tax Code §§ 351.161, 351.162, an 351.163).

The Tax Cuts and Jobs Act of 2017 enacted a number of important tax-law changes.  Few changes are more notable than those contained in the international tax provisions. Perhaps chief among the international tax changes was the Section 965 “transition” tax—a.k.a. the “deemed repatriation” tax.

Section 965 generally requires that shareholders—as defined under section 951(b) of the I.R.C.—pay a “transition” tax on their pro rata share of the untaxed foreign earnings of certain “specified foreign corporations.”  The tax is imposed by increasing a specified foreign corporation’s subpart F income for its last tax year beginning before January 1, 2018.  The shareholder’s pro rata share of that subpart F income is included in income as if those foreign earnings had been repatriated to the United States—hence the “deemed repatriation” moniker.  The mandatory inclusion is subject to tax at an effective tax rate of either 15.5% or 8%, depending upon the extent to which the inclusion is attributable to earnings and profits that are deemed to consist of “cash” or other liquid assets.

A “specified foreign corporation” is generally defined as any Controlled Foreign Corporation under section 957 or a foreign corporation (other than a PFIC) that has a “United States shareholder” (as defined under section 951) that is a domestic corporation.  Thus, a shareholder of such a foreign corporation is required to include its share of that foreign corporation’s historic earnings and profits in income as if the amount had been repatriated.

Amounts owed under Section 965 are generally due by the due date or extended due date of the taxpayer’s 2017 tax return.  However, the new law provided for an election to pay the tax in installments.  There are also special rules applicable to S-Corporations that may effectively allow for the indefinite postponement of such payment.

The IRS recently issued guidance on the section 965 tax in the form of FAQs. Below is a summary of that guidance:

Q1.  Who is required to report amounts under section 965 of the Code on a 2017 tax return?

A1.  A person that is required to include amounts in income under section 965 of the Code in its 2017 taxable year, whether because, the person is a United States shareholder of a deferred foreign income corporation (as defined under section 965(d) of the Code) or because it is a direct or indirect partner in a domestic partnership, a shareholder in an S corporation, or a beneficiary of another passthrough entity that is a United States shareholder of a deferred foreign income corporation, is required to report amounts under section 965 of the Code on its 2017 tax return.

Q2.  How are amounts under section 965 of the Code reported on a 2017 tax return?

A2.  Amounts required to be reported on a 2017 tax return should be reported on the return as reflected in the table included in Appendix: Q&A2. The table reflects only how items related to amounts included in income under section 965 of the Code should be reported on a 2017 tax return. It does not address the reporting in other scenarios, including distributions made in 2017, which should be reported consistent with the Code and the current forms and instructions.

Posted: 03/13/2018

Q3.  Is there any other reporting in connection with section 965 of the Code required on a 2017 tax return?

A3. Yes.  A person that has income under section 965 of the Code for its 2017 taxable year is required to include with its return an IRC 965 Transition Tax Statement, signed under penalties of perjury and, in the case of an electronically filed return, in Portable Document Format (.pdf) with a filename of “965 Tax”.  Multiple IRC 965 Transition Tax Statements can be combined into a single .pdf file.  The IRC 965 Transition Tax Statement must include the following information:

• The person’s total amount required to be included in income under section 965(a) of the Code.
• The person’s aggregate foreign cash position, if applicable.
• The person’s total deduction under section 965(c) of the Code.
• The person’s deemed paid foreign taxes with respect to the total amount required to be included in income by reason of section 965(a).
• The person’s disallowed deemed paid foreign taxes pursuant to section 965(g).
• The total net tax liability under section 965 (as determined under section 965(h)(6)). _[1]
• The amount of the net tax liability under section 965 to be paid in installments (including the current year installment) under section 965(h) of the Code, if applicable, which will be assessed. _[2]
• The amount of the net tax liability under section 965, the payment of which has been deferred, under section 965(i) of the Code, if applicable. _[3]
• A listing of elections under section 965 of the Code or the election provided for in Notice 2018-13 that the taxpayer has made, if applicable.

A model statement is included in Appendix: Q&A3.  Adequate records must be kept supporting the section 965(a) inclusion amount, deduction under section 965(c) of the Code, and net tax liability under section 965, as well as the underlying calculations of these amounts.  Moreover, additional reporting may be required when filing returns for subsequent tax years, and the manner of reporting may be different.  See also Q&A8 concerning Form 5471 filing.

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[1] Use section 965(h)(6) to calculate the total net tax liability under section 965 even if an election to pay the net tax liability under section 965 in installments has not been made and even if the person is not a United States shareholder of a deferred foreign income corporation.  Do not reduce this amount by any net tax liabilities under section 965 with respect to which section 965(i) is effective.  Section 965(h)(6) generally determines a person’s net tax liability under section 965 by starting with (i) the taxpayer’s tax liability with all section 965 amounts included and then subtracting (ii) the tax liability with no section 965 amounts included and with dividends received from deferred foreign income corporations disregarded.  See Publication 5292 for instructions to be used in computing the net tax liability under section 965.

[2]  If both one or more elections under section 965(i) have been made and an election under section 965(h) has been made, the amount of the net tax liability under section 965 to be paid in installments is: (i) the amount of the total net tax liability under section 965 as determined above less (ii) the aggregate amount of the taxpayer’s net tax liabilities under section 965 with respect to which section 965(i) elections are effective.   See Publication 5292 for more information.

[3]  See Publication 5292 for more information regarding the calculation of amounts eligible for S corporation shareholder deferral under section 965(i).

Updated: 04/13/2018

Q4.  What elections are available with respect to section 965 of the Code on a 2017 tax return?

A4.  Section 965 of the Code permits multiple elections related to amounts included in income by reason of section 965 of the Code or the payment of a taxpayer’s net tax liability under section 965 (as determined under section 965(h)(6)). Statutory elections can be found in section 965(h), (i), (m), and (n).

Furthermore, the Treasury Department and the IRS have announced another election that may be made with respect to the determination of the post-1986 earnings and profits of a specified foreign corporation. This election is described in Notice 2018-13, 2018-6 I.R.B. 341, Section 3.02.

Posted: 03/13/2018

Q5.  Who can make an election with respect to section 965 of the Code on a 2017 tax return?

A5.  The elections under section 965 of the Code are limited to taxpayers with a net tax liability under section 965 (in the case of section 965(h) of the Code), taxpayers that are shareholders of S corporations and that have a net tax liability under section 965 (in the case of section 965(i) of the Code), taxpayers that are REITs (in the case of section 965(m) of the Code), or taxpayers with an NOL (in the case of section 965(n) of the Code).  Thus, a domestic partnership or an S corporation that is a United States shareholder of a deferred foreign income corporation may not make any of the elections under section 965 of the Code.  The Treasury Department and the IRS provided further guidance concerning the availability of the elections under section 965 of the Code to direct and indirect partners in domestic partnerships, shareholders in S corporations, and beneficiaries in other passthrough entities that are United States shareholders of deferred foreign income corporations. See Section 3.05(b) of Notice 2018-26.

The election under Notice 2018-13, Section 3.02 may be made on behalf of a specified foreign corporation pursuant to the rules of §1.964-1(c)(3).

In the case of a consolidated group (as defined in §1.1502-1(h)), in which one or more members are United States shareholders of a specified foreign corporation, the agent for the group (as defined in §1.1502-77) must make the elections on behalf of its members.

Updated: 04/13/2018

Q6.  When must an election with respect to section 965 of the Code be made?

A6.  An election with respect to section 965 of the Code must be made by the due date (including extensions) for filing the return for the relevant year. However, even if an election is made under section 965(h) of the Code to pay a net tax liability under section 965 of the Code in installments, the first installment must be paid by the due date (without extensions) for filing the return for the relevant year.

Posted: 03/13/2018

Q7.  How is an election with respect to section 965 of the Code made on a 2017 tax return?

A7.  A person makes an election under section 965 of the Code or the election provided for in Notice 2018-13, Section 3.02, by attaching to a 2017 tax return a statement signed under penalties of perjury and, in the case of an electronically filed return, in Portable Document Format (.pdf), for each such election. Each such statement must include the person’s name, taxpayer identification number and any other information relevant to the election, such as the net tax liability under section 965 with respect to which the installment election under section 965(h)(1) of the Code applies, the name and taxpayer identification number of the S corporation with respect to which the deferral election under section 965(i)(1) of the Code is made, the section 965(a) inclusion amount with respect to which the election under section 965(m)(1)(B) of the Code applies, the amount described in section 965(n)(2) of the Code to which the election under section 965(n)(1) of the Code applies, and the name and taxpayer identification number, if any, of the specified foreign corporation with respect to which the election under Notice 2018-13, Section 3.02, is made. Model statements are included in Appendix: Q&A7. Each election statement must have the applicable title and, in the case of an attachment in Portable Document Format (.pdf) included with an electronically filed return, the file name reflected in the following table:

Posted: 03/13/2018

Q8.  Is a Form 5471 with respect to all specified foreign corporations with respect to which a person is a United States shareholder required to be filed with the person’s 2017 tax return, regardless of whether the specified foreign corporations are CFCs?

A8. Yes. In order to collect information relevant to the calculation of a United States shareholder’s section 965(a) inclusion amount, a person that was a United States Shareholder of a specified foreign corporation during its 2017 taxable year, including on the last day of such year, and owned stock of the specified foreign corporation on the last day of the specified foreign corporation’s year that ended during the person’s year must file a Form 5471 with respect to the specified foreign corporation completed with the identifying information on page 1 of Form 5471 above Schedule A, as well as Schedule J.  The exceptions to filing in the instructions to Form 5471 otherwise will continue to apply.  United States shareholders not otherwise required to file Form 5471 should consult the instructions to Form 5471 to determine the correct category of filer.  Notice 2018-13, Section 5.02 also provides an exception to filing Form 5471 for certain United States shareholders considered to own stock by “downward attribution” from a foreign person. The IRS intends to modify the instructions to the Form 5471 as necessary.

Updated: 04/13/2018

Q9.  Are domestic partnerships, S corporations, or other passthrough entities required to report any additional information to their partners, shareholders, or beneficiaries in connection with section 965 of the Code?

A9.  Yes. A domestic partnership, S corporation, or other passthrough entity should attach a statement to its Schedule K-1s, if applicable, that includes the following information for each deferred foreign income corporation for which such passthrough entity has a section 965(a) inclusion amount:

• The partner’s, shareholder’s, or beneficiary’s share of the partnership’s, S corporation’s, or other passthrough entity’s section 965(a) inclusion amount, if applicable.
• The partner’s, shareholder’s, or beneficiary’s share of the partnership’s, S corporation’s, or other passthrough entity’s deduction under section 965(c), if applicable.
• Information necessary for a domestic corporate partner, or an individual making an election under section 962, to compute its deemed paid foreign tax credits with respect to its share of the partnership’s, S corporation’s, or passthrough entity’s section 965(a) inclusion amount, if applicable.

For more information concerning the application of section 965 to domestic partnerships, S corporations, or other domestic passthrough entities, see Section 3.05(b) of Notice 2018-26.

Updated: 04/13/2018

Q10.  How should a taxpayer pay the tax resulting from section 965 of the Code for a 2017 tax return?

A10. A taxpayer should make two separate payments as follows: one payment reflecting tax owed without regard to section 965 of the Code, and a second, separate payment reflecting tax owed resulting from section 965 of the Code and not otherwise satisfied by another payment or credit as described in Q&A13 and Q&A14 (the 965 Payment).  See Q&A13 for information regarding how the IRS will apply 2017 estimated tax payments.  Both payments must be paid by the due date of the applicable return (without extensions).  But see Notice 2018-26, section 3.05(e), providing that if an individual receives an extension of time to file and pay under §1.6081-5(a)(5) or (6), the individual’s due date for the 965 Payment is also extended.

The 965 Payment must be made either by wire transfer or by check or money order. This may be the first year’s installment of tax owed in connection with a 2017 tax return by a taxpayer making the election under section 965(h) of the Code, or the full net tax liability under section 965 of the Code for a taxpayer who does not make such election and does not make an election under section 965(i) of the Code.  For the 965 Payment, there is no penalty for taxpayers electing to use wire transfers as an alternative to otherwise mandated EFTPS payments.  Accordingly, taxpayers that would normally be required to pay through EFTPS should submit the 965 Payment via wire transfer or they may be subject to penalties.  On a wire payment of tax owed under section 965 of the Code, the taxpayer would use a 5-digit tax type code of 09650 (for more information, see IRS, Same-Day Wire Federal Tax Payments). On a check or money order payment of tax owed resulting from section 965 of the Code, include an appropriate payment voucher (such as Form 1040-V or 1041-V) and along with all other required information write on the front of your payment “2017 965 Tax.”

For the payment owed without regard to section 965, normal payment procedures apply (for more information, see IRS, Pay Online). This payment may be made at the same or different time from the 965 Payment, but must be made by the due date of the return or penalties and interest may apply.

Updated: 04/13/2018

Q11.  If not already filed, when should an individual taxpayer electronically file a 2017 tax return?

A11. Individual taxpayers who electronically file their Form 1040 should file on or after April 2, 2018. Individual taxpayers who file a paper Form 1040 can do so at any time.

Posted: 03/13/2018

Q12. If a person has already filed a 2017 tax return, what should the person do?

A12. The person should consider filing an amended return based on the information provided in these FAQs and Appendices. Failure to submit a return in this manner may result in processing difficulties and erroneous notices being issued. Failure to accurately reflect the net tax liability under section 965 of the Code in total tax could result in interest and penalties.

In order to amend a return, a person would file the applicable form for amending the return pursuant to regular instructions and would attach:

• amended versions of forms and schedules necessary to follow the instructions in these FAQs,
• any election statements, and
• the IRC 965 Transition Tax Statement included in Appendix: Q&A3.

Posted: 03/13/2018

Q13. How will the IRS apply 2017 estimated tax payments (including credit elects from 2016) to a taxpayer’s net tax liability under section 965?

A13. The IRS will apply 2017 estimated tax payments first to a taxpayer’s 2017 net income tax liability described under section 965(h)(6)(A)(ii) (its net income tax determined without regard to section 965), and then to its tax liability under section 965, including those amounts that are subject to payment in installments pursuant to an election under section 965(h).

Added: 04/13/2018

Q14. If a taxpayer’s 2017 payments, including estimated tax payments, exceed its 2017 net income tax liability described under section 965(h)(6)(A)(ii) (its net income tax determined without regard to section 965) and the first annual installment (due in 2018) pursuant to an election under section 965(h), may the taxpayer receive a refund of such excess amounts or credit such excess amounts to its 2018 estimated income tax?

A14. No. A taxpayer may not receive a refund or credit of any portion of properly applied 2017 tax payments unless and until the amount of payments exceeds the entire unpaid 2017 income tax liability, including all amounts to be paid in installments under section 965(h) in subsequent years.  If a taxpayer’s 2017 tax payments exceed the 2017 net income tax liability described under section 965(h)(6)(A)(ii) (net income tax determined without regard to section 965) and the first annual installment (due in 2018) pursuant to an election under section 965(h), the excess will be applied to the next successive annual installment (due in 2019)  (and to the extent such excess exceeds the amount of such next successive annual installment due, then to the next such successive annual installment (due in 2020), etc.) pursuant to an election under section 965(h).

Added: 04/13/2018

Appendix: Q&A2

Updated: 04/13/2018

_________________________________

[4] This includes section 965(a) inclusion amounts of a United States shareholder of a deferred foreign income corporation and distributive shares and pro rata shares of section 965(a) inclusion amounts of domestic partnerships, S corporations, and other passthrough entities.
[5] This includes deductions under section 965(c) of a United States shareholder of a deferred foreign income corporation and distributive shares and pro rata shares of deductions under section 965(c) of domestic partnerships, S corporations, and other passthrough entities.
[6] See section 965(g).
[7] See section 965(h)(6) and Q&A3.
[8] To make the 965(i) election, the taxpayer will have to file a paper Form 1040.

Updated: 04/13/2018

_________________________________

[9] See also Q&A9.
[10] See section 965(f)(2) concerning the treatment of the income inclusion offset by the section 965(c) deduction for the purposes of computing adjustments to shareholder basis under section 1367(a)(1)(A) and calculating the accumulated adjustments account under section 1368(e)(1)(A).
[11] See also Q&A9.
[12]See section 965(f)(2) concerning the treatment of the income inclusion offset by the section 965(c) deduction for the purpose of computing adjustments to the basis of a partner’s interest in a partnership under section 705(a)(1)(B)

_________________________________

[13] See also Q&A9.

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Expert Tax Defense Attorneys

Need help with tax issues?  Contact us as soon as possible to discuss your rights and the ways we can assist in your defense. We handle all types of cases, including complex international & offshore tax compliance.  Schedule a consultation or call (214) 984-3000 to discuss your tax issues or questions.

Federal tax penalties have always been an IRS priority.  But, perhaps more so today than three decades ago.  For example, in 1987, the IRS reported that it had assessed penalties of approximately $14 billion.  Compare that figure with fiscal year 2019—a year in which the IRS assessed over $40 billion in penalties.  The number of penalty assessments (and corresponding government revenue) against taxpayers is only expected to grow in the near future.

IRS priority alone, however, has not been the sole cause of the staggering rise in penalties.  Indeed, congressional action has only buttressed this phenomenon.  In 1955, the Internal Revenue Code (the “Code”) housed approximately 14 penalties.  Today, the number of penalties hovers closer to 150.  Put simply, the IRS has an arsenal of various statutory provisions to use and penalize unwanted taxpayer conduct, from the late filing of a return or information return to the late payment of tax or even the negligent filing of a return.

Nevertheless, taxpayers and tax professionals are not helpless.  Rather, there are a multitude of penalty defenses against proposed or already assessed penalties.  This Insight discusses some of those defenses.  It further provides some helpful background information regarding the IRS’ administrative guidance for the imposition of penalties.

IRS Policy Statement 20-1 and the IRS Penalty Handbook

In November 1987, the IRS established a task force to study civil penalties imposed against taxpayers.  The task force eventually issued a report, which made several recommendations.  Chief amongst them were:  (1) the IRS should develop and adopt a single penalty policy statement emphasizing that penalties exist for the purpose of encouraging voluntary compliance; and (2) the IRS should develop a single consolidated penalty handbook for use by its employees.

Both of these recommendations were adopted and put into practice.  First, the IRS adopted IRS Policy Statement 20-1.  That statement recognizes that the IRS has a statutory responsibility to collect the proper amount of tax revenues in the most efficient manner feasible.  Given this responsibility, the IRS further recognizes in Policy Statement 20-1 that penalties provide the IRS with important tools to meet that responsibility.

Policy Statement 20-1 also provides guidance to examiners and managers regarding examinations and penalty determinations. It states: “In order to effectively use penalties to encourage compliant conduct, examiners and their managers must consider the applicability of penalties in each case, and fully develop the penalty issue when the initial consideration indicates that penalties should apply.”  In sum, the IRS statement specifically instructs examiners and managers to carefully look for potential penalties during the work up of their cases.

Second, the IRS adopted a Penalty Handbook, which is located now in the Internal Revenue Manual.  See I.R.M. pt. 20.1.  The Penalty Handbook serves as the primary source of authority for civil administration of penalties by the IRS.  Indeed, it includes guidance on almost any civil penalty in the Code, including:

1. Failure to File / Failure to Pay Penalties under I.R.C. §§ 6651, 6698, and 6699. See I.R.M. pt. 20.1.2.
2. Estimated Tax Penalties under I.R.C. § 6654 (individual) and I.R.C. § 6655 (corporation). See I.R.M. pt. 20.1.3.
3. Failure to Deposit Penalty under I.R.C. § 6656. See I.R.M. pt. 20.1.4.
4. Return Related Penalties under I.R.C. §§ 6662, 6662A, 6663, and 6676. See I.R.M. pt. 20.1.5.
5. Preparer, Promoter, and Material Advisor Penalties under I.R.C. §§ 6694, 6695, 6700, 6701, 6707, 6707A, 6708, 6713. See I.R.M. pt. 20.1.6.
6. Information Return Penalties under I.R.C. §§ 6011, 6721, 6722, 6723, and 6724. See I.R.M. pt. 20.1.7.
7. Employee Plans and Exempt Organizations Miscellaneous Civil Penalties under I.R.C. §§ 6652, 6684, 6685, 6690, 6692, 6693, 6704, 6710, 6711, and 6714. See I.R.M. pt. 20.1.8.
8. International Penalties under I.R.C. §§ 6038, 6038A, 6038D, 6039E, 6039G, 6039F, 6652(f), 6677, 6679, 6683, 6686, 6688, 6689, and 6712. See I.R.M. pt. 20.1.9.
9. Miscellaneous Penalties under various Code provisions. See I.R.M. pt. 20.1.10.
10. Excise Tax and Estate and Gift Tax Penalties under various Code provisions. See I.R.M. pt. 20.1.11.
11. Penalties applicable to incorrect appraisals. See I.R.M. pt. 20.1.12.

Commonly Imposed IRS Penalties

Although there are many civil penalties available, the IRS tends to impose some more than others.  A brief discussion of the more commonly imposed IRS penalties follows.

Failure-to-File (I.R.C. § 6651(a)(1))

The failure-to-file penalty under I.R.C. § 6651(a)(1) applies to a variety of different returns.  But, it is more common to see this penalty imposed on a taxpayer for failure to file an income tax return, estate return, gift tax return, or employment tax return.

The penalty for late filing is generally 5% of the amount of tax required to be shown on the return, if the failure is not more than one month.  Each additional month the return is not filed results in an additional 5% penalty.  However, the penalty cannot exceed 25% in the aggregate (and is adjusted to 4.5% in the event both this and the failure-to-pay penalty discussed below are applied for the same month).

Failure-to-Pay (I.R.C. § 6651(a)(2))

As the name suggests, the failure-to-pay penalty is imposed when a taxpayer makes a late payment of tax.  If the taxpayer fails to pay tax due by the deadline, I.R.C. § 6651(a)(2) permits the IRS to impose a penalty of 0.5% of the amount of tax shown on the return, if the failure is for not more than one month.  For each additional month, a penalty of 0.5% continues to apply until the tax is paid or until the penalty reaches an aggregate of 25%.

Fraudulent Failure to File (I.R.C. § 6651(f))

The Code has higher penalties if the IRS is able to show a return was not filed due to fraud.  In these instances, the penalty is increased from 5% each month to 15% each month, not to exceed 75%.  To prove this penalty applies, however, the IRS must show fraud by clear and convincing evidence.  See, e.g., Mohamed v. Comm’r, T.C. Memo. 2013-255 n.7; Harrington v. Comm’r, T.C. Memo. 2011-73.  Negligence or even gross negligence resulting in late filing is not sufficient to prove fraud.  See Estate of Windsberg v. Comm’r, T.C. Memo. 1978-101.

Failure to Pay Estimated Taxes (I.R.C. § 6654)

If an individual taxpayer fails to pay in sufficient axes at various intervals throughout the year, such taxpayer may be liable for the failure-to-pay estimated tax penalty.  The penalty is based on the underpayment and the period of the underpayment.  For these purposes, the underpayment means the excess of the required installment over the amount (if any) of the installment paid on or before the specified due date.  On the other hand, the period of the underpayment means the period which runs from the due date of the installment until the earlier of: (1) the date on which such portion is paid; or (2) April 15 of the following year.  The penalty amount—or the underpayment rate—is established under I.R.C. § 6621(a)(2).  Generally, this amount is 3% points over the federal short-term rate established under I.R.C. § 1274(d).

Failure to Deposit Taxes (I.R.C. § 6656)

Employers who fail to timely deposit employment taxes are subject to penalties for failure to deposit.  The penalty amount generally depends on when the deposit is made.  For example, the penalty can be as low as 2% of the underpaid deposit if made within 5 days or less of the deadline up to 10% if made more than 15 days past the deadline.  The penalty is increased to 15% in certain instances where the deposit has not been made and the IRS issues a delinquency notice to the taxpayer.

Accuracy-Related Penalty (I.R.C. § 6662)

The accuracy-related penalty under I.R.C. § 6662 seeks to penalize taxpayers for certain incorrect reporting positions claimed on a tax return.  For example, an accuracy-related penalty may be imposed against a taxpayer for filing a negligent return or a return that disregards rules or regulations.  See I.R.C. § 6662(b)(1).  In addition, an accuracy-related penalty may be imposed, regardless of negligence or disregard of rules or regulations, if there is a substantial understatement of income tax.  See I.R.C. § 6662(b)(2).  In all of these instances, the accuracy-related penalty is 20% of the underpayment.

Fraud Penalty (I.R.C. § 6663)

The accuracy-related penalty may be increased if the underpayment is due to fraud.  In these circumstances, the fraud penalty is 75% of the part of the underpayment attributable to fraud.  Similar to the penalty under I.R.C. § 6651(f), the IRS must establish by clear and convincing evidence that a portion of the underpayment is attributable to fraud.  If the IRS meets this burden, the entire underpayment is presumed attributable to fraud unless the taxpayer can show by a preponderance of the evidence that a portion is not attributable to fraud.

International Reporting Penalties

Title 31 and the Code both contain penalty provisions related to a taxpayer’s failure to file international information returns. For example, U.S. persons who have a financial interest in or signature authority over one or more financial accounts with an aggregate value of more than $10,000 at any time during the calendar year are required to file FinCEN Form 114.  See 31 U.S.C. § 5314; 31 C.F.R. § 1010.350.

A taxpayer’s failure to timely file a proper FBAR can result in either willful or non-willful penalties.  For willful violations, the IRS may impose a penalty equal to the greater of:  (1) $100,000 (adjusted for inflation); or (2) 50% of the balance of the account at the time of the violation.  31 U.S.C. § 5321(a)(5)(C).  For these purposes, the term “willfulness” means a voluntary, intentional violation of a known legal duty.  But, willfulness can also be found if the taxpayer acts with “willful blindness.”  If the failure to timely file a proper FBAR was non-willful, the IRS may impose a penalty of up to $10,000 (adjusted for inflation).  31 U.S.C. § 5321(a)(5).

There are other penalty provisions in the Code related to foreign transactions.  These include:

1. Certain Events Related to Foreign Trusts / Receipt of Foreign Gifts (IRS Form 3520);
2. Grantor Foreign Trusts (IRS Form 3520-A);
3. Ownership/Officer Positions with Foreign Corporations (IRS Form 5471);
4. Domestic Corporations Owned by 25% or More Foreign Shareholders (IRS Form 5472);
5. Transfers of Property to Foreign Corporations in Certain Tax-Free Exchanges (IRS Form 926);
6. U.S. Persons Ownership of Certain Foreign Financial Assets (IRS Form 8938);
7. Ownership of Foreign Partnerships (IRS Form 8865)

Failure to file these forms at the proper time and in the proper form can also result in significant civil penalties.

Penalty Defenses  

Reasonable Cause

The primary defense against most IRS penalties is the defense of reasonable cause.  Generally, this defense requires the taxpayer to show that he or she exercised ordinary business care and prudence with respect to the filing, reporting, or payment obligation but nevertheless was unable to comply.  See, e.g., U.S. v. Boyle, 469 U.S. 241 (1985).

By way of example, assume a taxpayer missed the filing deadline to file an individual income tax return by 2 months.  Under I.R.C. § 6651(a)(1), the IRS could impose a penalty for the late filing.  But, if the taxpayer can show he or she exercised ordinary business care and prudence and was unable to file the return by the filing deadline, the taxpayer can assert reasonable cause as a defense to the late-filing penalty.  For late filings, federal courts and the IRS have recognized a taxpayer has reasonable cause for:  (1) deaths, serious illness, or unavoidable absences; (2) fires, casualties, natural disasters, or other disturbances; (3) a taxpayer’s inability to obtain necessary records; and (4) bad legal advice regarding the proper filing deadline.

Reasonable cause can also be used as a defense to the accuracy-related penalty under I.R.C. § 6662.  In this context, the most important factor is generally the extent of the taxpayer’s efforts to assess his or her proper tax liability.  Treas. Reg. § 1.6664-4(b).  Circumstances that may constitute reasonable cause here include an honest misunderstanding of fact or law that is reasonable in light of all the facts and circumstances as well as honest mistakes.  Id.; see also Hummer v. Comm’r, T.C. Memo. 1988-528 (reasonable cause for negligence penalty where correct treatment of a deduction was not settled); Larotonda v. Comm’r, 89 T.C. 287 (1987) (taxpayers reasonable but erroneous belief that retirement income should not be included in gross income constituted reasonable cause for purposes of negligence penalty).

In many cases, a taxpayer may rely on a tax advisor or tax professional to prepare the return.  So, what happens when the tax advisor or tax professional is wrong on a reporting issue?  There is good news.  Federal courts and the IRS have recognized the defense of reasonable cause in these circumstances provided the taxpayer can show: (1) the adviser was a competent professional who had sufficient expertise to justify reliance; (2) the taxpayer provided necessary and accurate information to the adviser; and (3) the taxpayer actually relied in good faith on the adviser’s judgment.  See Neonatology Assocs., P.A. v. Comm’r, 115 T.C. 43 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002).

Section 6751(b)

I.R.C. § 6751(b) provides that the IRS may not assess certain penalties “unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.”  I.R.C. § 6751(b) applies to most penalties, but it does not apply to penalties under I.R.C. § 6651 (late-filing or late-payment penalties); I.R.C. § 6654 (failure to pay estimated tax of individual); I.R.C. § 6655 (failure-to-pay estimated tax of corporation); and “any other penalty automatically calculated through electronic means.”

In Clay, the Tax Court held that the IRS must obtain written managerial approval of a penalty in a deficiency case no later than when the IRS Revenue Agent Report (RAR), coupled with the 30-day Appeals letter, are sent to the taxpayer.  See 152 T.C. 223 (2019).  In that case, because the IRS obtained written managerial approval after the RAR and 30-day Appeals letter was issued, the Tax Court concluded that the IRS was prohibited from assessing the penalty.

For more on the I.R.C. § 6751(b) penalty defense, see Penalty Defenses and the Supervisory Approval Requirement.

Disclosure of Tax Items

A taxpayer may avoid certain accuracy-related penalties under I.R.C. § 6662 if the taxpayer:  (1) had substantial authority for the item; or (2) the item was adequately disclosed on the return or in a statement attached to the return, provided there was a reasonable basis for the tax treatment of such item.  I.R.C. § 6662(d)(2)(B).

The substantial authority standard is an objective standard, which requires the application of the law to the relevant facts.  It is less stringent than the “more likely than not” standard (i.e., greater than 50% likelihood of being upheld on the merits) but more stringent than the “reasonable basis” standard.  The tax authorities that may be considered as part of the substantial authority analysis are listed in Treas. Reg. § 1.6662-4(d)(3)(iii).  Significantly, a taxpayer may have substantial authority for the tax treatment of any given item on a return based solely only a well-reasoned construction of the applicable statutory provision.  Id.

