Taxpayers who acquire, inherit, or hold a (non-U.S.-located) foreign financial asset can trigger tax reporting obligations. For policy reasons, the U.S. federal government defines foreign financial asset broadly. Consequently, a single foreign financial asset may trigger one or more U.S. tax reporting obligations. Part I of this two-part series covers the situation where a taxpayer has both unreported foreign financial assets and unreported income from those assets.
This Part II covers the situation where a taxpayer has only unreported foreign financial assets. Taxpayers in this second situation typically ask three questions:
- Does an IRS voluntary disclosure program exist for taxpayers who paid all tax on income from foreign financial assets but failed to file required Reports of Foreign Bank and Financial Accounts (FBAR) during those years?
- Since the IRS Streamlined Filing Compliance Procedures require unreported income for eligibility, does another IRS voluntary disclosure program cover unreported foreign financial assets that did not generate unreported income?
- If the IRS has not yet contacted you about delinquent FBARs or international information returns, then what risks and penalties potentially apply?
Penalties & Programs for Unreported Foreign Financial Assets
Due to organizational and public pressures, the IRS increasingly targets taxpayers who fail to file required FBARs, international information returns, or both. Part I briefly touches on the FBAR crackdown, which ranges from enhanced penalties to greater litigation. For international information returns, the IRS Large Business and International (LB&I) Division leads the crackdown. As of August 9, 2021, the LB&I webpage openly proclaims that taxpayers with undisclosed assets will be targeted for IRS audits due to noncompliance. Once targeted by the IRS, a taxpayer with unreported foreign financial assets may face failure-to-file and other penalties.
Penalties deter violators, represent the “stick” to foreign financial asset reporting, and advance key U.S. federal government policies. Policy-wise, penalties incentivize information sharing used for investigating international money laundering schemes, identifying tax evasion, and conducting counter-terrorism intelligence operations by forcing taxpayers to choose between paying massive fines or reporting foreign financial assets. Even though penalty amounts depend on the facts and circumstances, U.S. taxpayers who fail to file a required FBAR or international information return risk incurring criminal and civil penalties.
For instance, the civil penalty for each willful, i.e., reckless or intentional, FBAR violation is the greater of $100,000 (USD) or 50 percent of the balance amount in the account(s) at the time of the violation. The $100,000 (USD) minimum civil penalty is adjusted annually for inflation and, in 2020, is $129,210 (USD) per willful violation. Although the FBAR penalty is “per violation,” whether per violation means per undisclosed account or per unfiled form depends on—among other things—the IRS auditor, the U.S. district court, and the U.S. federal circuit court of appeals whose jurisdiction the taxpayer is subject to. Depending on the international information return involved, the typical civil penalty assessed for each continuing, i.e., repeated or uncorrected, violation can be assessed up to $50,000 (USD).
Voluntary disclosure programs serve as the “carrot” to foreign financial asset reporting. Part I covers the Streamlined Filing Compliance Procedure (SFCP). The SFCP is an IRS voluntary disclosure program available to individuals or estates with unreported foreign financial assets and unreported income from those assets. Here, the relevant IRS voluntary disclosure programs are the Delinquent International Information Return Submission Procedures (DIIRSP) and the Delinquent FBAR Submission Procedures (DFSP). U.S. taxpayers who failed to file a required FBAR or other international information return and have no unreported income from a foreign financial asset should consider the DIIRSP, the DFSP, or both.
Delinquent International Information Return Submission Procedures
Historically, eligible taxpayers filing under the DIIRSP could reduce risks related to civil penalties and criminal prosecution. Although penalties can still theoretically be assessed in accordance with normal IRS procedures, the practical effect of filing under the DIIRSP is typically to reduce the taxpayer’s exposure to failure-to-file and late filing penalties.
To file under the DIIRSP, U.S. taxpayers must satisfy four eligibility criteria:
- The taxpayer must have not filed a required international information return, such as a Form 3520, 5471, 8621, 8865, 8938, etc.
- The taxpayer must have reasonable cause for failing to timely file the information return(s).
- The taxpayer must not be under a civil examination or criminal investigation by the IRS.
- The taxpayer must not have been contacted by the IRS about the delinquent international information return(s). Notably, unlike the SFCP—which limits eligibility to individual or estate taxpayers only—the DIIRSP is available to individuals, estates, trusts, corporations, and not-for-profit organizations that meet all four eligibility criteria listed above.
Taxpayers seeking DIIRSP-specific benefits must comply in two ways. First, these taxpayers must prepare delinquent international information returns, attach those to an amended return, and file according to the applicable amended return instructions. Second, if a taxpayer believes reasonable cause exists for the failure to file or late filing, then they also may attach a reasonable cause statement to each delinquent international information return for which reasonable cause is asserted. Reasonable cause is a term of art with several overlapping yet distinct standards. Typically, whether reasonable cause exists for a taxpayer’s failure to file or late filing depends on (i) which information return is delinquent, (ii) which reasonable cause standard applies, and (iii) whether the taxpayer’s facts fall within that standard. Importantly, the IRS may assess penalties on a taxpayer’s DIIRSP filing without considering the attached reasonable cause statement during processing. If applicable, the statement may still save the taxpayer money in accounting or attorney fees for responding to IRS penalty correspondence through resubmitting reasonable cause information.
