District Court Determines IRS Exceeded Regulatory Limit on FBAR Penalties

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1 IRS Insights A closer look. In this issue: District Court Determines IRS Exceeded Regulatory Limit on FBAR Penalties... 1 Internal Revenue Service Issues Guidelines for IRS Chief Counsel on Supervisory Approval of Penalties... 2 District Court Determines IRS Exceeded Regulatory Limit on FBAR Penalties The United States District Court for the Western District of Texas Austin Division ( District Court ) recently ruled the Internal Revenue Service ( IRS ) acted arbitrarily and capriciously in assessing penalties for willful failure to file Reports of Foreign Bank and Financial Accounts ( FBAR ) in excess of the $100,000 per account amount set forth in 31 CFR even though the statute allowed an FBAR penalty assessment of the higher of $100,000 or 50% of the maximum amount in the unreported foreign account. The District Court held that although the enabling statute of 31 CFR 5321 had been revised to increase the maximum potential penalty, 31 CFR could be read consistently with the revised statute and thus was still valid. Accordingly, the IRS was bound to maximum penalty of $100,000 as set forth in 31 CFR Background The Currency and Foreign Transactions Reporting Act of 1970, commonly known as the Bank Secrecy Act ( BSA ) requires US financial institutions to assist the US government agencies in detecting and preventing money laundering. 1 Pursuant to Section 5314 and 31 CFR , 2 a US person is required to report a financial interest, or signature or other authority, over foreign financial accounts with an aggregate value of at least $10,000 at any time during the 1 31 USC 5311 et seq. 2 This implementing regulation was originally 31 CFR IRS Insights Page 1 of 5 Copyright 2018 Deloitte Development LLC

2 reporting period. A US person is required to report these items on a Form 114 3, Report of Foreign Bank and Financial Account (FBAR), filed on a calendar year basis. 4 Under 31 USC 5321, a person who fails to timely file an FBAR will be subject to penalties. The amount of potential penalty varies based upon the type of violation, such as willful or non-willful. 5 The authority to enforce FBAR provisions, including assessing civil penalties, was delegated from the Financial Crimes Enforcement Network ( FinCEN ), a bureau of the Department of the Treasury, to the Internal Revenue Service in Willful Failure to File FBARs In this case, the IRS assessed penalties for willful failure to file FBARs for tax years 2007 through 2010 against Mr. Dominique G. Colliot ( Taxpayer ). The IRS assessed penalties for the four periods at issue, but the court was focused on the 2007 and 2008 penalties in the following respective amounts: $548,773 and $196,082. The Taxpayer asserted the IRS violated 31 CFR in asserting penalties in excess of $100,000 for these two periods and filed for summary judgment. The District Court first set forth the legislative history and noted prior to 2004, 31 USC 5321(a)(5) allowed the Secretary of Treasury to impose civil penalties amounting to the greater of $25,000 or the balance in the unreported account up to $100,000 for willful violations of Section CFR (renumbered to 31 CFR ) reiterates that the penalty for any willful violation of the requirements of 31 CFR was capped at $100,000. However, in 2004, 31 USC 5321(a)(5) was revised to provide for a minimum penalty of $100,000 and maximum of fifty percent of balance in the account for willful failure to file FBARs. The IRS asserted that the revision to 31 USC 5314 in essence invalidated 31 CFR , thus it was not bound to the lower penalty amounts set forth in 31 CFR The District Court noted that for a regulation to be valid, the regulation must be consistent with the statute. The District Court interpreted 31 USC 5314 to cap the maximum penalty at fifty percent of the unreported account value, however, it stated that 31 USC 5314 did not impose a floor on the maximum penalty amount. Accordingly, the interpretation in 31 CFR to impose only a $100,000 maximum penalty was not in conflict with 31 USC 5314, as it did not exceed the statutory cap. The District Court further held that as 31 CFR was valid and had been promulgated pursuant to the noticeand-comment procedures, then any revocation of 31 CFR would have to be based on same procedures. As 31 CFR had not been revoked, it was still valid and the IRS was bound by the limits imposed by the regulation. Accordingly, the District Court held the IRS has acted arbitrarily and capriciously when it imposed penalties in excess of $100,000 for tax years 2007 and 2008 against the Taxpayer. The District Court did not rule on the appropriate relief and instead requested the parties input regarding the proper next steps. This case presents a question that may become more prevalent pursuant to the passage of the legislation P.L , commonly known as Tax Cuts and Jobs Act of 2017 ( TCJA ). The TCJA revised a significant number of statutory provisions, which may have final or temporary regulations promulgated under the prior version of the statutes. As this case illustrates, a court may look towards whether a regulation is consistent with the statute and not invalidate a prior regulation, regardless of subsequent statutory revisions. Internal Revenue Service Issues Guidelines for IRS Chief Counsel on Supervisory Approval of Penalties On June 6, 2018, the Internal Revenue Service ( IRS ) released Chief Counsel Notice ( Notice ), which provides guidance to IRS Office of Chief Counsel attorneys ( Chief Counsel ) on how to address compliance with 3 For the periods at issue, the form was a TD F USC 5314; 31 CFR USC Memorandum of Agreement and Delegation of Authority for Enforcement of FBAR Requirements, dated April 8, IRS Insights Page 2 of 5 Copyright 2018 Deloitte Development LLC

