international tax lawyer minnesota

Sourcing of Income

The sourcing of income has very important tax consequences for U.S. and foreign taxpayers.  The IRS taxes U.S. taxpayers on all income, from any source derived; however, U.S. taxpayers will be relieved of double taxation and may utilize the foreign tax credit in many circumstances involving non-purely domestic taxation. Foreign taxpayers, on the other hand, will usually only pay U.S. taxes on income sourced in the U.S. Thus, the source of income rules are critical to determining where a taxpayer will pay applicable taxes. This article will examine both income sourced inside the U.S. and foreign-source income.

Income Source Determination

In order to determine the sourcing of income, income realized is first placed into certain categories (such as interest, dividends, rent, sale of property, etc.). At times, an item of income may overlap into more than one possible category, in which case, specific IRS rules will likely clarify the proper classification. Once income is categorized, income source rules will then be applied in order to ascertain whether the income is U.S. or foreign-source. As a rule of thumb, income will be either U.S. or foreign-source depending upon where property is located, or where the income was realized, however there are many exceptions to this principle.

Income Source Examples

In this section, common income categories such as dividends, interest, personal services income, rents and royalties, and sales or exchanges of property, and their income sourcing rules will be briefly explained (other common income source rules not detailed here apply to software income, and transportation and communications income).

Dividends

Generally speaking, dividends received from U.S. (domestic) corporations are considered to be U.S.-source income. The fact that a domestic corporation may be distributing dividends derived from overseas operations usually will not matter for these purposes.

Conversely, dividends paid by a foreign corporation will generally be deemed foreign-source income. An important exception to this rule occurs in situations where a foreign corporation earns 25% or more of its gross income from income effectively connected with a U.S. trade or business for the three years immediately preceding the year of the dividend payment. In this case, that percentage of the dividend will be treated as U.S.-source income.

Interest

Interest income received from domestic corporations, the U.S. government and state governments, and non-corporate U.S. residents (among others) are deemed U.S.-source income.
There are some exceptions to this rule. For example, income will is deemed to be foreign-source if interest is received from a U.S. corporation which, over the prior three-year period, earned 80% or more of its active business income from foreign sources.

Personal services income

Personal services income includes such items as salaries, wages, fees, commissions. The location of where the services are performed will usually determine whether the personal services income is U.S. or foreign-source.

There are some exceptions to this general rule, including a limited commercial traveler exception for short business trips and de minimus amounts.

Rents and Royalties

For income received from the use of tangible property, the location of the property will determine its income sourcing. Other factors, such as where the property was manufactured, are not considered.

For income received for the use of intangible property (e.g. patents, copyrights, goodwill, etc.), in general, the location of where the property was used will determine its income sourcing.

Sale or Exchange of property

In general, the source of income relating to disposition of real property will depend upon the location of the property.

Broadly speaking, the sale of personal property (i.e, stocks, securities, equipment, inventory, intangible assets) will depend upon the residence of the seller. However, there are various exceptions to this rule. For example, if a item of purchased inventory is sold, the location of the sale will determine its income source.

Tax Treaty versus Regular Sourcing of Income Rules

Under certain circumstances, the sourcing source of an item of income or deduction could be changed by the provisions of a treaty. However, taxpayers claiming this benefit will need to file their tax return along with Form 8833.

Contact Sherayzen Law Office

This is a general overview of the taxation rules relating to sourcing of income. There are many other complex issues that may apply, depending upon the circumstances. Do you have questions concerning taxes relating to your international transactions or income? Sherayzen Law Office can assist you with these matters. Call (952) 500-8159 to set up a consultation today.

2011 Offshore Voluntary Disclosure Initiative vs. Statute of Limitations

As I already described in an earlier article, the IRS instituted a new voluntary disclosure program, called 2011 Offshore Voluntary Disclosure Initiative (“OVDI”). One of the most problematic areas under OVDI is the length of the examination period.

