Appeals Judges Disagree Over Maximum Willful FBAR Penalty

Appeals Judges Disagree O…

The question of just how expensive a willful penalty for failing to report foreign financial accounts has been making its way through the federal court systems. Now, the Second Circuit has issued a split opinion that shows just how divided judges are over the maximum willful FBAR penalty.

The History of the Bank Secrecy Act

When the Bank Secrecy Act (BSA) was first passed in 1970 it was targeted at financial institutions, not taxpayers. The original law authorized the Secretary of Treasury to create and enforce reporting regulations. However, the resulting penalties -- up to $1,000 per violation -- could only be imposed on “domestic financial institutions” and their agents, not individuals. The Secretary issued a regulation in 1972 echoing the BSA and creating the first FBAR penalties.

1986 Amendment Turns the Focus on Taxpayers

In 1986, in response to concerns over money laundering, Congress amended the BSA. It added a civil penalty that could be levied against taxpayers for willfully failing to file FBAR forms. The maximum willful FBAR penalty was 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.”

In 1987, the Secretary sent out a new regulation (the 1987 Regulation) updating its policies to once again match the BSA’s language.

2004 Statute Increases Maximum Willful FBAR Penalty

In 2002, the Secretary of Treasury told Congress that as many as 1 million U.S. taxpayers had a foreign financial account overseas with a balance above $10,000 -- the reporting threshold. But less than 20% of those taxpayers were filing annual FBARs. Two years later, Congress amended the BSA again. It changed the requirements for the original penalty, setting the amount to $10,000, and removing the willfulness requirement. This allowed the IRS to assess non-willful FBAR penalties. It also added a section that said:

“(C) Willful violations -- In the case of any person willfully violating, or willfully causing any violation of, any provision of [the reporting requirements]

(i) the maximum penalty under subparagraph (B)(i) shall be increased to the greater of--

(I) $100,000, or

(II) 50 percent of the [balance of the account at the time of the violation.]”

Statute vs Regulation: The Arguments

Unlike the last two times the BSA had changed, the IRS never updated its regulations after the 2004 statute was passed. Now, the 1987 regulation still sets the maximum willful FBAR penalty at $25,000 or the balance of the account up to $100,000 (whichever is greater), but the 2004 Statute moved the cap far higher. The IRS has been assessing higher maximum penalties for years. In recent years, tax attorneys across the country have begun to argue that it cannot do that until it updates its regulation. But the IRS says the 2004 Statute replaced the regulation without the Secretary needing to do anything.

There have been federal court rulings in favor of both the IRS (finding that the 2004 Statute controls) and the taxpayers (finding that the IRS is bound by its regulations). Now, the issue has made its way to the United States Circuit Court, Second Circuit, where it appears the judges are just as divided over the issue.

Second Circuit Judges Divided Over Maximum Willful FBAR Penalty

The recently decided U.S. v Kahn put this dispute before the United States Court of Appeals for the Second Circuit, which includes New York. Harold Kahn failed to report two Swiss bank accounts with a combined balance of over $8.5 million in 2008. When Kahn died without paying the penalty, the IRS sued his estate to collect. Everyone involved agreed that Kahn’s failure to disclose his foreign financial accounts was willful. But his personal representative argued that the 1987 IRS’s regulation capped the maximum willful FBAR penalty at $200,000, while the IRS was trying to collect over $4.2 million from the estate.

U.S. District Court Judge Kiyo A. Matsumoto had sided with the IRS, saying that by amending the statute, Congress had superseded the prior IRS regulation. On appeal, the Circuit Court split. Two judges, Kearse and Bianco, agreed with Matsumoto, but Judge Menashi dissented, saying that the regulation was still valid.

Majority Says the 2004 Statute’s Mandatory Increase Superseded the Regulation

The two-thirds majority decision in Kahn was focused on one word in the 2004 Statute: “shall.” Those judges found that when Congress passed a law saying the maximum penalty “shall be increased” to $100,000 or 50% of the balance of the account, that mandatory increase necessarily swept up the 1987 regulation in its wake. The binding opinion of the court was that the Secretary could not continue to be bound by an earlier regulation that did not also increase the maximum willful FBAR penalty, because doing so would be stretching the IRS’s discretion too far, making that “shall” meaningless.

Dissent Refuses to Excuse IRS for Relaxed Approach to Updating Regulations

Judge Menashi filed a dissenting opinion, siding with the taxpayers. Menashi applied the “shall be increased” language to the lower non-willful maximum penalty contained in the 2004 Statute, rather than the earlier version of the maximum willful FBAR penalty.

Judge Menashi believed that while the 2004 Statute did increase the maximum willful FBAR penalty the IRS could impose, it did not contain any language restricting the Secretary’s discretion over whether to do so. Under the statute, the Secretary could have chosen not to impose any penalty at all. In Menashi’s view, moving the cap still allowed the Secretary to set the internal limits anywhere below that limit. Until the Secretary went through the process to update her regulations, the IRS was bound to follow them.

As a dissenting opinion, Menashi’s reasoning won’t help future taxpayers in the Second Circuit. They will continue to face FBAR penalties in the millions in spite of the IRS’s “relaxed approach to updating regulations” which even the majority opinion recognized. Unless the Supreme Court decides to take up the issue, the Kahn decision will excuse the IRS from even considering the effect of such substantial maximum willful FBAR penalties on taxpayers and their families.

Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 30 years of experience. If you have questions regarding maximum willful FBAR penalties, contact Joe Viola to schedule a free consultation.