On the other hand, a taxpayer meets the reasonable basis standard if the claim is more than arguable or colorable.  Treas. Reg. § 1.6662-4(e)(2)(i).  Thus, a return position that is reasonable and based on one or more authorities in Treas. Reg. § 1.6662-4(d)(3)(iii) will generally satisfy the reasonable basis standard.

But reasonable basis is not sufficient in itself to negate a reporting penalty.  Instead, the taxpayer must have a reasonable basis and also adequately disclose the item on the tax return.  Generally, the disclosure is made on IRS Form 8275 unless the position taken by the taxpayer is contrary to a regulation (the latter of which requires IRS Form 8275-R).  Moreover, certain disclosures without an IRS Form 8275 may be sufficient, provided the disclosed item falls within the guidance of an annual revenue procedure permitting such disclosure on the return or in an attachment.  Currently, that revenue procedure is Rev. Proc. 2020-54.

First-Time Penalty Abatement

The IRS’ first-time penalty abatement procedures are an administrative waiver.  To qualify, taxpayers must meet the conditions set forth in I.R.M. pt. 20.1.1.3.3.2.1 (10-19-20).  Generally, the IRS will abate certain types of penalties under these procedures if the taxpayer had no penalties for the previous three tax years, and the taxpayer has filed—or filed a valid extension for—all required returns currently due and paid or arranged to pay any tax currently due.

Parting Thoughts

To successfully request IRS penalty relief, a taxpayer must have a thorough understanding of the penalty (its statutory language, governing regulations, etc.) in addition to the applicability of potential penalty defenses.  This Insight provides some tools for taxpayers in both respects.  However, in many cases, the success of a penalty abatement or waiver request will depend largely on how the facts and applicable law are presented to the IRS.  If the penalty amounts at issue are large, it may pay to engage a competent tax professional to prepare the request.

Expert Penalty Defense Attorneys 

Need assistance with IRS penalty defense? Each individual civil penalty has different penalty defenses. It is important to raise the proper penalty defenses with the IRS at the appropriate time. Freeman Law can help you navigate these complex issues. We handle all types of cases including civil, failure-to-file and failure-to-pay, accuracy-related, fraud, tax shelters, international tax, employment tax, and trust fund recovery penalties. Schedule a consultation or call (214) 984-3000 to discuss your tax concerns. 

What is the Report of Foreign Bank and Financial Accounts (FBAR)?

Congress enacted the statutory basis for the requirement to report foreign bank and financial accounts in 1970 as part of the “Currency and Foreign Transactions Reporting Act of 1970,” which came to be known as the “Bank Secrecy Act” or “BSA.” These anti-money laundering and currency reporting provisions, as amended, were codified at 31 USC 5311 – 5332, excluding section 5315.

The Secretary of the Treasury subsequently delegated the authority to administer civil compliance with Title II of the BSA to the Director of FinCEN.  IRS Criminal Investigation (CI), however, maintains authority to enforce the criminal provisions of the BSA.

While FinCEN retains rule-making authority with respect to FBAR reporting, FinCEN redelegated civil FBAR enforcement authority to the IRS.

The FBAR regulations require that a United States person, including a citizen, resident, corporation, partnership, limited liability company, trust and estate, file an FBAR to report:

• a financial interest in or signature or other authority over at least one financial account located outside the United States if
• the aggregate value of those foreign financial accounts exceeded $10,000 at any time during the calendar year reported.

Penalties

A failure to file an FBAR report may result in criminal exposure—that is, the possibility of a criminal indictment or investigation.  For several years, the IRS has publicly touted its intention to strongly enforce the FBAR reporting requirements.

In addition, a failure to file a FBAR report may result in exposure to civil penalties, including up to half of the balance in all unreported accounts if the government determines that the failure to report was willful or reckless.

Current penalties (adjusted for inflation) are as follows:

FBAR Statutory Authority

The statutory authority for the FBAR is found under 31 USC § 5314.  Section 5314 directs the Secretary of the Treasury to require a resident or citizen of the United States to keep records and/or file reports when making transactions or maintaining a relationship with a foreign financial agency.

31 USC § 5321(a)(5) and (a)(6) establish civil penalties for violations of the FBAR reporting and recordkeeping requirements.

FBAR Regulatory Authority

31 CFR § 1010.350 sets forth the FBAR definitions and requirements. Section 1010.350 requires that “each United States person having a financial interest in, or signature or other authority over, a bank, securities, or other financial account in a foreign country shall report such relationship to the Commissioner of Internal Revenue for each year in which such relationship exists and shall provide such information as shall be specified in a reporting form prescribed under 31 USC § 5314 to be filed by such persons.”

The report is required to be electronically filed with FinCEN on FinCEN Report 114, Report of Foreign Bank and Financial Accounts (FBAR).

Recordkeeping Requirements

31 CFR § 1010.420 requires maintenance and retention of FBAR records for a period of five years.  31 CFR 1010.810(g) references a Memorandum of Agreement between FinCEN and the IRS, which redelegates, to the IRS, FinCEN’s authority to enforce the provisions of 31 USC 5314 and 31 CFR 1010.350 and 1010.420. This includes the authority to:

• Assess and collect civil FBAR penalties.
• Investigate possible civil violations of these provisions.
• Employ the summons power of subpart I of Chapter X.
• Issue administrative rulings under subpart G of Chapter X.
• Take any other action reasonably necessary for the enforcement of these and related provisions, including pursuit of injunctions.

FBAR Filing Criteria

An FBAR is required if all of the following apply:

• The filer is a U.S. person.
• The U.S. person has a financial interest in a financial account or signature or other authority over a financial account.
• The financial account is in a foreign country.
• The aggregate amount(s) in the account(s) valued in dollars exceed $10,000 at any time during the calendar year.

United States Person

A “United States person” is defined by 31 CFR § 1010.350(b) to include:

• A citizen of the United States.
• A resident of the United States.
• An entity formed under the laws of the United States, any state, the District of Columbia, any territory or possession of the United States, or an Indian tribe.

Notably, the federal tax treatment of a United States person does not determine whether the person has an FBAR filing requirement.

Example:  Single-member Limited Liability Companies (LLCs) are disregarded for federal tax purposes, but would have to file the FBAR if otherwise required to do so.

Example: Some trusts may not file tax returns but may have an FBAR filing requirement.

The definition of “United States” for this purpose is found in 31 CFR § 1010.100(hhh). For FBAR and other Title 31 purposes, a “United States” includes:

• The States of the United States.
• The District of Columbia.
• The Indian lands (as defined in the Indian Gaming Regulatory Act).
• The territories and insular possessions of the United States.

U.S. territories and insular possessions currently include:

• Puerto Rico
• Guam
• American Samoa
• S. Virgin Islands
• Northern Mariana Islands

U.S. Citizen

A citizen of the U.S. has a U.S. birth certificate or naturalization papers.

U.S. citizenship is not defined by residency. A citizen of the U.S. may reside outside the U.S.

Example:

Children born of U.S. citizens living abroad are U.S. citizens despite the fact that they may never have been to the U.S.

U.S. Resident

Prior to February 24, 2011, when revised regulations were issued, the FBAR regulations did not define the term “U.S. resident.”

For FBARs required to be filed by June 30, 2011, or later, 31 CFR 1010.350(b) defines “United States resident” using the definition of resident alien in IRC 7701(b), but using the Title 31 definition of “United States.” The major tests of residency found in section 7701(b) are:

• The green-card test. Individuals who at any time during the calendar year have been lawfully granted the privilege of residing permanently in the U.S. under the immigration laws automatically meet the definition of resident alien under the green-card test.
• The substantial-presence test. Individuals are defined as resident aliens under the substantial-presence test if they are physically present in the U.S. for at least 183 days during the current year, or they are physically present in the U.S. for at least 31 days during the current year and meet the specifications contained in IRC 7701(b)(3).
• The individual files a first-year election on his income tax return to be treated as a resident alien under IRC 7701(b)(4).
• The individual is considered a resident under the special rules in section 7701(b)(2) for first-year or last-year residency.

Individuals residing in the U.S. who do not meet one of these residency tests are not considered U.S. residents for FBAR purposes. This includes individuals in the U.S. under a work visa who do not meet the substantial-presence test.

Using these rules of residency can result in a non-resident being considered a U.S. resident for FBAR purposes. This would occur when a green-card holder actually resides outside the U.S.

FinCEN clarified in the preamble to the regulations that an election under IRC 6013(g) or (h) is not considered when determining residency status for FBAR purposes.

U.S. tax treaty provisions do not affect residency status for FBAR purposes. A treaty provision which allows a resident of the U.S. to file tax returns as a non-resident does not affect residency status for FBAR purposes if one of the tests of residency in IRC 7701(b) is met.

Diplomats residing at foreign embassies in the U.S. are not generally considered U.S. residents since foreign embassies are generally considered part of the sovereign nation they represent. 

U.S. Entity

A U.S. entity is a legal entity formed under the laws of the U.S., any state, the District of Columbia, any territory or possession of the U.S., or an Indian tribe.

31 CFR 1010.350(b) specifically names, but does not limit these types of entities to:

• Corporations
• Partnerships
• Trusts
• Limited Liability Companies

The preamble to the regulations clarifies that pension plans and welfare benefit plans are included as U.S. entities.

The definition of entities allows for new types of legal entities to be included in the future.

Financial Account

1. A reportable financial account includes a:
   • Bank account, such as a savings deposit, demand deposit, checking, time deposit (CD), or any other account maintained with a financial institution or other person engaged in the business of banking.
   • Securities account, securities derivatives account, or other financial instruments account held with a person engaged in the business of buying, selling, holding or trading stock or other securities.
   • Other financial account, as defined in (2) below.
2. “Other Financial Account” is defined by the regulations to include:
   • An account with a person in the business of accepting deposits as a financial agency.
   • An insurance or annuity policy that has a cash value.

Note:

The preamble to the regulations clarifies that there need be no current payment of an income stream to trigger reporting. The cash value of the policy is considered the account value.

• An account with a person that acts as a broker or dealer for futures or options transactions in any commodity on or subject to the rules of a commodity exchange or association.* A mutual fund or similar pooled fund defined as “a fund which issues shares available to the general public that have a regular net asset value determination and regular redemptions.”
• The following are not considered financial accounts:
  • Stocks, bonds, or similar financial instruments held directly by the person.
  • Real estate or an account holding solely real estate (e.g., Mexican “fideicomiso” ).
  • A safety deposit box.

Note:

A reportable account may exist where the financial institution providing the safety deposit box has access to the contents and can dispose of the contents upon instruction from, or prearrangement with, the person.

• Precious metals, precious stones, or jewels held directly by the person.

Note:

31 USC 5314 defines “foreign financial agency” as “a person acting for a person as a financial institution, bailee, depository trustee, or agent, or acting in a similar way related to money, credit, securities, gold, or a transaction in money, credit, securities, or gold.” Therefore, a reportable account relationship may exist where a foreign agency holds precious metals on deposit or provides insurance or other services as an agent of the person owning the precious metals. 

Financial Account Exceptions

The following are not considered reportable financial accounts for FBAR purposes:

• • An account of a department or agency of the U.S., an Indian tribe, any state or any political subdivision of a state, any territory or insular possession of the U.S., or a wholly-owned entity, agency or instrumentality of any of the foregoing.
  • An account of an international financial institution of which the U.S. government is a member. (e.g., the International Monetary Fund (IMF) and the World Bank.)
  • An account in an institution known as a “United States military banking facility,” that is, a facility designated to serve U.S. military installations abroad.
  • Correspondent or “nostro” accounts that are maintained by banks and used solely for bank-to-bank settlements.
  • Custodial or “omnibus” accounts held for the person by a U.S. institution acting as a global custodian, as long as the person cannot directly access the foreign custodial account.

Accounts not reported on FBAR

Individuals don’t report individual retirement accounts and tax-qualified retirement plans described in Internal Revenue Code Sections 401(a), 403(a) or 403(b) on the FBAR. The FBAR instructions list other exceptions.

Account Valuation

The FBAR is required for each calendar year during which the aggregate amount(s) in the foreign account(s) exceeded $10,000, valued in U.S. dollars, at any time during that calendar year. To determine the account value to report on the FBAR follow these steps:

• Determine the maximum value in locally denominated currency. The maximum value of an account is the largest amount of currency and non-monetary assets that appear on any quarterly or more frequent account statement issued for the applicable year.

Example:

If the statement closing balance is $9,000 but at any time during the year a balance of $15,000 appears on a statement, the maximum value reportable on an FBAR is $15,000.

Note:

If periodic account statements are not issued, the maximum account asset value is the largest amount of currency and non-monetary assets in the account at any time during the year.

• Convert the maximum value into U.S. dollars by using the official exchange rate in effect at the end of the year at issue for converting the foreign currency into U.S. dollars. The official Treasury Reporting Rates of Exchange for recent years are posted on the FBAR home page of the IRS website. Search for the keyword “FBAR” to find the FBAR home page. Current and recent quarterly rates are also posted on the Bureau of the Fiscal Service website.

If the filer has more than one account to report on the FBAR, each account is valued separately in accordance with the previous paragraphs.

If a person has one or more but fewer than 25 reportable accounts and is unable to determine whether the maximum value of these accounts exceeded $10,000 at any time during the calendar year, the FBAR instructions state that the person is to complete the applicable parts of the FBAR for each of these accounts and enter “value unknown” in Item 15.

Financial Interest

Direct Financial Interest:

• A U.S. person has a financial interest in each account for which such person is the owner of record or has legal title, whether the account is maintained for his own benefit or for the benefit of others including non-U.S. persons.
• If an account is maintained in the name of two persons jointly, or if several persons each own a partial interest in an account, each of those U.S. persons has a financial interest in that account and, generally, each person must file the FBAR. However, see special rules for spousal filing in IRM 4.26.16.4.4, below.

Note:

Because the FBAR is a report of foreign financial accounts, the entire account value for jointly-owned accounts is reported on each FBAR. Accounts are not prorated for a person’s percentage of ownership interest.

Indirect financial interest: A U.S. person has an “other financial interest” in each bank, securities, or other financial account in a foreign country for which the owner of record or holder of legal title is:

• A person acting as an agent, nominee, attorney, or in some other capacity on behalf of the U.S. person.
• A corporation, whether foreign or domestic, in which the U.S. person owns directly or indirectly more than 50 percent of the total value of shares of stock or more than 50 percent of the voting power for all shares of stock.
• A partnership, whether foreign or domestic, in which the United States person owns an interest in more than 50 percent of the profits (distributive share of income, taking into account any special allocation agreement) or more than 50 percent of the capital of the partnership.
• Any other entity in which the U.S. person owns directly or indirectly more than 50 percent of the voting power, total value of the equity interest or assets, or interest in profits.
• A trust, if the U.S. person is the trust grantor and has an ownership interest in the trust for U.S. federal tax purposes under 26 USC 671–679 and the regulations thereunder.
• A trust, whether foreign or domestic, in which the U.S. person either has a present beneficial interest, either directly or indirectly, in more than 50 percent of the assets of the trust or from which such person receives more than 50 percent of the trust’s current income.

The family attribution rules under Title 26 do not apply to FBAR reporting.

Anti-avoidance rule: A U.S. person that causes an entity including, but not limited to, a corporation, partnership, or trust, to be created for the purpose of evading the FBAR reporting and/or recordkeeping requirements shall have a financial interest in any bank, securities, or other financial account in a foreign country for which the entity is the owner of record or holder of legal title. 31 CFR 1010.350(e)(3).

Signature or Other Authority Over an Account

An individual has signature or other authority over an account if that individual (alone or in conjunction with another) can control the disposition of money, funds or other assets held in a financial account by direct communication (whether in writing or otherwise) to the person with whom the financial account is maintained.

Individuals not considered as having signature authority:

• Individuals with only the authority to buy or sell investments within the account, but no authority to disburse assets from the account.
• Individuals with supervisory authority over the individuals who actually communicate with the person with whom the account is maintained. FinCEN clarified, in the preamble to the regulations at 31 CFR 1010.350, that approving a disbursement that a subordinate actually orders is not considered signature authority.

Only individuals can have signature authority. Signature authority attributed to entities must be exercised by individuals.

Signature Authority Exceptions

An officer or employee of the following institutions need not report signature or other authority over a foreign financial account owned or maintained by the institution if the officer or employee has no financial interest in the account:

• A bank that is examined by the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, or the National Credit Union Administration.
• A financial institution that is registered with and examined by the Securities and Exchange Commission or Commodity Futures Trading Commission.
• An Authorized Service Provider for a foreign financial account owned or maintained by an investment company that is registered with the Securities and Exchange Commission.

Note:

Authorized Service Provider is an entity that is registered with and examined by the Securities and Exchange Commission and that provides services to an investment company registered under the Investment Company Act of 1940.

• An entity with a class of equity securities listed (or American depository receipts listed) on any U.S. national securities exchange.

Note:

Previously, instructions to the form allowed a “large corporation” exception for listed corporations. That exception was expanded to include all listed entities.

• An entity that has a class of equity securities registered (or American depository receipts registered) under section 12(g) of the Securities Exchange Act.
• An officer or employee of a U.S. subsidiary of an entity described above above need not report signature authority over accounts of the subsidiary if the entity files a consolidated FBAR listing the accounts of the subsidiary.

Foreign Country

A foreign country includes all geographical areas located outside of the United States as defined in 31 CFR 1010.100(hhh). An account is “foreign” for FBAR purposes if it is located outside:

• the States of the United States.
• The District of Columbia.
• The Indian lands (as defined in the Indian Gaming Regulatory Act).
• The territories and insular possessions of the United States. See IRM 4.26.16.3.1(4) above.

It is the location of an account, not the nationality of the financial institution, that determines whether an account is “foreign” for FBAR purposes. Accounts of foreign financial institutions located in the U.S. are not considered foreign accounts for FBAR; conversely, accounts of U.S. financial institutions located outside the U.S. are considered foreign accounts. Examples are:

• An account with a Hong Kong branch of a U.S.-based bank is a foreign financial account for FBAR purposes.
• An account with a New York City branch of a foreign-based bank is not a foreign financial account for FBAR purposes.

Aggregate Value Over $10,000

The final criterion triggering the FBAR filing requirement is the aggregate value of all foreign financial accounts in which the person has a financial interest, or over which the individual has signature or other authority, must be greater than $10,000, valued in U.S. dollars, at any time (on a particular day) during the calendar year.

Steps to aggregate account values:

• Each account should be separately valued according to the steps outlined in IRM 4.26.16.3.2.2 to determine its highest valuation during the year in the foreign denominated currency.

Exception:

Money moved from one foreign account to another foreign account during the year must only be counted once.

• Each account should be converted from foreign denominated value to U.S. dollars using the FMS conversion rate for December 31st of the calendar year being reported. See IRM 4.26.16.3.2.2, Account Valuation, above.

All reportable accounts should be aggregated, including:

• Solely-owned accounts.
• Jointly-owned accounts.
• Direct financial interest accounts.
• Indirect financial interest accounts.
• Signature authority accounts.

FBAR Filing Procedures

The determination to file the FBAR is made annually. For example, a person may be required to file an FBAR for one calendar year but not for a subsequent year if the person’s aggregate foreign account balance does not exceed $10,000 at any time during the year.

An FBAR must be filed for each calendar year that the person has a financial interest in, or signature authority over, foreign financial account(s) whose aggregate balance exceeds the $10,000 threshold at any time during the year. 

General FBAR Filing

The FBAR must be filed on or before June 30 each year for the previous calendar year.

All FBARs filed after June 30, 2013, must be filed electronically through the FinCEN BSA E-Filing website unless the filer requested, and was granted, an exception to e-filing by FinCEN.

The FBAR should not be filed with the filer’s federal income tax return or information return.

FBAR Filing Exceptions

Individual Retirement Account (IRA) owners and beneficiaries, and participants in and beneficiaries of U.S. tax-qualified retirement plans, are not required to report a foreign financial account held by or on behalf of the IRA or retirement plan.

Caution:

This exception is for U.S. plans only. Foreign plans (e.g., a Canadian Registered Retirement Savings Plan (RRSP) and accounts managed by Mexico’s Administrators of Retirement Funds (AFORES) are normally reportable on an FBAR.

A trust beneficiary with a financial interest is not required to report the trust’s foreign financial accounts on an FBAR if the trust, trustee of the trust, or agent of the trust:

• Is a U.S. person, and
• Files an FBAR disclosing the trust’s foreign financial accounts.

FBAR Filing by Married Couples

Accounts owned jointly by spouses may be filed on one FBAR. The spouse of an individual who files an FBAR is not required to file a separate FBAR if the following conditions are met:

• All the financial accounts that the non-filing spouse is required to report are jointly owned with the filing spouse.
• The filing spouse reports the jointly owned accounts on a timely, electronically filed FBAR.
• Both spouses complete and sign Part I of FinCEN Form 114a, Record of Authorization to Electronically File FBARs. The filing spouse completes Part II of Form 114a in its entirety.

Note:

The completed Form 114a is not filed but must be retained for five years. It must be provided to IRS or FinCEN upon request.

If these conditions are not met (as when both spouses have individual accounts in addition to the jointly-owned accounts), both spouses are required to file separate FBARs, and each spouse must report the entire value of the jointly-owned accounts.

For calendar years prior to 2014, use the instructions for spousal filing current for that filing year.

Electronic FBAR Filing by a Third Party

FBAR filers may authorize a paid preparer or other third party to electronically file the FBAR for them.

The person reporting financial interest in, or signature authority over, foreign accounts must complete and sign Part I of FinCEN Form 114a.

The preparer or other third-party filer must complete Part II of Form 114a.

Form 114a is not filed. Both parties must retain the form for five years. It must be provided to IRS or FinCEN upon request.

It remains the responsibility of the filer to ensure that filing takes place timely and the report is accurate. Form 114a contains a disclaimer that states: “…it is my/our legal responsibility, not that of the preparer listed in Part II, to timely file an FBAR if required by law to do so.”

FBAR Filing for Financial Interest in 25 or More Accounts

31 CFR 1010.350(g) provides that a United States person that has a financial interest in 25 or more foreign financial accounts only needs to provide the number of financial accounts and certain other basic information on the report, but will be required to provide detailed information concerning each account if the IRS or FinCEN requests it.

Filers must comply with FBAR record-keeping requirements.

FBAR Filing for Signature Authority for 25 or More Accounts

31 CFR 1010.350(g) provides that A United States person that has signature or other authority over 25 or more foreign financial accounts only needs to provide the number of financial accounts and certain other basic information on the report, but will be required to provide detailed information concerning each account if the IRS or FinCEN requests it.

Filers must comply with FBAR record-keeping requirements.

FBAR Filing for U.S. Persons Residing and Employed Outside the United States

The FBAR filing instructions allow for modified reporting by a U.S. person who meets all three of the following criteria:

• Resides outside the U.S.
• Is an officer or employee of an employer located outside the U.S.
• Has signature authority over a foreign financial account(s) of that employer.

In such cases, the U.S. Person should file the FBAR by:

• Completing filer information.
• Omitting account information.
• Completing employer information one time only.

Filing A Consolidated FBAR

31 CFR 1010.350(g) allows an entity that is a U.S. person that owns directly or indirectly a greater than 50 percent interest in another entity that is required to file an FBAR to file a consolidated FBAR on behalf of itself and such other entity.

Each controlled entity that has an FBAR filing obligation must be listed in Part V, even if that entity owns foreign accounts only indirectly.

No FBAR Filing Extension

There is no statutory authority to extend the time for filing an FBAR, and any request for such an extension will be denied.

Extensions of time to file federal income tax returns or information returns do not extend the time for filing FBARs.

IRC section 7508 “Time for performing certain acts postponed by reason of service in combat zone or contingency operation” does not grant U.S. persons that are U.S. Armed Forces members an extension to file the FBAR.

This is not to be confused with extension of the statute of limitations on assessment or collection of penalties, which is possible.

Delinquent FBAR Filing Procedures

Delinquent FBARs should be filed using the current electronic report, but using the instructions for the year being reported to determine if an FBAR filing requirement exists.

On page one of FinCEN Report 114, explain the reason the FBAR was not filed timely. Select a common reason from the drop-down box or select Other, and a 750-character text box appears to allow an explanation.

Keep a copy of the FBAR for recordkeeping purposes.

No penalty will be asserted if the IRS determines that the failure to timely file an FBAR was not willful and was due to reasonable cause.

Amending a Filed FBAR

To amend a filed FBAR, filers should:

• Check the “Amended” box in Item 1 at the top of page two and fill in the “Prior Report BSA Identifier” for the original filing in the block provided.
• Complete the report in its entirety using the amended information.

FBAR Recordkeeping

If the FBAR is required, certain records must be retained by the filer. 31 CFR 1010.420. Each person having a financial interest in or signature or other authority over any such account must keep the following records:

• Name in which the account is maintained.
• Number or other designation identifying the account.
• Name and address of the foreign financial institution or other person with whom the account is maintained.
• Type of account.
• Maximum value of each account during the reporting period.

The records must be kept for five years from the June 30 due date for filing the FBAR for that calendar year and be available at all times for inspection as provided by law.

Note that persons are not required to keep copies of FBARs filed, only the records that underlie the filing.

An officer or employee who files an FBAR to report signature authority over an employer’s foreign financial account is not required to personally retain records regarding that account.

FBAR Recordkeeping For Filers Having 25 Or More Accounts

A filer who has financial interest in or signature authority over 25 or more foreign financial accounts must also comply with the record keeping requirements.

Filers will be required to provide detailed information concerning each account if the IRS or FinCEN requests it.

FBAR Penalties

The IRS has been delegated authority to assess civil FBAR penalties.

When there is an FBAR violation, the examiner will either issue the FBAR warning letter, Letter 3800, Warning Letter Respecting Foreign Bank and Financial Accounts Report Apparent Violations, or determine a penalty. However, when multiple years are under examination and a monetary penalty is imposed for some but not all of the years under examination, a Letter 3800 will not be issued for the year(s) for which a monetary penalty is not imposed.

Penalties should be determined to promote compliance with the FBAR reporting and recordkeeping requirements. In exercising discretion, examiners must consider whether the issuance of a warning letter and the securing of delinquent FBARs, rather than the determination of a penalty, will achieve the desired result of improving compliance in the future.

Example:

An individual failed to report the existence of five small foreign accounts with a combined balance of $20,000 for all five accounts, but properly reported the income from each account and made no attempt to conceal the existence of the accounts. The examiner must consider all the facts and circumstances of this case to determine if a warning letter is appropriate in this case or if it would be appropriate to determine civil FBAR penalties.

• Civil FBAR penalties have varying upper limits, but no floor. The examiner has discretion in determining the amount of the penalty, if any.
• The IRS developed mitigation guidelines to assist examiners in determining the amount of civil FBAR penalties.
• There may be multiple civil FBAR penalties if there is more than one account owner, or if a person other than the account owner has signature or other authority over the foreign account. Each person can be liable for the full amount of the penalty.
• Managers must perform a meaningful review of the employee’s penalty determination prior to assessment.

FBAR Penalty Authority

IRS was delegated the authority to assess and collect civil FBAR penalties. 31 CFR 1010.810(g). The delegation includes the authority to investigate possible civil FBAR violations, provided in Treasury Directive No. 15-41 (December 1, 1992), and the authority to assess and collect the penalties for violations of the reporting and recordkeeping requirements.

When performing these functions, IRS is not acting under Title 26 but, instead, is acting under the authority of Title 31. Provisions of the Internal Revenue Code generally do not apply to FBARs.

Criminal Investigation was delegated the authority to investigate possible criminal violations of the Bank Secrecy Act. 31 CFR 1010.810(c)(2).  

FBAR Penalty Structure

There are four civil penalties available for FBAR violations:

• 31 USC 5321(a)(6)(A).
• Pattern of negligent activity. 31 USC 5321(a)(6)(B).
• Penalty for non-willful violation. 31 USC 5321(a)(5)(A) and (B).

Note:

Although the term “non-willful” is not used in the statute, it is used to distinguish this penalty from the penalty for willful violations.

• Penalty for willful violations. 31 USC 5321(a)(5)(C).

A filing violation occurs at the end of the day on June 30th of the year following the calendar year to be reported (the due date for filing the FBAR).

A recordkeeping violation occurs on the date when the records are requested by the IRS examiner if the records are not provided.

A civil money penalty may be imposed for an FBAR violation even if a criminal penalty is imposed for the same violation. 31 USC 5321(d).

BSA Negligence Penalties

There are two negligence penalties that apply generally to all BSA provisions. 31 USC 5321(a)(6)

• A negligence penalty up to $500 may be assessed against a financial institution or non-financial trade or business for any negligent violation of the BSA, including FBAR violations.
• An additional penalty up to $50,000 may be assessed for a pattern of negligent violations.

These two negligence penalties apply only to trades or businesses, and not to individuals.

The FBAR penalties under section 5321(a)(5) and the FBAR warning letter, Letter 3800, adequately address most FBAR violations identified. The FBAR warning letter may be issued in the cases where the revenue agent determines none of the 5321(a)(5) FBAR penalties are warranted. If the revenue agent believes, however, that assertion of a section 5321(a)(6) negligence penalty is warranted in a particular case, the revenue agent should contact a Bank Secrecy Act FBAR program analyst for guidance.

Negligence Defined

Actual knowledge of the reporting requirement is not required to find negligence. For example, if a financial institution or nonfinancial trade or business exercising ordinary business care and prudence for its particular industry should have known about the FBAR filing and record keeping requirements, failure to file or maintain records is negligent. Therefore, standards of practice for a particular industry are relevant in determining whether a negligent violation of 31 USC 5314 occurred. If the failure to file the FBAR or to keep records is due to reasonable cause, and not due to the negligence of the person who had the obligation to file or keep records, the negligence penalty should not be asserted.

Negligent failure to file does NOT exist when, despite the exercise of ordinary business care and prudence, the person was unable to file the FBAR or keep the required records.

Use general negligence principles in determining whether or not to apply the negligence penalty. Treas. Reg. 1.6664-4, Reasonable Cause and Good Faith Exception to section 6662 penalties, may serve as useful guidance in determining the factors to consider.

BSA Simple Negligence Penalty

A negligence penalty up to $500 may be assessed against a business for any negligent violation of the BSA, including FBAR violations.

The simple negligence penalty applies only to businesses, not individuals.

BSA Simple Negligence Penalty Amount

For each negligent violation of any requirement of the Bank Secrecy Act committed after October 27, 1986, a civil penalty may be assessed not to exceed $500.

Generally, the full amount of this $500 penalty is assessed. Although 31 USC 5321(a)(6) permits discretion to assert a lower amount, there are no mitigation guidelines for this penalty.

BSA Pattern of Negligence Penalty

31 USC 5321(a)(6)(B) provides for a civil money penalty of not more than $50,000 on a business that engages in a pattern of negligent BSA violations including violations of the FBAR rules. This penalty is in addition to any $500 negligence penalty.