Agreeing to assessment of taxes and penalties for all voluntary disclosure years is part of the resolution offered by the IRS for resolving offshore voluntary disclosures. The OVDI disclosure period is 2003 through 2010 – eight years in total.

This contrasts greatly with the general three-year statute of limitations for IRS examination. Therefore, a tax attorney should consider all options prior to engaging in OVDI in order to avoid subjecting his client to unnecessary penalties.

One of the major factors in electing quiet disclosure versus OVDI is considering whether one or more of the numerous exceptions to the general IRS statute of limitations may apply. For example, if the IRS can prove a substantial omission of gross income, the statute of limitations is likely to be expanded to six years. Moreover, if there was a failure to file certain information returns, such as Form 3520 or Form 5471, the statute of limitations will not have begun to run. If the IRS can prove fraud, there is no statute of limitations for assessing tax. In addition, the statute of limitations for asserting FBAR penalties is six years from the date of the violation, which would be the date that an unfiled FBAR was due to have been filed. See 31 U.S.C. § 5321(b)(1).

Obviously, other factors should be considered before the decision to engage into OVDI is made. The chief factor would of course be the likelihood of criminal prosecution if the taxpayer fails to make use of OVDI. Engaging in voluntary disclosure pursuant to OVDI virtually eliminates possibility of criminal prosecution.

These factors aside, though, close analysis of the IRS statute of limitations is one of the most important considerations of whether to engage in OVDI.

Contact Sherayzen Law Office NOW!

Sherayzen Law Office can help. Our international tax firm has guided our clients throughout the United States through a voluntary disclosure process, making sure that the rights of our clients are protected and they pay only fair taxes and penalties.

Failure to Conduct Voluntary Disclosure: Possible Penalties

The IRS just instituted a new voluntary disclosure program for taxpayers who have offshore accounts or assets and who failed to properly report them to the IRS and pay appropriate U.S. taxes. It is called 2011 Offshore Voluntary Disclosure Initiative (“2011 OVDI”). While 2011 OVDI is not available for everyone and some particular circumstances of a case may determine whether it is advisable to go through this program, this new voluntary disclosure program offers a great chance for taxpayers to bring their tax affairs in order and virtually eliminate the possibility of criminal prosecution.

However, what may happen if a taxpayer who should have voluntarily disclosed his offshore income and assets, but fails to do so through 2011 OVDI and the IRS discovers the noncompliance through later examination? This article addresses the common types of penalties that a taxpayer may be subject to in cases where IRS identifies noncompliance with U.S. tax laws before the taxpayer goes through the voluntary disclosure process.

Penalties in General

In general, if the IRS finds out that a taxpayer is not in compliance with U.S. tax laws and fails to voluntarily disclose his offshore assets and foreign bank accounts, the taxpayer may be subject to severe civil and criminal penalties. In additional to accuracy related penalties, the fraud-related penalties, FBAR penalties, and foreign asset reporting penalties (with interest) may be imposed. Combined, all of these penalties and interest may exceed the actual value of nondisclosed assets and foreign bank accounts. In the worst-case scenario, a criminal prosecution may be launched against the noncompliant taxpayers.

Finally, the voluntary disclosure process – which would otherwise be a far less painful way to deal with this problem – is automatically unavailable for taxpayers as soon as they are under civil examination of the IRS.

Let’s discuss the penalties in detail.

Accuracy-Related and Failure to File and Pay Penalties

An accuracy-related penalty on underpayments is imposed under IRC § 6662. Depending upon which component of the accuracy-related penalty is applicable, a taxpayer may be liable for a 20 percent or 40 percent penalty.

If a taxpayer fails to file the required income tax return, a failure to file (“FTF”) penalty may be imposed pursuant to IRC § 6651(a)(1). The penalty is generally five percent of the balance due, plus an additional five percent for each month or fraction thereof during which the failure continues may be imposed. The total penalty will not exceed 25 percent of the balance due.