3 Section 6751(b) when handling penalties in litigation, such as deficiency cases, collection due process cases, Tax Equity and Responsibility Act of 1982 ( TEFRA ) proceedings, and refund cases. Background Under Section 6751(b)(1), no penalty shall be assessed unless the initial determination of the penalty assessment is personally approved, in writing, by the immediate supervisor of the individual making the penalty determination. In this context, penalty is defined in broad terms to include any addition to tax or additional amount under Title 26; however, the following types of penalties are statutorily exempted: Section , Section , Section and other penalties automatically calculated through electronic means. In Graev v. Comm r., 149 T.C. 23 (2017) ( Graev III ), the Tax Court determined, in a deficiency case, that written supervisory approval must occur no later than the date the IRS mails the notice of deficiency or files an answer or amended answer asserting penalties. Further, Graev III held the IRS has the burden of production for supervisory approval, thus must provide support. 10 The Second Circuit had also examined the issue in Chai v. Comm r., 851 F.3d 190 (2nd Cir. 2017), and held that the IRS had the burden of proof with regards to Section 6751(b). 11 IRS Chief Counsel Notice Whether the IRS bears a burden of production in cases, i.e. must affirmatively introduce evidence to support the penalty, was at issue in both Graev III and Chai. The Notice states the IRS should not dispute that Section 6751(b)(1) compliance is part of the burden of production under Section 7491(c) 12 for individual taxpayers. In accordance, the Notice instructs Chief Counsel to introduce evidence of the supervisory approval for individual taxpayer, and as a best practice, to also provide support in the cases of entity taxpayers. Importantly, the Notice states that if the IRS bears the burden of production and Chief Counsel cannot obtain proof of proper supervisory approval, then the penalty must be conceded. The Notice also reiterates that Section 6751(b)(1) does not apply to any additions to tax under Sections 6651, 6654, or 6655, or penalties that are automatically calculated through electronic means. The Notice states the IRS position that any addition to tax under Section 6651 includes any subsection of section 6651, such as the Section 6651(a)(1) addition to tax for failure to file, the Section 6651(a)(2) and (3) additions to tax for failure to pay, and the Section 6651(f) addition to tax for fraudulent failure to file. Additionally, the Notice states that penalties set forth on a notice of deficiency pursuant to an automated program, such as the Automated Underreporter ( AUR ) and Combined Annual Reporting Wage Reporting ( CAWR ) program, qualify for the exemption of automated penalties. However, the Notice importantly distinguishes between penalties assessed through pure electronic means and penalties assessed after the taxpayer responds to an initial notice, either in writing or by other means. If a taxpayer contests a penalty prior to the issuance of the notice of deficiency and an IRS employee evaluates the response, then the penalty determination is no longer fully automated. In those cases, the IRS must then follow the procedures for Section 6751(b). Deficiency Proceedings: The Notice provides that if there is a Tax Court deficiency cases with a penalty is at issue, then Chief Counsel should submit evidence of written supervisory approval, regardless of whether the taxpayer raises the issue. Furthermore, the Notice clarifies the supervisory approval must either be prior to the (1) mailing of the 7 Section 6651 sets forth additions to tax for certain items, such as failure to timely pay tax or failure to timely file an income tax return. 8 Section 6654 sets forth an addition to tax for an individual that fails to pay estimated income tax. 9 Section 6655 sets forth an addition to tax for a corporation that fails to pay estimated income tax. 10 For additional discussion regarding Graev v. Comm r., 149 T.C. 23 (2017) and Chai v. Comm r., 851 F.3d 190 (2nd Cir. 2017), see IRS Insights, The Tax Court and the Court of Appeals for the Second Circuit Reach Contrary Conclusions as to the Section 6751(b)(1) Written-Approval Requirement for Sustaining an Accuracy-Related Penalty. URL: 11 Id. 12 Section 7491(c) provides that the IRS has the burden of production in court proceedings for an individual s liability of penalties, additions of tax and additional amounts imposed by Title 26. IRS Insights Page 3 of 5 Copyright 2018 Deloitte Development LLC

