Impact of IRS Foreign Bank Account Reporting on Gringos in Paradise

[The purpose of this article] is to advise readers as to what seems to this author to be a little known filing obligation that has been off the “radar screen” of tax advisors throughout the US as it impacts US persons holding stock or partnership interests in a “Sociedad Anónima” (SA) or, in certain circumstances, a “Sociedad de Responsibilidad Limitada” (SRL) or “LLC”.

By J. B. Friedman, Jr.
As many ex-patriots residing throughout Latin America and elsewhere are aware at this point in time as a result of the notoriety resulting from the United States Department of Justice’s success in breaching banking secrecy laws impacting UBS account holders in Switzerland, the Internal Revenue Service (IRS) has promulgated a number of notifications aimed specifically at bringing into the US tax system reporting obligations arising from foreign accounts held by US persons.

From this author’s perspective, it appears to be fairly widely known that US persons having a financial interest in, or signature or other authority over, financial accounts in a foreign country are required to report those accounts to the US Treasury Department on a Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (FBAR). This reporting obligation is imposed if the aggregate value of the foreign financial accounts exceeds $10,000 at any time during the calendar year.

As recently as February 26, 2010, the IRS issued Notice 2010-23, under which, in part, (1) the filing date for persons who have signature authority over, but no financial interest in, foreign financial accounts for which an FBAR would have otherwise been due on June 30, 2010, have until June 30, 2011, to file an FBAR for the 2010 and prior calendar years; (2) persons with a financial interest in, or signature authority over, a foreign commingled fund that is a “mutual fund” are required to file an FBAR, unless another filing exception applies, and are thus required to file an FBAR by June 30, 2010, for the 2009 and earlier calendar years; and (3) persons with a financial interest in, or signature authority over, foreign commingled funds which are not “mutual funds” are not required to file an FBAR with respect to those accounts for the 2009 and prior calendar years.

The purpose of this article is not to address the filing obligations applicable to US persons with foreign bank accounts or other foreign financial accounts exceeding, in the aggregate, $10,000 in value during any portion of such US person’s year; but rather, to advise readers as to what seems to this author to be a little known filing obligation that has been off the “radar screen” of tax advisors throughout the US as it impacts US persons holding stock or partnership interests in a “Sociedad Anónima” (SA) or, in certain circumstances, a “Sociedad de Responsibilidad Limitada” (SRL) or “LLC”.

To wit, US persons with a corporate or partnership interest in a “controlled foreign corporation” or “controlled foreign partnership” have an annual filing requirement on either IRS Form 5471 (with respect to US persons with an interest in a controlled foreign corporation) or IRS Form 8865 (with respect to US persons with in interest in a controlled foreign partnership) regardless of whether or not any tax is due from such entity or resulting from the activities of such entity. Further, IRS Form 8858 is required to be filed by certain US persons that own a foreign disregarded entity directly, or in certain circumstances, indirectly or constructively.

In connection with the FBAR reporting obligations, the IRS through its “Amnesty Program” extended through October 15, 2009, the time by which US taxpayers with undisclosed foreign financial accounts and holdings in undisclosed foreign entities could conform to the notice or filing obligations with penalties waived for non-timely disclosure of those return forms (where the taxpayers have reported and paid tax on all their taxable income related to the foreign corporations, partnerships or foreign bank accounts). The Amnesty Program was available even to US persons with unreported taxable income and unpaid taxes, although certain penalties applied to the understatement and underpayment of such taxable amounts.

The issue at this point in time concerns the expiration of the Amnesty Program in October 2009 and the affirmative action to be taken by taxpayers who own sufficient interests in SA’s or SRL’s outside of the US, where such entities are controlled by US persons. Unfortunately, the statutory penalty for failure to file IRS Forms 5471, 8858, or 8865 with the IRS is $10,000 per return, per year, per taxpayer for each year in which the required returns are not filed. This penalty is applicable regardless of whether or not such SA or SRL generated any income or caused the US person to understate US federal taxable income.

The penalty applies as a result of the failure to file the information return. In addition, where such returns have not been filed and the IRS has received no information that would put the IRS on notice that such a return may be required (ie, since there is no disclosure of any foreign accounts or entities), the statute of limitations with respect to such penalty never commences to run.

In essence, if the IRS were to learn of the existence of such an SA or SRL and the year in which the taxpayer took possession of the stock or partnership interest, even though many years had passed, the IRS could seek the $10,000 per return, per entity penalty without regard to any statute of limitations defense.

Given the depth of potential exposure for US persons holding such ownership interests (which, to the experience of the author is a common practice throughout Latin America, where it is not unusual for a US person to have total or partial control over numerous SA’s or SRL’s), US persons facing such potential liability have not only the obligation to report such accounts but, notwithstanding the expiration of the Amnesty Program, the opportunity to provide a “statement of reasonable cause” to the IRS requesting a full abatement of the non-disclosure penalties.

Treasury Regulations promulgated under Code Sections 6038, 6046 and 6046A, provide that “a taxpayer may show, by filing a written statement, that failure to file information with an IRS Form 5471 (or IRS Forms 8858 or 8865 as applicable), with respect to certain foreign corporations (or foreign disregarded entities or foreign partnerships) was due to reasonable cause and not due to willful neglect”. It is through this statement of reasonable cause that a delinquent taxpayer can provide information returns to the IRS, satisfying his or her filing obligation while at the same time asserting a position that such error was due to reasonable cause, and thus the penalty should be abated.

It has been the author’s experience that lack of knowledge and understanding with respect to foreign reporting of controlled foreign corporations, foreign partnerships, and foreign disregarded entities with the US tax preparer community has been significant. Specifically, even taxpayers who have utilized professional tax return preparation firms have failed in this filing obligation, even in some instances where such professional return preparers have actual knowledge of the US taxpayer’s interest in such controlled foreign corporations, foreign partnerships, or foreign disregarded entities.

Thus, with respect to taxpayers who have reported and paid tax on all taxable income with respect to these controlled foreign entities, they will be in the best possible position to conform to their information return filing requirements and establish reasonable cause to avoid the imposition of the $10,000 per return penalty.

In addition, even those US persons with underreported income can file these past due returns and establish reasonable cause for late filing. Obviously, past due taxes, interest, and potential penalties would be applicable.

Given the current attention given by the IRS to foreign reporting; notwithstanding the expiration of the initial Amnesty Program for reporting foreign accounts and foreign entitites, it seems reasonable, at least to this practitioner, that where US persons with interests in controlled foreign corporations, controlled foreign partnerships, and foreign disregarded entities have not evaded US income taxes, but have simply failed to file an information return on IRS Forms 5471, 8858, or 8865, where required, the closer in time to the expiration of the Amnesty Program on October 15, 2009, that the filing obligation can be satisfied, the better it will be with respect to supporting a reasonable cause position to preclude the imposition of penalties on such failure to timely report on IRS Forms 5471, 8858, and 8865.

Similarly, as set forth above, even those with undeclared income still have the ability to establish reasonable cause for the non-timely filing of any required returns. (3/16/10) (photo courtesy Internet)

Note: The author is a partner with the international law firm of Fulbright & Jaworski LLP in San Antonio, Texas.