If a taxpayer fails to pay the amount of tax shown on the return, a failure to pay (“FTP”) penalty may be imposed pursuant to IRC § 6651(a)(2). The penalty may be half of a percent of the amount of tax shown on the return, plus an additional half of a percent for each additional month or fraction thereof that the amount remains unpaid, not exceeding the total of 25 percent of the balance due.

Fraud Penalties

Fraud penalties may imposed under IRC §§ 6651(f) or 6663. Where an underpayment of tax, or a failure to file a tax return, is due to fraud, the taxpayer is liable for penalties that may essentially amount to 75 percent of the unpaid tax.

FBAR Penalties

Read this article discussing the penalties that may be imposed as a result of a taxpayers failure to file the FinCEN Form 114 formerly Form TD F 90-22.1 (Report of Foreign Bank and Financial Accounts, commonly known as an “FBAR”).

Other Penalties

Depending on a particular fact pattern, additional penalties may be imposed for failure to file Form 926, 3520, 3520-A, 5471, 5472, and 8865.

Criminal Prosecution

In the worst-case scenario, a criminal prosecution may be launched by the IRS. Huge penalties and potential jail time are the possible in case of tax evasion.

Contact Us to Let Us Help You

Sherayzen Law Office can help. We are a tax firm based in Minnesota who has helped taxpayers throughout the United States to disclose offshore assets, foreign bank accounts and unreported foreign income to the IRS, avoiding the nightmare scenarios for our clients.

For many taxpayers, 2011 OVDI is a chance to become compliant, avoid substantial civil penalties and generally eliminate the risk of criminal prosecution. A voluntary disclosure also provides the opportunity to calculate, with a reasonable degree of certainty, the total cost of resolving all offshore tax issues.

If you believe that you may not be in full compliance with U.S. tax laws, the worst course of action is to do nothing and wait for the IRS to discover your noncompliance. Once this happens, your options are likely to be severely limited and the penalties a lot higher. Therefore, call or e-mail us NOW to let us help you with your tax problems. Remember, all calls and e-mails are confidential and attorney-client privileged.

International Tax Lawyers | Passive Foreign Investment Company

Congress enacted the Passive Foreign Investment Company provisions (PFIC) as part of the Tax Reform Act of 1986 in order to deter U.S. investors from deferring or avoiding payment of U.S. taxes by investing in offshore entities. The PFIC rules are structured to provide a disincentive for U.S. investors to defer investment income taxes by owning passive investments in foreign companies that do not regularly distribute their earnings. If it is determined that a U.S. investor is a PFIC shareholder, there can be severe tax implications for the taxpayer.

U.S. taxpayers who are shareholders of PFIC are likely to pay a significant additional tax on realized gains from sales of PFIC shares, and on PFIC dividends that meet the definition of “excess distributions” (an “excess distribution” applies to gains or distributions that exceeds 125% of the average distributions for the previous three years, or less if applicable). In both cases, the tax is applied at the taxpayer’s ordinary income tax rate, regardless of whether capital gains rates would typically apply. Further, an interest charge may be imposed, to offset the years of tax deferral in holding the offshore investment. As an additional disincentive, PFIC shares may not receive a stepped-up cost basis at the shareholder’s death.

Definition of a PFIC and Two-Part Test

In general, a foreign corporation that is determined to be neither a “controlled foreign corporation” (CFC) as defined in IRC section 957, nor a “foreign personal holding company” (FPHC) as defined in IRC section 552, will be determined to be a PFIC if it includes at least one U.S. shareholder and meets either one of the two tests found in IRC section 1297. If at least 75% or more of its gross income is passive income (based upon investments as opposed to operating income), or if at least 50% of the average percentage of its assets are investments that produce, or are held for the production of passive income, the foreign corporation will meet the definition of a PFIC. Passive income generally includes interest, dividends, rents, capital gains, and similar items. There is no requirement of ownership of a certain minimum percentage of shares, as there is with CFCs or FPHCs. Thus, if the test is met, PFIC status will apply, even if a shareholder owns a minimal percentage of shares with no ability to influence the business decisions of the company.