Like the SFCP, complying with the DIIRSP raises risks and brings benefits. For risks, amended filings under the DIIRSP (i) can still be selected for IRS audit through the existing audit selection processes in place for any tax or information return, and (ii) may still result in penalties for failure to file or late filing. For benefits, amended filings under the DIIRSP (i) do not automatically get selected for IRS audit, (ii) start the three-year statute of limitations clock on tax years that otherwise failed to start the clock due to omissions of required international information returns, and (iii) can reduce the taxpayer’s exposure to failure-to-file as well as late filing penalties.
Delinquent FBAR Submission Procedures
In addition to—or separate from—the DIIRSP, eligible taxpayers filing under the DFSP can minimize or eliminate FBAR failure-to-file penalties. This penalty relief is potentially significant as the statute of limitations for FBARs is six years rather than the general three-year rule for most tax items.
To file under the DFSP, U.S. taxpayers must satisfy four eligibility criteria. First, the taxpayer must have not filed a required FBAR. Second, the taxpayer must not be under a civil examination or criminal investigation by the IRS. Third, the IRS must not have already contacted the taxpayer about either the delinquent FBARs or the years for which the delinquent FBARs are submitted. Fourth, the taxpayer must have properly reported on her, his, or its U.S. tax returns—and paid all tax on—the income (if any) from the foreign financial accounts reported on the delinquent FBARs. Importantly, like the DIIRSP, the DFSP is available to individuals, estates, trusts, corporations, and not-for-profit organizations that meet all four eligibility criteria listed above.
Taxpayers seeking DFSP-specific benefits must comply in three ways. First, taxpayers must prepare delinquent FBARs for electronic filing (e-filing) on the Financial Crimes Enforcement Network’s (FinCEN) website. If you, your company, or your organization are unable to file electronically, then consider contacting FinCEN’s Regulatory Helpline at 1.800.949.2732 (if calling from inside the U.S.) or 1.703.905.3975 (if calling from outside the U.S.) to determine possible alternatives to e-filing. Second, when filing the delinquent FBARs, taxpayers must select a reason for filing late on the cover page of the electronic form. Third, taxpayers must draft a brief reasonable cause-type statement explaining why the FBARs are filed late.
When compared to the DIIRSP, complying with the DFSP raises similar—yet slightly different—risks and benefits. For risks, like the DIIRSP, filings under the DFSP can still be selected for IRS audit through the existing audit selection processes in place for all tax and information returns. Unlike the DIIRSP, however, filings under the DFSP can receive stronger protection against IRS penalties for failure to file so long as the taxpayer meets all four eligibility criteria. For benefits, filings under the DFSP (i) do not automatically get selected for IRS audit, (ii) start the three-year statute of limitations clock on years that otherwise never started the clock due to the taxpayer’s failure to file the required FBAR(s), and (iii) can offer strong protection from failure-to-file as well as late filing penalties.
Readers should remember three things about foreign financial asset reporting:
- Taxpayers are required to file FBARs and international information returns, e.g., Forms 3520, 5471, 8621, 8865, 8938, etc., once the applicable reporting thresholds are crossed.
- Taxpayers with a reporting obligation and unreported foreign financial assets may indefinitely expose themselves to criminal as well as civil penalties since tax returns filed without a required information report and not falling within an exception never start the three-year statute of limitations clock on IRS penalty assessments.
- Taxpayers who reported income from all foreign financial assets and are not yet under IRS examination or criminal investigation but failed to file required international information returns for those assets, wish to reduce or avoid costly penalties, and have not been contacted by the IRS about the delinquent international information returns or FBARs should consider the DIIRSP, the DFSP, or both.
Readers also should take away three observations about the DIIRSP and the DFSP.
- Although both are IRS voluntary disclosure programs, the DIIRSP covers non-FBAR international information returns whereas the DFSP specifically covers FBARs.
- Taxpayers interested in just the DIIRSP must meet four DIIRSP-specific eligibility criteria, taxpayers interested in just the DFSP must meet four separate DFSP-specific eligibility criteria, and taxpayers interested in both programs must separately meet each one’s eligibility rules.
- Unique risks and benefits exist to filing under the DIIRSP, the DFSP, or both.
Contact your BKD Trusted Advisor™ or submit the Contact Us form below to determine whether the DIIRSP, the DFSP, or both are appropriate for you, your organization, or your company. If you have unreported foreign financial assets and unreported income from those assets, consider reading Unreported Foreign Financial Assets? Part I: Consider Streamlined Filing Compliance Procedures.