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Civil FBAR Penalties: The Possible (Over)Breadth of Willfulness

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TaxNotes recently published an article by Baker Botts Partner Jon Feldhammer, Special Counsel Benjamin Koodrich, Senior Associate Benjamin Cohen-Kurzrock, and Associate Tyler Murray assessing the possible overbreadth of the foreign bank account report case law on civil willful penalties that may affect taxpayers who do not file an accurate and timely Financial Crimes Enforcement Network Form 114.

 

This article is republished in its entirety below:

 

In 2020 we undertook a substantial research project examining the Bank Secrecy Act’s (BSA) civil penalties for failure to file an accurate and timely Financial Crimes Enforcement Network Form 114, “Report of Foreign Bank and Financial Accounts.” Using that research, we published an in-depth overview of the IRS’s enforcement of these penalties and judicial trends across the country.1 Therein, we expressed our concern that enforcement trends suggest that even non-willful violators face an uphill battle to avoid severe willfulness penalties whenever the IRS detects even a minor or unintentional infraction. 

 

Subsequent developments in case law during the latter half of 2020 tend to confirm this concern. And we have not seen much movement by the courts in establishing precedent that distinguishes filers that make less serious foreign bank account reporting missteps.

 

Although several factors likely have contributed to this trend, the most relevant is that the IRS strategically focused on litigating the more egregious violations of the FBAR regime first in order to establish favorable case law on willful (as opposed to non-willful) violations of the BSA, which has had the effect of extending determinations to situations in which the filer’s missteps are much less severe. This means that the precedential foundation on which the IRS relies was built on filers who objectively warranted a penalty (for example, those who used foreign banks and financial accounts to evade taxes).3 These cases should carry less precedential value when applied to filers who, for example, are not guilty of tax evasion. Nevertheless, the IRS frequently leverages these decisions to convince courts that a filer willfully violated the BSA, even though the nature of the filer’s violation — whether viewed from the standpoint of the actual violation or the filer’s intent when it occurred — is less severe, especially relative to cases that involve egregious violations, like those regarding a filer’s effort to evade paying U.S. taxes.4

 

In doing so, the IRS typically persuades courts to apply the civil standard to define willfulness rather than the criminal standard. Its focus seems to be more on rolling forward this legal interpretation than on showing factual similarities to prior cases. This is problematic because the broad interpretation of “willfulness” that encompasses both willful blindness and recklessness arguably overextends the penalty’s reach, at least on an as-applied basis.5 Inferences from case law charging filers with knowledge of their returns once they are signed highlights the issue, as it effectively means that no filer under any circumstance can act negligently.6

 

From a strategic standpoint, this tactic is intuitive because the IRS’s litigation position and enforcement ability are strengthened each time it persuades a court to adopt its interpretation of the BSA. However, the IRS’s interpretation of willfulness, and the evidence that establishes it, is so broad that it effectively (1) makes the section 5321(a)(5)(C) penalty for willful violations the default penalty, rather than an exception for penalty enhancement; (2) obviates the default $10,000 penalty under section 5321(a)(5)(B)(i); and (3) eliminates the reasonable cause defense under section 5321(a)(5)(B)(ii) because virtually no case will fall under the non-willful penalty umbrella.7

 

Consequently, the IRS has arguably focused on establishing favorable case law to expand liability for FBAR penalties beyond what Congress intended.Its interpretation and application of section 5321(a)(5) functions to create surplus text under the BSA9 that allows it to use signed individual income tax returns as swords for proving willfulness. Ironically, the IRS has transformed an individual filer’s tax compliance (that is, filing his income tax return) into a tool for proving willfulness under the BSA. As previously stated, the IRS typically leverages the filer’s response to Schedule B, line 7a of his income tax return, regardless of whether that response is “yes” or “no,” to prove recklessness and willfulness. This approach reveals what appears to be the predominant view of the IRS when it comes to BSA enforcement — that is, a binary, strict-liability approach in which the filer is either liable for a willful violation or nothing at all.10

 

Not surprisingly, courts have started to notice the one-sided interpretation of the BSA asserted by the IRS, raising concerns that prior courts may have been wrongfully persuaded to extend the IRS’s interpretation too far. For instance, in Schwarzbaum, the Southern District of Florida heard and rejected the IRS’s argument that the filer’s signature on a tax return showed recklessness sufficient to establish a willful violation of the BSA.11 The court reasoned as follows:

 

Imputing constructive knowledge of filing requirements to a taxpayer simply by virtue of having signed a tax return would render the distinction between a nonwillful and willful violation in the FBAR context meaningless. . . . Applying the [government’s] suggested reasoning would lead to a draconian result and one that would preclude a consideration of other evidence presented.12

