daniel Downey for forbes
The penalty for fairly innocent goofs can run into the millions of dollars.
Is there any limit to how unpleasant the IRS can be with people who pay all their taxes but don’t fill out the forms correctly?
Monica Toth, 82, is a naturalized American whose family escaped the Nazis. The Boston area resident prepared her own tax returns, by hand, using forms copied from a public library. She omitted transactions in a Swiss bank account her father gave her in 1999. Until 2010, she also failed to send in reports listing the foreign account.
That year she apologetically sent in the form, called an FBAR, and followed up with forms for the previous five years. The result of this confession was an IRS audit, which discovered that she had overpaid her taxes in some years and underpaid in others. She settled the back taxes for just under $40,000.
Monica Toth, following nasty surprise from IRS
INSTITUTE FOR JUSTICE
End of the matter? Not quite. The IRS decided that, apart from miscalculations on the tax returns, sending the forms in late was itself a grave offense. It sent her a bill for $2.2 million for the late filing.
Representing herself in the litigation, Toth pleaded that this penalty would violate the Eighth Amendment’s prohibition of “cruel and unusual punishments” and “excessive fines.” She lost twice in lower courts. Now the Institute for Justice, which crusades against government overreach, is asking the Supreme Court to take a look.
Richard Collins, 85, is a Canadian-born engineer living in Pennsylvania. He spent much of his career abroad, and had accounts in France, Canada and Switzerland. In some cases these accounts were necessary in order to receive pay on government contracts.
Collins had a CPA prepare his returns and he paid all the tax he owed on his earned income. The accountant was unaware of the FBAR rules. This went on for years.
Then, in 2010, Collins realized he should have been filing FBARs. He went back to the accountant to fix the mistake, sending in those forms along with amended tax returns. The amended returns didn’t call for additional tax because an early loss on the Swiss account more than covered any investment gains.
But the IRS had a trump card up its sleeve. In addition to the FBAR regime, it imposes on U.S. taxpayers with foreign mutual funds a punitive “passive foreign investment company” tax. A taxpayer can sidestep this burden by filing the right forms, but it was too late for Collins to take that route. The IRS hit him up for $81,000 in PFIC duties. He paid.
“The average citizen cannot afford to fight the IRS in court.”
IRS wasn’t done. The PFIC gotcha meant that the FBAR errors were connected, as in Toth’s case, to an underpayment of tax. This left the agency feeling justified in imposing penalties for the dilatory FBARs, even though Collins had volunteered those disclosures without any prompting from an audit.
Collins was assessed a $308,000 FBAR penalty, plus a $98,000 penalty for not paying the penalty. The IRS beat him in lower courts. Collins is asking the Supreme Court to step in. If it declines the case, he will lose a large chunk of his retirement money.
Krzysztof Wrzesinski, 36,is a Philadelphia police officer. His mother won a lottery in Poland and sent him $830,000 over the course of two years. Were these gifts taxable? he asked his tax preparer, an enrolled agent. Not at all, was the correct answer he was given. Any other forms needed? Again, a no, but this answer was incorrect. Wrzesinski should have filed two Forms 3520, reporting gifts from abroad.
Years later, the conscientious cop wanted to wire some of the money back to Poland to help a godson. Googling “foreign gifts,” he stumbled on Form 3520. This time he went to a lawyer, who sent in the delinquent forms. For this act of belated honesty, the IRS assessed a $41,500 penalty. Wrzesinski paid. Now he’s suing the government to recover the money.
Take note, all you taxpayers who have, or might someday have, an expat job, a foreign investment or a foreign benefactor. A plethora of filing mandates confronts you (see sidebar below, on overseas dalliances), even if you pay all your income taxes.
Mess up, and you become a revenue raiser for the federal government. For the nine years through 2020, the IRS assessed $1.5 billion in FBAR penalties. Samuel Gedge, an Institute for Justice lawyer working on the Toth case, describes the government’s philosophy this way: “Take the most money from the most number of people with the least oversight.”
The tough rules on overseas accounts go back half a century to a statute that is called the Bank Secrecy Act but would better be characterized as the Bust Open Swiss Accounts Act. Subsequent legislation has expanded their reach.
The intended targets were drug dealers, terrorists and tax cheats. Sometimes, the disclosure rules hit the mark. A few years ago a former University of Rochester professor paid $100 million in FBAR penalties for using a Zurich bank to conceal profits from a business venture. Not out of line for unreported offshore assets totaling $200 million that enabled an income tax dodge.
But now the IRS is using disclosure rules to extract cash from rather innocent taxpayers, says Elizabeth Atkinson, a Richmond, Virginia lawyer and board member at the Center for Taxpayer Rights, which, like the Institute for Justice, combats overeager revenuers. (Founder Nina Olson spent 18 years as the IRS’s taxpayer advocate.)