The PFIC rules apply to each U.S. person (the precise definition of who constitutes U.S. person is beyond the scope of this article, but it may become an issue in many situations) rerarding who a shareholder of a PFIC is. PFIC rules, however, do not apply to foreign shareholders or the foreign corporation itself. PFICs may include different types of entities such as various investment vehicles and foreign-based mutual funds.

Two options are commonly suggested by the U.S. tax lawyers to the shareholders in order to avoid PFIC taxation burden: Qualified Election Fund and Mark-to-Market. Both of these options, however, have their own peculiar characteristics and impose different types of tax obligations on the shareholders.

Qualified Electing Fund

In general, U.S. shareholders who own shares either directly or indirectly in a PFIC may be able to avoid the burdensome standard PFIC taxation provisions by electing to treat the PFIC as a Qualified Electing Fund (QEF) on Form 8621. Shareholders making this annual election are taxed on their pro rata share of the PFIC’s ordinary earnings as ordinary income, and their pro rata share of the net capital gains as long-term capital gain. A shareholder’s basis in the stock of a QEF is increased by the earnings included in gross income and decreased by a distribution from the QEF to the extent of previously taxed amounts. Finally, U.S. shareholders interested in making this election must also be able to obtain the required information from the PFIC.

While treating a PFIC as a QEF may be beneficial in that it allows taxpayers to opt out of the standard PFIC tax and interest rules, it also forces shareholders to pay taxes currently on undistributed income earned by a foreign corporation. Thus, QEF may be of limited use to taxpayers who lack adequate liquidity to pay taxes. Another important point about a QEF is that, due to the complexity of the rules and possible additional tax amounts, if the decision is made to elect QEF treatment of PFIC, it may be advisable to elect a QEF in the first year of holding an offshore investment.

Mark-to-Market

Another option for U.S. shareholders of a PFIC (who do not elect to treat a PFIC as a QEF), is to elect the mark-to-market method. This election is only available if the shares are considered “marketable stock”. Marketable stock is regularly traded stock with an ascertainable value on recognized exchanges as defined in the IRC regulations. If the shareholder elects to mark the stock to market, he will annually report, as ordinary income, the amount equal to any excess of the fair market value (FMV) of the PFIC stock as of the close of the taxable year over the adjusted basis of the shares (i.e. as if the shares had actually been sold at FMV). If the adjusted basis of the PFIC shares exceeds its FMV as of the close of the taxable year, the shareholder may generally deduct an ordinary loss (subject to certain statutory limitations).

Shareholders who directly own shares in a PFIC electing the mark-to-market method may increase their adjusted basis in PFIC shares through income recognized, and decrease the adjusted basis through deductions taken.

Conclusion

The tax issues surrounding PFICs are very complex and should be handled by a tax professional. Sherayzen Law Office can help you analyze your tax situation, determine whether PFIC rules apply, identify the alternatives in light of your whole tax situation, and implement the tax strategy most suited to your business and investment needs.

Call NOW to discuss your tax situation with an experienced tax lawyer!

Preventing the Disaster: Understanding When to File the Report on Foreign Bank and Financial Accounts (FBAR)

Despite the potentially grave consequences, many U.S. taxpayers are completely unaware of the extensive reporting requirements under the Bank Secrecy Act, particularly of the disclosure of ownership or other interest in or authority over financial accounts in a foreign country by filing the Report of Foreign Bank and Financial Accounts (the “FBAR”). While one can often fault the desire for secrecy on the part of the taxpayers or insufficient diligence of their tax advisors, it seems that the greater part of the blame for this failure should be ascribed to the ever-increasing scope of the reporting requirements (for example, see increasing disclosure requirements and new penalties imposed under Title V of the Hiring Incentives to Restore Employment Act). A person with a foreign account of only $10,500 is unlikely to imagine that he needs to file every year unfamiliar additional paperwork by a date which usually does not coincide with the rest of his tax filings. Nor is this person likely to forward to his tax advisors any information about the account. Given the severe penalties for non-compliance, however, the tax practitioners must be able to alert their clients to the FBAR requirements. This is precisely the purpose of this essay – to clarify for tax attorneys and other tax advisors the situations in which their clients need to file the FBAR. First, I will discuss the definition of “U.S. persons” who may need to file FBARs. Second, I will explain the crucial term “financial accounts.” Then, I will review the procedures for determining the aggregate maximum value of these accounts. I will turn next to the confusing issues of what constitutes a financial interest in or signature and comparable authority over a “financial account.” Finally, I will examine the consequences of failing to file the FBARs.

