This is coming up a lot in my discussions with clients. So here’s the story (as delivered from the IRS).
What the boss said
Go look at the March 23, 2009 memo from Linda E. Stiff, Deputy Commissioner for Services and Enforcement, titled “Authorization to Apply Penalty Framework to Voluntary Disclosure Requests Regarding Unreported Offshore Accounts and Entities.” (PDF; you have been warned).
The important part is here:
If, (a) the taxpayer did not open or cause any accounts to be opened or entities formed, (b) there has been no activity in any account or entity (no deposits, withdrawals, etc.) during the period the account/entity was controlled by the taxpayer, and (c) all applicable U.S. taxes have been paid on the funds in the accounts/entities (where only account/entity earnings have escaped U.S. taxation), then the penalty in (3) is reduced to 5%.
There are three components to this requirement:
What the FAQ says
The FAQ for this stuff is FAQ #46:
Q46. A taxpayer moved to the U.S. in 2007 and is now a permanent resident of the U.S. The taxpayer had a requirement to file an FBAR for one year but failed to do so. Is the taxpayer subject to a penalty equal to 20 percent of the account?
A46. First, the taxpayer should confirm that the taxpayer had an FBAR filing requirement. Assuming that the taxpayer was required to report the interest earned on the account during the year the taxpayer was in the U.S. and failed to do so, the taxpayer is subject to a penalty based on the high account balance during the year. The penalty may be limited to five percent if the taxpayer did not avoid U.S. tax with respect to the deposits and if the account was passively held during the year the taxpayer was in the U.S. If there was no unreported taxable income related to the unreported foreign accounts that would have been reported on the FBAR, the taxpayer will not be subject to the 20 percent offshore penalty. In that case, the taxpayer should file delinquent FBARs attaching a statement explaining why the FBAR was not timely filed. For more information, see Q&A 9.
Emphasis added for your easy reading pleasure.
This is obtuse as hell.* That language “unreported taxable income related to the unreported foreign accounts that would have been reported on the FBAR . . . .” What does that mean? Does it mean the money deposited into the account–the principal? Or the account earnings on that principal?
What we’re hearing
Well, I can relay some second-hand information about what the IRS thinks it means.
We’ve heard that Revenue Agents are saying that the 5% penalty should be disallowed because there were deposits to the accounts during the time frame in question — and those deposits were the crediting of interest on inert accounts. They’ve also said that there were withdrawals which disqualified the accounts – where those withdrawals were normal bank fees.
[Insert expletive here.]
I haven’t had that experience firsthand; these are reports from other lawyers I know who have cases like this.
If this indeed is the operating procedure for the IRS, then the number of accounts for which the 5% penalty will apply = zero. Please show me a bank account that does not accrue interest and is not assessed a bank fee.
And if that is the case then IRS management has dangled a carrot in front of the taxpayers which no one can reach. This is the government’s equivalent of the “never-pay insurance policy.” (YouTube).
The IRS just doesn’t know what to do. It went out to catch tuna (the big bad tax evaders putting away millions of dollars at UBS) and killed a bunch of dolphins (the ordinary people living ordinary lives with trivial amounts of unreported income). Now it is finally dawning on them that they have a potential PR disaster on their hands. How to back down from publicly uttered threats without looking toothless and weak?
* A direct quote from one of my clients: “Why is virtually everything from the IRS so murky and badly written?” I think it was a rhetorical question. 🙂 But Amen, brother.