Willfulness and the Civil FBAR Penalty
In 2008, when it was revealed that wealthy individuals around the world were utilizing accounts and trusts in Liechtenstein to evade taxes, the United States initiated a coordinated effort with foreign governments to combat tax evasion through the use of offshore trusts and accounts. The U.S. Department of Justice (DOJ) has since launched criminal investigations of several foreign banks, many of which are ongoing.
In 2013, the DOJ announced an amnesty program for Swiss banks, which requires that the participating banks provide information related to their American clients and pay penalties related to the number of the undisclosed accounts at issue and the values in those accounts. Roughly one-third of all Swiss banks joined the program. Banks already under criminal investigation, such as Credit Suisse and HSBC, were not eligible for the program. 1
Most notably, the United States passed the Foreign Account Tax Compliance Act (FATCA), requiring foreign financial institutions to provide information related to their American account holders. To date, Intergovernmental Agreements have been reached with more than fifty countries to implement FATCA, including many countries historically regarded as U.S. tax havens.
Another successful effort by the U.S. has been the Offshore Voluntary Disclosure Program (OVDP), which allows those with previously undisclosed foreign accounts to come into compliance and, in most cases, pay a set civil penalty in exchange for immunity from criminal prosecution or more substantial civil penalties. The 2009 and 2011 programs led to 33,000 voluntary disclosures and the collection of $5 billion in taxes, interest, and penalties. 2 The procedures and penalty structures associated with the 2012 program ended on June 30, 2014. Taxpayers entering into the OVDP after July 1, 2014 will be required to comply with the new OVDP procedures announced on June 18, 2014. Though these new procedures are substantially similar to those associated with the 2012 program, there are some additional document requirements and an increased penalty structure for taxpayers with accounts at a specified list of financial institutions.
Congress passed the Bank Secrecy Act of 1970 (BSA) in an effort to crack down on commonly utilized strategies to evade taxes or conceal criminally obtained funds. One requirement of the BSA is that those who have $10,000 or more in a foreign account at any time during the year file a Report of Foreign Bank and Financial Accounts (FBAR). 3 The failure to file an FBAR can have both civil and criminal consequences. Under 31 USC § 5321, the Service can assess a penalty of up to $10,000 for each non-willful failure to file an FBAR. If the failure is willful, then the maximum penalty is increased to the greater of $100,000 or 50% of the amount in the account at the time of the violation. The willful failure to file an FBAR is also a crime, punishable by a prison term of up to 10 years and a fine of up to $500,000. 4
The authority to assess civil FBAR penalties has been designated to the IRS by Congress. The Internal Revenue Manual (IRM) explains the criteria used by the IRS to determine the amount of this penalty, or whether a penalty is appropriate at all. The penalty amount is largely determined by whether the taxpayer’s conduct was willful or non-willful. While there are upper limits on the amount of penalties that can be imposed, there is no floor. This means that the IRS is not required to impose a penalty if they determine that an FBAR violation occurs. The IRM instructs Revenue Agents to exercise discretion in determining whether to assess penalties or issue a warning letter instead (Letter 3800).
Penalties should be asserted only to promote compliance with the FBAR reporting and recordkeeping requirements. In exercising their discretion, examiners should consider whether the issuance of a warning letter and the securing of delinquent FBARs, rather than the assertion of a penalty, will achieve the desired result of improving compliance in the future. 5
For a long time, there was very little guidance from the courts regarding how the willfulness element should be applied in FBAR cases. The line of cases discussed below has shed some light on how courts will apply the requirement. Notably, none of the on-point cases decided thus far are binding, because Williams is unpublished, while McBride, Sturman, and Zwerner are district court decisions. These cases involve several important issues, including (1) the government’s burden for proving willfulness; (2) whether willful blindness or recklessness are sufficient; and (3) how aggressive the IRS can be in imposing multiple willful penalties.