General Requirements of the FBAR

Pursuant to the Bank Secrecy Act, 31 U.S.C. §5311 et seq., the Department of Treasury (the “DOT”) has established certain recordkeeping and filing requirements for the United States persons with financial interests in or signature authority (and other comparable authority) over financial accounts maintained with financial institutions in foreign countries. If the aggregate balances of such foreign accounts exceed $10,000 at any time during the relevant year, FinCEN Form 114 formerly Form TD F 90-22.1 (the FBAR) must be filed with the DOT. Thus, the FBAR filing is required if four conditions are present:

1). The filer is a U.S. person;
2). There is one or more financial accounts in a foreign country;
3). The aggregate balances of these foreign financial accounts exceed $10,000; and
4). This U.S. person has either a financial interest in or signature authority (or other comparable authority) over these foreign financial accounts.

Definition of “U.S. Person”

Since October of 2008, the definition of a “U.S. person” has been going through a turbulent phase of uncertainty with periodic expansions and retractions. The pre-2008 FBAR instructions (dating back to July of 2000 version) defined the “U.S. person” broadly as: “(1) a citizen or resident of the United States, (2) a domestic partnership, (3) a domestic corporation, or (4) a domestic estate or trust.”

Two important features of this definition stand out. First, the term “person” is defined to include not only individuals, but also virtually any type of business entity, estate or trust. Even a single-member LLC, which is generally disregarded for tax purposes, may be classified as a U.S. person because it has a separate juridical existence from its owner. A partnership or a corporation created or organized in the United States is considered “domestic” under 26 U.S.C. §7701(a)(4).

Second, the definition of who should be considered as a U.S. resident is interpreted under 26 U.S.C. §7701. Under 26 U.S.C. §7701(b), an individual is a U.S. resident if he meets any of the three bright-line tests: (1) lawful admission for permanent residence to the United States (“green card”); (2) substantial presence in the U.S.: the sum of the number of days on which such individual was present in the United States during the current year and the 2 preceding calendar years (when multiplied by the applicable multiplier determined under the relevant IRS table) equals or exceeds 183 days; and (3) first-year election to be treated as a resident under 26 U.S.C. §7701(b)(4). Thus, the definition of a U.S. resident under the tax rules is much broader than the one used in immigration law.

In October of 2008, the IRS revised the FBAR instructions and further expanded the definition of a “U.S. person” by including the persons “in and doing business in the United States.” This revision caused a widespread confusion among tax professionals. The outburst of comments and questions prompted the IRS to issue Announcements 2009-51 and 2010-16, suspending FBAR filing requirement through June of 2010 (i.e. for calendar years 2008 and 2009) for persons who are not U.S. citizens, U.S. residents, and domestic entities. Instead, the tax professionals were referred back to July of 2000 FBAR definition of a “U.S. person.”

In the meantime, in February of 2010, the IRS published new Proposed FBAR regulations under 31 C.F.R. §103. The proposed rules modify the definition of a “U.S. person” as follows: “a citizen or resident of the United States, or an entity, including but not limited to a corporation, partnership, trust or limited liability company, created, organized, or formed under the laws of the United States, any state, the District of Columbia, the Territories, and Insular Possessions of the United States or the Indian Tribes.” This definition applies even if an entity elected to be disregarded for tax purposes. The determination of a U.S. resident status is to be done according to 26 U.S.C. §7701(b) and regulations thereunder, except the meaning of the “United States”(which is to be defined by 31 U.S.C. 103.11(nn)).