The pattern of negligence penalty has applied to financial institutions since 1986. For violations occurring after October 26, 2001, the penalty applies to all trades or businesses. This penalty does not apply to individuals.

BSA Pattern of Negligence Penalty Amount

If any trade or business engages in a pattern of negligent violations of any provision (including the FBAR requirements)] of the BSA, a civil penalty of not more than $50,000 may be imposed. This is in addition to the simple negligence $500 penalty. 31 USC 5321(a)(6)(B). The examiner is given discretion to determine the penalty amount up to the $50,000 ceiling.

There are no mitigation guidelines for this penalty. The pattern of negligence penalty should be asserted only in egregious cases.

Penalty for Nonwillful FBAR Violations

For violations occurring after October 22, 2004, a penalty, not to exceed $10,000 per violation, may be imposed on any person who violates or causes any violation of the FBAR filing and recordkeeping requirements. 31 USC 5321(a)(5)(B).

The penalty should not be imposed if:

• The violation was due to reasonable cause, and
• The person files any delinquent FBARs and properly reports the previously unreported account.

Penalty for Nonwillful Violations – Calculation

After May 12, 2015, in most cases, examiners will recommend one penalty per open year, regardless of the number of unreported foreign accounts. The penalty for each year is limited to $10,000. Examiners should still use the mitigation guidelines and their discretion in each case to determine whether a lesser penalty amount is appropriate.

For multiple years with nonwillful violations, examiners may determine that asserting nonwillful penalties for each year is not warranted. In those cases, examiners, with the group manager’s approval after consultation with an Operating Division FBAR Coordinator, may assert a single penalty, not to exceed $10,000, for one year only.

For other cases, the facts and circumstances (considering the conduct of the person required to file and the aggregate balance of the unreported foreign financial accounts) may indicate that asserting a separate nonwillful penalty for each unreported foreign financial account, and for each year, is warranted. In those cases, examiners, with the group manager’s approval after consultation with an Operating Division FBAR Coordinator, may assert a separate penalty for each account and for each year. The examiner’s workpapers must support such a penalty determination and document the group manager’s approval.

In no event will the total amount of the penalties for nonwillful violations exceed 50 percent of the highest aggregate balance of all unreported foreign financial accounts for the years under examination.

Penalty for Willful FBAR Violations

The penalty for willful FBAR violations may be imposed on any person who willfully violates or causes any violation of any provisions of 31 USC 5314 (the FBAR filing and recordkeeping requirements). 31 USC 5321(a)(5)(C).

The penalty applies to individuals as well as financial institutions and nonfinancial trades or businesses for all years.

For violations occurring after October 22, 2004, the statutory ceiling is the greater of $100,000 or 50% of the balance in the account at the time of the violation.

There may be both a reporting and a recordkeeping violation regarding each account.

The date of a violation for failure to timely file an FBAR is the end of the day on June 30th of the year following the calendar year for which the accounts are being reported. This date is the last possible day for filing the FBAR so that the close of the day with no filed FBAR represents the first time that a violation occurred. The balance in the account at the close of June 30th is the amount to use in calculating the filing violation.

The date of a violation for failure to keep records is the date the examiner first requests records. The balance in the account at the close of the day that the records are first requested is the amount used in calculating the recordkeeping violation penalty. The date of the violation is tied to the date of the request, and not a later date, to assure the taxpayer is unable to manipulate the amount in the account after receiving a request for records. The balance in the account at the close of the day on which the records are first requested is the amount to use in calculating the penalty for failing to keep records as required by statute.

IRS developed guidelines for the exercise of the examiner’s discretion in arriving at the amount of a penalty for a willful violation. See discussion of mitigation, below.

Willful FBAR Violations – Defining Willfulness

The test for willfulness is whether there was a voluntary, intentional violation of a known legal duty.

A finding of willfulness under the BSA must be supported by evidence of willfulness.

The burden of establishing willfulness is on the Service.

Willfulness is shown by the person’s knowledge of the reporting requirements and the person’s conscious choice not to comply with the requirements. In the FBAR situation, the person only need know that a reporting requirement exists. If a person has that knowledge, the only intent needed to constitute a willful violation of the requirement is a conscious choice not to file the FBAR.

Under the concept of “willful blindness,” willfulness is attributed to a person who made a conscious effort to avoid learning about the FBAR reporting and recordkeeping requirements.

Example:

Willful blindness may be present when a person admits knowledge of, and fails to answer questions concerning, his interest in or signature or other authority over financial accounts at foreign banks on Schedule B of his Federal income tax return. This section of the income tax return refers taxpayers to the instructions for Schedule B, which provides guidance on their responsibilities for reporting foreign bank accounts and discusses the duty to file the FBAR. These resources indicate that the person could have learned of the filing and recordkeeping requirements quite easily. It is reasonable to assume that a person who has foreign bank accounts should read the information specified by the government in tax forms. The failure to act on this information and learn of the further reporting requirement, as suggested on Schedule B, may provide evidence of willful blindness on the part of the person.

Note:

The failure to learn of the filing requirements coupled with other factors, such as the efforts taken to conceal the existence of the accounts and the amounts involved, may lead to a conclusion that the violation was due to willful blindness. The mere fact that a person checked the wrong box, or no box, on a Schedule B is not sufficient, in itself, to establish that the FBAR violation was attributable to willful blindness.

The following examples illustrate situations in which willfulness may be present:

• A person files the FBAR, but omits one of three foreign bank accounts. The person had previously closed the omitted account at the time of filing the FBAR. The person explains that the omission was due to unintentional oversight. During the examination, the person provides all information requested with respect to the omitted account. The information provided does not disclose anything suspicious about the account, and the person reported all income associated with the account on his tax return. The penalty for a willful violation should not apply absent other evidence that may indicate willfulness.
• A person filed the FBAR in earlier years but failed to file the FBAR in subsequent years when required to do so. When asked, the person does not provide a reasonable explanation for failing to file the FBAR. In addition, the person may have failed to report income associated with foreign bank accounts for the years that FBARs were not filed. A determination that the violation was willful would likely be appropriate in this case.
• A person received a warning letter informing him of the FBAR filing requirement, but the person continues to fail to file the FBAR in subsequent years. When asked, the person does not provide a reasonable explanation for failing to file the FBAR. In addition, the person may have failed to report income associated with the foreign bank accounts. A determination that the violation was willful would likely be appropriate in this case.

Willful FBAR Violations – Evidence

Willfulness can rarely be proven by direct evidence, since it is a state of mind. It is usually established by drawing a reasonable inference from the available facts. The government may base a determination of willfulness on inference from conduct meant to conceal sources of income or other financial information. For FBAR purposes, this could include concealing signature authority, interests in various transactions, and interests in entities transferring cash to foreign banks.

Documents that may be helpful in establishing willfulness include:

• Copies of statements for the foreign bank account.
• Notes of the examiner’s interview with the foreign account holder/taxpayer about the foreign account.
• Correspondence with the account holder’s tax return preparer that may address the FBAR filing requirement.
• Documents showing criminal activity related to the non-filing of the FBAR (or non-compliance with other BSA provisions).
• Promotional material (from a promoter or offshore bank).
• Statements for debit or credit cards from the offshore bank that, for example, reveal the account holder used funds from the offshore account to cover everyday living expenses in a manner that conceals the source of the funds.
• Copies of any FBARs filed previously by the account holder (or FinCEN Query printouts of FBARs).
• Copies of Information Document Requests with requested items that were not provided highlighted along with explanations as to why the requested information was not provided.
• Copies of debit or credit card agreements and fee schedules with the foreign bank, which may show a significantly higher cost than typically associated with cards from domestic banks.
• Copies of any investment management or broker’s agreement and fee schedules with the foreign bank, which may show significantly higher costs than costs associated with domestic investment management firms or brokers.
• The written explanation of why the FBAR was not filed, if such a statement is provided. Otherwise, note in the workpapers whether there was an opportunity to provide such a statement.
• Copies of any previous warning letters issued or certifications of prior FBAR penalty assessments.
• An explanation, in the workpapers, as to why the examiner believes the failure to file the FBAR was willful.

Documents available in an FBAR case worked under a Related Statute Determination under Title 26 that may be helpful in establishing willfulness include:

• Copies of documents from the administrative case file (including the Revenue Agent Report) for the income tax examination that show income related to funds in a foreign bank account was not reported.
• A copy of the signed income tax return with Schedule B attached, showing whether or not the box pertaining to foreign accounts is checked or unchecked.
• Copies of tax returns (or RTVUEs or BRTVUs) for at least three years prior to the opening of the offshore account and for all years after the account was opened, to show if a significant drop in reportable income occurred after the account was opened. (Review of the three years’ returns prior to the opening of the account would give the examiner a better idea of what the taxpayer might have typically reported as income prior to opening the foreign account).
• Copies of any prior Revenue Agent Reports that may show a history of noncompliance.
• Two sets of cash T accounts (a reconciliation of the taxpayer’s sources and uses of funds) with one set showing any unreported income in foreign accounts that was identified during the examination and the second set excluding the unreported income in foreign accounts.
• Any documents that would support fraud (see IRM 4.10.6.2.2 for a list of items to consider in asserting the fraud penalty). 

Penalty for Willful FBAR Violations – Calculation

For violations occurring after October 22, 2004, a penalty for a willful FBAR violation may be imposed up to the greater of $100,000 or 50% of the amount in the account at the time of the violation, 31 USC 5321(a)(5)(C). For cases involving willful violations over multiple years, examiners may recommend a penalty for each year for which the FBAR violation was willful.

After May 12, 2015, in most cases, the total penalty amount for all years under examination will be limited to 50 percent of the highest aggregate balance of all unreported foreign financial accounts during the years under examination. In such cases, the penalty for each year will be determined by allocating the total penalty amount to all years for which the FBAR violations were willful based upon the ratio of the highest aggregate balance for each year to the total of the highest aggregate balances for all years combined, subject to the maximum penalty limitation in 31 USC 5321(a)(5)(C) for each year.

Note:  Examiners should still use the mitigation guidelines and their discretion in each case to determine whether a lesser penalty amount is appropriate

Examiners may recommend a penalty that is higher or lower than 50 percent of the highest aggregate account balance of all unreported foreign financial accounts based on the facts and circumstances. In no event will the total penalty amount exceed 100 percent of the highest aggregate balance of all unreported foreign financial accounts during the years under examination.

If an account is co-owned by more than one person, a penalty determination must be made separately for each co-owner. The penalty against each co-owner will be based on his her percentage of ownership of the highest balance in the account. If the examiner cannot determine each owner’s percentage of ownership, the highest balance will be divided equally among each of the co-owners.

Mitigation

The statutory penalty computation provides a ceiling on the FBAR penalty. The actual amount of the penalty is left to the discretion of the examiner.

IRS has adopted mitigation guidelines to promote consistency by IRS employees in exercising this discretion for similarly situated persons. Exhibit 4.26.16-1.

Mitigation Threshold Conditions

For most FBAR cases, if IRS has determined that if a person meets four threshold conditions, then that person may be subject to less than the maximum FBAR penalty depending on the amounts in the accounts.

For violations occurring after October 22, 2004, the four threshold conditions are:

• The person has no history of criminal tax or BSA convictions for the preceding 10 years, as well as no history of past FBAR penalty assessments.
• No money passing through any of the foreign accounts associated with the person was from an illegal source or used to further a criminal purpose.
• The person cooperated during the examination (i.e., IRS did not have to resort to a summons to obtain non-privileged information; the taxpayer responded to reasonable requests for documents, meetings, and interviews; and the taxpayer back-filed correct reports).
• IRS did not sustain a civil fraud penalty against the person for an underpayment for the year in question due to the failure to report income related to any amount in a foreign account.

FBAR Penalties – Examiner Discretion

The examiner may determine that the facts and circumstances of a particular case do not justify asserting a penalty.

When a penalty is appropriate, IRS penalty mitigation guidelines aid the examiner in applying penalties in a uniform manner. The examiner may determine that a penalty under these guidelines is not appropriate or that a lesser penalty amount than the guidelines would otherwise provide is appropriate or that the penalty should be increased (up to the statutory maximum). The examiner must make such a determination with the written approval of the examiner’s manager and document the decision in the workpapers.

Factors to consider when applying examiner discretion may include, but are not limited to, the following:

• Whether compliance objectives would be achieved by issuance of a warning letter.
• Whether the person who committed the violation had been previously issued a warning letter or assessed an FBAR penalty.
• The nature of the violation and the amounts involved.
• The cooperation of the taxpayer during the examination.

Given the magnitude of the maximum penalties permitted for each violation, the assertion of multiple penalties and the assertion of separate penalties for multiple violations with respect to a single FBAR, should be carefully considered and calculated to ensure the amount of the penalty is commensurate to the harm caused by the FBAR violation.

Managerial Involvement and Approval of FBAR Penalties

Managers must perform a meaningful review of the examiner’s penalty determination prior to assessment.

The manager must verify that the penalties were fairly imposed and accurately computed; that the examiner did not improperly assert the penalties in the first instance; and that the conclusions regarding “reasonable cause” (or the lack thereof) were proper.

For BSA cases, written managerial approval must be documented on the Violations Summary Form – Title 31, workpaper 400-1.1.

For SB/SE examination cases, written managerial approval must be documented on the Penalty Approval Form, workpaper 300.

For LB&I cases, managerial approval must be documented on the penalty leadsheets.

For SB/SE campus cases, written managerial approval must be documented on Form 4700, Examination Workpapers.

FBAR Penalty Mitigation Guidelines for Violations Occurring After October 22, 2004

The Bank Secrecy Act (BSA) allows the Secretary of the Treasury some discretion in determining the amount of penalties for violations of the FBAR reporting and record keeping requirements. There is a penalty ceiling but no minimum amount. This discretion has been delegated to the FBAR examiner.

The examiner may determine that the facts and circumstances of a particular case do not justify a penalty.

If there was an FBAR violation but no penalty is appropriate, the examiner must issue the FBAR warning letter, Letter 3800.

When a penalty is appropriate, IRS established penalty mitigation guidelines to ensure the penalties determined by the examiner’s discretion are uniform. The examiner may determine that:

• A penalty under these guidelines is not appropriate, or
• A lesser amount than the guidelines otherwise provide is appropriate.

The examiner must make this determination with the written approval of that examiner’s manager. The examiner’s workpapers must document the circumstances that make mitigation of the penalty under these guidelines appropriate. When determining the proper penalty amount, the examiner should keep in mind that manager approval is required to assert more than one $10,000 non-willful penalty per year, and in no event can the aggregate non-willful penalties asserted exceed 50% of the highest aggregate balance of all accounts to which the violations relate during the years at issue. Similarly, manager approval is required to assert willful penalties that, in the aggregate, exceed 50% of the highest aggregate balance of all accounts to which the violations relate during the years at issue, and in no event can the aggregate willful penalties exceed 100% of the highest aggregate balance of all accounts to which the violations relate during the years at issue.

To qualify for mitigation, the person must meet four criteria:

1. The person has no history of criminal tax or BSA convictions for the preceding 10 years and has no history of prior FBAR penalty assessments.
2. No money passing through any of the foreign accounts associated with the person was from an illegal source or used to further a criminal purpose.
3. The person cooperated during the examination.
4. IRS did not determine a fraud penalty against the person for an underpayment of income tax for the year in question due to the failure to report income related to any amount in a foreign account.

Money Transmitter FBAR Filing Requirements
Money transmitters in the U.S. send money overseas generally through the use of foreign banks or non-bank agents located in foreign countries. The arrangement permits the money transmitter to readily send payments, in the currency of the foreign country, to the recipient. The U.S. money transmitter wires funds to the foreign bank or non-bank agent and provides instructions to make payments to the recipient located in the foreign country. The money transmitter typically does not have signature or other authority over the agent’s bank account. In this situation, the money transmitter is not required to file an FBAR for the agent’s bank account.

However, if the money transmitter has a direct financial interest in the foreign financial account, has signature authority, or other authority, over the foreign financial account and the aggregate value is in excess of $10,000 at any time during the year in question, the money transmitter is required to file an FBAR. Another person holding the foreign account on behalf of the money transmitter does not negate the FBAR filing requirement.

Frequently Asked Questions (FAQ’s):

Is there an FBAR filing requirement when the money transmitter wires funds to a foreign bank account or has a business relationship with someone located in a foreign country?

• Answer: No. Merely wiring funds to a foreign bank account or having a business relationship with someone located in a foreign country does not create an FBAR filing requirement.

Is there an FBAR filing requirement where the money transmitter owns a bank account located in a foreign country or has signature authority over someone else’s bank account located in a foreign country?

• Answer: Yes, if the account exceeded $10,000 at any time during the calendar year and the money transmitter was a United States person for FBAR purposes.

Is an FBAR required to be filed by a money transmitter engaged in Informal Value Transfer System (IVTS)/Hawala transactions?

• Answer: There would be no FBAR filing requirement if there is no foreign bank or other foreign financial accounts involved. The money transmitter’s relationship with a foreign affiliate, by itself, does not create an FBAR filing requirement. However, if the money transmitter owned a bank account located in a foreign country or had signature authority over someone else’s bank account located in a foreign country, was a United States person, and the account value exceeded $10,000 at any time, the money transmitter would be required to file an FBAR.

What constitutes “other authority” for FBAR reporting purposes?

• Answer: “Other authority” is comparable to signature authority in that a person exercising “other authority” can through communication to the bank or other person with whom the account is maintained exercise power over the account. A distinction, however, must be drawn between having authority over a bank account of a non-bank foreign agent and having authority over a foreign agent who owns a foreign bank account. Having authority over a person who owns a foreign bank account is not the same as having authority over a foreign bank account.

Does a money transmitter who has a business relationship with a person located in a foreign country have a financial interest in a foreign financial account if the person in the foreign country is providing services of a financial institution (such as money transmission services) and both parties maintain books and records of their business transactions (including books and records of offsetting transactions or trade accounts receivable or payable)?

• Answer: No. The money transmitter does not have a financial interest in a foreign financial account. A “financial account” for FBAR filing purposes includes bank accounts, investment accounts, savings accounts, demand checking, deposit accounts, time deposits, or any other account maintained with a financial institution or other person engaged in the business of a financial institution. “Accounts” as used to describe or identify the books and records of ordinary business transactions between businessmen are not “financial accounts” for FBAR reporting purposes.

Do receivables accounts maintained by foreign non-bank agents which net out the US money transmitter settlement obligations to the foreign agent constitute a financial account for FBAR filing purposes?

• Answer: No. Such receivables in accounting records are not financial accounts for FBAR reporting purposes.

Do the FBAR filing requirements apply when a money transmitter maintains a bank account with a foreign bank for the purpose of settling money transmission transactions with a foreign bank?

• Answer: Yes. If a money transmitter owns the account maintained with the foreign bank or has signature or other authority over it, the money transmitter may be required to file an FBAR.

FBAR Penalty Defense Attorneys

FBAR penalty defense requires a proactive representation and a deep knowledge of the nuances of FBAR compliance and its defenses. Freeman Law represents clients with offshore tax compliance disputes involving FBAR penalties and international information return penalties. Failing to file an FBAR can give rise to significant penalties, including a non-willful penalty and willful FBAR penalty. The risks of tax and reporting non-compliance have never been more real and the threat of international penalties, particularly FBAR penalties, has never been more clear. Schedule a consultation or call (214) 984-3000 to discuss your FBAR penalty concerns or questions. 

There are currently more than 150 penalties contained in the Internal Revenue Code—a penalty for nearly every conceivable reporting, filing, and payment requirement failure.  While penalties have long been a component of the Federal tax laws, the number of penalties has grown substantially over time.  There are, to put it in perspective, nearly ten times more penalties in the current Code than were contained in the 1954 Code.

During the most recent fiscal year, the IRS assessed over $27 billion in civil penalties, an amount that is slightly higher than in recent years.  At the same time, the IRS abated nearly $9 billion in penalties.  In other words, almost a third of penalties were abated.

The Purpose of Tax Penalties

The Internal Revenue Manual provides some insight into the purpose of tax-related penalties: they exist primarily “to encourage voluntary compliance.”  According to the Internal Revenue Manual, “[v]oluntary compliance is achieved when a taxpayer makes a good faith effort to meet the tax obligations defined by the Internal Revenue Code.”  Practitioners seeking penalty abatement may sometimes find support for their position by invoking the underlying purpose of those penalties.

Common Penalties

While there are many tax-related penalties, there are a handful of particularly common penalties that tax practitioners should be familiar with. These include the failure-to-file, failure-to-pay, failure-to-deposit, accuracy-related, and fraud penalties.  Of course, there are other penalties that practitioners should be familiar with, such as penalties for aiding and abetting the understatement of a tax liability, filing frivolous returns, and promoting abusive tax shelters, but the following penalties are among the most frequently encountered in most tax practices.

The Failure-to-File Penalty under Code Sec 6651(a)(1)

The Internal Revenue Code imposes a delinquency penalty for failing to timely file a tax return.  This failure-to-file penalty is equal to five percent of the outstanding tax due on the return for each month that the return is delinquent, up to a maximum of 25 percent.

The Failure-to-Pay Penalty under Code Sec. 6651(a)(2)

The Code also imposes a penalty for failing to timely pay the tax shown as due on a tax return.  This failure-to-pay penalty is equal to one-half of one percent of the delinquent tax amount for each month that the amount remains unpaid, up to a maximum of 25 percent.

The Failure-to-Timely-Deposit Penalty under Code Sec. 6656

The Code imposes a penalty for failing to properly deposit taxes.  The penalty is imposed at a rate of 2 percent for a failure of not more than 5 days.  The rate is increased to 5 percent for a failure of 5-15 days.  And the rate is increased to 10 percent for a failure of more than 15 days.

The Accuracy-Related Penalty under Code Sec. 6662

The Code imposes an accuracy-related penalty generally equal to 20 percent of an understatement of tax attributable to one or more of the following:

• Negligence or disregard of rules or regulations;
• a substantial understatement of income tax;
• a substantial valuation misstatement;
• a substantial overstatement of pension liabilities;
• a substantial estate or gift tax valuation understatement;
• a disallowance of claimed tax benefits by reason of a transaction lacking economic substance (within the meaning of section 7701(o)) or failing to meet the requirements of any similar rule of law;
• an undisclosed foreign financial asset understatement;
• an inconsistent estate basis.

The general 20-percent penalty is increased to 40 percent for certain types of understatements, including understatements attributable to gross valuation misstatements, gross estate or gift tax valuation understatements, undisclosed transactions lacking economic substance, and undisclosed foreign financial assets.

The most common accuracy-related penalties include the negligence and substantial-understatement penalties.  Negligence in this context is defined as a failure to make a reasonable attempt to comply with the Internal Revenue Code, and the term “disregard” is defined to include any careless, reckless, or intentional disregard.  A substantial understatement of income tax is generally defined as the amount by which an understatement exceeds the greater of (i) ten percent of the tax required to be shown on the return for the tax year or (ii) $5,000.  For corporations other than S corporations or personal holding companies, however, the phrase is defined differently.  For such corporations, there is a substantial understatement if the amount of the understatement exceeds the lesser of (i) ten percent of the tax required to be shown on the return (or if greater, $10,000) or (ii) $10,000,000.

The Fraud Penalty

Finally, the Code provides for a fraud penalty equal to 75 percent of any underpayment attributable to fraud.  The term fraud has been defined as an intentional wrongdoing on the part of a taxpayer with the specific purpose of evading a tax known or believed to be owing.  The IRS bears a heightened burden of proof when it comes to establishing fraud.  It must establish, by clear and convincing evidence, that there is an underpayment and that the underpayment is attributable to fraud.  In order to substantiate the existence of fraud, the IRS generally looks for the existence of so-called badges of fraud.

Penalty Defenses

Several defenses may be available to penalty assessments.  Practitioners should consider whether statutory exceptions may be available, whether the penalty may be due to a service error, or whether the taxpayer may have a reasonable cause defense or satisfy the criteria for first-time abatement relief.

Reasonable cause is perhaps the most common defense to accuracy-related and fraud penalties.  It is a penalty defense, or at least a component of a defense, to most civil penalties.  Reasonable cause is generally defined as the exercise of ordinary business care and prudence in determining one’s tax obligations.  The “reasonable cause” standard draws on a broad range of guidance, and whether it exists is based upon all the surrounding facts and circumstances.  Taxpayers seeking reasonable cause relief should ensure that they submit a detailed reasonable cause statement that complies with the governing regulation at issue.  Depending on the context of the submission, taxpayers should also consider tailoring the submission to maximize the chances of acceptance under the IRS’s Reasonable Cause Assistant software—artificial intelligence software employed by the IRS for certain penalty abatement decisions.

Practitioners should also consider whether first-time abatement relief may be available to the taxpayer.  First-time abatement relief is an administrative waiver that may be available for failure-to-file, failure-to-pay, and failure-to-deposit penalties.  It is generally available where a taxpayer can demonstrate that they have no penalties (other than estimated tax penalties) for the prior three years, have filed a return or valid extension for all currently required returns, and have paid or made arrangements to pay any tax due.  Where available, first-time abatement relief can be a cost-effective mechanism to reduce penalties.

There are, of course, other potential avenues to avoid or minimize penalty exposure depending on the context.  Practitioners should, for example, consider whether a qualified amended return may allow a taxpayer to reduce their exposure to accuracy-related penalties or whether proactive disclosure, such as through the procedures of Revenue Procedure 94-69, may provide a taxpayer with an opportunity to reduce accuracy-related penalty exposure even after contact by the IRS.  And, of course, taxpayers may be able to mitigate penalty exposure through proper use of Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement, attached to an original or qualified amended return.

Conclusion

While the Code contains a mind-numbing array of penalties, many can be avoided through proper procedures and diligence on the front end.  But where that fails, practitioners should vet the applicable penalty defenses.  As indicated above, while the Service assessed over $27 billion in civil penalties during the most recent fiscal year, it also abated nearly one-third of those penalties.  As these figures imply, where penalties have been assessed, practitioners would often be wise to heed the advice that “those who do not ask do not receive.”  A well-crafted and reasoned penalty abatement request may be well worthwhile.

For more posts on IRS penalties, see:

• The Badges of Fraud
• IRS Tax Penalties on the Rise, Particularly Employment Tax Penalties
• Litigating IRS Penalties
• The Accuracy-Related Penalty and the Reasonable Cause Defense

As published by Jason B. Freeman in Today’s CPA Magazine:

https://issuu.com/thewarrengroup/docs/tcpa_septoct2017/6

Representation in Tax Audits & Appeals

Need assistance in managing the audit process? Freeman Law’s team of attorneys and dual-credentialed attorney-CPAs regularly represents taxpayers before the IRS and Texas Comptroller. Our team also provides tax return-related representations and helps taxpayers navigate state tax laws. Our Firm offers value-driven services and provides practical solutions to complex issues. Schedule a consultation or call (214) 984-3410 to discuss our tax representation services.

It has been more than 60 years since the Supreme Court held that, under 28 U.S.C. § 1346(a)(1), taxpayers seeking to file federal tax claims against the government in federal court must pay the full amount of tax prior to filing suit.  See Flora v. U.S., 362 U.S. 145, 177 (1960).  As a result, many taxpayers with large tax assessments often find it more difficult to obtain judicial review of IRS actions, particularly where important procedural rights are lost due to inaction.

But, by its own terms, 28 U.S.C. § 1346(a)(1) only applies to “internal-revenue taxes” and claims related to “internal-revenue laws.”  Clearly, federal income taxes and penalties within Title 26 of the United States Code (i.e., the “I.R.C.”) may fall within these definitions.  However, do other statutory provisions outside the I.R.C. also fall within the purview of 28 U.S.C. § 1346(a)(1) and the Flora rule?

Federal courts have struggled with this issue.  For example, in 2018, the Third Circuit Court of Appeals hinted that FBAR penalties (located in Title 31) may fall within the reach of 28 U.S.C. § 1346(a)(1).  See Bedrosian v. U.S., 912 F.3d 144, 149 (3d Cir. 2018).  If this position were accepted by all federal courts, taxpayers subject to “willful” FBAR penalties—often up to 50% of the highest account balance of the foreign account—would find it much more difficult to seek judicial review of the FBAR penalty assessment.

Fortunately, the United States Court of Federal Claims recently issued a decision flatly rejection the Third Circuit’s Bedrosian decision.  Specifically, on April 7, 2021, the court issued its decision in Mendu, which held that FBAR penalties are not subject to the Flora rule because FBAR penalties are not internal-revenue laws or internal-revenue taxes within the scope of 28 U.S.C. § 1346(a)(1).  See Mendu v. U.S., No. 17-cv-738-T (Fed. Cl. Apr. 7, 2021).  This Insight provides a quick overview of the Mendu decision.

Procedural Facts of Mendu

Procedurally, the Mendu decision was an interesting one.  On June 2, 2017, Mr. Mendu filed an action in the Court of Federal Claims challenging the assessment of approximately $750,000 of “willful” FBAR penalties.  To ensure that the Court of Federal Claims had jurisdiction over his illegal exaction claim, Mr. Mendu paid a paltry portion of the FBAR penalties assessed against him—or $1,000—and then filed suit seeking a recovery of that amount.

Shortly thereafter, the government filed an answer and counterclaim seeking judgment of the entire $750,000 of FBAR penalties and interest.  After the government filed its answer and counterclaim, Mr. Mendu sought to dismiss his own complaint on the basis that the court lacked jurisdiction over his illegal exaction claim under Flora, thereby further nullifying jurisdiction regarding the government’s counterclaim.

The Court of Federal Claims’ Jurisdiction over Illegal Exaction Claims

To better understand Mendu, it is necessary to discuss the Court of Federal Claims’ jurisdiction over illegal exaction claims.  Under the Tucker Act, the court has jurisdiction over illegal exaction claims “when the plaintiff has paid money over to the Government, directly or in effect, and seeks return of all or part of that sum that was improperly paid, exacted, or taken from the claimant in contravention of the Constitution, a statute, or a regulation.”  Aerolineas Argentinas v. U.S., 77 F.3d 1564, 1572 (Fed. Cir. 1996) (internal quotes omitted).  Although the Tucker Act provides the Court of Federal Claims with jurisdiction over illegal exaction claims, the Court of Federal Claims has also recognized that such claims related to federal taxes must also meet the Flora rule.  This ensures that taxpayers cannot work around the Flora rule, which would otherwise govern in federal district court proceedings.

Whether FBAR Penalties are Subject to 28 U.S.C. § 1346(a)(1)?

Because Mr. Mendu had paid a portion of the FBAR penalties and filed suit under an illegal exaction claim against the government, but later sought to dismiss his own complaint as violative of the Flora rule—the Court of Federal Claims was presented squarely with the issue of whether FBAR penalties were “internal-revenue taxes” or “internal-revenue laws” under 28 U.S.C. § 1346(a)(1).  And to make this determination, the court turned to the purpose and structure of FBAR penalties.  Moreover, because Mr. Mendu relied on the Bedrosian decision, the court also carefully analyzed whether its reasoning was persuasive.