The Government’s Burden for Proving Willfulness
In tax cases, there is generally a presumption of correctness regarding an additional tax assessment by the IRS, which places the burden on the taxpayer to prove that the taxes and tax penalty assessed are incorrect. 6 However to assess a willful FBAR penalty, the IRS has the burden of establishing that the taxpayer’s failure to file was willful.
For similar civil penalties, such as the civil fraud penalty associated with incorrectly reported income tax, the IRS must prove their case by clear and convincing evidence. As such, the IRS and taxpayer advocates expected that a willful FBAR penalty would have to be proved by the same standard. However, in the line of cases listed above, the courts have used the lower, preponderance of the evidence standard to uphold willful civil FBAR penalties. Particularly, the court in McBride, following the United States Supreme Court’s reasoning in Herman & MacLean v. Huddleston7, determined that the preponderance of the evidence standard was appropriate when only money, rather than the taxpayers’ “particularly important individual interests or rights,” were at issue. This means that the government can support a willful FBAR penalty with a lower standard of evidence than is needed to prove a civil fraud penalty.
Distinguishing Between Willfulness, Willful Blindness, and Recklessness
Willfulness has been defined by the courts as a “voluntary, intentional violation of a known legal duty.” 8 The legal duty under 31 U.S.C. § 5314 requires United States persons to report their financial interests that have an aggregate of $10,000 or more in foreign financial accounts by filing an FBAR. Since willfulness is a state of mind for which there is rarely any direct evidence, it must usually be proven circumstantially. Courts evaluate the taxpayer’s conduct and draw inferences therefrom.
However, using the doctrine of “willful blindness”, the courts thus far have not even required the government to prove that a taxpayer had actual knowledge of the legal duty to file an FBAR. Under the doctrine of “willful blindness,” a taxpayer is willful if he or she purposely sought to avoid knowledge. This was first applied in the FBAR context in Sturman9, a 1991 Sixth Circuit opinion that upheld a criminal conviction for willful failure to file an FBAR. In this case, the defendant argued that the government had failed to show he was actually aware of the FBAR filing requirements. He admitted that he was aware of and failed to answer the question on line 7a of Schedule B of his Form 1040, concerning whether or not he had signature authority over or financial interest in a foreign bank account. The court held that “evidence of acts to conceal income and financial information, combined with the defendant’s failure to pursue knowledge of further reporting requirements as suggested on Schedule B, provide a sufficient basis to establish willfulness on the part of the defendant.” Other evidence of Sturman’s willfulness included skimming money from a U.S. adult entertainment business and depositing those funds into Swiss bank accounts through the use of multiple transactions and corporations, providing false information to federal authorities, and destroying documents.
In Williams10, the taxpayer opened two Swiss bank accounts in the name of Alqi, a British Corporation. Between 1993 and 2000, he deposited more than $7,000,000 into the accounts, earning more than $800,000 in interest. For each of these years, he failed to disclose his interest in the account by filing an FBAR or to report his income from the accounts on his tax returns. By the fall of 2000, the government had discovered his Swiss accounts and had the Swiss authorities freeze them.
Eventually, Williams pled guilty to one count of conspiracy to defraud the government, in violation of 18 U.S.C. § 371, and one count of tax evasion under 26 U.S.C. § 7201. In his allocution, he stated, “I also knew that I had the obligation to report to the IRS and/or the Department of the Treasury the existence of the Swiss accounts, but for the calendar year tax returns 1993 through 2000, I chose not to in order to assist in hiding my true income from the IRS and evade taxes thereon, until I filed my 2001 tax return.”
After Williams finally filed his FBARs for 1993 through 2000, the IRS assessed two $100,000 willful civil FBAR penalties against him for 2000 11. When Williams refused to pay the penalties, the IRS brought an enforcement action against him. Williams argued that he could not have willfully failed to file his 2000 FBAR, because by the time it was due, the government already had knowledge of his Swiss accounts and had put a freeze on them. In a rare taxpayer victory, the district court agreed with him, holding Williams “lacked any motivation to willfully conceal the accounts from authorities” because the authorities were already aware of them, and his failure to file an FBAR “was not an act undertaken intentionally or in deliberate disregard for the law, but instead constituted an understandable omission given the context in which it occurred.”