 

Shortly after the Schwarzbaum decision, in Jones, the Central District of California reiterated that “signing a tax return on its own cannot automatically make the taxpayer’s violation ‘willful’ as that would collapse the willfulness standard to strict liability.”13

 

The courts’ reasoning in both Schwarzbaum and Jones resonates with cases decided outside of the BSA.14 For example, imagine a taxpayer who files a timely income tax return but fails to report income appearing on a Form 1099-C, “Cancellation of Debt,” that the taxpayer received. If decided under the BSA, the IRS would likely assert and convince a court that the taxpayer’s mistake resulted in a willful violation, regardless of whether the taxpayer consulted a professional.15 And yet, when the Tax Court addressed this very scenario in Simonsen, it negated the penalty asserted by the IRS on the grounds that the taxpayer had reasonable cause.16 In Simonsen, the Tax Court explained that the use of return preparation software (like TurboTax) did not undermine the ability of the taxpayer — who was an attorney — to establish a reasonable cause defense or affect the complexity of the underlying legal or technical issue that led to the error and, as a result, helped establish the reasonable cause for that error.17 In the FBAR context, however, taxpayers have faced willful violations because of the software’s failure to prompt the taxpayer about the need to file the FBAR, despite their having answered “yes” to the question posed by Schedule B, line 7.18

 

Why, then, are violations under the BSA treated differently than those under the Internal Revenue Code? To date, the IRS has provided no principled answer to this question, and it may be hard for it to do so. FBAR rules are complicated with nuanced features that trigger a filing obligation that is distinct from a filer’s typical obligation to file an annual income tax return.19 Further, the obligations imposed by the BSA have only a limited connection to the obligations under the code, and neither set of laws cross-references the other, and despite the arguments made by the IRS, there are several legitimate barriers to filers appreciating their obligation to file an FBAR and the severity of not filing one.20 The placement and on-form instructions for line 7 (“Foreign Accounts and Trusts”) of Schedule B (“Interest and Ordinary Dividends”) illustrates this point well because it seems intuitive that filers would read the form’s title without appreciating the FBAR trap lurking within, especially for years preceding 2019, when the IRS revised Schedule B to include a bolded warning about the possibility of substantial FBAR penalties resulting from the failure to file the form when required to do so.21

 

Compliance with these complicated filing requirements remains a challenge for most filers (and the IRS), not because of attempts to hide assets, but because filers are simply unaware of the requirements and are unable to untangle the knot of laws because of the lack of clear, easy-to-follow guidance.22 Outside of hiring professional help, which might not be possible in some cases and certainly is not required to show reasonable cause, there is also limited authoritative guidance for filers to rely on because courts have a history of disregarding the IRS’s own internal guidance outlined in the Internal Revenue Manual and form instructions, even in the context of FBAR reporting.23 Even when professional help is around, mistakes may still occur and then get repeated in subsequent years.24 These issues are not new either, as tax professionals, and even the IRS, have complained about them since at least 2010.25 These realities underscore the importance of interpreting the BSA in a manner that preserves its statutory integrity.26 Pragmatically, given the large and growing compliance gap in international reporting, courts and the IRS alike should read the BSA as it was written and maintain the rich and meaningful distinctions between each penalty possibility under the BSA. This is necessary to prevent injustice.

 


 

Jon Feldhammer is a partner and Benjamin Koodrich is special counsel at Baker Botts LLP in San Francisco.  Benjamin Cohen-Kurzrock is a senior associate and Tyler Murray is an associate at Baker Botts LLP in Houston.

 