Structure and Purpose of FBAR Penalties

Regarding the structure and purpose of FBAR penalties, the court first recognized that FBAR penalties are housed in Title 31 of the United States Code.  The court concluded this placement by Congress was significant and “not a mere technicality.”  Indeed, the court further recognized that the Internal Revenue Code had been initially created by Congress in an effort “to consolidate and codify the internal revenue laws of the United States.”  Internal Revenue Code of 1939, ch. 2, 53 Stat. 1 (emphasis mine).  Moreover, the court noted that FBAR penalties, unlike civil penalties under the I.R.C., contain no statutory cross-references that equate “penalties” with “taxes”.  See, e.g., 26 U.S.C. § 6201(a).

In addition, the court found that the Supreme Court’s decisions in Flora I and Flora II were distinguishable from the case at hand.  With respect to Flora I, the court noted that the Supreme Court had disapproved of a taxpayer’s efforts to miss the Tax Court filing deadline but then subsequently file a refund claim based on only a partial payment of the federal income tax.  In this regard, the Supreme Court indicated that 28 U.S.C. § 1346(a)(1) was not intended to alter the historical practice that a taxpayer must “pay first and litigate later.”  Flora I, 357 U.S. at 63-64.

And the Court of Federal Claims recognized that in Flora II, the Supreme Court again held that a taxpayer must pay the full tax amount prior to filing a refund suit under 28 U.S.C. § 1346(a)(1).  See Flora II, 362 U.S. at 155.  In so holding, the Supreme Court noted that the full payment rule was established because permitting partial payment in tax-refund suits could “seriously impair the government’s ability to collect taxes.”  Flora II, 362 U.S. at 164, 176 n.41 & n.43.  Moreover, the Supreme Court recognized that such a suit would be analogous to a suit for declaratory judgment and would thus contravene Congress’ prohibition on declaratory judgments over disputes related to federal taxes.  Flora II, 362 U.S. at 164.

After reviewing Flora I and Flora II, the Court of Federal Claims concluded that “there is no concern that the collection of FBAR penalties will be seriously impaired without the application of a full payment rule.”  This was so according to the court because “[u]nlike the internal-revenue laws included in section 1346, FBAR penalties are enforced primarily through ‘a civil action to recover a civil penalty.’”  Compare 26 U.S.C. §§ 6301-6344 (providing that the IRS can collect internal-revenue penalties through a lien or levy) with 31 U.S.C. § 5321(b)(2) (providing that FBAR penalties may only be collected through “a civil action to recover a civil penalty”).  Thus, there were “no administrative collection procedures for FBAR penalties with which a partial payment illegal exaction claim would interfere.”

The Bedrosian Decision

The Court of Federal Claims found the footnote in Bedrosian equally unpersuasive.  In that footnote, the Third Circuit had indicated that it was “inclined to believe” that an account holder must “pay the full . . .  [FBAR] penalty before filing suit,” but left “a definitive holding on this issue for another day.”  As summarized by the Court of Federal Claims, the Bedrosian footnote relied on the following rationale:

First, the footnote cites to a concurrence in Wyodak Res. Dev. Corp. v. U.S., 637 F.3d 1127 (10th Cir. 2011) for the proposition that ‘internal-revenue laws’ are defined by their function and not their placement in the U.S. Code.  Second, the footnote analogizes FBAR reporting penalties to reporting penalties levied pursuant to I.R.C. § 6038(b), which are subject to the Flora full payment rule.  Third, Bedrosian relies on another footnote in a United States Tax Court decision for the proposition that not all internal-revenue laws exist in Title 26. (citing Whistleblower 21276-13W v. Comm’r, 147 T.C. 121, 130 n.13 (2016)).  Piecing these propositions together, the Bedrosian court was ‘inclined to believe’ that FBAR penalties may be subject to the Flora full payment rule.

After reviewing the rationale for the footnote, the Court of Federal Claims carefully analyzed the decisions cited and concluded that they were inapposite.  With respect to the Wyodak decision, the court concluded that the “concurrence in Wyodak actually supports the conclusion that an FBAR penalty is not a tax.”  In the concurrence, then-Judge Gorsuch argued that the proper inquiry for an “internal-revenue tax” under 28 U.S.C. § 1346(a)(1) was to analyze whether the statute in question should be “properly understood as levying a tax or imposing a regulatory fee.”  In this regard, Judge Gorsuch further explained:

If a law’s purpose was to regulate private behavior, the costs imposed by it were treated as fees—and so required justification under the legislature’s regulatory authority . . . Meanwhile, a charge imposed for the purpose of raising general revenue was a tax, and so needed to be consistent with the sovereign’s authorized taxing powers.

Applying a similar approach, the Court of Federal Claims reasoned that Title 31—like the statute at issue in Wyodak—had a stated purpose that is regulatory in nature.  See 31 U.S.C. § 5311 (stating that the Bank Secrecy Act’s purpose is “to require certain reports or records where they have a high degree of usefulness in criminal, tax, or regulatory investigations or proceedings, or in the conduct of intelligence or counterintelligence activities, including analysis, to protect against international terrorism.”).  On this basis, the court held that “[t]hese functions clearly extend beyond ‘general revenue raising’ and are more akin to a ‘regulatory fee.’”

The Court of Federal Claims also disagreed that the civil penalties under 26 U.S.C. § 6038 were similar to FBAR penalties.  Indeed, the court reasoned that “[a]ny similarities between the FBAR and section 6038 are superficial.”  Thus, the court recognized that although the reporting requirements under both provisions may be similar, the penalties assessed for a violation of either is “very different.”  More specifically, “unlike the FBAR penalty, section 6038 penalties are treated as a tax and are subject to pre-suit collection procedures, including lien and levy collection procedures, which are traditionally used to collect taxes under Title 26.”

And with respect to the last case relied upon in Bedrosian—Whistleblower 21276-13W v. Comm’r, 147 T.C. 121, 130 (2016)—the Court of Federal Claims held that it did not support the characterization of the FBAR penalty as an internal-revenue law.  Rather, that decision merely addressed the meaning of “collected proceeds” under a prior version of 26 U.S.C. § 7623(b)(1).  Moreover, the Court of Federal Claims located three other Tax Court decisions that supported its view that FBAR penalties should not be characterized as “internal-revenue laws.”

Court’s Conclusion. 

The Court of Federal Claims concluded that FBAR penalties were not subject to the Flora rule because they were not “internal-revenue laws” or “internal-revenue taxes” under 28 U.S.C. § 1346(a)(1).  In so concluding, the court held that although “[i]t may be accurate that every internal-revenue law is not necessarily contained in Title 26 . . . Congress’s specific placement of the FBAR in Title 31, the stated purpose of the BSA, and the fact that Congress chose not to employ traditional tax collection procedures to recover FBAR penalties collectively demonstrate that Congress did not intend to subject FBAR penalty suits to the Flora full payment rule.”

FBAR Penalty Defense Attorneys

FBAR penalty defense requires a proactive representation and a deep knowledge of the nuances of FBAR compliance and its defenses. Freeman Law represents clients with offshore tax compliance disputes involving FBAR penalties and international information return penalties. Failing to file an FBAR can give rise to significant penalties, including a non-willful penalty and willful FBAR penalty. The risks of tax and reporting non-compliance have never been more real and the threat of international penalties, particularly FBAR penalties, has never been more clear. Schedule a consultation or call (214) 984-3000 to discuss your FBAR penalty concerns or questions. 

IRS Penalty Defense 

• Freeman’s tax controversy and litigation practice and attorneys have been nationally and regionally recognized, including in U.S. News and World Report’s Best Lawyers in America, Chambers & Partners, and “Leading Tax Controversy Litigation Attorney of the Year” in the State of Texas.
• Freeman’s tax controversy and litigation attorneys are highly credentialed and experienced. They include a former Internal Revenue Service (IRS) trial attorney, a former clerk to the Chief Judge of the United States Tax Court, multiple tax law professors at highly-ranked and respected law schools, dual-credentialed Certified Public Accountants (CPAs), and multiple attorneys with advanced LL.M. tax degrees from the most prestigious advanced tax law programs in the United States. One-third of our attorneys are law professors at tier one law schools, effectively teaching the next generation of tax lawyers.
• Freeman regularly takes on the nation’s biggest tax litigation firms: The Department of Justice Tax Division and IRS Chief Counsel. We bring a systematic approach to tax litigation, and we are rewriting the odds in complex tax disputes, one case at a time.

IRS Civil Penalties Tax Litigation

The Internal Revenue Code (the “Code”) houses more than 150 civil penalties.  And additional civil penalties exist outside of the Code.  For example, Title 31 of the United States Code imposes draconian civil penalties related to FBAR filings.

IRS guidance specifically advises IRS examiners to look for and propose all appropriate civil penalties during the course of their examinations.  Therefore, the IRS routinely—and sometimes even systemically—imposes civil penalties against taxpayers.

Taxpayers are not left without options.  Rather, they can contest the civil penalties by properly and strategically invoking various penalty defenses.  Freeman’s tax controversy and litigation attorneys are well-versed in raising these penalty defenses, including successfully having such penalties waived or abated at various stages, including IRS examination, IRS Appeals, or through Tax Court and federal court litigation, if necessary.

Failure-to-File and Failure-to-Pay Penalties 

Taxpayers who file tax returns late or make late payments of tax to the IRS may be liable for late-filing and late-payment penalties.  Generally, these penalties apply to a host of various tax return and tax payment obligations, including those related to individual income tax returns, corporate income tax returns, estate and gift tax returns, and employment tax returns.

The late-filing penalty is 5 percent of the amount of tax required to be shown on the return if the failure is not more than one month, increasing to additional 5 percent penalties for each subsequent month.  The penalty may not exceed 25 percent in the aggregate and may be reduced to the extent that the late-payment penalty is also imposed for the same month.

The late-payment penalty is 0.5% of the amount of tax shown on the return if the failure is not more than one month, increasing to additional 0.5% penalties for each subsequent month.  Similar to the late-filing penalty, the late-payment penalty may not exceed 25 percent in the aggregate.

Accuracy-Related Penalties 

The Code contains a litany of civil penalties designed to ensure that taxpayers file accurate and complete tax returns with the IRS.  One of the more common civil penalty provisions—section 6662—imposes an accuracy-related penalty on the portion of any underpayment of tax attributable to, among other things: (1) negligence or disregard of rules or regulations; (2) any substantial understatement of income tax; (3) any substantial valuation misstatement for income tax purposes; and (4) any inconsistent estate basis.  In these cases, the civil penalty is 20% of the amount of the underpayment of tax unless any portion of the underpayment is attributable to a gross valuation misstatement, which increases the civil penalty to 40% of that same amount.

Fraud Penalties 

The IRS commonly seeks to find taxpayers who are purposely filing false tax returns or fraudulently not filing tax returns at all.  In these instances, the IRS may impose increased civil penalties against such taxpayers under section 6663 or section 6651(f) of the Code.

Section 6663 governs fraudulent filings.  Under that provision, the IRS may impose a fraud penalty of 75% of the underpayment of tax attributable to fraud if any part of the underpayment of tax required to be shown on a tax return is due to fraud.  Federal courts have held that taxpayers who file a fraudulent return may not generally cure the fraud through a later filing of a corrected amended tax return.  Moreover, if the IRS can prove fraud, the statute of limitations for the IRS to make adjustments to any part of the fraudulent tax return remains open indefinitely.

Section 6651(f) governs the fraudulent failure to file a tax return.  Under that provision, the IRS may impose a fraud penalty of 75% of the tax required to be shown on a tax return if the tax return is not filed with the specific intent to evade tax.

The potential for civil fraud penalties raises complex issues that require careful advice of tax counsel.  In many instances, an IRS examination related to civil tax fraud may escalate to a referral for criminal prosecution.

Tax Shelter Penalties 

The Code imposes certain reporting obligations on so-called “tax shelters.”  For example, taxpayers who participate in a “reportable transaction” must generally file IRS Form 8886, Reportable Transaction Disclosure Statement.  In addition, the taxpayer is required to send the same form to the Office of Tax Shelter Analysis (the “OTSA”) when the taxpayer first files the form for the reportable transaction.  If the taxpayer fails to properly report the transaction, the taxpayer may be subject to a penalty under section 6707A.  The section 6707A penalty is generally equal to 75 percent of the decrease in tax reflected on the return as a result of the transaction.

The types of reportable transactions include:  (1) listed transactions; (2) confidential transactions; (3) contractual protection transactions; (4) loss transactions; and (5) transactions of interest.  As a general matter, these types of reportable transactions are ones that the IRS has determined are subject to potential abuse or tax evasion.

International Tax Penalties 

The Code and Title 31 contain civil penalty provisions for a taxpayer’s failure to properly report certain foreign transactions or holdings.  In recent years, the IRS has ramped up its enforcement and compliance efforts in this area, subjecting more and more taxpayers to international tax penalties.

International tax penalties apply to the following international tax reporting forms:

• Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations;
• Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business;
• Form 8865, Return of U.S. Persons with Respect to Certain Foreign Partnerships;
• Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation;
• Form 8938, Statement of Specified Foreign Financial Assets;
• Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Foreign Gifts;
• Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner;
• FinCEN Form 114, Report of Foreign Bank and Financial Accounts.

Employment Tax Penalties 

Employers are required to timely file employment tax returns (e.g., Forms 940 and Forms 941) with the IRS.  In addition, they must timely remit employment taxes to the IRS.  If an employer fails to meet either obligation, the Code permits the IRS to impose various civil penalties against the employer.

Under section 6656, the IRS may impose failure-to-deposit civil penalties, which relate to the deposit requirement for payment of employment taxes.  Generally, the amount of the civil penalty depends largely on when the deposit is eventually made.  The maximum civil penalty may be 15% of the amount of the underpayment.

The failure-to-file, failure-to-pay, and fraud civil penalties may also be imposed against employers who fail to timely file or timely pay employment taxes to the IRS.

Trust Fund Recovery Penalties 

Certain persons have statutory obligations to account for, collect, and remit employment taxes to the IRS on behalf of an employer.  If the person willfully fails to do so, the IRS may assess trust fund recovery penalties directly against the individual.  Certain important administrative procedures are provided to individuals prior to an assessment of the trust fund recovery penalty and such individuals should ensure that they exercise these important rights.  Significantly, the trust fund recovery penalty—once assessed—is not subject to discharge in bankruptcy.

Penalty Defenses 

Each individual civil penalty has different penalty defenses.  Stated differently, not all penalty defenses apply to all civil penalties.  Accordingly, it is important to raise the proper penalty defenses with the IRS at the appropriate time.

In many penalty cases (but not all), taxpayers may raise “reasonable cause” as a defense.  This defense looks at the particular facts and circumstances as to why the taxpayer failed to comply with a statutory or regulatory obligation.  Because the facts and circumstances drive the analysis—i.e., whether the IRS and federal courts will accept it—taxpayers should be mindful of governing case law and IRS guidance on the issues raised in their reasonable cause defense to increase their likelihood of success in obtaining penalty relief with this defense.

Certain penalties are also subject to procedural defenses.  For example, with respect to some penalties, taxpayers may raise the defense of section 6751(b), which requires the IRS to obtain managerial approval of the penalty determination.

Moreover, taxpayers should be mindful of the evidentiary burden of the particular penalty at issue.  In fraud cases, the IRS must generally satisfy a higher evidentiary standard—“clear and convincing evidence”—rather than the general preponderance of the evidence standard.  In these instances, taxpayers should attempt to rebut indicia of fraud through the introduction of favorable evidence.  Taxpayers should also have a careful understanding of the factors that the IRS looks to when determining whether a taxpayer potentially engaged in fraud.

Representative Matters 

• Obtained penalty abatement and removal of IRS penalties in excess of $14 million.
• Represented estate before IRS in having over $500,000 in late-filing and late-payment penalties removed.
• Represented client in Tax Court proceedings, resulting in over $400,000 of late-filing, late-payment, and failure to make estimated tax payment penalties waived.

A federal district court in Texas recently took up an interesting FBAR issue: whether civil FBAR penalties survive death?  That is, if a taxpayer/account holder dies after the IRS assesses an FBAR penalty against them, do the FBAR penalties remain against the decedent’s estate?  Or do the penalties die, so to speak, along with them?

The analysis typically turns on a subsidiary question: Are the penalties, for these purposes at least, penal or remedial?  If penal, the FBAR penalties would potentially dissolve at death.  If, on the other hand, they are remedial, maybe not.

FBAR penalties can be notoriously draconian.  If a U.S. person fails to file an FBAR, the IRS can impose a civil monetary penalty.  31 U.S.C. § 5321(a)(5)(A).  The amount of the penalty can vary.  If, for example, the failure to file results from willful conduct, the statute provides for a penalty equal to the greater of $100,000 or 50% percent of the amount of “the balance in the account at the time of the violation.”  31 U.S.C. § 5321(a)(5)(C), (D).

But the issue is an intricate one.  Ultimately, whether a federal statutory claim survives the death of the defendant is a question of federal law—and one that ultimately looks to the congressional intent behind the statute.  “Penalties” can and often do serve multiple purposes.  So what, then, is the “primary purpose” of FBAR penalties?

The court in United States v. Gill took up that inquiry in the context of FBAR penalties that had been assessed against an individual who later passed away.  The Gill court concluded that the purpose of FBAR penalties is primarily remedial and that the claim therefore survives death.

Let’s take a deeper dive into the facts and the court’s analysis in Gill.

Background

The United States filed a complaint against Jagmail Gill, asserting that Mr. Gill, who became a green card holder and later a citizen of the United States, failed to report any of his foreign income on his originally filed U.S. income tax returns for 2005 through 2010.  He also did not file an FBAR to report that he had signature authority, control or authority over, or an interest in numerous foreign bank accounts that had an aggregate balance of more than $10,000.

The Government asserted that the failures to file were non-willful, but assessed FBAR Penalties of $740,848 for Mr. Gill’s non-willful failure to timely file FBARs reporting his financial interest in the foreign bank accounts.

While the case was pending, Mr. Gill passed away.  In response, the government filed a motion to appoint and substitute a personal representative for Mr. Gill’s estate.  Mr. Gill’s counsel filed an opposition, arguing that the Government’s claims did not survive death, so no representative was needed.

Section 2404

The analysis begins with 28 U.S.C. § 2404.  Under § 2404, a “civil action for damages commenced on or behalf of the United States or in which it is interested shall not abate on the death of a defendant but shall survive and be enforceable against his estate as well as against surviving defendants.” 28 U.S.C. § 2404. The government maintained that the FBAR penalties were “damages” within the meaning of this statute because they are remedial in nature and that the claims therefore survived Mr. Gill’s death.

Because § 2404 would allow a claim to proceed against the Estate if it is remedial and thus a “civil action for damages,” the court turned to the next analytical inquiry: whether the claim is primarily remedial or penal?

Statutes Surviving Death

Whether a federal statutory claim survives the death of the defendant (survivability) is a matter of federal law. “It has long been established that causes of action predicated on penal statutes do not survive . . . death, . . . whereas remedial damage actions do survive.” In re Wood, 643 F.2d 188, 190 (5th Cir. 1980).  “A remedial action is one that compensates an individual for specific harm suffered, while a penal action imposes damages upon the defendant for a general wrong to the public.” United States v. NEC Corp., 11 F.3d 136, 137 (11th Cir. 1993).

In the Fifth Circuit, courts analyze three factors to determine whether a statute is penal or remedial: “‘(1) whether the purpose of the statute was to redress individual wrongs or more general wrongs to the public; (2) whether recovery under the statute runs to the harmed individual or to the public; and (3) whether the recovery authorized by the statute is wholly disproportionate to the harm suffered.’” In re Wood, 643 F.2d at 191.  Other course have applied the so-called Hudson framework, utilizing the test set forth in Hudson v. United States, 522 U.S. 93 (1997).

Courts tend to agree that if a claim does not “fall neatly within the penal or remedial categories,” the court should consider the “primary purpose” of the statute.

Thus, the court turned to yet another analytical inquiry: whether the primary purpose of the FBAR penalties at issue penal or remedial?

What Are FBAR Penalties?

Congress enacted the statutory basis for the requirement to report foreign bank and financial accounts in 1970 as part of the “Currency and Foreign Transactions Reporting Act of 1970,” which came to be known as the “Bank Secrecy Act” or “BSA.” These anti-money laundering and currency reporting provisions, as amended, were codified at 31 USC 5311 – 5332.

The specific statutory authority for the FBAR is found under 31 USC § 5314, which directs the Secretary of the Treasury to require a resident or citizen of the United States to keep records and/or file reports when making transactions or maintaining a relationship with a foreign financial agency.

The FBAR regulations likewise require that a United States person, including a citizen, resident, corporation, partnership, limited liability company, trust and estate, file an FBAR to report:

• a financial interest in or signature or other authority over at least one financial account located outside the United States if
• the aggregate value of those foreign financial accounts exceeded $10,000 at any time during the calendar year reported.

31 U.S.C. § 5314(a) imposes penalties for a failure to file a FBAR report and the regulations implement that penalty, providing: “Each United States person having a financial interest in, or signature authority over, a bank, securities, or other financial account in a foreign country shall report such relationship” to the IRS “each year in which such relationship exists.” 31 C.F.R. § 1010.350(a).

The FBAR penalty regulation read as follows:

((g))  For any willful violation committed after October 27 1986, of any requirement of [§ 1010.350, § 1010.360 or § 1010.420], the Secretary may assess upon any person, a civil penalty:

…

((2))  In the case of a violation of [§ 1010.350 or § 1010.4201 involving a failure to report the existence of an account or any identifying information required to be provided with respect to such account, a civil penalty not to exceed the greater of the amount (not to exceed $100,000) equal to the balance in the account at the time of the violation, or $25,000.

Id. at 11446 (codified as amended at 31 C.F.R. § 1010.820(g)).

As a side note, it should be noted that taxpayers/account holders facing FBAR penalty exposure often have exposure to other foreign-reporting penalties.  Some of the more common foreign-reporting requirements are:

• FinCEN Form 114, Report of Foreign Bank and Financial Accounts;
• IRS Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Foreign Gifts;
• IRS Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner;
• IRS Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations;
• IRS Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business;
• IRS Form 926, Filing Requirement for U.S. Transferors of Property to a Foreign Corporation;
• IRS Form 8938, Statement of Specified Foreign Financial Assets;
• IRS Form 8865, Return of U.S. Persons with Respect to Certain Foreign Partnerships.

A failure to file any of these forms can lead to criminal prosecution and/or civil penalties.  See, e.g., U.S. v. Little, 828 Fed. Appx. 34 (2d Cir. 2020) (affirming criminal conviction for failure to file FBARs and willfully assisting in the filing of false Forms 3520); Wilson v. U.S., No. 20-603 (July 28, 2021) (discussing duel civil penalties under 26 U.S.C. § 6048 for foreign trust non-reporting).

But let’s turn back to the FBAR issues and the Gill court’s analysis.

Cases That Support the Government’s View: Estate of Schoenfeld, Green, Park, and Wolin

The district court reviewed a series of cases favoring the government’s and the estate’s positions.  We will look at each of those in turn, starting with the cases that tend to favor the government’s view.

Estate of Schoenfeld

In United States v. Estate of Schoenfeld, the Government originally filed a case to obtain a judgment for a failure to file an FBAR with respect to an account in Switzerland. After the taxpayer died, the Government amended the complaint to name the estate and the taxpayer’s son. The penalty at issue in Estate of Schoenfeld was assessed for a willful failure to file an FBAR. The defendants moved to dismiss or for summary judgment on grounds that the statute was punitive and the action did not survive the taxpayer’s death. The court determined whether the FBAR penalty was punitive or remedial by considering the Kennedy factors set forth in Hudson. Notably, though, the parties had agreed that these factors applied.

The Estate of Schoenfeld court found that, under the Kennedy framework, the FBAR penalty was remedial in nature and the claim survived the original defendant’s death. It considered each of the seven Kennedy factors and found that (1) the penalty did not involve an affirmative disability or restraint (like being imprisoned); (2) monetary penalties have not historically been regarded as punishment; (3) the penalty applies regardless of scienter (though it impacts the amount); (4) it promotes retribution and deterrence, though “all civil penalties have some deterrent effect” and “none are solely remedial”; (5) a willful failure can result in a criminal penalty, but the inclusion of a criminal penalty does not render the money penalty criminally punitive; (6) the “FBAR penalty serves the additional alternative purpose of acting as a safeguard for the protection of the revenue and to reimburse the Government for the heavy expense of investigation and the loss resulting from the taxpayer’s funds; and (7) “the FBAR penalty is not excessive in relation to this alternative purpose.” Id. at 1370–73. The court concluded that there was no indication that the FBAR penalty, which Congress specifically expressed is a civil sanction, is penal in nature.

United States v. Green

In United States v. Green, the U.S. district court for the Southern District of Florida considered whether FBAR penalties assessed for willfully failing to disclose accounts and file FBARs survived death by considering whether they were penal or remedial.  It noted that courts typically examine the factors in In re Wood to make this distinction, but pointed out that the factors “do not allow for a situation where the United States itself has suffered a harm because of a defendant’s conduct.” Thus, while finding the In re Wood factors instructive, the court also found the Kennedy factors relied upon in Estate of Schoenfeld “helpful because the analysis may be implemented to provide a robust examination as to whether a penalty is remedial or penal in nature.” The court decided to examine “the relevant considerations which are embodied in both [the Kennedy and In re Wood] analyses to determine whether the FBAR penalty is remedial or penal.”

In conducting this analysis, the Green court noted that the statute itself denotes that the penalties are “civil.”  It then found that the Government had suffered an individual monetary harm (as opposed to a more general harm to the public) due to the decedent’s conduct because the Government “likely expends significant resources on investigating foreign accounts.”  It found that “the FBAR penalty has a remedial purpose [because] it allows the Government to recover for the aforementioned monetary harm.” The statute, however, also has “deterrent and retributive purposes” but “those purposes [do] not unilaterally render the FBAR penalty penal in nature.”  It determined that the penalty “is not wholly disproportionate to the harm the Government itself has suffered” because, for willful violations, the amount is tied to the account’s balance (or $100,000), and it “need not be tied to the Government’s loss directly to be remedial.” The penalty for willful violations “ties the amount to the balance of the account, which reflects Congress’ likely determination that the value of harm to the Government itself is correlated to the balance of the account.” The court asserted that the penalty amount “was selected to ensure that the Government would be made completely whole.”  It found that “because FBAR violations likely deprive the Government of taxes on investment gains and require the Government to expend significant resources investigating foreign accounts, the FBAR penalty is not wholly disproportionate to the monetary harm the Government itself suffers.” In addition to these factors, the court opined that it would be inappropriate to grant a “windfall to estates of violators of the FBAR requirements.” While it found, after these considerations, that the penalty does not fit neatly in either the remedial or penal category, it determined the penalty is “primarily remedial with incidental penal effects.”

United States v. Park

In United States v. Park, the U.S. district court for the Northern District of Illinois similarly held that FBAR Penalties survive the death of the person who willfully failed to file an FBAR form during his lifetime. The court relied on Estate of Schoenfeld and agreed that the penalties are remedial rather than punitive. It held that “the estate of a person who willfully fails to file an FBAR form during his lifetime cannot avoid the penalty that person would not have avoided if he had lived.”

In United States v. Wolin, the U.S. district court for the Eastern District of New York considered the same issue and noted that all the courts that had considered whether FBAR Penalties survive the death of a party have found that the penalty is remedial. The estate’s representative in Wolin had requested that the In re Wood test be applied, but the court rejected the use of the In re Wood test, stating that the In re Wood factors do not work when the wronged party is the United States itself. The Wolin court was persuaded by the “predominant consensus that the FBAR penalty claim is remedial”; it relied heavily on United States v. Green.

Cases Supporting the Estate’s View: Simonelli, Bajakajian, Bittner, Kaufman, and Boyd

Simonelli

In Simonelli, the U.S. District Court for the District of Connecticut held that a debt for an FBAR penalty was not dischargeble in bankruptcy. The defendant had three accounts in the Bahamas and was required to report them on an FBAR but failed to do so. He consented to an assessment of $25,000 for a willful failure to file. He, however, failed to pay the penalty, and the Government filed a civil case to collect the penalty plus interest. In the interim, the defendant had obtained a general discharge in bankruptcy, and he argued that the FBAR penalty was discharged at that time. The Government argued that the penalty was exempt from a bankruptcy discharge.  The defendant argued that the FBAR penalty was a tax penalty imposed in lieu of taxes and was thus dischargable under 11 U.S.C. § 523(a)(7).

The court considered whether an FBAR penalty for willfully failing to provide a report is a “penalty” or a “tax.” It noted that a plain reading of the Bank Secrecy Act indicates it is a “civil penalty,” notwithstanding the defendant’s argument that it is, “in essence, actually a tax.” The court found that the debt “was imposed pursuant to a non-tax law,” which the defendant sought “to recharacterize as a tax law.” The court determined that “[b]ecause there is no tax underlying the FBAR penalty, the FBAR penalty cannot be considered a tax penalty.” It found the penalty was a “penalty” (not a “tax”) within the meaning of § 523(a)(7) and, as such, it was excepted from discharge in bankruptcy. While the court found the FBAR penalty assessed in Simonelli was a “penalty” within the meaning of 11 U.S.C. § 523(a)(7), which supports the Estate’s arguments that it is a penalty in this case, the Simonelli court was considering whether it was a “civil money penalty” or a “tax”; it was not considering whether the penalty was primarily penal or remedial.

United States v. Bajakajian

United States v. Bajakajian for the proposition that if there is some retributive or deterrent purpose, the statute is punitive. The Bajakajian Court concluded that a forfeiture of currency under 18 U.S.C. § 982(a)(1) constitutes punishment. 524 U.S. at 328. Under that statute, forfeiture is “an additional sanction when ‘imposing sentence on a person convicted of’ a willful violation of” the reporting requirement in 31 U.S.C. § 5316.  The Court noted that the forfeiture was “imposed at the culmination of a criminal proceeding and requires conviction of an underlying felony, and it cannot be imposed upon an innocent owner of unreported currency, but only upon a person who has himself been convicted of a § 5316 reporting violation.”  The Government had argued that a forfeiture under § 982(a)(1) also served a remedial purpose, which was to control what property leaves and enters the country and that forfeiture deters “‘illicit movements of cash’” and aids “in providing the Government with ‘valuable information to investigate and detect criminal activities associated with that cash.’”  The Court pointed out, however, that “[d]eterrence . . . has traditionally been viewed as a goal of punishment, and forfeiture of the currency here does not serve the remedial purpose of compensating the Government for a loss.”  The Court reasoned that the loss of information suffered by the Government “would not be remedied by the Government’s confiscation of the respondent’s $357,144.” The Court found that the “forfeiture serves no remedial purpose, is designed to punish the offender, and cannot be imposed upon innocent owners.” It thus found that the forfeiture is punitive and constitutes a “fine” under the Excessive Fines Clause. While the Supreme Court’s viewpoint on the remedial purpose espoused by the Government in Bajakajian is certainly instructive, this case is not be as helpful as the Estate asserts because the forfeiture—unlike the penalty in this case— could not be imposed on an innocent owner of unreported currency. Moreover, while the Bajakajian Court noted that the Government’s loss would not be remedied by confiscating the money in that case, here, the Government asserts that it had to conduct an examination into Mr. Gill’s accounts because he did not file the reports, so it seems the recovery would be a direct remedy for that loss, at least to some extent, here.

