Foreign Mutual Funds Lead to Willful Penalties for FBAR Filing Error
Sometimes, the interest earned through foreign mutual funds and investment accounts can result in income taxpayers don’t realize they have. These earnings are often reinvested automatically. If you and your accountant are not careful, an error in disclosing your foreign mutual fund income could result in bigger problems, such as willful penalties for FBAR filing errors.
Tax on Foreign Mutual Funds Reveals FBAR Filing Error
Richard Collins worked internationally as a professor in the U.S., Canada, and France. He had bank accounts in each country to receive his earnings. He opened a Swiss bank account in the 1970s, and periodically transferred the funds from his income and later pensions into the account. Collins moved to the U.S. in 1994, but continued his Swiss banking practices. By 2007 the account was worth more than $800,000.
Collins never reported his foreign bank accounts to the IRS. Then, in 2010, Collins applied to the now-defunct Offshore Voluntary Disclosure Program (OVDP). At that time the applicable OVDP penalty was 20% of the high year-end aggregate balance over a six-year period. His accountant helped him file amended returns for 2002 through 2009. However, because he had sustained a large capital loss in 2002, those amended returns yielded modest refunds with no new tax owed. Collins withdrew from the OVDP rather than pay the 20% penalty, triggering an audit, a strategy then called “opting out.”.
The audit revealed something new: Collins’s Swiss assets had been invested in foreign mutual funds. That meant they were subject to additional taxes on passive foreign investment companies. Collins’s tax preparer hadn’t accounted for that, so his amended returns were short $71,324 in taxes over three years, plus penalties.
Then in June 2015, the IRS determined that, because he had withdrawn from the OVDP, Collins was subject to willful failure penalties for his FBAR filing error. After applying mitigation, the IRS assessed a penalty of $308,064 for 2007 and 2008, in addition to the late taxes and penalties on the foreign mutual funds income. When Collins failed to pay the new penalties, the IRS sued for collection. The District Court agreed with the IRS that Collins’s behavior was willful, finding a “decades-long course of conduct, omission and scienter” (intent) in failing to disclose his foreign accounts.
Appeals Court Upholds Willful Penalty for FBAR Filing Error
The base penalty for a failure to disclose foreign financial accounts on a Report of Foreign Bank and Financial Accounts (FBAR) is $10,000 per year. However, if the IRS determines that the FBAR filing error was “willful” the penalty increases to up to 50% of the balance of the account at the end of the tax year. In this context, “willfulness” is broader than an intentional act. Recklessness, or conduct that entails an “unjustifiably high risk of harm that is either known or so obvious that it should be known,” can support a willful penalty as well.
On appeal, Collins challenged whether his FBAR filing error was “willful” to trigger the higher penalty. He said that by voluntarily correcting his tax returns and applying for the OVDP, he demonstrated his FBAR filing error was “a simple honest mistake, rather than willfulness.” He pointed out that neither he nor his accountant or his tax lawyer believed he owed any tax prior to the audit. He made prompt payments on the passive foreign investment company tax once it was discovered, which he said also showed “good faith compliance inconsistent with willfulness.” He also argued that he could not have been expected to know about the filing requirement since his experienced accountant was not aware of it and thought it was new.
When the District Court heard the case, it found that, as a sophisticated taxpayer, Collins was aware his foreign accounts existed and intentionally managed the accounts to avoid disclosure, including avoiding receiving mail in the U.S. and “discreetly” transferring funds to the U.S. The District Court said this showed “an actual intent to deceive” and Collins’ explanations for the decisions were “objectively unreasonable.”
The Court of Appeals agreed. It noted that Collins repeatedly checked “no” on Schedule B of his tax returns, stating he had no signature authority over a foreign financial account. At the same time he was “managing investments worth hundreds of thousands of dollars in his French, Canadian, and Swiss accounts.” The Court found “Collins did not plausibly claim he should not have known about the FBAR filing requirement.” The Court also noted that a voluntary correction does not negate a willful violation. Similarly, a subjective belief that Collins owed no overdue taxes was “at best, tangential to the core inquiry of a [FBAR] violation.” Based on this, the Court affirmed the lower court’s finding as to willfulness.
Can Taxpayers Discover the IRS’s Calculation of an FBAR Penalty?
Discovery is the fact-finding phase of every civil lawsuit. It involves the exchange of information and documents so that both parties have the opportunity to prepare for trial. Collins argued that he had a right to discovery into internal IRS discussions on how his FBAR penalty was calculated.
Collins was not charged the maximum 50% penalty for his willful FBAR filing error. The IRS revenue agent calculated the balances and maximum penalties, but then applied mitigation according to the Internal Revenue Manual. When this mitigated penalty was still “excessive” given the facts and circumstances, she reduced the mitigated penalty by an additional 50%, for an overall reduction of 75% below the maximum penalty.
During discovery, the magistrate judge issued a protective order, shielding the IRS from turning over information about “the opinions, conclusions, and reasoning of government officials.” The District Court said that discovery was unnecessary because the “fundamental documents” for calculating the penalty had already been produced, and the revenue agent who calculated the FBAR penalty testified at trial. But Collins wanted to examine the supervisor who overruled an earlier lower penalty as well. The Court of Appeals said this was not appropriate. The supervisor had acted according to the Manuals’s guidelines, so Collins was not prejudiced by the limits placed on his discovery of the IRS’s calculations discussions. Finding no error, the Court of Appeals affirmed the willful penalty for FBAR filing errors, along with interest incurred during the appeal.
Collins didn’t think he was doing anything wrong. His accountant didn’t realize his foreign mutual funds were accruing taxes, or that he needed to file annual FBARs. But when those FBAR filing errors caught up with him, even the mitigated willful penalty ended up costing him hundreds of thousands of dollars. If you have investments overseas, be sure to work with accountants familiar with international tax issues, or you might find yourself making the same mistakes.
Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 35 years experience. If you have questions regarding FBAR filing errors, contact Joe Viola to schedule a consultation.