1 Jon D. Feldhammer et al., “Civil FBAR Penalties: Overview and Trends,” Tax Notes Federal, Sept. 14, 2020, p. 2009.
In fact, on December 4, 2020, the U.S. District Court for the Eastern District of Pennsylvania vacated its decision on remand from the Third Circuit and, in turn, expanded its interpretation of the willfulness standard to include “reckless conduct considered from an objective point of view.” See Bedrosian v. United States, No. 2:15-cv-05853, slip op. at 6 (E.D. Pa. 2020) (Bedrosian III). It is important to avoid a one-size-fits-all approach that subjects more than the most severe violations to the willfulness penalty, which is a risk given the inclusion of “willful blindness” and “recklessness” within willfulness. 
Feldhammer et al., supra note 1, at 2013 (trend no. 5).
At least in some respects, the IRS’s success in establishing legal standards applicable to cases involving civil penalties for violating FBAR reporting obligations has exceeded even its own expectations. See, e.g., ILM 200603026 (As it relates to evidentiary issues, “we expect that a court will find the burden in civil FBAR cases to be that of providing ‘clear and convincing evidence,’ rather than merely a ‘preponderance of the evidence.’”).
See, e.g., Norman v. United States, 942 F.3d 1111 (Fed. Cir. 2019); Bedrosian v. United States, 912 F.3d 144, 153 (3d Cir. 2018) (Bedrosian II); United States v. Williams, 489 F. App’x 655 (4th Cir. 2012) (unpublished). Recklessness is shown by a taxpayer failing to “comply with an IRS filing requirement when he or she ‘(1) clearly ought to have known that (2) there was a grave risk that [the filing requirement was not being met] and if (3) he was in a position to find out for certain very easily.’” Bedrosian II, 912 F.3d at 153 (citing United States v. Carrigan, 31 F.3d 130, 134 (3d Cir. 1994) (quoting United States v. Vespe, 868 F.2d 1328, 1335 (3d Cir. 1989))) (alterations in original).
See, e.g., Feldhammer et al., supra note 1, at 2011 n.6. Although other articles deal with the standard for the burden of proof applicable to civil FBAR penalty cases, an important point concerning statutory interpretation has surfaced in recent cases such as Jones v. United States, No. 2:19-cv-04950 (C.D. Cal. 2020), and United States v. Schwarzbaum, No. 9:18-cv-81147 (S.D. Fla. 2020): If signing an income tax return with Schedule B, line 7a, checked evidences willful blindness or recklessness in any meaningful way, then the knowledge imputed on the filer by case law may be — and has been by the IRS — construed as effectively reading out of section 5321 the situations in which alleged violations are non-willful or excused because of the reasonable cause defense.
Under 31 U.S.C. section 5321(a)(5)(B)(ii), the reasonable cause exception applies only when the IRS pursues the default penalty for a non-willful violation under 31 U.S.C. section 5321(a)(5)(B)(i). Nevertheless, as a practical matter, the arguments made by filers to avoid the imposition of a willful penalty under 31 U.S.C. section 5321(a)(5)(C) are similar to reasonable cause arguments. See, e.g., Schwarzbaum, No. 9:18-cv-81147, at *9 (negating the willful violation penalty based on an argument underlying a typical reasonable cause defense under the code).
8 This does not, however, mean that previously decided cases would have produced different results, because the IRS cherry-picked the more egregious cases to establish case law that bears fruit when applied to less egregious cases. Feldhammer et al., supra note 1, at 2012-2013 (“Many reported FBAR decisions involve cases with egregious facts, consistent with a litigation strategy by the IRS to establish favorable precedent. . . Those bad facts laid the groundwork for case law that is adverse to filers. It might also be impeding the ability of more recent courts . . . to differentiate between the truly willful conduct that existed in some early decisions and the more justifiable errors that have appeared in later cases.”).
If Congress intended to conflate the standard, it would have expressly included a recklessness standard within the willfulnes subpart of 31 U.S.C. section 5321(a)(5), just as it articulated other levels of culpability — from willful to negligent — in that section. See 31 U.S.C. section 5321(a)(5)-(6). Thus, the plain language has a limited hook for subjecting an individual filer to the most severe punishment for a willful violation because of “willful blindness” or “recklessness” when he should have been aware of (as opposed to having known of) a substantial or unjustifiable risk that a violation of the BSA would result from his conduct. This matters because of the overlap between negligence and recklessness: Arguably, the level of risk is the same under both standards, but the awareness or knowledge of the risk differs. 
10 See, e.g., United States v. Horowitz, 361 F. Supp. 3d 511, 529 (D. Md. 2019) (relying heavily on the filer’s responses to Schedule B, line 7).
11 Schwarzbaum, No. 9:18-cv-81147, at *8.
12 Id.
13 Jones, No. 2:19-cv-04950, at *9.
14 The reasonable cause exception under 31 U.S.C. section 5321(a)(5)(B)(ii) is interpreted in pari materia with the reasonable cause exception under sections 6651 and 6664. See, e.g., Jarnagin v. United States, 134 Fed. Cl. 368, 376 (2017); and Moore v. United States, No. 2:13-cv-02063, at *4 (W.D. Wash. 2015).