Other Cases

The Estate also pointed to cases that have found that the fact that the Government applies the penalty for non-willful violations per account as opposed to per missing FBAR filing is excessive: United States v. Bittner, 469 F. Supp. 3d 709 (E.D. Tex. 2020), and United States v. Kaufman, No. 3:18-CV-00787 (KAD), 2021 WL 83478 (D. Conn. Jan. 11, 2021). The Estate contended that these cases supported its argument that the FBAR penalties were disproportionate to the alleged harm suffered.

United States v. Bittner

In United States v. Bittner, the federal district court for the Eastern District of Texas considered whether the text of § 5321(a)(5)(A) and (B)(i) for non-willful violations of the regulations implementing § 5314 indicates that the penalties apply per foreign account or per annual FBAR report. The court “conclude[d] that non- willful FBAR violations relate to each FBAR form not timely or properly filed rather than to each foreign financial account maintained but not properly reported.” The court determined that because Congress used different language for the penalty for non-willful violations than it did for willful violations—excluding references to the existence of and balance on accounts in the former—it must have “intended the penalty for willful violations to relate to specific accounts and the penalty for non-willful violations not to.” It also noted that interpreting the statute this way would avoid “absurd outcomes.” The Government argued in Bittner, like it argues here, that hidden foreign accounts increase investigation costs and potential damage to the government in terms of lost tax revenue, rendering the penalties remedial; the court found this concern legitimate but overstated. It noted that there may not be any connection between the number of foreign accounts and lost tax revenue, and even though there may be higher costs associated with investigating extra accounts, “that concern is simply not strong enough” to convince the court to “change its analysis of the statute’s meaning.”

United States v. Kaufman

In United States v. Kaufman, the court also construed the statute to determine if the Government could impose the penalty per account as opposed to per report. It reasoned that the reporting obligation is triggered by the aggregate balance of all foreign accounts, so it does not make sense to read the section imposing penalties for non-willful violations to apply on a per account basis rather than a per report basis. Also, interpreting the statute as applying per account “could readily result in disparate outcomes among similarly situated people” because the penalties could vary drastically for the same aggregate amount in foreign accounts if one person has this amount split among multiple accounts.

United States v. Boyd

The Ninth Circuit recently considered the same issue and reached a similar conclusion. The Ninth Circuit strictly construed the statute and determined that the “non-willful penalty provision allows the IRS to assess one penalty not to exceed $10,000 per violation, and nothing in the statute or regulations suggests that the penalty may be calculated on a per-account basis for a single failure to file a timely FBAR that is otherwise accurate.” While these cases would be helpful if the court were determining the propriety of the amount assessed, in general, here the court simply must consider the amount that was assessed and determine if it is not proportionate to the amount of loss as part of its remedial versus penal analysis.

Conclusion

FBAR penalties can be significant.  And when the accountholder passes away, it raises an interesting legal question: whether civil FBAR penalties assessed during life survive their death?  The court in United States v. Gill took up that inquiry, ultimately concluding that, under its analysis, the purpose of the FBAR statute is primarily remedial and that the government’s claim for FBAR penalties therefore survives death.

For other relevant FBAR posts, check out these Insights:

• The FBAR (Report of Foreign Bank and Financial Accounts): Everything You Need to Know
• Everything That You Need To Know About International Tax Penalties
• FBAR Penalty Update
• The Colliot Decision: The Government Loses an FBAR Case that May Change International Reporting Penalties
• Court Strikes Down Largest Non-Willful FBAR Penalty Ever
• The Largest Non-Willful FBAR Penalty Case Ever?

FBAR Penalty Defense Attorneys

FBAR penalty defense requires a proactive representation and a deep knowledge of the nuances of FBAR compliance and its defenses.  Freeman Law represents clients with offshore tax compliance disputes involving FBAR penalties and international information return penalties. Failing to file an FBAR can give rise to significant penalties, including a non-willful penalty and willful FBAR penalty. The risks of tax and reporting non-compliance have never been more real and the threat of international penalties, particularly FBAR penalties, has never been more clear. Schedule a consultation or call (214) 984-3000 to discuss your FBAR penalty concerns or questions. 

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.

The IRS made initial and continuation penalty assessments against the taxpayer.  Thereafter, the IRS moved to collect on the assessments through levy actions.  After the IRS issued the taxpayer a Letter 1058, Final Notice of Intent to Levy and Notice of Your Right to a Hearing, the taxpayer timely filed a request for a Collection Due Process (CDP) hearing.  During the CDP hearing, the taxpayer contended that the IRS lacked the statutory authority to make the civil penalty assessments against him.

Predictably, the IRS Settlement Officer  (“SO”) disagreed with the taxpayer’s contention and issued a Notice of Determination sustaining the levy actions.   The taxpayer timely filed a petition with the Tax Court, again asserting that the IRS lacked the statutory authority to make the civil penalty assessments against him.

The Statutory Arguments

Under section 6201(a), the IRS has the authority to make various types of assessments, such as “all taxes (including interest, additional amounts, additions to tax, and assessable penalties).” The IRS argued that this provision permitted it to assess civil penalties against the taxpayer on the basis that the section 6038(b) civil penalties were a tax or an assessable penalty.  The Tax Court disagreed.

First, the Tax Court recognized that Congress specifically empowered the IRS to make certain penalty assessments in various parts of the Code.  For example, section 6671(a) provides that numerous penalties found in subchapter B of chapter 68 of subtitle F (i.e., sections 6671 through 6725) “shall be assessed and collected in the same manner as taxes.”  In addition, section 6665(a)(1) similarly provides that additions to tax, additional amounts, and penalties provided in chapter 68 of subtitle F (i.e., sections 6651 through 6751) “shall be assessed, collected, and paid in the same manner as taxes.”  Regarding penalties outside the scope of these provisions, the Tax Court further noted that Congress embedded within the particular penalty statute the express authority for the IRS to make such penalty assessments.  By contrast, section 6038 only cross-referenced criminal penalties and not civil penalties.  See I.R.C. § 6038(f)(1).

Second, the Tax Court reasoned that Congress enacted 28 U.S.C. § 2461 to capture instances in which the means or mode of recovery or enforcement was not specified.  Under 28 U.S.C. § 2461(a), if Congress fails to so specify for a “civil fine, penalty or pecuniary forfeiture,” the fine, penalty, or forfeiture must be “recovered in a civil action.”

Third, the Tax Court squarely rejected the IRS’s position that the term “assessable penalties” within section 6201 applied to all penalties in the Code that were not subject to deficiency procedures.  In this regard, the Tax Court noted:

‘Assessable penalties’ is not a term used to distinguish between penalties subject to deficiency procedures and those that are not.  The label of assessable penalty . . . does not automatically bar a taxpayer from using the deficiency procedures to challenge the liability.  An assessable penalty, rather, must be paid upon notice and demand and assessed and collected in the same manner as taxes.  While some provisions explicitly exempt certain assessable penalties from deficiency procedures, others do not specify whether those procedures apply.  In those cases, we consider whether the assessable penalty at issue is included in the statutory definition of ‘deficiency,’ or whether the assessable penalty depends upon a deficiency or, to the contrary, may be assessed even if there is an overpayment of tax.

Respondent’s argument that section 6038(b) penalties are necessarily assessable penalties because they are not subject to deficiency procedures assumes a faulty premise and must be rejected.

Fourth, the Tax Court held that the term “taxes” in section 6201(a) did not include the section 6038(b) penalties.  The Tax Court reasoned that “[p]recedent firmly establishes that taxes and penalties are distinct categories of exactions, at least in the absence of a provision treating the same.”  See Grajales v. Comm’r, 156 T.C. 55, 61 (2021); Nat’l Fed’n of Indep. Bus. v. Sebelius, 567 U.S. 519, 546 (2012).

In sum, the Tax Court concluded that the IRS lacked the statutory authority to make the assessment of civil penalties against the taxpayer.  Accordingly, the Tax Court held that the IRS could not proceed with levy action against the taxpayer to collect the section 6038(b) civil penalties.

Conclusion

The Farhy decision is a major win for taxpayers.  Although the government will no doubt appeal the decision, taxpayers should take proactive actions now to protect their rights.  These actions may include, for example, filing claims for refund prior to the statutory deadline to claim the refund expires.  Taxpayers should also consult their tax professionals regarding the impact of Farhy on other potential compliance decisions, such as an upcoming filing of a voluntary disclosure or a submission under the IRS Streamlined Compliance Procedures.

Tax Court Litigation Attorneys

Need assistance litigating in the U.S. Tax Court? Freeman Law’s tax attorneys are experienced litigators with trial-tested litigation skills and in-depth substantive tax knowledge, having collectively litigated hundreds of cases before the U.S. Tax Court. Our tax controversy lawyers have extensive experience in Tax Court matters involving partnership audits and litigation under both the TEFRA and BBA regimes, international tax penalties, foreign trusts, valuation, reasonable compensation disputes, unreported income, fraud penalties, other tax penalties, any many other matters. We draw on our experience and wealth of tax knowledge to advise and guide clients through the entire tax controversy process, building the right strategy to resolve tax controversies from day one. Schedule a consultation or call (214) 984-3000 to discuss your Tax Court concerns or questions. 

The concept of “willfulness” is an important one in the FBAR civil penalty context.  Indeed, a taxpayer’s willful failure to file a timely and accurate FBAR may result in significant penalties:  the higher of 50-percent of the unreported account balance at the time of the violation or $100,000 (adjusted for inflation).  Take this simple example:

Mark is a dual citizen of the United States and Australia.  Mark routinely travels to Australia to visit his family. In one year, Mark chooses to live and work in Australia, making $300,000 as an independent contractor.  Mark deposits the funds from his work in an Australian bank account.

When tax time comes, Mark files an income tax return reporting the $300,000 of income.  However, he fails to file an FBAR reporting the maximum account balance in the foreign account, which was $200,000.  If the IRS determines that Mark’s failure to file an FBAR was willful, the IRS may assess a $100,000 willful FBAR penalty against him.

Admittedly, the facts in the above hypothetical alone are not sufficient to indicate willfulness.  But a few additional facts can easily change this result.  For example, assume the same facts above except assume further that Mark failed to report the $300,000 on his income tax return.  Are the above facts in conjunction with his failure to report income sufficient to constitute a willful FBAR penalty?  Instead, what if Mark reported all of the income but improperly checked the box “No” on Schedule B, where it asks if Mark has any foreign accounts during the tax year.  Is this additional fact sufficient to find willfulness?

Maybe, or maybe not.  It all hinges on the proper definition of the term “willfulness.”  Regrettably, many taxpayers reasonably believe that the term willful must have its commonly-understood meaning—that is, Mark would be liable for willful FBAR penalties only if he knew of the FBAR reporting obligation and purposely chose not to file.  Although it is true that the government could sustain its burden by showing intentional conduct, it is also true that the government does not have to go that far.  Federal courts have routinely sided with the IRS in concluding that the term “willful” encompasses not only intentional conduct but “reckless” conduct as well.   Because reckless conduct is much easier to prove in these instances, the IRS generally attempts to show mere recklessness on the part of the taxpayer to sustain the willful FBAR penalty.

This article discusses the evolution of the willfulness standard.  It starts by providing a brief history of the FBAR provisions in general.  From there, it discusses the Supreme Court’s decision in Safeco Ins., which significantly changed the definition of willfulness for most federal civil penalty statutes, including the FBAR provisions.  Finally, the article concludes with some of the more seminal FBAR cases and an analysis of the willfulness standard today.  

Quick History of the FBAR Rules

The Bank Secrecy Act

Congress enacted the Bank Secrecy Act (the “BSA”) in 1970.[i]  Codified in Title 31 of the United States Code, the BSA was enacted “to require certain reports or records where such reports or records have a high degree of usefulness in criminal, tax, or regulatory investigations or proceedings.”[ii]  Among other requirements, the BSA mandated new reporting obligations for United States persons who had relationships with foreign financial institutions.[iii]

After passage of the BSA, the Secretary of the Treasury (“Treasury”) was authorized to promulgate regulations for the implementation and enforcement of the new BSA reporting requirements.[iv]   Pursuant to this authority, in 1972 Treasury began requiring individuals to file information reports with the United States government.  Significantly, however, at this time, Congress did not authorize Treasury to impose civil penalties against individual taxpayers for failure to file required information returns—rather, only “domestic financial institutions” and their agents were subject to civil monetary penalties.[v]

Congress Amends the BSA

In response to money-laundering concerns, Congress amended the BSA in 1986 to provide for civil monetary penalties against individuals.[vi]  Under the Money Laundering Control Act of 1986,[vii] Congress imposed penalties against individuals, but only if the failure to report was willful.[viii]   And by statute, Congress set the maximum amount of the willful penalty as the greater of $25,000 or an amount (not to exceed $100,000) equal to the balance in the account at the time of the violation.[ix]  This willful penalty would remain the same until 2004.

The PATRIOT Act and Treasury’s Report to Congress

On September 11, 2001, the United States was attacked domestically by a group of terrorists.  In response, Congress passed the United and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “PATRIOT ACT”).[x]  The PATRIOT Act required Treasury to “study methods for improving compliance with the [FBAR] reporting requirements established in section 5314 of title 31, United States Code,” and to submit regular reports to Congress on this subject.[xi]

Under this requirement, Treasury submitted a report to Congress in 2002.[xii]  The report indicated that although it was difficult to determine with certainty how many taxpayers complied with the existing FBAR reporting requirements, it was estimated that compliance rates were low, or “less than 20 percent.”[xiii]

The American Jobs Creation Act of 2004

Congress drastically changed the BSA after Treasury’s 2002 report with enactment of the American Jobs Creation Act of 2004 (the “ACJA”), which divided FBAR reporting violations into one of two categories:  willful violations and non-willful violations.[xiv]  Under the ACJA, willful violations could result in monetary penalties against taxpayers equal to the greater of $100,000 or 50-percent of the amount of the balance in the account at the time of the violation.[xv]  Conversely, if the taxpayers’ conduct was non-willful, Treasury was authorized to impose a maximum penalty of $10,000 per violation.[xvi]

The Current FBAR Reporting Requirements  

Not much has changed since 2004.  Currently, 31 U.S.C. § 5314 provides the statutory authority for the imposition of the FBAR reporting and filing requirements.  Under that statute, Treasury “shall require a resident or citizen of the United States . . . to keep records, file reports, or keep records and file reports, when the resident . . . [or] citizen . . . makes a transaction or maintains a relation for any person with a foreign financial agency.”  Treasury regulations under this provision provide:

Each United States person having a financial interest in, or signature or other authority over, a bank, securities, or other financial account in a foreign country shall report such relationship to the Commissioner of Internal Revenue for each year in which such relationship exists and shall provide such information as shall be specified in a reporting form prescribed under 31 U.S.C. § 5314 to be filed by such persons.  The form prescribed under section 5314 is the Report of Foreign Bank and Financial Accounts (TD-F 90-22.1), or any successor form.[xvii]

These regulations also provide that an FBAR is required if the foreign financial accounts cumulatively exceed $10,000 at any time in the prior reporting year.[xviii]  Today, the penalties for willful and non-willful conduct remain substantially the same as they were under the ACJA, except that the penalties are now adjusted for inflation.

The Safeco Ins. Decision

It may surprise you to learn that the definition of “willfulness” for purposes of the FBAR statute is borrowed from the United States Supreme Court’s interpretation of another “willful” penalty provision in the Fair Credit Reporting Act (the “FCRA”).  More specifically, in 2007, the Supreme Court held in Safeco Ins. [xix]  that the statutory term of “willfully” under the FCRA penalty provisions included not only intentional conduct but also reckless conduct.  In recognizing that reckless conduct was within the definition of willfulness, the Supreme Court reasoned:

We have said before that ‘willfully’ is a word of many meanings whose construction is often dependent on the context in which it appears . . . and where willfulness is a statutory condition of civil liability, we have generally taken it to cover not only knowing violations of a standard, but reckless ones as well[.]  This construction reflects common law usage, which treated actions in ‘reckless disregard’ of the law as ‘willful’ violations.  The standard civil usage thus counsels reading the phrase ‘willfully fails to comply’ in . . . [the FCRA] as reaching reckless FCRA violations, and this is so both on the interpretative assumption that Congress knows how we construe statutes and expects us to run true to form . . . and under the general rule that a common law term in a statute comes with a common law meaning, absent anything pointing another way.[xx]

Thus, after Safeco Ins., federal courts have generally interjected the concept of recklessness into any potential statutory penalty for willfulness.

The Government Argues for Recklessness in the FBAR Context

The 2012 decisions in Williams and McBride were two of the first federal court decisions to interpret the term “willful” for purposes of the FBAR penalty provisions.  Both decisions drew heavily from the Supreme Court’s decision in Safeco Ins. and both agreed that the term willful in the FBAR context should include a taxpayer’s reckless behavior.

Williams  

In Williams, the federal government filed suit against Williams for failing to report two Swiss bank accounts for his 2000 tax year.  Williams had opened the foreign account in 1993 in the name of a British Corporation in which he held an ownership interest.  Between 1993 and 2000, Williams deposited more than $7 million into the Swiss bank accounts, earning substantial income.  Williams did not file FBARs or report the income on a federal income tax return.

Williams was later found guilty of, among other things, criminal tax evasion.  In his plea agreement, Williams admitted that he committed all of the acts necessary for the government to prove its criminal claims against him.

In January 2007, Williams filed late FBARs for his 1993 through 2000 tax years.  Because the statute of limitations to assess FBAR penalties had expired with respect to all years except 2000, the government moved to assess the willful FBAR penalty against Williams for that later year.  After the government assessed the 2000 willful FBAR penalty, the government brought suit against Williams to reduce the assessment to judgment.  Williams contended at trial that his conduct was not willful and therefore the willful penalty should not apply.

The lower court agreed with Williams.[xxi]  It held that “the Government ha[d] failed to prove a ‘willful’ violation.”  In addition, although recognizing that willful conduct included reckless behavior under Safeco Ins., the lower court concluded that the facts in that case did not support imposition of the willful FBAR penalty against Williams.

The government appealed the decision in Williams to the Fourth Circuit Court of Appeals.[xxii]   In an unpublished opinion, the Fourth Circuit held that the lower court had erred in concluding that Williams had not acted willfully.  First, the Fourth Circuit held that the term “willful” encompassed not only intentional acts, but also reckless acts and willful blindness.  Second, with respect to willful blindness, the Fourth Circuit stated:

‘[W]illful blindness’ may be inferred where ‘a defendant was subjectively aware of a high possibility of the existence of a tax liability, and purposely avoided learning the facts point to such liability.’ Importantly, in cases ‘where willfulness is a statutory condition of civil liability, [courts] have generally taken it to cover not only knowing violations of a standard, but reckless ones as well.’  Whether a person has willfully failed to comply with a tax reporting requirement is a question of fact.

Under this relaxed standard, the court had little trouble finding that Williams acted at least recklessly or with willful blindness. More specifically, the court recognized that:  (1) Williams had signed a 2000 tax return under penalties of perjury and was therefore deemed to have constructive knowledge of its contents, including the question on Schedule B regarding foreign accounts; (2) nothing in the record suggested that Williams ever consulted the FBAR form or instructions for further guidance; (3) Williams gave false answers on a tax organizer; and (4) Williams’ guilty plea included a concession by Williams that he had acted willfully.

McBride  

Shortly after Williams was decided in the Fourth Circuit, a lower court in Utah similarly concluded that a taxpayer may be liable for a willful FBAR penalty where the taxpayer’s conduct was reckless or done with willful blindness.  In McBride,[xxiii] the taxpayer-owned a company that he reasonably believed would increase its profits in the near future.  In an attempt to shelter this projected income from U.S. income taxes, McBride met with a financial management firm.

The financial management firm advised McBride that he could legally shelter income from his company through annuities, International Business Corporations (“IBCs”), and foreign financial accounts held in nominee names.  McBride chose to move forward with the tax plan and eventually sheltered over $2.7 million of income from U.S. income taxes through his use of the plan.

McBride never informed his tax preparer of the plan.  In addition, McBride never sought a tax opinion from an outside attorney regarding the propriety of the tax plan.  For his 2000 and 2001 tax returns, McBride checked the boxes “No” on Schedule B regarding whether he had interests in foreign accounts.  When the IRS initiated an examination of his tax returns, McBride was uncooperative and, at times, untruthful.  After the examination concluded, the IRS assessed two willful FBAR penalties against him for his 2000 and 2001 tax years.

On these facts, the lower court held that McBride’s conduct was willful under either the reckless or willful blindness standard.   In holding in favor of the government, the lower court found the following facts dispositive on the issue of willfulness:  (1) McBride failed to discuss the foreign accounts with his tax preparer; (2) McBride failed to obtain a tax opinion on his reporting obligations; (3) McBride signed the tax returns for 2000 and 2001 and answered “No” on Schedule B regarding whether he had interests in foreign accounts; and (4) certain marketing and promotional materials provided to McBride by the financial management firm suggested that McBride may have U.S. reporting obligations regarding his interests in foreign accounts.

Bedrosian

In 2018, the Third Circuit Court of Appeals also weighed in on the proper definition of willfulness for purposes of FBAR penalties. [xxiv] In that case, Bedrosian was a successful businessman who worked in the pharmaceutical industry.

He initially opened a foreign account in Switzerland so that he could make purchases while traveling abroad for work without relying on traveler’s checks.  Sometime in 2005, Bedrosian later opened another foreign account in Switzerland to use for investment purposes.

In the 1990s, Bedrosian informed his tax preparer that he maintained a foreign account.  Although the tax preparer advised Bedrosian that he had a duty to file FBARs, Bedrosian contended that the tax preparer also advised him that his failure to file FBARs could be resolved when he passed away.  On the basis of this advice, Bedrosian opted to continue to not file FBARs.

When Bedrosian’s tax preparer passed away, Bedrosian’s new tax preparer prepared an FBAR on Bedrosian’s behalf.  However, the FBAR only reported one of Bedrosian’s foreign accounts and omitted another account in which Bedrosian had over $2 million of assets.

Bedrosian later became concerned that he was not complying fully with his FBAR reporting obligations.  He sought legal counsel and thereafter corrected several years of inaccuracies on his prior year FBARs.  However, the IRS initiated an examination of Bedrosian in April of 2011.

At the conclusion of the examination, the IRS assessed against Bedrosian a penalty for willful failure to disclose the larger foreign bank account.  Moreover, the IRS assessed the statutory maximum, or 50-percent of the account balance, which resulted in a $957,789 FBAR penalty.  Bedrosian filed suit against the government and the government counterclaimed for the full amount.

The lower court held a one-day bench trial and ruled in favor of Bedrosian.  The government appealed the decision to the Third Circuit Court of Appeals.

The Third Circuit disagreed with the lower court’s judgment.  In recognizing that a taxpayer may be liable for a willful FBAR penalty through reckless conduct alone, the court stated:

[A] person commits a reckless violation of the FBAR statute by engaging in conduct that violates an objective standard:  action entailing an unjustifiably high risk of harm that is either known or so obvious that it should be known.  This holding is in line with other courts that have addressed civil FBAR penalties, as well as our prior cases addressing civil penalties assessed by the IRS under the tax laws.  With respect to IRS filings in particular, a person ‘recklessly’ fails to comply with an IRS filing requirement when he or she (1) clearly ought to have known that (2) there was a grave risk that [the filing requirement was not being met] and if (3) he [or she] was in a position to find out for certain very easily.

Under this standard for willfulness, the Third Circuit held that the lower court had erred in analyzing Bedrosian’s subjective motivations in not filing an FBAR and the overall “egregiousness” of his conduct.  On this basis, the court remanded Bedrosian’s case to the lower court for additional findings of fact and conclusions of law.

With the new standard, the lower court found against Bedrosian, concluding that he was at least reckless because: (1) he cooperated with the government only after he was exposed as having foreign hidden accounts; (2) shortly after filing the FBAR at issue, he sent letters to the foreign bank directing closure of two accounts (although he only disclosed one foreign account on the FBAR); (3) his foreign accounts were subject to a “mail hold”; and (4) he was aware of significant amounts of money held in the foreign accounts.  Accordingly, on these facts, the lower court held that “Bedrosian’s actions were willful because he recklessly disregarded the risk that his FBAR was inaccurate.”

Post-Bedrosian

After the Third Circuit’s decision in Bedrosian, both the Fourth[xxv]  and the Eleventh[xxvi]  Circuit Court of Appeals have held that the Bedrosian three-prong test should apply to determine whether a taxpayer had sufficient recklessness to constitute willful conduct.  Moreover, district courts within the First, Fifth, Sixth, and Ninth Circuits have also adopted the Bedrosian test in civil cases involving FBAR-reporting violations.[xxvii]

None of these cases are very helpful for taxpayers.  Nevertheless, there have been a handful of federal decisions that have seemingly heightened the standard for recklessness in the taxpayer’s favor.  For example, in many cases, the government will contend that a taxpayer acted with reckless conduct or willful blindness merely by signing a tax return under penalties of perjury and marking the box “No” on Schedule B as to whether the taxpayer had foreign accounts during the year. In U.S. v. Schwarzbaum, the Southern District of Florida disagreed that this was sufficient in and of itself to put a taxpayer on notice of the FBAR filing obligation and stated that:

[i]mputing constructive knowledge of filing requirements to a taxpayer simply by virtue of having signed a tax return would render the distinction between a non-willful and willful violation in the FBAR context meaningless.  Because taxpayers are required to sign their tax returns, a violation of the FBAR filing requirements could never be non-willful.  Yet, the statute provides for non-willful penalties.  Applying the USA’s suggested reasoning would lead to a draconian result and one that would preclude a consideration of other evidence presented.

Accordingly, the USA cannot satisfy its burden of proof in this case on the issue of willfulness simply by relying on the fact that Schwarzbaum signed his tax returns or neglected to review them as thoroughly as he should have. [xxviii]

The Standard of Willfulness Today  

Currently, federal courts have found taxpayers liable for willful FBAR penalties if the conduct fits within one of three circumstances:   (1) the taxpayer knowingly violated the FBAR filing requirements; (2) the taxpayer recklessly violated the FBAR filing requirements; or (3) the taxpayer acted with “willful blindness” by making a conscious effort to avoid learning about the FBAR reporting requirements.  In analyzing the decisions of federal courts, many of which have already been discussed above, the IRS defines each of these circumstances more fully as follows:

Knowing violation.  Willfulness is shown when a person knew of the FBAR reporting and recordkeeping requirements and made a voluntary, intentional, or conscious choice not to accurately report an account on a timely filed FBAR or keep required records.[xxix]

Reckless violation.  Willfulness is also shown when a person recklessly disregards the FBAR reporting and recordkeeping requirements.  Recklessness is evaluated using an objective standard, not by looking at whether a person subjectively believed that he or she was not required to accurately report the account on a timely filed FBAR or keep required records.  The objective standard looks at whether conduct entailed an unjustifiably high risk of harm that is either known or so obvious that it should be known.  A person recklessly violates the FBAR reporting or recordkeeping requirements when the person clearly ought to have known that there was a grave risk that the requirements were not being met and the person was in a position to very easily find out for certain whether or not the requirements are being met.[xxx]

Willful blindness.  Willfulness is also shown when a person acted with willful blindness by making a conscious effort to avoid learning about the FBAR reporting or recordkeeping requirements.  Example:  Willful blindness may be present when a person admits knowledge of, and fails to answer questions concerning, their interest in or signature or other authority over financial accounts at foreign banks on Schedule B of their Federal income tax return.  This section of the income tax return refers taxpayers to the instructions for Schedule B, which provides guidance on their responsibilities for reporting foreign bank accounts and discusses the duty to file the FBAR.  These resources indicate that the person could have learned of the reporting requirements quite easily.  It is reasonable to assume that a person who has foreign bank accounts should read the information specified by the government in tax forms.  The failure to act on this information and learn of further reporting requirements, as suggested on Schedule B, may provide evidence of willful blindness on the part of the person.[xxxi]

Notably, the National Taxpayer Advocate (“NTA”) has been a routine critic of the current willful FBAR penalty regime.  For example, in her last report to Congress, the NTA noted that “[t]he maximum FBAR penalty is among the harshest civil penalties the government may impose.”[xxxii]  And with respect to the blurred distinction between willful and non-willful conduct, the NTA has stated:

While the distinction between willful and non-willful violations makes sense, it generates controversy because it can be difficult for taxpayers to establish that a violation was not willful.  Schedule B of Form 1040, U.S. Individual Income Tax Return, asks if the taxpayer has a foreign account and references the FBAR filing requirement.  Taxpayers are presumed to know the contents of their returns when they sign the return under penalty of perjury . . . It may be considered reckless or ‘willful blindness’ for them not to learn about the FBAR filing requirement after having been directed to the FBAR form by Schedule B.  For this reason, the government might reasonably argue (and a court might reasonably find) that any failure to file an FBAR form is willful where the taxpayer filed a federal tax return that included Schedule B, which directs taxpayers to the FBAR filing requirement.  This is particularly true if a taxpayer has taken steps to hide the account to protect his or her financial privacy.

Account holders who do not file required FBAR forms due to negligence, inadvertence, or similar non-nefarious causes may be subject to penalties for non-willful violations (which have a reasonable cause exception).  But they should not face uncertainty regarding the possible application of the extraordinarily harsh penalties for ‘willful’ violations.  The National Taxpayer Advocate recommends that Congress clarify that the IRS must prove a violation was ‘willful’ without relying so heavily on the instructions to Schedule B or the failure to check the box on Schedule B before imposing a willful FBAR penalty.  To address violations that result from recklessness or willful blindness, Congress should establish a separate penalty that is greater than the penalty applied to non-willful violations but less than the penalty applied to willful violations.[xxxiii]

As noted above by the NTA, it is common for taxpayers (and even tax professionals) to mistakenly believe that a taxpayer’s conduct was non-willful.  Regrettably, the writer of this article has seen instances in which taxpayers and tax professionals have made critical mistakes in making this determination, particularly with respect to the IRS’s Streamlined Filing Compliance Procedures.  Under those procedures, taxpayers may receive reduced penalties for coming forward for certain non-filings, including FBARs.  However, the IRS cautions that only taxpayers who were non-willful qualify for the benefits of the program and that taxpayers who do not qualify should use the IRS’s Voluntary Disclosure Program instead—which, predictably, has higher penalties.