Thus, if the proposed regulations will ultimately be codified in their current form, the definition of the “U.S. person” will be slightly broader than that of the July of 2000, but will represent a major regression from October 2008 definition. Nevertheless, based on even contemporary definition of the “U.S. person,” the IRS has been able to cast a wide net over U.S. taxpayers, trying to force disclosure of as many foreign financial accounts as possible. This trend toward maximizing the scope of disclosure also dominates the definition of what constitutes a foreign financial account – the issue to which I now turn.

Definition of “Foreign Financial Account”

The term “foreign financial accounts” is described expansively and includes any bank, brokerage, securities, securities derivatives and other financial instruments accounts located outside of the United States and its territories. In the instructions to the Form 114, the IRS also includes in this definition savings, demand, deposit, time deposit, debit card, prepaid credit card and any other account maintained with a financial institution or other person engaged in the business of a financial institution. Since October 2008, accounts, such as mutual funds, where the assets are held in a commingled fund and the account owner holds an equity interest in the fund are also considered “financial accounts.” It should be noted that the IRS granted the extension for reporting mutual fund accounts (and certain other filers) for the tax year 2008 and earlier years until June 30, 2010. Individual bonds, notes and stock certificates are not considered as “financial accounts.”

The Proposed Regulations further elaborate the definition of “foreign accounts.” The term includes all “bank, securities, and other financial accounts,” but the understanding of what these terms mean is expanded. The IRS expressly states that, in defining types of the accounts that must be reported on the FBAR, it will focus on the kinds of financial services for which a person maintains an account with a foreign financial institution, irrespective of how long this account is being maintained. The IRS, however, limits itself by stating that “an account is not established simply by conducting transactions such as wiring money or purchasing a money order where no relationship has otherwise been established.”

Outside of this limitation, the Proposed Regulations tend to add the types of accounts that need to be reported on the FBAR. The definition of the “bank account” expressly includes time deposits, such as certificates of deposit accounts that allow an account owner to “deposit funds with a banking institution and redeem the initial amount, along with interest earned after a prescribed period of time.” A “securities account” is defined as “an account maintained with a person in the business of buying, selling, holding, or trading stock or other securities.”

The term “other financial accounts” receives most attention under the Proposed Regulations. The IRS states that, due to the fact that this term covers a broad range of relationships with foreign financial institutions, the new regulations strive to delineate clearly what accounts should be included in the definition. Hence, the Proposed Regulations include in “other financial accounts” the following types of accounts:

“an account with a person that is in the business of accepting deposits as a financial agency; an account that is an insurance policy with a cash value or an annuity policy; an account with a person that acts as a broker or dealer for futures or options transactions in any commodity on or subject to the rules of a commodity exchange or association; or an account with a mutual fund or similar pooled fund which issues shares available to the general public that have a regular net asset value determination and regular redemptions.”

Foreign retirement accounts present an interesting classification problem. The Proposed Regulations state that “participants and beneficiaries in retirement plans under sections 401(a), 403(a) or 403(b) of the Internal Revenue Code as well as owners and beneficiaries of individual
retirement accounts under section 408 of the Internal Revenue Code or Roth IRAs under section 408A of the Internal Revenue Code are not required to file an FBAR with respect to a foreign financial account held by or on behalf of the retirement plan or IRA.” This exception, however, is not extended to the foreign financial accounts. Therefore, it appears that a foreign retirement account that is similar in design to an IRA needs to be disclosed in the FBAR.

The readers must also be aware that other reporting requirements may apply to a foreign retirement account. For example, Canadian Registered Retirement Savings Plans (RRSPs) and Registered Retirement Income Funds (RRIFs) should be reported by U.S. residents on Form 8891. In other cases, a foreign retirement plan may be considered as “foreign trust” by the IRS and should be reported on Form 3520.