4 notice of deficiency or (2) raised in an answer or amended answer if the penalty was not raised in the notice of deficiency. Depending upon the circumstances, the relevant party to provide immediate supervisory approval may vary. If an attorney reviews a statutory notice of deficiency before it is issued and recommends to include a penalty not originally set forth in the statutory notice of deficiency, then the attorney should obtain approval from their immediate supervisor. The Notice suggests that the attorney should prepare a memorandum, to be signed by the attorney s immediate supervisor, to memorialize the initial penalty recommendation and approval. Collection Due Process Proceedings: The Notice also addresses Collection Due Process ( CDP ) proceedings and states that compliance with Section 6751(b)(1) must be evaluated in all CDP cases. Further, as the Office of IRS Appeals ( Appeals ) is primarily responsible for conducting the CDP proceedings, the Notice provides that Appeals should verify written supervisory approval. If the penalty is at issue in the CDP case, then Appeals must verify compliance with Section 6751(b) as part of the liability determination. The Notice also sets forth guidelines for Chief Counsel relating to CDP cases in litigation. In cases where the liability of the penalty is at issue, then the Notice specifies the IRS bears the burden of production for compliance with Section 6751(b). Regardless of whether the liability is at issue, Chief Counsel should evaluate the evidence of supervisory approval and if necessary, obtain additional documentation. If the Chief Counsel cannot obtain appropriate documentation of supervisory approval, pursuant to Section 6751(b), then generally the IRS should concede the penalty. 13 Partnerships Tax Equity and Fiscal Responsibility Act of 1982 ( TEFRA ): For partnerships subject to TEFRA procedures, the Notice states Chief Counsel should introduce evidence of written supervisory approval, regardless of whether the taxpayer raises the issue. This portion of the Notice may be in response to a court case that evaluated whether Section 6751(b) is applicable to TEFRA cases. In Dynamo Holdings v. Comm r., 150 T.C. No. 10 (May 7, 2018), the Tax Court held that the IRS does not bear the burden of production for partnership cases as it is an entitylevel proceeding, and not an individual s proceeding. However, Section 6751(b) could be raised as a defense to the penalty. The Notice states that written supervisory approval should be submitted where penalties are at issue in the case. Similar to deficiency proceedings, evidence of supervisory approval should be obtained before the mailing of the Final Notice of Administrative Adjustment ( FPAA ). If the penalty is not raised in the FPAA, then it may be raised in an answer or amended answer and the attorney s supervisor should provide the written approval. The Notice states that Chief Counsel should assert written supervisory approval at the partnership level is sufficient compliance with Section 6751(b) in related partner proceedings. Refund Cases: Additionally, the Notice details specific procedures and requirements of Section 6751(b) for refund claims. The Notice clarifies that if the IRS seeks to assert penalties as an offset to refund claims, then supervisory approval is not required. However, in some instance, such as a taxpayer filing suit to seek a refund of a paid penalty, Chief Counsel must address compliance with Section 6751(b) in defense letters to the Department of Justice. The Notice directs Chief Counsel to evaluate whether a section 6751(b)(1) argument was raised in the administrative claim for refund. If the taxpayer did not properly raise Section 6751(b) in its initial refund claim, then Notice provides the variance doctrine may bar the taxpayer from raising the issue for the first time in a refund suit as a taxpayer must set forth all the grounds for the refund in its original claim to apprise the IRS of the grounds. If the grounds are not raised in the refund claim, then generally a taxpayer is barred from later raising the issue in a suit for refund. 13 The Notice provides for a narrow exception if certain judicial doctrines or if Section 6330(c)(4) bars judicial review of supervisory approval. IRS Insights Page 4 of 5 Copyright 2018 Deloitte Development LLC

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