In its instructions to the Streamlined Filing Compliance Procedures, the IRS provides that “[n]on-willful conduct is conduct that is due to negligence, inadvertence, or mistake or conduct that is the result of a good faith misunderstanding of the requirements of the law.”  The IRS does not inform taxpayers, however, that there is a fine line between negligence, inadvertence, and mistake, on the one hand, and reckless conduct or willful blindness, on the other hand.  Thus, taxpayers and tax professionals who advise their clients to enter into the IRS’s Streamlined Filing Compliance Procedures without reviewing all of the relevant facts and circumstances often do so at their own peril.  To the extent the IRS catches the taxpayer, the taxpayer is removed from the program and can potentially face perjury charges.  Moreover, the IRS can use the information in the submission as admissions against the taxpayer at a later trial.

On a final note, the IRS also acknowledges that willful cases are not always slam dunks.  Accordingly, IRS examiners are instructed to carefully build a case by looking for certain helpful documents and other information, such as: (1) copies of foreign bank statements; (2) correspondence between the taxpayer and the tax preparer; (3) copies of FBARs filed from previous years (if any); and (4) copies of income tax returns filed by the taxpayer, particularly if the return includes a Schedule B.[xxxiv]  IRS examiners are also instructed to discuss the issue with the taxpayer and solicit an explanation as to why the FBAR was not timely filed or why a timely filed FBAR omitted a foreign account.[xxxv]  Taxpayers should exercise caution in providing answers to these questions as those answers may be used against them later in trial as admissions.  Taxpayers should also bear in mind that federal courts have concluded that the IRS bears the burden of proof on the issue of whether the conduct was willful and/or reckless.

Conclusion

Willfulness is a term of art with respect to FBAR penalties.  In many cases, it may be difficult to determine whether a taxpayer’s conduct was willful—particularly because federal courts and the IRS view willfulness to include reckless conduct and willful blindness.  Taxpayers who have failed to timely and accurately report their foreign accounts on FBARs (and potentially other foreign information returns) should consult with a tax advisor to determine whether actions can be taken to reduce or mitigate an IRS’s determination to impose willful FBAR penalties.  In most cases, the tax professional should review all of the relevant facts and circumstances to determine whether the conduct could be viewed as willful by the IRS.  If there is a risk of such a finding, taxpayers may be properly advised to make a submission under the IRS’s Voluntary Disclosure Program.

FBAR Penalty Defense Attorneys

FBAR penalty defense requires a proactive representation and a deep knowledge of the nuances of FBAR compliance and its defenses. Freeman Law represents clients with offshore tax compliance disputes involving FBAR penalties and international information return penalties. Failing to file an FBAR can give rise to significant penalties, including a non-willful penalty and willful FBAR penalty. The risks of tax and reporting non-compliance have never been more real and the threat of international penalties, particularly FBAR penalties, has never been more clear. Schedule a consultation or call (214) 984-3000 to discuss your FBAR penalty concerns or questions. 

[i] Pub. L. No. 91-508, 84 Stat. 1114 (1970).

[ii] Id. at § 202.

[iii] See id. at § 241; see also U.S. v. Kahn, 5 F.4th 167, 170 (2d Cir. 2021).

[iv] See id.; U.S. v. Cohen, No. 17-1652-MWF, 2019 WL 4605709, at *3 (C.D. Cal. Aug. 6, 2019).

[v] Kahn, 5 F.4th at 170; Cohen, at *3.

[vi] See Khan, 5 F.4th at 170.

[vii] Pub. L. No. 99-570.

[viii] Khan, 2019 WL 8587295, at *4.

[ix] Id. at *5.

[x] Pub. L. No. 107-56,

[xi] Khan, 2019 WL 8587295, at *6.

[xii] Secretary of the Treasury, A Report to Congress in Accordance with § 361(b) of the USA PATRIOT Act, Apr. 26, 2002.

[xiii] Id. at 6.

[xiv] See Pub. L. No. 108-357.

[xv] Id. at (a)(5)(C), (D).

[xvi] Id. at (a)(5)(A).

[xvii] 31 C.F.R. § 1010.350.

[xviii] 31 C.F.R. § 1010.306(c).

[xix] Safeco Ins. Co. of Am. v. Burr, 551 U.S. 47 (2007).

[xx] Id. at 57-58.

[xxi] See U.S. v. Williams, No. 1:09-cv-437, 2010 WL 3473311 (E.D. Va. Sept. 1, 2010).

[xxii] See U.S. v. Williams, 489 Fed. Appx. 655 (4th Cir. 2012).

[xxiii] U.S. v. McBride, 908 F. Supp. 2d 1186 (D. Utah 2012).

[xxiv] Bedrosian v. Dep’t of Treasury, 912 F.3d 144 (3d Cir. 2018).

[xxv] U.S. v. Horowitz, 978 F.3d 80 (4^th Cir. 2020).

[xxvi] U.S. v. Rum, 995 F.3d 882 (11^th Cir. 2021).

[xxvii] See, e.g., U.S. v. Goldsmith, No. 3:20-cv-00087, 2021 WL 2138520, at *26 (S.D. Cal. May 25, 2021).

[xxviii] U.S. v. Schwarzbaum, No. 18-CV-81147, 2020 WL 1316232, at *8 (S.D. Fla. Mar. 20, 2020).

[xxix] I.R.M. pt. 4.26.16.5.5.1 (06-24-2011).

[xxx] Id.

[xxxi] Id.

[xxxii] NTA 2021 Purple Book.

[xxxiii] Id.

[xxxiv] I.R.M. pt. 4.26.16.5.5.2 (06-24-2021).

[xxxv] Id.

Applying Texas Sales and Use Tax to New Construction and Real Property Repair and Remodeling Services

One of the more complicated areas involving Texas sales and use tax is the taxation of various new construction and real property repair and remodeling services.[1] Determining what’s taxed and what’s not requires delving through myriad definitions scattered across the Texas Tax Code and Comptroller’s rules. It can get confusing fast. Here’s a quick breakdown.

What’s a “Contractor”?

Let’s get this out of the way up front. When the Comptroller says “contractor,” it may not mean what you think it means. The term “contractor” as used for purposes of the Texas sales and use tax is a term of art.  The term is defined as:

Any person who builds new improvements to residential or nonresidential real property, completes any part of an uncompleted new structure that is an improvement to residential or nonresidential real property, makes improvements to real property as part of periodic and scheduled maintenance of nonresidential real property, or repairs, restores, maintains, or remodels residential real property, and who, in making the improvement, incorporates tangible personal property into the real property that is improved.[2]

Notice what the term doesn’t cover: nonresidential repair and remodeling. That’s because while new construction and residential repair or remodeling aren’t taxable services, nonresidential repair and remodeling is a taxable service and subject to Texas sales and use tax.[3]

This is important, because the Comptroller uses the designation “contractor” as a way to distinguish between taxable and nontaxable construction services. This can cause considerable confusion to those new to the Comptroller’s rules, since the Comptroller has one rule for contractors (i.e., persons who perform new construction and residential repair and remodeling) and one rule for nonresidential repair and remodeling (let’s call them “service providers”).[4]

New Construction vs. Repair or Remodeling

The first thing to ask in determining the taxability of construction services is whether what is being performed is 1) new construction or 2) repair or remodeling.

“New construction” is defined as:

All new improvements to real property, including initial finish-out work to the interior or exterior of the improvement. An example is a multiple story building that has had only its first floor finished and occupied. The initial finish-out of each additional floor before initial occupancy or use is new construction. New construction also includes the addition of new usable square footage to an existing building. Examples include the addition of a new wing onto an existing building. Reallocation of existing square footage inside a building is remodeling and does not constitute the addition of new square footage. For example, the removal or relocation of interior walls to expand the size of a room or the finish out of an office space that was previously used for storage is remodeling. Raising the ceiling of a room or the roof of a building is not new construction if new usable square footage is not created.[5]

On the other hand, “repair” is defined as “[t]o mend or bring back real property that was broken, damaged, or defective as near as possible to its original working order.”[6]  “Remodeling” means “[t]o rebuild, replace, alter, modify, or upgrade existing real property.”[7]

As can be seen through these definitions, the primary factors in determining whether a job is new construction are whether the structure has already been occupied and, if so, whether new usable square footage is created.  If the structure has not already been occupied and the work performed is an initial finish-out, then the work would probably be considered new construction.[8]  If the structure has been occupied but the work creates new usable square footage, the work again probably would be considered new construction.[9] If neither one of these factors applies, the work likely will be considered repair or remodeling.

Again, nonresidential repair and remodeling is a taxable service, while residential repair and remodeling is not a taxable service. So, the next thing to ask whether the real property is residential or nonresidential.

Residential vs. Nonresidential

“Residential property” means:

Property that is used as a family dwelling, a multifamily apartment or housing complex, nursing home, condominium, or retirement home. The term includes homeowners association-owned and apartment-owned swimming pools that are for the use of the homeowners or tenants, laundry rooms for tenants’ use, and other common areas for tenants’ use. The term does not include hotels or any other facilities that are subject to the hotel occupancy tax.[10]

Nonresidential real property is not defined, so apparently any property that is not residential real property is nonresidential real property.

Taxability of Nonresidential Repair or Remodeling

If a job is purely nonresidential repair or remodeling, then the tax treatment is clear. The total charge (less separately stated charges for unrelated services) is taxable unless an exemption applies.[11]  The service provider generally would be able to issue a resale certificate to vendors for materials that are incorporated into the realty as part of the service.[12]

Taxability of New Construction and Residential Repair or Remodeling

If a job is new construction or residential repair and remodeling, an additional question must be asked: Is the contract lump sum or separately stated?[13]

A contract is lump sum if “the agreed contract price is one lump-sum amount and in which the charges for incorporated materials are not separate from any charges for skill and labor, including fabrication, installation, and other labor that the contractor performs.”[14]

On the other hand, a contract is separately stated if “the agreed contract price is divided into a separately stated agreed contract price for incorporated materials and a separately stated amount for all skill and labor that includes fabrication, installation, and other labor that is performed by the contractor.”[15]

“Incorporated materials” are defined as:

Tangible personal property that becomes a part of any building or other structure, project, development, or other permanent improvement on or to such real property including tangible personal property that, after installation, becomes real property by virtue of being embedded in or permanently affixed to the land or structure constituting realty and which property after installation is necessary to the intended usefulness of the building or other structure.[16]

So, turning at last to the taxability of new construction and residential repair or remodeling, if the contact for such work is lump sum, then no part of the charge generally is taxable, but the contractor must pay tax on the materials purchased for the job.[17]  If the contract for such work is separately stated, then the contractor must collect tax on charges for incorporated materials (unless an exemption applies), but may be able to issue a resale certificate to vendors on its purchase of such materials.[18]

Conclusion

Still confused? Here’s a chart that sums up the taxability of new construction, residential repair and remodeling, nonresidential repair and remodeling under the Texas sales and use tax:

And, of course, if you have any questions regarding the Texas sales or use tax or Texas taxes in general, don’t hesitate to give us a call to schedule a free consultation. 

*******

[1] Part of the complexity in this area is due to history, that nightmare from which we’re trying to awake.  Prior to 1988, contracting and repair services generally weren’t taxable. See Acts 1987, 70th Leg., 2nd C.S., ch. 5, art. 1, pt. 4, Sec. 12 (adding real property repair and remodeling as a taxable service effective January 1, 1988). However, separately stated charges for materials incorporated into realty as a result of such services even then were subject to tax.  See Acts 1981, 67th Leg., p. 1551, ch. 389, Sec. 1 (distinguishing between the taxability of separated and lump sum contracts for contractors). As we’ll see, this treatment continues for new construction and residential repair and remodeling. Nonresidential repair and remodeling (and maintenance, which we won’t discuss in this post) could just be considered an exception to this rule.

[2] 34 Tex. Admin. Code §§ 3.291(a)(3); see also 34 Tex. Admin. Code § 3.357(a)(2); accord Tex. Tax Code § 151.056(d) (defining “contractor” as a person who makes an improvement on real estate and who, as a necessary or incidental part of the service, incorporates tangible personal property into the property improved.”).

For these purposes, an “improvement to real property” is defined as work to:

• erect, construct, alter, or repair any building or other structure, project, development, or other permanent improvement on, under the surface of, or to real property, whether fee or leasehold;
• furnish and install property becoming a part of any building or other structure, project, development, or other permanent improvement on or to such real property, including tangible personal property, which after installation becomes real property by virtue of being embedded in or permanently affixed to the land or to a structure constituting realty and which property after installation is necessary to the intended usefulness of the building or other structure; or
• alter the land surface of real property by such means as creating roads, earthen dams, and stock tanks. However, mining or timber operations do not, in and of themselves, constitute improvements to realty.

See 34 Tex. Admin. Code §§ 3.291(a)(6), 3.347(a).

Generally, the question of whether tangible personal property has been affixed to realty so as to become an improvement to realty is determined by reference to the test set forth by the Texas Supreme Court in Hutchins v. Masterson, 46 Tex. 551 (1887).  See, e.g., Comptroller’s Decision No. 112,152 (2018).  Under this test, one asks three questions:

1. Has there been a real or constructive annexation of the article in question to the realty?
2. Was there a fitness or adaptation of such article to the uses or purposes of the realty with which it was connected?
3. Was it the intention of the party making the annexation that the chattel becomes a permanent accession to the freehold?

Id.

[3] See Tex. Tax Code §§ 151.0047(a), 151.0101(a)(13); 34 Tex. Admin. Code § 3.357(b)(2).

[4] See 34 Tex. Admin. Code §§ 3.291 (entitled “Contractors” and covering new construction and residential repair and remodeling), 3.357 (entitled “Nonresidential Real Property Repair, Remodeling, and Restoration; Real Property Maintenance. (Tax Code, §§151.0047, 151.0101, 151.056, 151.058, 151.311, 151.350, 151.429)” and covering periodic and scheduled nonresidential real property maintenance but referring back 34 Tex. Admin. Code § 3.291 when tangible personal property is incorporated into realty as part of such maintenance).

[5] 34 Tex. Admin. Code § 3.291(a)(9); see also 34 Tex. Admin. Code 3.357(a)(8) (stating that “new construction” also includes “the addition of a new mezzanine level within an existing building”).

[6] 34 Tex. Admin. Code § 3.357(a)(12).

[7] 34 Tex. Admin. Code § 3.357(a)(11).  Repainting is also remodeling, as is the partial demolition of existing nonresidential real property. Id.  However, a complete demolition isn’t remodeling and is nontaxable. Id.

[8] See 34 Tex. Admin. Code §§ 3.291(a)(9), 3.357(a)(8).

[9] Id.

[10] 34 Tex. Admin Code § 3.291(a)(12); see also 34 Tex. Admin. Code § 3.357(a)(13) (adding that “residential property” doesn’t include “any commercial area open to nonresidents, retail outlets, [or] hospitals”).  “Prisons” also may not be residential property. See The Geo Group, Inc. v. Hegar, No. 03-15-00726-CV (Tex. App.—Austin Aug. 10, 2017, pet. denied) (holding that a prison was a not a residence for purposes of the exemption for the purchase of natural gas and electricity for residential use under Tex. Tax Code § 151.317).

Note that the term “residential property” also doesn’t include “facilities that are subject to hotel occupancy the tax.”  34 Tex. Admin. Code §§ 3.291(a)(12), 3.357(a)(13).  This creates some uncertainty as to whether houses used for short term rentals are residential property, since short term rentals generally subject to hotel occupancy tax.  See Tex. Tax Code §§ 156.001(b) (stating that the term “hotel” includes a short-term rental, and that a “short-term rental” is “the rental of all or part of a residential property to a person who is not a permanent resident . . . .”), 156.051(a) (imposing a tax on a person who pays for the use or possession of a room or space in a hotel).

[11] 34 Tex. Admin. Code § 3.357(b)(2). A service is unrelated if it: 1) is not nonresidential repair or remodeling or any other taxable service, 2) is of a type that is commonly provided on a stand-alone basis, and 3) is distinct and identifiable. Id. § 3.357(a)(15).

[12] 34 Tex. Admin. Code § 3.357(e)(1).

[13] While the distinction between lump-sum and separately stated contracts used when determining the taxability of nonresidential repair and remodeling (presumably before nonresidential repair and remodeling was made a taxable service), it generally is no longer relevant for that purpose. See 34 Tex. Admin. Code § 3.357(b)(2). However, the distinction is still relevant in certain contexts. For example, “labor to repair real or tangible personal property that is damaged within a disaster area by the condition or occurrence that caused the area to be declared a disaster area is exempt from tax if the charge for labor is separately stated to the customer. The materials that are used to perform the repairs are taxable.”  34 Tex. Admin. Code § 3.357(d)(9).

[14] 34 Tex. Admin. Code § 3.291(a)(8).

[15] Tex. Tax Code § 151.056(b); 34 Tex. Admin. Code § 3.291(a)(13).

[16] 34 Tex. Admin. Code § 3.291(a)(7).

[17] See Tex. Tax Code § 151.056(a); 34 Tex. Admin. Code § 3.291(b)(3)(A).

[18] See Tex. Tax Code § 151.056(b); 34 Tex. Admin. Code § 3.291(b)(4)(A), (B).

Willful FBAR Penalties

The Schwarzbaum case has received a lot of attention in the last few years from tax professionals.  For example, in 2020, the district court concluded—contrary to some other federal court decisions—that the simple act of signing a federal tax return and not filing an FBAR does not in and of itself constate a finding that there was a willful FBAR violation.  See U.S. v. Schwarzbaum, No. 18-CV-81147, 2020 WL 1316232, at *8 (S.D. Fla. Mar. 20, 2020).  In 2021, after finding that Schwarzbaum’s conduct in failing to file FBARs was willful, the district court granted the government’s motion for an order requiring Schwarzbaum to repatriate millions of dollars of foreign assets to provide security to the government for full payment on the affirmed willful FBAR penalties.  See U.S. v. Schwarzbaum, 128 AFTR 2d 2021-6436 (S.D. Fla. Oct. 26, 2021).  Months later, though, the district court changed course and granted Schwarzbaum a stay of repatriation until after the Eleventh Circuit reviewed the district court’s decision on willfulness.

On January 25, 2022, the Eleventh Circuit Court of Appeals issued a published decision in Schwarzbaum.  U.S. v. Schwarzbaum, No. 20-12061 (Jan. 25, 2022).  In that decision, the Eleventh Circuit upheld the district court’s determination that Schwarzbaum was willful—even if his conduct was only reckless.  However, the Eleventh Circuit further held that the district court had erred in failing to remand Schwarzbaum’s case back to the IRS for computation of penalties under the Administrative Procedure Act (“APA”).  This article discusses the Eleventh Circuit decision and the ever-growing presence of the APA in FBAR penalty cases.

Background Facts

Schwarzbaum was born in Germany.  Later, he moved to the United States and became a naturalized U.S. citizen.  After he became a naturalized U.S. citizen, he held foreign accounts in Switzerland and Costa Rica.  And from 2006 through 2009, he held interests in eleven Swiss foreign bank accounts and two Costa Rican foreign bank accounts.

Schwarzbaum had various United States reporting obligations, including income tax returns and FBARs.  To comply with these obligations, he relied on Certified Public Accountants (“CPAs”).  Although Schwarzbaum had FBAR reporting obligations for many years, his prior CPAs had advised him that he had no FBAR filing requirement because the foreign accounts did not have a “U.S. connection.”  As indicated by the court in its opinion, “[t]his was bad advice.”

In 2006, Schwarzbaum’s CPA prepared and filed an FBAR on his behalf which listed only a single Costa Rican bank account. In 2007, he attempted to self-prepare and file his own FBAR, which again listed only a single Costa Rican bank account.  In 2008, Schwarzbaum did not file an FBAR, and in 2009, he self-prepared and filed his own FBAR, reporting only one of his Swiss bank accounts and his two Costa Rican accounts.

Schwarzbaum later consulted with a tax attorney regarding his FBAR non-compliance for 2006 through 2009.  In 2011, Schwarzbaum voluntarily disclosed to the IRS the existence and balance of the foreign accounts that he had previously failed to disclose on FBARs.  The IRS eventually initiated an examination of the foreign accounts and concluded that he should be liable for $13,729,591 of willful FBAR penalties for 2006 through 2009.  In computing the total assessed penalties, the IRS used its mitigation procedures for some years and the statutory maximum for other years, eventually reducing the penalties further and dividing the total penalties amongst 2006 through 2009.  The IRS then made the assessments of willful FBAR penalties against Schwarzbaum.

The government initiated a lawsuit against Schwarzbaum in federal court.  The district court held a five-day bench trial and issued an opinion sustaining the willful FBAR penalties for 2007, 2008, and 2009, but not for 2006.  The district court concluded that although Schwarzbaum did not knowingly violate the FBAR reporting requirement statute, he acted recklessly, which was sufficient alone to have a willful violation.  Finding recklessness, the district court noted that Schwarzbaum had read the FBAR instructions in self-preparing his FBAR in 2007 and therefore should have been aware of a high probability of tax liability with respect to his unreported accounts.

But the district court also picked up on IRS errors in making the assessment computations against Schwarzbaum.  Specifically, the court found that the IRS had used maximum account balances self-reported by Schwarzbaum and not the applicable violation dates for the penalty base—i.e., the latter of which should be the amount in the foreign accounts as of the FBAR filing dates.  On this basis, the district court found that the penalties were unlawful under the Administrative Procedure Act (the “APA”).

After the parties submitting briefing on the appropriate amounts for 2007, 2008, and 2009, the district court imposed new FBR penalties against Schwarzbaum totaling $12,907,952.  The court then entered a judgment for this amount.

The government filed a motion to alter or amend the judgment.   In its motion, the government contended that the willful FBAR penalties should be reduced further to $12,555,813, or the amount that the IRS had already assessed against Schwarzbaum for 2007, 2008, and 2009.  Schwarzbaum timely appealed.

Opinion of the Court

Schwarzbaum was Willful  

Schwarzbaum contended that the district court erred in finding that his failure to file FBARs was willful.  More specifically, Schwarzbaum maintained that the proper standard for willfulness should not include acts of recklessness.

The Eleventh Circuit disagreed, reasoning that its prior decision in U.S. v. Rum, 995 F.3d 882 (11^th Cir. 2021), already held that “willful conduct, in the FBAR civil penalty context, includes knowing or reckless conduct.”  And for purposes of showing recklessness, the government merely had to show “conduct violating an objective standard:  action entailing an unjustifiably high risk of harm that is either known or so obvious that it should be known.”  Given this relaxed standard of willfulness, the Eleventh Circuit found that the district court did not err in finding that although Schwarzbaum did not knowingly violate the FBAR reporting requirements, he acted recklessly when he reviewed the FBAR instructions in 2007 and then, for the next three years, failed to report the foreign assets those instructions directed him to report.

Significantly, the Eleventh Circuit also rejected Schwarzbaum’s tax professional defense and reliance on U.S. v. Boyle, 469 U.S. 241 (1985). In that case, the Supreme Court stated that, at least for purposes of another late filing penalty associated with income tax returns: “When an accountant or attorney advises a taxpayer on a matter of tax law, such as whether liability exists, it is reasonable for the taxpayer to rely on that advice.”  The Eleventh Circuit found Boyle inapplicable, stating that Boyle“concerned a different tax statute and did not provide the legal standard for willfulness in the FBAR context.”

The FBAR Penalties were Unlawful Under the APA  

Although the Eleventh Circuit sustained the willful FBAR penalties, it concluded that the district court had erred in redetermining the amount of the willful FBAR penalties.  In this regard, the court noted that the district court, as a reviewing court, must hold unlawful and set aside agency action that is arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.  See 5 U.S.C. § 706(2)(A).  Under the APA, the district court effectively sits as “an appellate tribunal” and does not function in its normal role.  Cnty. Of L.A. v. Shalala, 192 F.3d 1005, 1011 (D.C. Cir. 1999).  And the court is generally bound to judge the propriety of the agency’s action solely on the grounds invoked by the agency—if those grounds are inadequate or improper, the court is powerless to affirm the administrative action by substituting what it considers to be a more adequate or proper basis.  SEC v. Chenery Corp, 332 U.S. 194, 196 (1947).  Based on these well-known rules of administrative law, the Eleventh Circuit stated:

The district court lacked the power to recalculate Schwarzbaum’s FBAR penalties.  Nonetheless, finding that the IRS had miscalculated, the district court prepared new penalties from scratch, substituting its judgment for the agency’s.   Courts do not have ‘original calculation’ jurisdiction over FBAR penalties.  That power belongs to the IRS.  By replacing the IRS’s penalty calculations with its own, the district court invaded the agency’s turf.

Given the agency’s error, the district court should have remanded Schwarzbaum’s FBAR penalties to the IRS for recalculation.  Remand is the appropriate remedy when an administrative agency makes an error of law, for it affords the agency an opportunity to receive and examine the evidence in light of the correct legal principle.  And, as the district court correctly found, the IRS’s original penalties were not in accordance with law.  The statutory maximum penalty for a willful FBAR violation is the greater of $100,000 or 50% of the balance in the account at the time of the violation.  The “time of [an FBAR] violation is June 30, the annual FBAR filing deadline.  Indeed, the government concedes that the IRS mistakenly calculated Schwarzbaum’s statutory maximum penalties using his foreign accounts’ highest annual balances rather than their June 30 balances.  Because the IRS miscalculated Schwarzbaum’s penalties, a remand is in order to allow the IRS to fix the mistake.

Conclusion

The Schwarzbaum decision is not the first federal court decision to conclude that the APA applies in the FBAR penalty context.  However, the decision adds to a growing list of FBAR penalty cases that have now directly interacted with the APA.  Tax professionals should take notice that more FBAR penalty cases involving the APA will surely follow in the future.  Accordingly, tax professionals should ensure that they have a good working knowledge of the APA when representing taxpayers against potential FBAR penalties.  Tax professionals who do not raise APA arguments, where appropriate, are leaving good penalty defenses on the table.

Other Helpful FBAR Articles:

• The FBAR (Report of Foreign Bank and Financial Accounts):  Everything You Need to Know
• Beware of Your FBAR Obligations – U.S. v. Solomon
• A Current “Playoff Picture” of Non-Willful FBAR Violations
• United States v. Hughes:  FBAR Penalties and a Willfulness Roadmap
• Challenging FBAR Penalties in Federal Court:  FBAR Litigation

FBAR Penalty Defense Attorneys

FBAR penalty defense requires a proactive representation and a deep knowledge of the nuances of FBAR compliance and its defenses. Freeman Law represents clients with offshore tax compliance disputes involving FBAR penalties and international information return penalties. Failing to file an FBAR can give rise to significant penalties, including a non-willful penalty and willful FBAR penalty. The risks of tax and reporting non-compliance have never been more real and the threat of international penalties, particularly FBAR penalties, has never been more clear. Schedule a consultation or call (214) 984-3000 to discuss your FBAR penalty concerns or questions. 

Texas Tax Roundup — July 2022

Aloha! It’s summer doldrums round here at Texas Tax Roundup this month. Everybody in Texas tax world must be off on vacation in some tropical paradise somewhere where it’s not too hot and the Mai Tais flow more abundantly than our more circumspect mixed beverages back home.

Except for me and them administrative law judges, apparently. Let’s see what they have to say.

Notable Additions to the State Automated Tax Research (STAR) System

General

Burden of proof/Detrimental Reliance/Insolvency

Comptroller’s Decision No. 115,242 (2022)—The administrative law judge (“ALJ”) upheld a sales and use tax assessment against a taxpayer that operated an advertising agency when the taxpayer didn’t provide documentation showing that the assessment was incorrect.[1] The administrative law judge also determined that the taxpayer couldn’t rely on advice that it was purportedly provided during a previous audit, because such advice wasn’t in the form of a private letter ruling.[2]  Finally, the administrative law judge found that the taxpayer hadn’t provided all of the documentation required for an insolvency settlement.[3]

Hotel Occupancy Tax

Estimated Audits

Comptroller’s Decision No. 118,352 (2022)—The ALJ found that when a taxpayer failed to provide complete records to the auditor, an audit estimating tax based on the taxpayer’s hotel occupancy tax history, sales and use tax returns, and franchise tax reports was valid.[4]

Franchise Tax

Total Revenue

Comptroller’s Decision Nos. 117,954, 117,955, and 117,956 (2022)—The ALJ ruled that a taxpayer failed to demonstrate that its reporting of income from long-term contracts on its federal income tax returns complied with federal tax law and, therefore, that the taxpayer hadn’t established that its amended franchise tax returns were properly calculated.

Comptroller’s Decision Nos. 117,086 and 117,087 (2022)—The ALJ found that a taxpayer had not established that its revenue should be reduced by the exclusion of income from uniform replacement charges under a reimbursement theory.[5]

Cost of Goods Sold

Comptroller’s Decision No. 110,947 (2022)—The ALJ found that a taxpayer that primarily installed parts that it purchased into aircraft that it didn’t own wasn’t entitled to deduct labor costs associated with such installation as cost of goods sold.[6]

Comptroller’s Decision No. 118,267 (2022)—The ALJ ruled that a taxpayer engaged in the business of building and selling houses could only include costs and fees that it paid while it owned the properties in its cost of goods sold deduction.[7]  Such costs and fees paid after the houses were sold could not be deducted.

Forfeiture of Corporate Privileges

Comptroller’s Decision No. 116,927 (2022)—The ALJ determined that the officer of a company whose corporate privileges had been forfeited due to failure to file a franchise tax report was liable for the sales and use tax assessment against the company during the period of forfeiture.^[8]  The ALJ also ruled that the officer could not challenge the underlying corporate tax liability that is administratively final without paying the liability and requesting a refund.

Sales and Use Tax

Telecommunications Services

Comptroller’s Decision No. 117,876 (2022)—The ALJ found that a taxpayer that electronically transmitted television commercials and syndicated programming to broadcasters had not shown that any of such content was exempt from sales and use tax by reason of being transmitted outside the state.[9]

Security Services

Comptroller’s Decision No. 116,947 (2022)—The ALJ found that a taxpayer licensed as a security services contractor was required to collect sales tax from customers on charges for guard services performed by off-duty police officers.[10]The taxpayer couldn’t detrimentally rely on advice provided during a previous audit, because such advice was not communicated directly to the taxpayer in a private letter ruling and the Comptroller’s office has long included a disclaimer in its notification of audit results that taxpayers cannot sue the audit to assert detrimental reliance in a subsequent audit.[11] The administrative law judge also rejected the taxpayer’s arguments that its purchase of uniforms for its security officers was exempt under the resale exemption (the ALJ found that this exemption didn’t apply because the taxpayer didn’t transfer care, custody, or control over the uniforms to its customers)[12] or the manufacturing exemption (the ALJ noted that the taxpayer wasn’t a manufacturer).[13]

Comptroller’s Decision No. 117,142 (2022)—The ALJ found that canine explosive detection services purchased by a taxpayer prior to September 1, 2019, was a taxable security service under the Texas sales and use tax.[14] The ALJ also determined that a security service purchased by an amusement service provider didn’t qualify for the sale for resale exemption because a security service wasn’t an integral part of an amusement service.[15]  Furthermore, the ALJ rejected the argument that the federal Support Anti-Terrorism by Fostering Effective Technologies (SAFETY) Act, which was part of the Homeland Security Act of 2002 and which incentivizes the deployment of anti-terrorism technologies by creating systems of risk and litigation management, preempted Texas sales and use tax laws.[16] In this regard, the ALJ noted that the taxpayer had failed to cite to any legal authority to support its preemption claim.