There are three narrow categories of foreign financial accounts for which the U.S. persons do not have to file the FBAR. First, accounts held in a military banking facility designated by the U.S. government to serve U.S. Government installations located abroad. Second, officers or employees of most banks regulated by the federal government are exempt from filing the FBARs (unless an officer or an employee has personal financial interest in the account). Finally, officers or employees of publicly-traded domestic corporations or privately-owned corporations with assets exceeding $10 million and 500 or more shareholders of record, need not file an FBAR concerning the signature authority (usually acquired by virtue of the officer’s or employee’s position) over a foreign financial account of the corporation (as long as an officer or an employee has no personal financial interest in the account, and he is advised in writing by the chief financial officer of the corporation that the corporation has filed a current report which includes that account).

Aggregate Balance Exceeds $10,000

Despite appearances, the requirement that the aggregate value of all of the foreign financial accounts exceeds $10,000 at any time during a calendar year is not without complications. In order to figure out the account value in a calendar year, one needs to look first at the largest amount of currency and/or monetary instruments that appear on any quarterly or more frequently issued account statement for the relevant year. If the financial institution which manages the account does not issue any periodic account statements, then the maximum account value is the largest amount of currency and/or monetary instruments in the account at any time during the applicable year. If the account consists of stocks or other non-monetary assets, then one only needs to consider fair market value at the end of the relevant year. If, however, the non-monetary assets were withdrawn before the end of the calendar year, then the account value is determined to be the fair market value of the withdrawn assets at the time of the withdrawal.

The maximum value of a foreign financial account must be reported in U.S. dollars on the FBAR. Therefore, a taxpayer needs to convert foreign currency into the corresponding amount of U.S. dollars using the official exchange rate at the end of the relevant calendar year.

A final word of caution on the topic of the account balance. Notice the word “aggregate” – it means that the balances of all of the filer’s foreign financial accounts should be tallied to determine whether the $10,000 threshold is exceeded. For example, if the filer has one foreign bank account of $6,000 and another of $5,000, then he still needs to file the FBAR with the DOT, because the aggregate value of both accounts exceeds the required $10,000.

Financial Interest, Signature Authority, and Other Comparable Authority

The final condition that must be met before the requirement to file the FBAR arises is that the U.S. person has either a financial interest in, or a signature authority or other comparable authority over the relevant foreign financial accounts. In deciding whether the FBAR is required, it is useful to go through all three of these requirements in order.

First, the filer needs to determine whether he has a financial interest in the account. If the account is owned by an individual, the financial interest exists if the filer is the owner of record or has legal title in the financial account, whether the account is maintained for his own benefit or for the benefit of others, including non-U.S. persons. Hence, if the owner of record or holder of legal title is a U.S. person acting as an agent, nominee, or in some other capacity on behalf of another U.S. person, the financial interest in the account exists and this agent or nominee needs to file the FBAR. If a corporation is the owner of record or the holder of legal title in the financial account, a shareholder of a corporation has a financial interest in the account if he owns, directly or indirectly, more than 50 percent of the total value of the shares of stock or has more than 50 percent of the voting power. Where a partnership is the owner of record or the holder of legal title in the financial account, a partner has a financial interest in the financial account if he owns, directly or indirectly, more than 50 percent of the interest in profits or capital. Similar rule applies to any other entity (other than a trust) where a U.S. person owns, directly or indirectly, more than 50 percent of the voting power, total value of the equity interest or assets, or interest in profits. Special rules apply to trust and can be found in the Proposed Regulations. Finally, a U.S. person who “causes an entity to be created for a purpose of evading the reporting requirement shall have a financial interest in any bank, securities, or other financial account in a foreign country for which the entity is the owner of record or holder of legal title.”

If there is no financial interest in the foreign financial account, the filer should determine whether he has signature authority over the account. A U.S. person has account signature authority if that person can control the disposition of money or other property in the account by delivery of a document containing his signature to the bank or other person with whom the account is maintained. Notice, once again, that control over the disposition of assets in the account is one of the main factors in deciding whether the FBAR needs to be filed.