Nevertheless, on appeal, the Fourth Circuit reversed the district court’s decision as clearly erroneous. As part of their reasoning, the court applied the doctrine of willful blindness, holding that even if Williams had not read line 7a of Schedule B or consulted the instructions for the FBAR, he had made a “conscious effort to avoid learning about the reporting requirements.” As further proof of Williams’ willful blindness, the government offered a copy of a tax organizer Williams had filled out for his return preparer, in which he answered “no” when asked whether or not he had an interest in any foreign bank accounts.
Williams is equally noteworthy for its positions regarding constructive knowledge of the reporting requirements and reckless conduct. The Williams court held that when a taxpayer signs a return, he or she declares under penalty of perjury to have “examined this return and accompanying schedules or statements” to make sure that the return is “true, accurate, and complete.” Consequently, when a taxpayer signs a return, “he or she is charged with constructive knowledge of its contents.” Those contents include line 7a on Schedule B, which asks whether the taxpayer had a financial interest in or signature authority over any financial account in a foreign country, at any time during the year. If the answer is yes, the taxpayer is instructed to review the instructions and filing requirements for the FBAR. Williams testified at trial that he had not read line 7a of Schedule B or “paid attention to any of the written words.”
Citing the United States Supreme Court case of Safeco Insurance Co. of America v. Burr, the Williams court also noted that “[w]here willfulness is a statutory condition of civil liability, it is generally taken to cover not only knowing violations of a standard, but reckless ones as well.” 12 Accordingly, Williams established that recklessness can satisfy the element of willfulness in civil FBAR cases. Such conduct can be inferred from actions such as signing a tax return without reading the instructions, failing to provide honest answers, and avoiding learning the reporting requirements. In its holding, the court said it was “convinced that, at a minimum, Williams’s undisputed actions establish reckless conduct, which satisfied the proof requirement under § 5314.”
Since Williams was an unpublished opinion, it cannot be cited as legal precedence. Many tax professionals viewed the case as an aberration. Less than four months later, however, the United States District Court for the District of Utah issued its opinion in McBride13 which seemed to affirm several aspects of the Williams‘ court’s interpretation of the willfulness element, including applying preponderance of the evidence as the burden of proof, and also accepting both willful blindness and recklessness as alternatives to proof that the taxpayer had actual knowledge of the reporting requirement.
The defendant in McBride was a U.S. citizen who was a partner in an LLC that sold cell phone accessories imported from Taiwan. After signing lucrative contracts with several U.S. retailers, McBride sought advice from Merrill Scott and Associates (Merrill Scott) on how to avoid or defer taxes. Merrill Scott introduced him to a potential strategy referred to as the “Financial Master Plan,” which involved the use of foreign entities and accounts. While meeting with Merrill Scott, McBride received several pamphlets discussing how the plan could affect U.S. tax reporting requirements. One of the pamphlets stated that “U.S. citizens are subject to specific U.S. reporting requirements for interests in foreign corporations, trusts and bank accounts.” It further stated, “As a U.S. taxpayer, the law requires you to report your financial interest in, or signature authority over, any foreign bank account…[and] intentional failure to comply with the foreign account reporting rule is a crime and the IRS has means to discover such unreported assets.”
Merrill Scott also gave him a legal opinion prepared by an estate firm, which McBride would learn was controlled by Merrill Scott. Craig Taylor, who was the accountant for McBride’s business partner, sent McBride a memo detailing his concern about the plan and enclosing a newspaper article discussing how foreign bank accounts were often used for tax evasion and other fraudulent activity. Nonetheless, McBride did not seek independent legal counsel and went forward with the plan. Merrill Scott established multiple foreign entities, with associated bank accounts. McBride also negotiated an arrangement between his company and the Taiwanese manufacturer, whereby the manufacturer would increase its price, thus decreasing the profit for McBride’s business. The excess amount paid to the manufacturer would then be rerouted to one of the foreign entities created for McBride by Merrill Scott, in the form of loans.