Manufacturing Exemption

Comptroller’s Decision Nos. 117,870 and 117,997 (2022)—The ALJ ruled that a taxpayer’s purchases of returnable containers used to package the chemicals that it manufactured were not exempt from sales and use tax under the manufacturing exemption.[17] The ALJ reasoned that the taxpayer was required to pay tax on its purchase of the returnable containers, because its sales of the returnable containers would be exempt from tax under Tex. Tax Code § 151.322(a)(3) (Containers).[18] [Tip: The Comptroller tends to get testy when someone selling an item tax free attempts to purchase that item tax free, even if the plain language of the statute supports that result.] The ALJ also found that the taxpayer’s purchases of cleaning services performed on the returnable containers were not exempt from tax under Tex. Tax Code § 151.3111 (Services on Certain Exempted Personal Property) because the containers themselves were not exempt from tax.

Enterprise Projects

Comptroller’s Decision No. 116,600 (2022)—The ALJ determined that a business wasn’t entitled to a refund of taxes paid on taxable items that it purchased for use at a qualified business site at an enterprise project when the municipality nominating the business for an enterprise project zone designation didn’t approve the business’s name change for the designation.[19] Apparently, project designation was for a business whose name didn’t match the federal employer identification number included in the designation.

See you next time and stay cool!

********

[1] See 34 Tex. Admin. Code § 1.26(a), (d) (Burden and Standard of Proof in Contested Cases).

[2] See 34 Tex. Admin. Code §§ 3.1(c), (d) (Private Letter Rulings and General Information Letters), 3.10(c) (Taxpayer Bill of Rights).

[3] See 34 Tex. Admin. Code § 1.30 (Settlement in a Contested Case Based on Insolvency).

[4] See Tex. Tax Code § 111.0042(d) (Sample in Auditing; Projecting Assessments).

[5] The starting point for calculating Texas franchise tax is income as reported on the taxpayer’s federal income tax return. See Tex. Tax Code § 171.1011(c) (Determination of Total Revenue from Entire Business); 34 Tex. Admin. Code § 3.587(d) (Margin: Total Revenue).  Under the federal income tax, a taxpayer may deduct ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business in calculating its taxable income. See 26 U.S.C. § 162 (Trade or Business Expenses).

[6] In this connection, the ALJ cited Hegar v. Autohaus, L.L.P., 514 S.W.3d 897 (Tex. App. —Austin 2017, pet. den.).

[7] See Tex. Tax Code § 171.1012(i) (Determination of Costs of Goods Sold) (“A taxable entity may make a subtraction under this section in relation to the cost of goods sold only if that entity owns the goods.”); 34 Tex. Admin. Code § 3.588(g)(2), (9) (Margin: Cost of Goods Sold). However, a taxpayer generally may not deduct expenses made with a right or expectation of reimbursement, because they are in the nature of loans or advancements and are not ordinary and necessary business expenses.  Burnett v. Comm’r, 356 F.2d 755 (5th Cir. 1966), cert. denied, 385 U.S. 832 (1966); Flower v. Comm’r, 61 T.C. 140 (1973), aff’d memo., (5th Cir. Dec. 12, 1974); Rev. Rul. 78-‑388, 1978-2 C.B.  On the other hand, amounts received in reimbursement of such expenditures also wouldn’t be included in taxable income.  The Comptroller had applied this analysis in Comptroller’s Decision No. 107,457 (2014).

[8] For forfeiture of corporate privileges due to failure to file a franchise tax report, see Tex. Tax Code § 171.255(a) (Liability of Director and Officers).

[9] Telecommunications services are subject to Texas sales and use tax only if the transmission originates and terminates in Texas. See Tex. Tax Code § 151.323 (Certain Telecommunications Services); 34 Tex. Admin. Code § 3.344(a)(4), (5), (b)(4), (5) (Telecommunications Services).

[10] See Tex. Occ. Code § 1702.322 (Law Enforcement Personnel); 34 Tex. Admin. Code § 3.333(i) (Security Services).

[11] See 34 Tex. Admin. Code §§ 3.1(c), (d) (Private Letter Rulings and General Information Letters), 3.10(c) (Taxpayer Bill of Rights).

[12] For the resale exemption, see Tex. Tax Code §§ 151.006 (“Sale for Resale”), 151.302 (Sales for Resale); 34 Tex. Admin. Code § 3.285 (Resale Certificate; Sales for Resale).

[13] For the manufacturing exemption, see Tex. Tax Code § 151.318 (Property Used in Manufacturing); 34 Tex. Admin. Code § 3.300 (Manufacturing; Custom Manufacturing; Fabricating; Processing (Tax Code, §§151.005, 151.007, 151.318, and 151.3181)).

[14] See Tex. Tax Code §§ 151.0075 (“Security Service”), 151.0101 (“Taxable Services”); Tex. Occ. Code § 1701.102(a)(1) (Security Services Contractor License Required; Scope of License) (as amended by S.B. 616, 86th Leg., R.S. (2019) (removing guard dogs from security license requirements)).

[15] See Tex. Tax Code § 151.006(a) (“Sale for Resale”) (defining a “sale for resale” in part as a sale of “tangible personal property or a taxable service to a purchaser who acquires the property or service for the purpose of reselling it as a taxable item as defined by Section 151.010 in the United States of America or a possession or territory of the United States of America or in the United Mexican States in the normal course of business in the form or condition in which it is acquired or as an attachment to or integral part of other tangible personal property or taxable service . . . .”).

[16] Preemption may occur when the scheme of federal regulation is so pervasive as to make reasonable the inference that Congress left no room for the States to supplement it.  See U.S. Const., art. VI, cl. 2; Hyundai Motor Co. v. Alvarado, 974 S.W.2d l, 9 (Tex. 1998).

[17] For the manufacturing exemption, see Tex. Tax Code § 151.318 (Property Used in Manufacturing); 34 Tex. Admin. Code § 3.300 (Manufacturing; Custom Manufacturing; Fabricating; Processing (Tax Code, §§151.005, 151.007, 151.318, and 151.3181)).

[18] As authority for this, the ALJ cited 34 Tex. Admin. Code § 3.314(g)(3) (Wrapping, Packing, Packaging Supplies, Containers, Labels, Tags, Export Packers, and Stevedoring Materials and Supplies) (sellers of taxable items in returnable containers must pay sales and use tax on its purchases of the containers because its sales of the containers are exempt).

[19] For enterprise zones, see Tex. Gov’t Code ch. 2303 (Enterprise Zones); Tex. Tax Code § 151.429 (Tax Refunds for Enterprise Projects); 34 Tex. Admin. Code § 3.329 ( Enterprise Projects, Enterprise Zones, and Defense Readjustment Zones).

(a) Interest and penalties determined from reviewed year

(1) In general: Except to the extent provided in section 6226(c), in the case of a partnership adjustment for a reviewed year—

(A) interest shall be computed under paragraph (2), and

(B) the partnership shall be liable for any penalty, addition to tax, or additional amount as provided in paragraph (3).

(2) Determination of amount of interest

The interest computed under this paragraph with respect to any partnership adjustment is the interest which would be determined under chapter 67 for the period beginning on the day after the return due date for the reviewed year and ending on the return due date for the adjustment year (or, if earlier, the date payment of the imputed underpayment is made). Proper adjustments in the amount determined under the preceding sentence shall be made for adjustments required for partnership taxable years after the reviewed year and before the adjustment year by reason of such partnership adjustment.

(3) Penalties

Any penalty, addition to tax, or additional amount shall be determined at the partnership level as if such partnership had been an individual subject to tax under chapter 1 for the reviewed year and the imputed underpayment were an actual underpayment (or understatement) for such year.

(b) Interest and penalties with respect to adjustment year return

(1) In general:In the case of any failure to pay an imputed underpayment on the date prescribed therefor, the partnership shall be liable—

(A) for interest as determined under paragraph (2), and

(B) for any penalty, addition to tax, or additional amount as determined under paragraph (3).

(2) Interest

Interest determined under this paragraph is the interest that would be determined by treating the imputed underpayment as an underpayment of tax imposed in the adjustment year.

(3) PenaltiesPenalties, additions to tax, or additional amounts determined under this paragraph are the penalties, additions to tax, or additional amounts that would be determined—

(A) by applying section 6651(a)(2) to such failure to pay, and

(B) by treating the imputed underpayment as an underpayment of tax for purposes of part II of subchapter A of chapter 68.

(c) Deposit to suspend interest

For rules allowing deposits to suspend running of interest on potential underpayments, see section 6603.

(Added Pub. L. 114–74, title XI, § 1101(c)(1), Nov. 2, 2015, 129 Stat. 633; amended Pub. L. 115–141, div. U, title II, § 206(i), Mar. 23, 2018, 132 Stat. 1180.)

The state of Texas imposes two taxes on alcoholic beverages that impact holders of certain permits under the Texas Alcoholic Beverage Code. These taxes are the mixed beverage gross receipts tax and the mixed beverage sales tax. Both are set forth in Texas Tax Code, Chapter 183 (“Chapter 183”) and Texas Comptroller Rule 3.1001 (“Rule 3.1001”).[1]

Who’s Subject to Mixed Beverage Taxes?

The folks who get hit with mixed beverage taxes (other than consumers) are what are called “permittees.” [2] Chapter 183 defines a “permittee” is defined as someone who holds one of the following permits under the Texas Alcoholic Beverage Code:

• a mixed beverage permit;
• a private club registration permit;
• a private club exemption certificate;
• a private club registration permit with a retailer late hours certificate;
• a nonprofit entity temporary event permit;
• a private club registration permittee holding a food and beverage certificate;
• a mixed beverage permit with a retailer late hours certificate;
• a mixed beverage permit with a food and beverage certificate; or
• a distiller’s and rectifier’s permit.[3]

What’s a Mixed Beverage?

Chapter 183 defines a “mixed beverage” as “a beverage composed in whole or part of an alcoholic beverage in a sealed or unsealed container of any legal size for consumption on the premises when served or sold by the holder of a mixed beverage permit, the holder of certain nonprofit entity temporary event permits, the holder of a private club registration permit, or the holder of certain retailer late hours certificates.”[4]

What’s the Mixed Beverage Gross Receipts Tax?

A 6.7% tax is imposed on the gross receipts of a permittee from the sale, preparation, or service of mixed beverages as well as from the sale, preparation, or service of ice or nonalcoholic beverages that are sold, prepared, or served for the purpose of being mixed with an alcoholic beverage and consumed on the premises of the permittee.[5] Taxable mixed beverage gross receipts also include:

• receipts from cover charges, door charges, entry fees, or admission fees when the TABC has determined that the collection of the cover charge, door charge, entry fee, or admission fee is in violation of TABC rules or regulations;
• the normal selling price of alcoholic beverages served with meals with no separate charge;
• any portion of a reasonable mandatory gratuity charge that is not disbursed to qualified employees;
• the entire mandatory gratuity charge when in excess of 20%, regardless of how the gratuity is disbursed;
• miscellaneous charges in conjunction with the sale or service of alcoholic beverages such as bar set-up fees, bartender fees, corkage fees, maîtres d’hôtel charges, etc.;
• all sales or services of alcoholic beverages by caterers;
• all sales or services of alcoholic beverages sold or served by the holder of a temporary permit or by the holder of a beer and wine only temporary permit issued to a mixed beverage permittee; and
• all sales of coupons, tokens, tickets, etc., that are redeemed or used in any manner to purchase or pay for the sale or service of an alcoholic beverage.[6]

Receipts not included in the mixed beverage gross receipts tax base include:

• complimentary alcoholic beverages (although use tax under Texas Tax Code, Chapter 151 (Limited Sales, Excise, and Use Tax) is due on taxable ingredients used to make the complimentary alcoholic beverages);
• complimentary alcoholic beverages served during promotional periods such as happy hours at hotels or motels (although if there is an increase in the guest room rates attributable to these promotional periods, the Comptroller has the option to tax either the increase in the room rate under Tax Code, Chapter 156 (Hotel Occupancy Tax), or assess use tax on the taxable ingredients of the complimentary drinks);
• complimentary alcoholic beverages served to holders of free drink cards or free drink tokens, for which no consideration is paid to the permittee;
• voluntary gratuities;
• reasonable mandatory gratuity charges of 20% or less that are separated from the sales price of the alcoholic beverage being served, identified as a tip or gratuity, and disbursed to employees who customarily and regularly provide the service upon the gratuity is based;
• walked checks or tabs;
• receipts from cover charges, door charges, entry fees, or admission fees that are for entertainment, food specials, and other purposes, and receipts from the sale of temporary membership cards (although these receipts would be subject to sales tax as amusement services under Tax Code, Chapter 151);
• bad debts;
• mixed beverage sales taxes;
• alcohol loss due to spillage or breakage; and
• alcoholic beverages used in cooking.[7]

Permittees are allowed to provide an informational statement to customers disclosing the amount of mixed beverage gross receipts tax to be paid by the permittee in relation to the mixed beverage sold, although they may not separately charge the customer for this tax.[8]

What’s the Mixed Beverage Sales Tax?

An 8.25% tax is imposed on each mixed beverage sold, prepared, or served by a permittee in this state and on ice and each nonalcoholic beverage sold, prepared, or served by a permittee in Texas for the purpose of being mixed with an alcoholic beverage and consumed on the premises of the permittee.[9] The tax base for mixed beverage sales tax generally is the same as for mixed beverage gross receipts tax and is generally administered, collected, and enforced in the same way as sales and use tax under Texas Tax Code, Chapter 151 is administered, collected, and enforced.[10]

What About To-Go Drinks?

In 2021, the Legislature amended the Texas Alcoholic Beverage Code to allow holders of mixed beverage permits with a food and beverage certificate and private club registration permit holders with a food and beverage certificate to sell alcoholic beverages with to-go food orders under certain circumstances.[11]

As you might have noticed, mixed beverage gross receipts tax and mixed beverage sales tax are both keyed to on-premises consumption of an alcoholic beverage.[12] Thus, the sale of alcoholic beverages with to-go food orders generally will not be subject to mixed beverage gross receipts tax and mixed beverage sales tax, but instead sales and use tax under Texas Tax Code, Chapter 151.[13]

So, Alcoholic Beverages Sold by Non-Permittees Aren’t Taxed?

No! Alcoholic beverages sold by folks who don’t hold a permit subject to mixed beverage taxes usually are going to be subject to plain-old sales or use tax under Texas Tax Code, Chapter 151.[14]

State and Local Tax Services 

Freeman Law works with tax clients across all industries, including manufacturing, services, technology, oil and gas, financial services, and real estate. State and local tax laws and rules are complex and vary from state to state. As states confront budgetary deficits due to declining tax revenues and increased government spending, tax authorities aggressively enforce state tax laws to recapture lost revenues. 

At Freeman Law, our experienced attorneys regularly guide our clients through complex state and local tax issues—issues that are frequently changing as states seek to keep pace with technology and the evolution of business. Staying ahead requires sophisticated legal counsel dedicated to understanding the complex state tax issues that confront businesses and individuals. Schedule a consultation or call (214) 984-3000 to discuss your local & state tax concerns and questions. 

[1] For those interested, which admittedly is probably only me, the mixed beverage gross receipts tax (then the only mixed beverage tax in the state and imposed at a rate of 14%), was administered originally by the Texas Alcoholic Beverage Commission (“TABC”). In 1993, the Legislature reassigned administration of the tax to the Texas Comptroller by enacting Chapter 183. See Acts 1993, 73rd Leg., ch. 934, Sec. 106. The idea being the Comptroller was already performing tax collection and auditing functions similar to what the TABC was then performing and was already auditing holders of alcohol permits and licenses for sales and use tax (more on that later), so moving administration of mixed beverage gross receipts tax to the Comptroller “would elimination duplication of effort, institute a more balanced auditing process and provide a more cost effective and convenient tax system.” House Research Organization, Bill Analysis for HB 1445 at 7 (May 6, 1993). The problem being that since splitting Chapter 183 off from the Texas Alcoholic Beverage Code, the Legislature sometimes forgets to incorporate changes made in the Texas Alcoholic Beverage Code in Chapter 183, and vice versa.

In 2013, the Legislature decided to reduce the mixed beverage gross receipts tax rate to 6.7% and create a new mixed beverage sales tax imposed at rate of 8.25%. Acts 2013, 83rd Leg., R.S., ch. 1403, Sec. 12. As we’ll discuss, mixed beverage gross receipts tax is a tax on permittees selling the mixed beverage and can’t be passed on to the consumer (although permittees presumably build the tax into the cost they charge to consumers), while mixed beverage sales tax is a tax ultimately imposed on the consumer. House Research Organization, Bill Analysis for HB 2572 at 2 (May 2, 2013). Separating out a mixed beverage sales tax from the mixed beverage gross receipts tax was intended to promote transparency, because consumers would know that mixed beverage sales tax applies to the stated cost on the receipt. Id.

[2] See Tex. Tax Code §§ 183.001(b)(1), 183.021, 183.041.

[3] See Tex. Tax Code § 183.001(b). Comptroller Rule 3.1001 provides a slightly different list of permits whose holders would be mixed beverage taxes:

• mixed beverage permit;
• mixed beverage late hours permit;
• mixed beverage permit holding a food and beverage certificate;
• daily temporary mixed beverage permit;
• private club registration permit;
• private club exemption certificate permit;
• private club late hours permit;
• daily temporary private club permit;
• private club registration permit holding a food and beverage certificate;
• caterer’s permit; or
• rectifier’s and distiller’s permit.

34 Tex. Admin. Code § 3.1001(a)(6).

[4] See Tex. Tax Code § 183.001(a); Tex. Alc. Bev. Code § 1.04(13). Under Chapter 183 (incorporating the Texas Alcoholic Beverage Code), a mixed beverage apparently does not include an alcoholic beverage sold by a holder of a distiller’s and rectifier’s permit. This results in a discrepancy between the list of permittees subject to mixed beverage taxes (which includes holders of a distiller’s and rectifier’s permit) and the definition of a mixed beverage (which does not include those holders), raising the question of a where holders of distiller’s and rectifier’s permits are even making sales of mixed beverages that are subject to tax.

Perhaps attempting to avoid potential discrepancies resulting from the Chapter 183’s reliance on the Texas Alcoholic Beverage Code, Rule 3.1001 defines a “mixed beverage” more broadly as “[a] serving of a beverage composed in whole or in part of an alcoholic beverage in a sealed or unsealed container of any legal size for consumption on the premises where served or sold by a permittee.” Tex. Tax Code § 183.021.

[5] Id.; 34 Tex. Admin. Code § 3.1001(b).

[6] 34 Tex. Admin. Code § 3.1001(c)(1).

[7] 34 Tex. Admin. Code § 3.1001(a)(9), (f), (g), (h), (i).

[8] Tex. Tax Code § 183.0212(a)(1), (c); 34 Tex. Admin. Code § 3.1001(b)(3).

[9] Tex. Tax Code § 183.041; 34 Tex. Admin. Code § 3.1002(b).

[10] 34 Tex. Admin. Code § 3.1002(b), (c)(1).

[11] Acts 2021, 87th R.S., ch. 6.

[12] See Tex. Tax Code § 183.021, 183.041.

[13] See STAR Accession No. 202108009L (Aug. 2021).

[14] See Tex. Tax Code § 151.010, 151.051, 151.101, 151.308(a)(5).

STATUTES

• 26 U.S. Code §6221. Determination at partnership level
• 26 U.S. Code §6222. Partner’s return must be consistent with partnership return
• 26 U.S. Code § 6223. Partners bound by actions of partnership
• 26 U.S. Code § 6225. Partnership adjustment by Secretary
• 26 U.S. Code § 6226. Alternative to payment of imputed underpayment by partnership
• 26 U.S. Code § 6227. Administrative adjustment request by partnership
• 26 U.S. Code § 6231. Notice of proceedings and adjustment
• 26 U.S. Code § 6232. Assessment, collection, and payment
• 26 U.S. Code § 6233. Interest and penalties
• 26 U.S. Code § 6234. Judicial review of partnership adjustment
• 26 U.S. Code § 6235. Period of limitations on making adjustments
• 26 U.S. Code § 6241. Definitions and special rules

TREASURY REGULATIONS

• 26 CFR § 301.6221-1. Tax treatment determined at partnership level.
• 26 CFR § 301.6222-1. Partner’s return must be consistent with partnership return.
• 26 CFR § 301.6223-1. Partnership representative.
• 26 CFR § 301.6223-2. Binding effect of actions of the partnership and partnership representative.
• 26 CFR § 301.6225-1. Partnership adjustment by the Internal Revenue Service.
• 26 CFR § 301.6226-1. Election for an alternative to the payment of the imputed underpayment.
• 26 CFR § 301.6225-2. Modification of imputed underpayment.
• 26 CFR § 301.6225-3. Treatment of partnership adjustments that do not result in an imputed underpayment.
• 26 CFR § 301.6226-2. Statements furnished to partners and filed with the IRS.
• 26 CFR § 301.6226-3. Adjustments taken into account by partners.
• 26 CFR § 301.6227-1. Administrative adjustment request by partnership.
• 26 CFR § 301.6227-2. Determining and accounting for adjustments requested in an administrative adjustment request by the partnership.
• 26 CFR § 301.6227-3. Adjustments requested in an administrative adjustment request taken into account by reviewed year partners.
• 26 CFR § 301.6231-1. Notice of proceedings and adjustments.
• 26 CFR § 301.6232-1. Assessment, collection, and payment of imputed underpayment.
• 26 CFR § 301.6234-1. Judicial review of partnership adjustment.
• 26 CFR § 301.6235-1. Period of limitations on making adjustments.
• 26 CFR § 301.6241-1. Definitions.
• 26 CFR § 301.6241-3. Treatment where a partnership ceases to exist.
• 26 CFR § 301.6241-4. Payments nondeductible.
• 26 CFR § 301.6241-5. Extension to entities filing partnership returns.
• 26 CFR § 301.6241-6. Coordination with other chapters of the Internal Revenue Code.

Under subchapter K of the Internal Revenue Code, a partnership does not compute and pay an income tax upon filing Form 1065 but instead passes through any profits and losses to its partners. However, when a partnership is examined under the BBA regime, any partnership adjustment resulting in an imputed underpayment and the applicability of any penalty, addition to tax, or additional amount (plus interest as provided by law) that relates to such adjustment is determined, assessed and collected at the partnership level.

There are two types of imputed underpayments: a general imputed underpayment and a specific imputed underpayment. Each type of imputed underpayment is based solely on partnership adjustments with respect to a single taxable year.

Determination of an imputed underpayment 

Section 6225(b)(1)(B) provides that the determination of an imputed underpayment is made by “applying the highest rate of tax in effect for the reviewed year under section 1 or 11.” Consistent with section 6225(b)(1)(B), §301.6225-1 provides that an imputed underpayment is determined by multiplying the total netted partnership adjustment by the highest rate of federal income tax in effect for the reviewed year under section 1 or 11 and increasing or decreasing that product by certain adjustments to credits and creditable expenditures.

The Single-Year Approach.

§301.6225-1(a)(1) provides that each imputed underpayment determined under §301.6225-1 is based solely on partnership adjustments with respect to a single taxable year.

Section 6225(b) sets forth the rules for determining an imputed underpayment. The statutory structure of section 6225(b) is premised on the concept that an imputed underpayment is determined with respect to a reviewed year and that adjustments with respect to the reviewed year result in such imputed underpayment or are adjustments that do not result in an imputed underpayment. Section 6225(a). Section 6225(b)(1)(A) expressly provides that “any imputed underpayment with respect to any reviewed year shall be determined by the Secretary by appropriately netting all adjustments with respect to such reviewed year . . . .” (emphasis added). The statute does not reference adjustments with respect to any year other than the reviewed year. Accordingly, the IRS takes the position that the statute does not provide for the netting of adjustments across tax years.

The IRS takes the position that netting across multiple tax years would not constitute “appropriately netting” within the meaning of section 6225(b)(1)(A). A fundamental federal income tax principle is that each taxable year stands alone. Commissioner v. Sunnen, 333 U.S. 591 (1948) (“Income taxes are levied on an annual basis. Each year is the origin of a new liability and of a separate cause of action.”). A rule that provides for netting across tax years could be viewed, it is argued, as inconsistent with this fundamental principle. Because adjustments relating to multiple years may affect items that are allocable to different partners or in different amounts, the IRS does not allow for offsetting those types of adjustments against each other when determining the imputed underpayment.

Adjustments Subject to Additional Limitations.

Section 6225(b)(4) provides that if any adjustment would result in a decrease in the amount of the imputed underpayment and could be subject to any additional limitation under the Code if taken into account by any person, such adjustment should not be taken into account in the netting process described in section 6225(b)(1)(A). This provision codifies the presumption that, except as otherwise provided, taxpayer favorable adjustments subject to any possible limitation under the Code if taken into account by any person are disregarded when determining an imputed underpayment. The statute does not require the IRS to determine whether taxpayer favorable adjustments are in fact subject to such limitations.

The regulations under §301.6225-1(a)(1) maintain the requirement that an imputed underpayment be based solely on partnership adjustments with respect to a single taxable year.

Grouping, Subgrouping, and Netting of Partnership Adjustments 

In order to determine an imputed underpayment, each partnership adjustment determined by the IRS is first placed into one of four groupings pursuant to §301.6225-1(c) according to the type of partnership-related item being adjusted: the reallocation grouping, the credit grouping, the creditable expenditure grouping, or the residual grouping. Adjustments are then subgrouped, if appropriate, and netted to produce the total netted partnership adjustment. §301.6225-1(b)(2), (d) and (e).

Grouping involves placing each proposed audit adjustment into one of four groupings: reallocation, credit, creditable expenditure and residual.

After an adjustment is placed into a grouping, subgrouping is the process of further defining that adjustment into a subgrouping, generally in accordance with how that adjustment would be required to be taken into account separately under section 702(a) or any other provision of the Code. This is necessary to keep adjustments that are similar in nature together while keeping adjustment that are different apart. These subgroups generally follow the line items on Schedule K/K-1 or other separate and distinct line items on Form 1065 and schedules. However, subgrouping is only necessary when any proposed adjustment within a grouping is a negative adjustment.

A negative adjustment is any adjustment that is a decrease in an item of gain or income, an increase in item of loss or deduction, or an increase in an item of credit or creditable expenditure.

A positive adjustment is any adjustment that is not a negative adjustment.

Generally, netting is the process of summing all adjustments together within each grouping or subgrouping, as appropriate.

Once all adjustments have been grouped, subgrouped (if applicable) and netted, the total netted partnership adjustment (TNPA) can be determined. The TNPA is the sum of all net positive adjustments in the reallocation grouping and the residual grouping. If, after netting, either the reallocation or residual grouping summed total is less than or equal to zero, it is not taken into account in calculating the TNPA.

A net positive adjustment means an amount that is greater than zero which results from netting adjustments within a grouping or subgrouping. A net positive adjustment includes a positive adjustment that was not netted with any other adjustment.

A net negative adjustment means any amount which results from netting adjustments within a grouping or subgrouping that is not a net positive adjustment. A net negative adjustment includes a negative adjustment that was not netted with any other adjustment.Multiply the TNPA by the highest rate of Federal income tax in effect for the reviewed year under section 1 or 11 and increase or decrease the product by the net positive adjustments from the creditable expenditure grouping.

The design of section 6225(a) and (b) and the grouping and netting rules under §301.6225-1 is to create an imputed underpayment amount that is based on the highest rate of tax and that disregards any taxpayer favorable adjustments which would otherwise reduce the imputed underpayment. Given this formula, an imputed underpayment determined under §301.6225-1 will likely reflect an amount that is larger than the cumulative amount of tax the partners would have paid if the partners took the partnership adjustments into account separately.

This formula is a feature of section 6225(a) and (b). The statute expressly disregards certain adjustments that may be subject to limitations and that would otherwise reduce the imputed underpayment and mandates the application of the highest applicable tax rate. Section 6225(b)(1)(B), (2) and (4).

By removing the obligation on the IRS to consider partners’ facts and circumstances, such as whether adjustments that would otherwise reduce the imputed underpayment might be allowed at the partner level or whether adjustments might be taken into account by partners at a rate lower than the highest rate, section 6225(b) shifts the burden from the IRS during this phase of a partnership examination. Because the imputed underpayment determined at this phase in the examination is not required to reflect the facts and circumstances of the ultimate partners, modifications may be necessary to more closely reflect the proper tax treatment.

Modifications and Push Outs.

After the preliminary determination of the imputed underpayment amount under §301.6225-1, the burden is shifted to the partnership to utilize the modification procedures under §301.6225-2 if the partnership so chooses. Modification is designed to allow the partnership and its partners to arrive at an imputed underpayment amount that is closer to the correct amount of tax while maintaining the assessment and collection efficiencies of a centralized audit process. See Joint Comm. on Taxation, JCS-1-16, General Explanations of Tax Legislation Enacted in 2015, 65-66 (2016) (JCS-1-16). As an alternative to modification and paying an imputed underpayment, the partnership can elect under section 6226 to push out the adjustments to its partners. Both modification and the push out election provide the opportunity to establish that the correct amount of tax is collected from the partnership and its partners.

Thus, a partnership and its partners may be able to reduce the rate used in computing an imputed underpayment by requesting modification under section 6225(c). For example, the partnership may request modification under §301.6225-2(d)(3) with respect to partnership adjustments that are allocable to a tax-exempt entity or modification under §301.6225-2(d)(4) with respect to adjustments to capital gains or qualified dividends that are attributable to an individual. The partnership may also make a push out election under section 6226, allowing partners to take into account the adjustments and pay tax using their respective marginal tax rates, including taking into account the effect of the alternative minimum tax.

Tax Attributes and Grouping.

The regulations require that adjustments be placed into groupings and subgroupings based on how the adjusted items are treated pursuant to the Code, the regulations, forms, instructions, and other guidance and do not generally permit the netting of adjustments that might otherwise be subject to limitations or restrictions under the tax laws. Accordingly, the grouping and netting rules are designed with regard to generally applicable provisions of the Code.

The tax attributes of the partnership’s partners generally do not factor into the preliminary determination of the imputed underpayment. Rather, the imputed underpayment determined under §301.6225-1 is computed without regard to the partners’ tax circumstances, for example whether a partner would be able to offset additional partnership income with additional deductions or whether a partner’s tax attributes would reduce the amount of tax due as a result of the adjustments. See section 6225(b)(1)(B), (2) and (4). Modification as described under section 6225(c) and §301.6225-2 was deemed the more appropriate stage of the examination for the IRS to take into account specific partner tax attributes.