It is important to mention that, pursuant to the IRS Announcement 2010-23, persons with signature authority over, but no financial interest in, a foreign financial accounts for which an FBAR would otherwise have been due on June 30, 2010, will now have until June 30, 2011, to report those foreign financial accounts. Combined with IRS Announcement 2009-62, this means that the deadline has been extended for the calendar year 2009 and all prior years.

Finally, even if no financial interest or signature authority exists, the filer has to continue his analysis and determine whether he has “other comparable authority” over the account. This catch-all, ambiguous term is not defined by the IRS. Nevertheless, the instructions to Form 114 generally state that the other comparable authority exists when the filer can exercise power comparable to the signature authority over the account by communication with the bank or other person with whom the account is maintained, either directly or through an agent, or in some other capacity on behalf of the U.S. person.

Penalties

Now that the reader has received an extensive background on the FBAR filing requirements, I would like to discuss some of the penalties that may be imposed as a result of the failure to file the FBAR even though your client was required to do so. In particular, I will focus on three general scenarios describing specific penalties commonly attributed to each of them. The first scenario is where your client willfully failed to file the FBAR, or destroyed or otherwise failed to maintain proper records of account, and the IRS learned about it when it launched an investigation of your client. This is the worst type of scenario which carries substantial penalties. The IRS may impose civil penalties of up to the greater of $100,000, or 50 percent of the value of the account at the time of the violation, as well as criminal penalties of up to $500,000, or 10 years of imprisonment, or both. It should be noted these penalties apply separately to each undisclosed account. Hence, if your client fails to disclose two or more accounts, the penalties are likely to be significantly higher.

Another scenario is where your client negligently and non-willfully failed to file the FBAR, and the IRS learned about it during an investigation of your client. Unlike the first scenario, there are no criminal penalties for non-willful failure to file the FBAR; only civil penalties of up to $10,000 per each violation (unless there is a pattern of negligence which carries additional civil penalties of no more than $50,000 per any violation). Each undisclosed account constitutes a separate violation, and, therefore, the penalties may be significantly higher where your client fails to disclose two or more accounts . In this scenario, your client fares much better, and you may be able to obtain lower penalties by showing of reasonable cause for the failure to file.

The third scenario is where your client non-willfully fails to file the FBAR, accidentally discovers his mistake, and comes to you before the IRS commences its investigation of your client’s finances. This is the most favorable of all scenarios due to the fact that your client may qualify for the benefits of a voluntary disclosure program, despite the fact that the position of the IRS regarding civil penalties for voluntarily filed but delinquent FBARs is uncertain following the October 15, 2009 voluntary disclosure deadline. The best strategy for addressing delinquent FBARs, however, varies depending on the facts and circumstances of the particular case.

A word of caution: this discussion focuses solely on the penalties associated with the failure to file the FBAR. This article does not address the various strategies that may be employed in dealing with the delinquent FBAR filings in the post-October 15, 2009 world, including qualification for the voluntary disclosure program. In certain situations, there may also be other relevant significant tax issues outside of the FBAR realm – the most important of which is non-payment of taxes on undisclosed income by the U.S. taxpayers – which may significantly alter the amount of penalties, interest, and taxes due to the IRS.

Conclusion

Based on the analysis above, it is easy to see now why so many of the U.S. taxpayers fail to file an FBAR when it is required. While the seemingly simple instructions of the FBAR can readily become complex and unpredictable when applied to specific individual circumstances, the main cause of non-filing seems to be simply a failure to recognize that the FBAR report needs to be filed. This problem is exactly what this article is designed to address, and I hope that I have provided the readers with the necessary legal knowledge to conduct a proper legal analysis of relevant circumstances and recognize when the FBAR needs to be filed. This is the crucial first step in preventing regulatory non-compliance and its potentially disastrous consequences for you and your clients.