When having his tax returns prepared, McBride never told his accountants about his involvement with Merrill Scott or mentioned that he might have an interest in any foreign entities or accounts. Consequently, line 7a on his Schedule B had the “No” box checked in response to the question asking about foreign bank accounts.
In 2004, the IRS began an examination of McBride related to his participation in the Financial Master Plan. During the course of the examination, McBride refused to provide certain documents to the Revenue Agent and denied having any knowledge about the plan. He also refused to submit FBARs for 2000 or 2001. Eventually, the Revenue Agent assessed willful penalties of $100,000 for both 2000 and 2001 ($25,000 per account per year).
The District Court ultimately found that McBride’s failure to file FBARs was willful on various grounds. They held that when McBride signed his returns under penalty of perjury, he had constructive knowledge of the contents therein, including the false statement on Schedule B. Further, they identified a long list of facts demonstrating that, even if he did not have actual knowledge of the filing requirements, he had recklessly disregarded the obvious risk that he was violating the law. This included the memo that he had received from his partner’s accountant in 1999, his decision not to seek independent counsel, his failure to disclose the plan to either of the accountants who prepared his tax returns, and his own admission that his initial impression of the Financial Master Plan was that it constituted “tax evasion.”
Despite agreeing with the Williams court on the issues of constructive knowledge and recklessness, the court ultimately found that McBride had actual knowledge of the FBAR filing requirement. Facts supporting this conclusion include the fact that he read the pamphlets received from Merrill Scott detailing reporting requirements for U.S. citizens, contradictory statements made during trial and the discovery process, and his evasive course of conduct in dealing with the Revenue Agent during the examination.
An interesting aspect of McBride was that the Revenue Agent assessed penalties of $25,000 per account ($100,000 total) per year, which is less than the $100,000 per account per year maximum allowed by law. One explanation is that the Revenue Agent may have mistakenly thought that $100,000 is the maximum FBAR penalty that can be assessed against a taxpayer per year. Many in tax community interpreted it as evidence that the IRS would not be overly aggressive in asserting FBAR penalties. As will be seen in Zwerner14 two years later, however, that was not necessarily the case.
Zwerner and the Assessment of Multiple Maximum Penalties in a Single Year
Carl Zwerner, an 87 year old businessman and banker, set up a foundation in Liechtenstein, which held a bank account in Switzerland. Over the years, Zwerner would visit Europe “a couple of times a year” and would take money with him to deposit into the account, always in increments smaller than $10,000, which can be considered a crime in and of itself. Beginning in the 1990s, he would withdraw funds to use while on vacation in Europe. In 2006, the account was transferred to a new foundation. According to Zwerner, this was done on the advice of family law counsel, in order to conceal the funds from his wife during their divorce.
From the time that the account was established until 2008, Zwerner neither reported the income earned from the accounts nor disclosed the existence of the accounts through the filing of an FBAR. Zwerner had only told his wife and children about the account. According to him, the account was “as far as I was concerned my secret account. And I didn’t mention it to anybody. Even my lawyer of 40 years.” He instructed the bank not to send him records pertaining to the account, because “it was a secret account. A private account.”
Each year, Zwerner’s accountant sent him a questionnaire to complete for his tax return. One of the questions asked, “Did you have an interest in or signature authority over a financial account in a foreign country, such as a bank account, securities account, or other financial account?” Zwerner answered “No.” Another question asked whether he had any foreign income during the year, to which he also answered “No.” According to Zwerner, he did not realize at the time that his answers to these questions were inaccurate. Since he did not have signature authority over the account and his financial interest flowed through an entity, he believed that he had answered the questions honestly.