Nonetheless, §301.6225-1(c)(1) and (d)(1) provide that the IRS may, in its discretion, place adjustments in groupings and subgroupings in a manner different from that described in the regulations to appropriately reflect the facts and circumstances of each examination. This rule is intended to allow the partnership to provide information to the IRS to demonstrate that certain partner tax attributes should be taken into account when grouping and subgrouping to achieve a more appropriate netting of the adjustments.

The regulations give the IRS the discretion to decide whether or not to use this information in the initial examination phase, that is, prior to modification. This rule contemplates that the partnership and the IRS may not agree as to whether the groupings and subgroupings requested by the partnership are appropriate. If the partnership and the IRS do not agree on the groupings and subgroupings recommended by the partnership during the exam, the partnership is not without recourse. The partnership may request during modification that the IRS include one or more partnership adjustments in a particular grouping or subgrouping or request that certain partnership adjustments be treated as if no limitations or restrictions apply with the result those adjustments may be subgrouped with other adjustments. See §301.6225-2(d)(6).

Accordingly, modification is generally the appropriate point in the administrative phase at which partner tax attributes may be raised by the partnership and considered by the IRS. For example, the partnership and its partners can utilize the amended return procedure or the alternative procedure to filing amended returns, which require partners to take the adjustments into account in light of their individual tax attributes. Those procedures would potentially allow partners to offset passive income with any passive losses.  In the alternative, the partnership may elect to push out the adjustments under section 6226, and the partners would be required to take into account the adjustments and any effects on the partners’ tax attributes. At that stage, the partners could use passive losses to the extent permitted by the rules under §301.6226-3 (regarding how partners take into account pushed out adjustments).

Although the IRS is permitted to consider partner tax attributes during the first phase of the partnership exam, the statute and the regulations provide clear guidance on the modification process and specifically how a partnership may request that partners’ tax attributes be taken into account to reduce the imputed underpayment.

However, a partnership may request that the IRS take into account facts and circumstances relating to its partners pursuant to the rules under §301.6225-1(d)(1) and (e)(1), which may allow for more appropriate grouping and subgroupings of adjustments. The partnership may also request during modification to reduce the amount of the imputed underpayment based on the partners’ specific tax attributes.

“Appropriately netting” within the meaning of section 6225(b)(1)(A) means, as a general matter, that when netting partnership adjustments for purposes of determining an imputed underpayment, all limitations under the Code should be considered, including limitations that would otherwise prevent the partnership from netting certain items. Section 6225(b)(4)’s rule regarding taxpayer favorable adjustments subject to additional limitations under the Code if taken into account by any person supports this interpretation. Because certain items could be subject to limitations in the hands of certain partners, the statute requires that limitations be accounted for by assuming they exist for purposes of determining the imputed underpayment during the initial stage of the examination. The partnership may ameliorate any discrepancies caused by that assumption by demonstrating that no such limitations exist either under §301.6225-1(d)(1) or (e)(1) or in the modification phase. The partnership can also make the election under section 6226, and the partners will account for such limitations when taking into account the adjustments.

The Code permits corporate taxpayers to deduct capital losses to the extent of capital gains. Section 1211(a). In the case of taxpayers other than corporations, the Code allows a deduction for any capital loss exceeding capital gain up to $3,000 ($1,500 in the case of a married individual filing separately). Section 1211(b).

A partnership that wishes to request that the IRS take into account its partner’s tax circumstances, including that certain partners are otherwise entitled to a capital loss deduction under section 1211(b), may utilize the discretionary grouping and subgrouping rules under §301.6225-1(d)(1) and (e)(1) or make a modification request under §301.6225-2(d)(6).

Section 6225(b)(1) provides that the imputed underpayment is determined by appropriately netting all partnership adjustments and applying the highest rate of tax under section 1 or 11. Section 6225(b)(3) requires that the partnership adjustments are first separately determined and netted as appropriate within each category of items that are required to be taken into account separately under section 702(a) or other provision of the Code. When “appropriately netting” under section 6225(b)(1)(A), section 6225(b)(4) requires that negative adjustments that could be subject to any limitation or restriction if taken into account by any person be disregarded unless provided otherwise by regulation. The regulations incorporate this rule in §301.6225-1(d)(3). The regulations also provide the ability, however, to take facts and circumstances into account to allow negative or downward adjustments, where appropriate, to be subgrouped and thus netted with other adjustments. See §301.6225-1(d)(1).

Subgrouping Principles.

Section 202(a) of the TTCA added section 6225(b)(3) to provide that partnership adjustments shall first be separately determined (and netted as appropriate) within each category of items that are required to be taken into account separately under section 702(a) or other provision of the Code. Section 6225(b)(4) provides if any adjustment would (but for section 6225(b)(4)) result in a decrease in the amount of the imputed underpayment, and could be subject to any additional limitation under the provisions of the Code (or not allowed, in whole or in part, against ordinary income) if such adjustment were taken into account by any person, such adjustment shall not be taken into account when appropriately netting partnership adjustments under section 6225(b)(1)(A) except to the extent otherwise provided by the Secretary.

§301.6225-1(d)(3)(i) provides that adjustments are subgrouped, when appropriate, according to how the adjustment would be required to be taken into account separately under section 702(a) or any other provision of the Code or regulations applicable to the adjusted partnership- related item. By separating adjustments into subgroupings according to how and whether the adjustments would be separately stated pursuant to section 702(a), the rules under §301.6225-1(d)(3)(i) seek to ensure that items that do not properly net against each other at the partnership level under section 702(a) do not net against each other for purposes of determining an imputed underpayment.

For example, under §301.6225-1(c) a positive adjustment to intangible drilling costs and a negative adjustment to gain or loss from a sale of property described in section 1231 are both placed in the residual grouping. Pursuant to §301.6225-1(d)(3)(i), each adjustment is then placed in a separate subgrouping to reflect that one adjustment is a negative adjustment and that the items being adjusted are required to be separately stated pursuant to section 702(a). See section 702(a)(3), §1.702-1(a)(8)(i). Under §301.6225-1(e)(1), adjustments from separate subgroupings cannot be offset against one another. Accordingly, just as a positive amount of intangible drilling costs would not be netted with a section 1231 loss under section 702(a), a positive adjustment to intangible drilling costs would not net against a negative adjustment to 1231 gain or loss for purposes of determining an imputed underpayment.

Some items that are not separately stated pursuant to section 702(a) may nevertheless be subject to other limitations under the Code or may not otherwise be allowed to net against ordinary income. To account for those types of limitations, §301.6225-1(d)(3)(i) further provides that if any adjustment could be subject to any preference, limitation, or restriction under the Code (or not allowed, in whole or in part, against ordinary income) if taken into account by any person, the adjustment is placed in its own separate subgrouping. For example, an increase in loss attributable to a trade or business activity of the partnership may not be deductible in the hands of a particular partner because that partner did not materially participate in the partnership activity.  See section 469. Because the loss may be limited in the hands of a particular partner, the increase in loss is placed in its own separate subgrouping to prevent any inappropriate netting against an adjustment increasing income of the partnership.

Generally, under §301.6225-1(d), reallocation adjustments must be placed into their own subgroupings, but there is an exception for when multiple reallocation adjustments apply to a single partner or group of partners. §301.6225-1(d)(3)(ii) provided that if a particular partner or group of partners has two or more reallocation adjustments allocable to such partner or group, such adjustments may be subgrouped in accordance with §301.6225-1(d)(3)(i) and netted in accordance with §301.6225-1(e). §301.6225-1(d)(3)(iv) provides a similar rule with respect to recharacterization adjustments.

Negative Adjustments.  

Under §301.6225-1(e), adjustments from each subgrouping (or grouping if there is no subgrouping within that grouping) are netted to produce either a net positive adjustment or a net negative adjustment with respect to each grouping or subgrouping. When determining an imputed underpayment, generally only net positive adjustments are taken into account, and net negative adjustments are generally treated as adjustments that do not result in an imputed underpayment. Adjustments to credits and creditable expenditures are treated separately.

§301.6225-1(b)(4) provides that if the effect of a partnership adjustment under chapter 1 of the Code is reflected in another adjustment taken into account in the imputed underpayment determination, the IRS may treat an adjustment as zero for the purposes of calculating the imputed underpayment. This rule is designed to ensure that when calculating an imputed underpayment, an adjustment is not counted twice if the tax effect of that adjustment is reflected by another adjustment made by the IRS. A partnership can request that the IRS utilize this rule to treat an adjustment as zero if the partnership believes it will avoid double taxation.

The regulations under §301.6225-1(b)(4) clarify that the IRS has the discretion to treat adjustments as zero for purposes of determining the imputed underpayment if the effect of the adjustment under the Code is reflected in another adjustment.

Other Issues Regarding Grouping and Netting Adjustments.

Section 6225(a)(1) refers to adjustments to partnership-related items “with respect to any reviewed year.” Section 6225(b)(1) provides that any imputed underpayment “with respect to any reviewed year” shall be determined by appropriately netting all partnership adjustments “with respect to such reviewed year.” In addition, section 6225(d)(2) defines adjustment year to mean, in the case of an examination, the year in which an FPA is mailed under section 6231 or in the case of adjustment pursuant to a decision in a proceeding under section 6234, the year in which the decision is final. As a result, at the time of the modification phase of the examination, the adjustment year will not yet be determined.

The modification period will in every case come before the issuance of the FPA. As a result, the adjustment year will not yet have been determined, and therefore the adjustment year partners will not yet be known. In addition, section 6225(c)(2) provides the ability for partners to file amended returns in modification. The statute’s use of the phrase “amended return” implies that a prior return must have been filed. A prior return could not have been filed for the adjustment year at this point in the examination because the adjustment year would not yet be determined. The partners from the reviewed year, therefore, must be the partners that utilize the modification procedures under section 6225(c)(2) through the filing of amended returns for the reviewed year. The reviewed year partners’ amended returns could not take into account adjustment year adjustments and apply them against reviewed year returns. Under the statute, adjustments for purposes of determining an imputed underpayment are the adjustments with respect to a reviewed year, not the adjustment year.

Furthermore, section 6225(a)(1) provides the partnership shall pay an amount equal to such imputed underpayment in the adjustment year as provided in section 6232. In the case of adjustments that do not result in an imputed underpayment, section 6225(a)(2) provides that such adjustments shall be taken into account in the adjustment year. Section 6225(a)(2)’s explicit statement that adjustments not resulting in an imputed underpayment are taken into account in the adjustment year, and the absence of similar language in section 6225(a)(1) makes clear that only those partnership adjustments that do not result in an imputed underpayment are taken into account in the adjustment year.

§301.6225-3 provides that adjustments that do not result in an imputed underpayment are taken into account in the adjustment year, that is, when the imputed underpayment is also required to be paid. To that extent, any adjustments that do not result in an imputed underpayment may mitigate the burden of the imputed underpayment on adjustment year partners.

Section 6225 provides that if the adjustments result in an imputed underpayment, the partnership shall pay an amount equal to such imputed underpayment in the adjustment year as provided in section 6232. Accordingly, the year partnerships must pay is, by statute, the adjustment year, and if the partnership pays the imputed underpayment without modification or does not make an election under section 6226, the statute is designed so that the adjustment year partners bear the burden of that payment. See section 6241(4) and §301.6241-4 (denying any deduction to the partnership for any payment made by the partnership, including the imputed underpayment). Additionally, there is no authority within subchapter C of chapter 63 to allow the Treasury Department or the IRS to require that reviewed year partners file amended returns, though partners have the option to do so in modification. The partnership may also make the election under section 6226 which would result in adjustments relating to the imputed underpayment for which the election was made being taken into account by the reviewed year partners.

Section 6225 is prescriptive as to how an imputed underpayment is determined. The determination process expressly does not determine the imputed underpayment as if the partnership were an individual or an entity. Instead, the process for determining the imputed underpayment, including “appropriately netting all partnership adjustments” under section 6225(b)(1)(A) in accordance with §301.6225-1 generally does not take into account partner tax attributes, including whether a partner is an individual or a person subject to the Code provisions that apply to individuals. The IRS has the discretion to take into account an attribute of a particular partner when grouping or subgrouping the adjustments, but the IRS is not required to do so. §301.6225-1(d)(1), (e)(1). For instance, the IRS may consider whether a certain ownership percentage of the partnership was held by individuals, S corporations, or closely-held corporations and group adjustments based on information submitted by the partnership.

The statute provides a baseline assumption that partners’ tax attributes are not taken into account. The imputed underpayment that best reflects the facts and circumstances of the partners should be determined through application of the permissive grouping and subgrouping rules under §301.6225-1(d)(1), (e)(1) or through modification.

Section 6225(b) only provides specific rules with respect to one type of adjustment, that is, the rule that adjustments to distributive shares of partners not be netted under section 6225(b)(2). In order to effectuate the rule under section 6225(b)(2), there is no need to know whether a partner is an individual, a corporation, a pass-thru partner, or some other entity. Section 6225(b)’s lack of reference to any particular tax attributes of specific partners indicates that the determination of an imputed underpayment is not dependent on knowing any partner’s specific tax attributes.

Section 6225 does not reference either partner tax attributes or current year partners as a consideration in determining the imputed underpayment. The Treasury Department and the IRS ultimately took the position that section 6225(b) supports a process in which the determination of the imputed underpayment does not depend on specific partners’ tax attributes.

Recharacterization Adjustments.

Facts and circumstances unique to specific partners are generally not taken into account in determining whether the adjustments result in an imputed underpayment. The regulations give the IRS wide latitude to consider such facts and circumstances, but the rules do not narrowly define the circumstances when that occurs. See §301.6225-1(d)(1) and (e)(1).

§301.6225-1(c)(6)(iii) provides that a recharacterization adjustment results in at least two separate adjustments: one adjustment reversing the improper characterization of the partnership- related item, and the other adjustment effectuating the proper characterization of the partnership-related item. Generally, one of those adjustments is a positive adjustment and the other is a negative adjustment, but each adjustment is normally the same numerical amount. Under §301.6225-1(d)(3)(iv), the positive adjustment and the negative adjustment are each placed into its own separate subgrouping. Because an adjustment in one subgrouping may not be netted against an adjustment from another subgrouping, the positive adjustment is not offset by the negative adjustment, and the result is a net positive adjustment that forms the base for an imputed underpayment amount. §301.6225-1(e)(2) and (3)(i).

The regulations under §301.6225-1(e)(2) provide that positive adjustments and negative adjustments within the same subgrouping may only net within that same subgrouping. No netting is permitted across subgroupings.

Credits and Creditable Expenditures.  

In determining whether partnership adjustments result in an imputed underpayment, adjustments to credits are placed in the credit grouping described under §301.6225-1(c)(3).

The subgrouping rules under §301.6225-1(d)(3)(i), including the application of those rules to the credit grouping, take into account any limitations or restrictions under the Code.

Adjustments to creditable expenditures are placed in the creditable expenditure grouping described under §301.6225-1(c)(4). §301.6225-1(c)(4)(B), (d)(3)(iii), and (e)(3)(iii) provide specific rules relating to foreign creditable tax expenditures.

With the exception of the rules under §301.6225-1 regarding foreign tax creditable expenditures, the Treasury Department and the IRS did not issue regulations regarding the treatment of creditable expenditures. However, the regulations do clarify that the general subgrouping principles under §301.6225-1(d)(3)(i) apply when subgrouping adjustments to creditable expenditures. The regulations also clarify that a net positive adjustment to creditable foreign tax expenditures is excluded from the calculation of the total netted partnership adjustment under §301.6225-1(b)(2).

A recapture of a credit generated by partnership activities constitutes a partnership adjustment as defined under §301.6241-1(a)(6), and the credit recapture would constitute a positive adjustment under §301.6225-1(d)(2)(iii)(A) and be placed in the credit grouping under §301.6225-1(c)(3). The full amount of the credit recapture would be taken into account in the determination of the imputed underpayment, unless the partnership requests, subject to IRS approval, that the credit recapture should be taken into account differently during the partnership-level proceeding or pursuant to a modification request. See §301.6225-1(d)(1), (e)(1), §301.6225-2. This rule is necessary because the initial determination of an imputed underpayment does not account for the attributes of the partnership’s partners, including whether and to what extent any partners actually benefited from the original credits. Accordingly, the regulations include a credit recapture amount in the amount of the imputed underpayment, and this amount is not limited to the amount partners actually benefited from the recaptured credits unless the partnership can affirmatively demonstrate to the satisfaction of the IRS during exam either before issuance of the NOPPA or on modification the appropriate partner-level tax treatment.

Because a net negative adjustment to a credit, that is, an increase in an item of credit, would generally be subject to limitations under the Code, the regulations under §301.6225-1(e)(3)(ii) clarify that a net negative adjustment to a credit is treated as an adjustment that does not result in an imputed underpayment as described in §301.6225-1(f)(1), unless the IRS determines otherwise. This rule is intended to prevent the total netted partnership adjustment from inappropriately being reduced by an increase in credit that would subject to limitations in the hands of the partners of the partnership.

Steps in computing the imputed underpayment (IU)

Computing the IU requires approximately 7 steps:

Step 1

The first step in computing an IU involves the placing of each proposed adjustment into one of four groupings: reallocation, credit, creditable expenditure and residual groupings. Each of the four groupings is explained below:

• Reallocation grouping – In general, any adjustment that allocates or reallocates a PRI to and from a particular partner or partners is a reallocation adjustment, except for an adjustment to a credit or to a creditable expenditure. Each reallocation adjustment generally results in at least two separate adjustments, each of which become a separate subgrouping. See step 2 which discusses the concept of “subgrouping.”
• One leg of the reallocation adjustment reverses the effect of the improper allocation of a PRI that will result in a negative adjustment. This adjustment must be taken into account by the partnership in the adjustment year and cannot generally be netted against other adjustments. See step 3 which discusses the concept of “netting.”
• The other leg of the adjustment makes the proper allocation of the PRI and will result in a positive adjustment.
• These reallocations are theoretical to the actual partners impacted, that is, they will not impact the partner themselves.

Credit grouping – Any adjustment to a PRI that is reported or could be reported by a partnership as a credit on the partnership’s return, including a reallocation adjustment to such PRI, is placed in the credit grouping.

1. Generally, a decrease in credits is treated as a positive adjustment, and an increase in credits is treated as a negative adjustment.
2. A reallocation adjustment relating to the credit grouping is placed into two separate subgroupings and will not be netted together nor will they be netted with other credit adjustments (except for other credit reallocation adjustments allocable to that partner or group of partners).
   1. A decrease in credits allocable to one partner or group of partners is treated as a positive adjustment generally in its own subgrouping.
   1. An increase in credits allocable to another partner or group of partners is treated as a negative adjustment generally in its own subgrouping and does not result in an IU and must be taken into account by the partnership in the adjustment year.

Creditable expenditure grouping – Any adjustment to a PRI where any person could take the item that is adjusted (or item as adjusted if the item was not originally reported by the partnership) as a credit (i.e., creditable foreign tax expenditure or qualified research expense), including a reallocation adjustment to a creditable expenditure, is placed in the creditable expenditure grouping.

Generally, a decrease in creditable expenditures is treated as a positive adjustment to credits, and an increase in creditable expenditures is treated as a negative adjustment.

A reallocation adjustment relating to creditable expenditure grouping is placed into two separate subgroupings and will not be netted together.

A decrease in creditable expenditures allocable to one partner or group of partners is treated as a positive adjustment to credits.

An increase in creditable expenditures allocable to another partner or group of partners is treated as a negative adjustment and does not result in an IU and must be taken into account by the partnership in the adjustment year.

Example: if the adjustment is a reduction of qualified research expenses, the adjustment is to a creditable expenditure grouping because any person allocated the qualified research expenses by the partnership could claim a credit with respect to their allocable portion of such expenses under section 41, rather than a deduction under section 174.

Residual grouping – Any adjustment to a PRI that doesn’t belong in the reallocation, credit, or creditable expenditure grouping is placed in the residual grouping. Also includes any adjustment to a PRI that derives from an item that would not have been required to be allocated by the partnership to a reviewed year partner under section 704(b), such as an adjustment to a liability amount on the balance sheet.

Creditable expenditure grouping – Any adjustment to a PRI where any person could take the item that is adjusted (or item as adjusted if the item was not originally reported by the partnership) as a credit (i.e., creditable foreign tax expenditure or qualified research expense), including a reallocation adjustment to a creditable expenditure, is placed in the creditable expenditure grouping.

1. Generally, a decrease in creditable expenditures is treated as a positive adjustment to credits, and an increase in creditable expenditures is treated as a negative adjustment.
2. A reallocation adjustment relating to creditable expenditure grouping is placed into two separate subgroupings and will not be netted together.
   1. A decrease in creditable expenditures allocable to one partner or group of partners is treated as a positive adjustment to credits.
   1. An increase in creditable expenditures allocable to another partner or group of partners is treated as a negative adjustment and does not result in an IU and must be taken into account by the partnership in the adjustment year.
   1. Example: if the adjustment is a reduction of qualified research expenses, the adjustment is to a creditable expenditure grouping because any person allocated the qualified research expenses by the partnership could claim a credit with respect to their allocable portion of such expenses under section 41, rather than a deduction under section 174.

Residual grouping – Any adjustment to a PRI that doesn’t belong in the reallocation, credit, or creditable expenditure grouping is placed in the residual grouping. Also includes any adjustment to a PRI that derives from an item that would not have been required to be allocated by the partnership to a reviewed year partner under section 704(b), such as an adjustment to a liability amount on the balance sheet.

Any adjustment that changes the character of a PRI is a recharacterization adjustment. A recharacterization adjustment will generally result in at least two separate adjustments in the appropriate grouping (reallocation, credit, creditable expenditure, or residual).

1. One adjustment reverses the improper characterization of the PRI that will result in a negative adjustment.
2. The other adjustment makes the proper characterization of the PRI and will result in a positive adjustment.
3. The adjustments that result from a recharacterization are generally placed into separate subgroupings.

If the effect of a partnership adjustment is reflected and taken into account in one or more other partnership adjustments, you may treat the adjustment amount as zero solely for purposes of computing the IU.

Step 2.

The second step in computing an IU is to determine if any proposed adjustment, within one of the four groupings, needs to be subgrouped. If all the proposed adjustments within any grouping are positive adjustments only, then subgrouping is not required for such grouping, and you can determine the IU at this point by plugging in the positive numbers to the above formula. If any of the proposed adjustments within a grouping is a negative adjustment, then subgrouping for that grouping is required. Each of the proposed adjustments will need to be subgrouped according to the following rules.

• Each adjustment is subgrouped according to how the adjustment would be required to be taken into account separately under section 702(a) or any other provision of the Code, regulations, forms, instructions, or other guidance prescribed by the IRS applicable to the adjusted PRI. For purposes of creating subgroupings, if any adjustment could be subject to any preference, limitation, or restriction under the Code (or not allowed, in whole or in part, against ordinary income) if taken into account by any person, the adjustment is placed in a separate subgrouping from all other adjustments within the grouping.
• Generally, each separate line item of Schedule K/K-1 or return schedule (i.e., Schedule L, etc.), represents a separate and distinct subgrouping. The format for Schedule K/K-1 generally follows the requirement of section 702(a) that each partner is required to take into account separately their distributive share of each class or item of partnership income, gain, loss, deduction or credit. Thus, adjustments to ordinary income must be placed in a different subgroup as capital gain income or interest income since each of those items is required to be separately stated under section 702(a).
• Separate line items on Schedule K/K-1 (or other schedules onForm 1065) may include multiple components making up the total shown. If any line item on Schedule K/K-1 or other schedules consists of multiple items and the components are required to be taken into account separately under the Code, regulations, forms, instructions, or other guidance prescribed by the IRS, then such line item must be further subgrouped. For example, if there is more than one type of income to be included on Schedule K/K-1, line 11, Other Income/(loss), the partnership is required to attach a statement to Form 1065 that separately identifies each type and amount of income for each distinct category and each of those would constitute a separate subgroup. As another example, if the Schedule K/K-1, line 1 ordinary income/(loss) entry includes income/loss from more than one trade or business activity, the partnership must identify on an attached statement to Schedule K/ K-1 the amount from each separate activity. Accordingly, the income/(loss) from each separate activity from Schedule K/K-1, line 1 would constitute a separate subgroup.
• The ordinary income/(loss) amount reflected on line 1 of Schedule K/K-1, is sourced from Form 1065, page 1 and is a net amount consisting of various page 1 line items of income and expenses. Although those separate page 1 line items are distinct items of income and expense, if they are appropriately netted and included on line 1, Schedule K/K-1, the net amount will be considered a single subgroup, unless such amount is required to be separately delineated, such as when the partnership has more than one trade or business as previously noted.
• If you have a negative adjustment along with a positive adjustment in the same line item of Schedule K/K-1, you must consider whether they may be properly netted at the partnership level and whether they are required to be taken into account separately by any partner because it may be subject to a limitation or preference under the Code before you can place them in the same subgroup.
• A negative adjustment that is not otherwise required to be placed in its own subgrouping must be placed in the same subgrouping as another adjustment if the negative adjustment and the other adjustment would have been properly netted at the partnership level and such netted amount would have been required to be allocated to the partners of the partnership as a single item for purposes of section 702(a) or other provision of the Code and regulations.

A partnership may request to subgroup adjustments in a manner other than the manner described above, such request is generally done in modification under §301.6225-2 after the issuance of the NOPPA. With that being said, you have discretion to review and grant such request based on the facts and circumstances and you must contact the BBA POC before agreeing to the request.

Any request must be supported by the facts and circumstances, such as partner-level information that a negative adjustment is not subject to a presumed preference, limitation, or restriction under the Code, or in fact allowed in full against ordinary income.

Step 3.

The third step in computing the imputed underpayment is to appropriately net all the proposed adjustments within each of the groupings and subgroupings.

• Netting means summing all adjustments together within each grouping or subgrouping, as appropriate.
• Positive adjustments and negative adjustments may only be netted against each other if they are in the same grouping or subgrouping. An adjustment in one grouping or subgrouping may not be netted against an adjustment in any other grouping or subgrouping. Adjustments from one taxable year may not be netted against adjustments from another taxable year.
• If any grouping only includes positive adjustments (i.e., there are no subgroupings for that grouping), all adjustments in that grouping are added together to come up with a sum of all net positive adjustments.
• All adjustments within a subgrouping are netted to determine whether there is a net positive adjustment or net negative adjustment for that subgrouping.
  • A net positive adjustment means an amount that is greater than zero which results from netting adjustments within a grouping or subgrouping. A net positive adjustment includes a positive adjustment that was not netted with any other adjustment. A net positive adjustment includes a net decrease in an item of credit.
  • A net negative adjustment means any amount which results from netting adjustments within a grouping or subgrouping that is not a net positive adjustment. A net negative adjustment includes a negative adjustment that was not netted with any other adjustment.

Step 4.

The fourth step is to compute the TNPA. The TNPA is the sum of all net positive adjustments in the reallocation grouping and the residual groupings.Each net positive adjustment with respect to a particular grouping or subgrouping in the residual or reallocation grouping that results after netting the adjustments is included in the calculation of the TNPA.

• Each net negative adjustment with respect to a residual or reallocation grouping or subgrouping that results after netting the adjustments is excluded from the calculation of the TNPA because those adjustments do not result in an imputed underpayment.

Step 5.

• The fifth step is to determine the highest rate in effect for the reviewed year under section 1 or 11.

Step 6.

• The sixth step is to determine the sum of net positive adjustments to creditable expenditure and credit groupings that will increase or decrease the product of the TNPA times the highest rate in effect.
• A net decrease to creditable expenditures is treated as a net positive adjustment to credits and increases the product of the TNPA times the highest tax rate in effect. A net increase to creditable expenditures is treated as a net negative adjustment that is excluded from the calculation of the TNPA and is an adjustment that does not result in an imputed underpayment.
• For the credit grouping, a net positive adjustment will increase the product of the TNPA times the highest tax rate in effect. A net negative adjustment, including net negative adjustments resulting from a credit reallocation adjustment, will be treated as an adjustment that does not result in an imputed underpayment, unless the examination team determines that it is appropriate to allow the net negative adjustment to credit to reduce the product of the TNPA times the highest tax rate in effect.

Step 7.

The seventh and final step is to compute the IU based on the results of steps 4 through 6 and insert those results into the IU formula identified above.

Examples

1. The AB Partnership’s 2019 return is under examination. Form 1065, page 1 consists of gross receipts of $1,000 and COGS of $250 for a net ordinary business income of $750 from a single activity. The $750 of net ordinary business income was included on Schedule K, line 1. The revenue agent proposes to increase gross receipts by $100 and increase COGS by $30. The $100 increase in gross receipts represents a positive adjustment while the increase in COGS represents a negative adjustment. Both of these adjustments are placed in the residual grouping since neither is properly classified as a reallocation, credit or creditable expenditure grouping. Since one of the adjustments is negative, subgrouping is required. The agent verified that AB Partnership netted the gross receipts and COGS as a single partnership-related item on Schedule K, line 1, and therefore, the negative adjustment for COGS will be subgrouped with the positive gross receipts adjustment. After netting these adjustments, the result is a net positive adjustment of $70 in the Schedule K, line 1 subgroup as well as a net positive adjustment in the residual grouping. The $70 will be included in the total netted partnership adjustment for purposes of computing the imputed underpayment.

2. The facts are the same as example 1 above, except the partnership’s operations included two distinct activities (“Activity A” and “Activity B”). The net income from each activity were separately stated on a statement attached to Form 1065. The audit adjustment to gross receipts of $100 (increase) was identified as being related to Activity “A” while the adjustment to COGS of $30 (increase) was identified as being related to Activity “B.” Again, both the positive adjustment to gross receipts of $100 and the negative adjustment of $30 to COGS are placed in the residual grouping. Since the separate net income from each activity are required to be separately stated on line 1 of Schedules K/K-1 (via an attached schedule), those amounts were not treated as a single partnership-related item for purposes of section 702(a) and were not allocated as a single item on the filed tax return as was proper. Therefore, each adjustment must be placed into a separate subgroup within the residual grouping. The two subgroups (within the residual grouping) could be identified as “Schedule K, line 1, Activity A” and “Schedule K, line 1, Activity B” or similar. Under the netting rules, netting adjustments across subgroups is not permitted and the positive $100 adjustment and the negative $30 adjustment may not be netted. Thus, the residual grouping contains a net positive adjustment of $100 (netting rules only allow positive adjustments to be added together in each grouping to arrive at a net positive adjustment). This amount will be included in the total net partnership adjustment for purposes of computing the imputed underpayment. The net negative adjustment of $30 is an adjustment that does not result in an imputed underpayment and must be included on the partnership’s tax return for the year in which such adjustment becomes final.For any reallocation adjustment, the IRS will include the name and TIN of the impacted partner and whether the allocation is “to” or “from” such partner.