15 See, e.g., United States v. Ott, No. 2:18-cv-12174, at *6 (E.D. Mich. 2019) (holding that the taxpayer further acted recklessly toward his reporting obligations because “he chose to rely solely on advice he received decades ago concerning foreign investments”); see also Williams, 489 F. App’x at 660 n.6 (unpublished); Horowitz, 361 F. Supp. 3d at 525-529.
16 Simonsen v. Commissioner, 150 T.C. 201, 203-205, 217 (2018) (holding that the taxpayer had reasonable cause for improperly reporting a home’s sale, even though the taxpayer admitted that reporting the sale on the return was a “little tricky” and required her to upgrade her free version of TurboTax, which she did not do). Under the code, reasonable cause does not require a taxpayer to seek professional assistance in preparing a tax return. See, e.g., Robinson v. United States, No. 93-860-civ-J-10, at *4 (M.D. Fla. 1995) (“However, consultation with a tax advisor is not necessary to establish reasonable cause.”); Alba v. United States, No.80-764 C(2), at *2 (E.D. Mo. 1980) (“A taxpayer should not be penalized because necessity requires him to be his own tax advisor.”).
17 Simonsen, 150 T.C. at 203-205, 217. The case does not stand alone; the Tax Court has repeatedly forgiven taxpayer errors arising out of an honest misunderstanding of fact or law that was reasonable under the circumstances. See, e.g., Comenout v. Commissioner, T.C. Memo. 1982-40, at 411, aff’d, 746 F.2d 1484 (9th Cir. 1984) (“After considering the entire record, we are convinced that petitioner’s failure to file income tax returns for 1975 and 1976, and his failure to comply with applicable rules and regulations, was due to a sincere (albeit erroneous) belief that his smokeshop income was exempt from tax under the Treaty.”).
18 See, e.g., United States v. Clemons, No. 8:18-cv-258-T-36SPF (M.D. Fla. 2019).
19 “The federal tax treatment of an entity does not affect the entity’s requirement to file an FBAR. FBARs are required under a Bank Secrecy Act provision of Title 31 and not under any provisions of the Internal Revenue Code.” IRS, “IRS Reference Guide on the Report of Foreign Bank and Financial Accounts (FBAR)”; see also Treasury, “A Report to Congress in Accordance With Section 361(b) of the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001,” at 3 n.3 (Apr. 24, 2003).
20 See generally 31 U.S.C. Subt. IV, ch. 53, Subch. II.
21 Compare, e.g., 2018 Form 1040, “Schedule B, Interest and Ordinary Dividends” (“See instructions”), with 2019 Form 1040, “Schedule B, Interest and Ordinary Dividends” (“Caution: If required, failure to file FinCEN Form 114 may result in substantial penalties. See instructions.”).
22 In Bedrosian v. United States, No. 2:15-cv-05853, *3 (E.D. Pa. 2017) (Bedrosian I), the court acknowledged that no definitive authority established the standard for “willful” conduct; rather, “authorities ranging from various federal courts, the Internal Revenue Manual, and the Office of Chief Counsel for the Internal Revenue Service reach different conclusions about the level of intent necessary to satisfy the willfulness requirement.”
23 For example, in Norman, the Federal Circuit specifically refused to be bound by language in the IRM requiring willfulness to be shown by the filer’s “knowledge of the reporting requirements and the person’s conscious choice not to comply with the requirements.” Norman, 942 F.3d at 1115.
24 If this occurs, defensive arguments that analogize to Herrera v. Commissioner, T.C. Memo. 2015-251, and Thomas v. Commissioner, T.C. Memo. 2013-60, might be available to counsel. In these situations, overplaying the knowledge that a taxpayer has of the accuracy of his income tax return is not only counterfactual, but borders on charging the taxpayer with knowing the answers to complex, mixed questions of fact and law (and not just tax law at that). Indeed, modern individual income tax returns are recognized as being complex documents with countless technical questions and forms that quickly grow to the size of a small (annually published) book if there is any genuine level of economic complexity. Thus, in most cases, errors are, at worst, much better characterized as negligent, not reckless.
25 See, e.g., New York State Bar Association, “Report on Qualified Intermediary and Related Withholding and Information Reporting Legislation Proposed by the Administration,” 41-43 (2010) (“Achieving that clarity is very difficult under the current [FBAR] system. . . . [There is a] lack of adequate guidance on the application of FBAR filing requirements.”); and IRS, “Internal Revenue Service Advisory Council 2010 Public Report,” at 75 (2010) (stating that FBAR filing requirements are “confusing and extremely overbroad”).
26 Based on current case law in the civil FBAR arena, it seems entirely possible that the Fifth, Ninth, and Eleventh circuits will provide the most fruitful ground for interpreting 31 U.S.C. section 5321(a)(5) in a manner that avoids the IRS’s strict liability view. See Schwarzbaum, No. 9:18-cv-81147; United States v. Flume, No. 5:16-00073 (S.D. Tex. 2018); United States v. Pomerantz, No. 2:16-cv-00689 (W.D. Wash. 2017); and United States v. Zwerner, No. 1:13-cv-22082 (S.D. Fla. 2014).

 

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