In 2008, Zwerner hired an attorney, who recommended that he make a voluntary disclosure to the IRS. The attorney met with IRS Criminal Investigations and discussed the facts related to Zwerner’s account, though there are no records of his attorney ever disclosed his identity to the IRS, which is a prerequisite to making a voluntary disclosure. After being told that a criminal investigation would not be initiated, Zwerner filed FBARs and amended tax returns for 2001-2007. These filings triggered an audit in 2010.
Zwerner attempted to join the 2011 Offshore Voluntary Disclosure Initiative, but was told that he was ineligible due to his ongoing audit. Eventually, the Revenue Agent determined that Zwerner had willfully failed to file FBARs for 2004 through 2007 and asserted a penalty of 50% of the year-end balance in the account – the maximum allowed by law – for each of the years. This resulted in a total penalty of $3,090,000, which far exceeded the amount that Zwerner held in the account. The jury in the Southern District of Florida ultimately upheld the assessments for 2004-2006, but did not feel the IRS met its burden of establishing willfulness for 2007.
At trial, Zwerner accused the Revenue Agent of “unrealistic aggression” and misconduct, specifically accusing him of falsely promising to reduce penalties in exchange for Zwerner signing a letter admitting that he “had [an] FBAR filing requirement and he should have reported the account.” Further, Zwerner argued that the IRS policy had traditionally been to impose only a single penalty, even in cases where the taxpayer does not voluntarily disclose and is criminally convicted. In a December 2013 meeting of the American Bar Association Tax Section, John McDougal of the IRS Office of Chief Counsel stated, “You’re not seeing heavy-duty FBAR penalties…where the taxpayer is cooperative.” The Revenue Agent conceded that Zwerner was cooperative during the audit.
Defense counsel argued that one of the reasons the FBAR penalties were excessive was because the amount of taxes that Zwerner failed to pay during the years at issue totaled $80,025, only a small fraction of the FBAR penalties assessed against him. The IRS denied this argument and said that Congress’s determinations about what range of fines are appropriate should be entitled great deference. While the issue of willfulness was decided by the jury, the parties settled the case before the court could decide the issue of whether the assessment in this case violates the Eighth Amendment’s prohibition against excessive fines.
With the increased focus on offshore account compliance and the implementation of FATCA, U.S. taxpayers can expect to see an increase in FBAR penalty cases and the development of new and evolving case law in this area. One implication for taxpayers and tax advisors involves the ability to “opt out” of the 27.5% penalty structure of the Offshore Voluntary Disclosure Program, in favor of traditional audit procedures. While the IRS has mostly been reasonable in its handling of opt out cases so far, Zwerner raises concerns and may give the IRS the support it needs to take a more aggressive stance in its assertion of civil FBAR penalties. Before a taxpayer makes the irrevocable decision to opt out, it is important to seek the counsel of a qualified attorney who can analyze the particular facts and circumstances of the case and advise as to whether there is a risk of having willful penalties assessed.
2 http://www.irs.gov/uac/IRS-Says-Offshore-Effort-Tops-$5-Billion,-Announces-New-Details- on-the-Voluntary-Disclosure-Program-and-Closing-of-Offshore-Loophole.
331 C.F.R. Part 103.
431 U.S.C § 5322.
5IRM 4.26.16 (emphasis added).
6See Welch v. Helvering, 290 U.S. 111, 115 (1933).
7459 U.S. 375, 389 (1983).
8 United States v. Pomponio, 429 U.S. 10, 13 (1976).
9 United States v. Sturman, 951 F.2d 1466, 1476 (6 th Cir. 1991).
10 United States v. Williams, 489 Fed. Appx. 655 (4 th Cir. 2012) (unpublished).
11 For years 1993-1999, the Statute of Limitations had already expired.
12 Safeco Ins. Co. of America v. Burr, 551 U.S. 47, 57 (2007).
13 United States v. McBride, 908 F. Supp. 2d 1186 (D. Utah 2012).
14 United States v. Zwerner, Case No. 13-22082-CIV-ALTONAGA/O’Sullivan.