Part of the problem for the little guy is that, in most of these disputes, the taxpayer does not have the option to appeal to the Tax Court, a friendly venue that accommodates do-it-yourself litigants. (Olson’s successor as taxpayer advocate has recommended that Congress extend the Tax Court’s turf to cover international reporting penalties.)
Under present law, Atkinson says, “usually the taxpayer has to pay first and then litigate in District Court or the Court of Claims, which is very expensive. The average citizen cannot afford to fight the IRS in court.”
What if your accountant didn’t even know about that FBAR form? No luck. Ignorance of the law is no excuse.
One of her clients got an unexpected inheritance from his mother, a British citizen. It was enough to tip him over a reporting threshold. He filed his 1040 tax return on time and the bequest had no impact on the amount due. But the IRS wants to collect a penalty because he sent in Form 3520 three weeks late. Atkinson is asking for mercy. She says there are hundreds of cases like this one pending.
Another IRS weapon is the ability to see multiple violations where ordinary folk would see only one. Alexandru Bittner is a Rumanian-U.S. businessman with complicated affairs and a lot of bank accounts. He paid taxes correctly. The IRS assessed him for five years of failing to report his foreign accounts. He should have sent in one FBAR, listing every account, annually.
The statutory penalty is $10,000 per violation. That sounds like $50,000 for this offender. Oh, no, said the IRS. We want $10,000 per account, per year. So give us $2.7 million. The tax collectors won in the Fifth Circuit.
This is ludicrous, argued Bittner’s attorney, Daniel L. Geyser of Dallas, in a Supreme Court hearing last month. For one thing, three of the accounts had trivial balances (below $50). For another, the IRS’s interpretation would permit a criminal case, if the government had taken that course, seeking a 1,360-year jail sentence. This for someone who paid all his taxes but omitted some forms.
Where’s the limit? asked Geyser. Is there anything to stop the IRS from requiring taxpayers to file a report every quarter, or, for that matter, every minute, and fining accordingly?
There’s an interesting precedent in such matters: State ex rel. Garvey v. Whitaker, decided by the Louisiana Supreme Court in 1896. Three men were charged with damaging plants in a public park. What, exactly, they did is not clear. Maybe they ignored a “Keep off the Grass” sign.
The penalty for this misdemeanor was a $10 fine or, on failure to pay, 30 days in jail. The imaginative prosecutor determined that there would be a separate count for every one and a half minutes that the offense took place. A lower court imposed a fine of $720 on each defendant, money they evidently didn’t have, meaning six years in the slammer.
Louisiana? 1896? It crosses your mind that the prosecutor’s zeal had something to do with the race of the defendants. The record is silent on that point. But whatever the motivation, the sentencing was enough to make the higher court gag. It reversed.
It would certainly be helpful for taxpayers to have the U.S. Supreme Court hand down a decision putting constitutional limits on runaway IRS penalties. The court, though, probably won’t do that. At the oral argument in Bittner v. U.S., the justices fixated on statutory interpretation, and Geyser didn’t bring up the Constitution. As for the Toth case, which raises an explicit Eighth Amendment defense: Most petitions for Supreme Court review are turned down.
To answer the question posed above: Is there any limit to how nasty the IRS can get? Yes, there is. A U.S. Supreme Court case from 1878, Wilkerson v. Utah, does interpret the Eighth Amendment. It makes clear that the government would lack the power to disembowel a taxpayer. Take what comfort you will from that.
Gotcha
An assortment of penalties for tax misbehavior
A Day Late And A Dollar Short. There are separate penalties for filing a 1040 late and for paying the balance due after April 15. They can add up to 47.5% of the tax owed.
Sloppy Work. If you do a really bad job filling out your tax return, and make an error in your favor, then you owe, besides the additional tax, a penalty equal to 20% of the shortfall. Penalty doubles if it involves a wacky appraisal (such as of donated artwork).
W-2 Booboos. Employers who screw up wage statements are penalized $50 apiece, up to a $3 million maximum.
Refund Grabbing. A professional tax preparer who negotiates a check from the IRS to the taxpayer is fined $435.
Partnership Delay. Partnership returns are due March 15, not April 15. Late fee: $195 per month per partner.
Bouncing A Check. If your check or other payment to the IRS doesn’t go through, you owe an additional 2%.
Late Withdrawal. Delaying a mandated withdrawal from a retirement account for a year will net you, given mid-range tax brackets and investment results, an ill-gotten gain of not quite 2% of the amount delayed. The IRS fine for this delay, though, is 50% of the amount.
Checklist Missing. A tax preparer who fails to fill out a two-page “due diligence” checklist before claiming that a client is eligible for specified goodies, including the earned-income and college credits, is fined $545 per credit.
Dalliances Overseas: A Safety Checklist
The IRS has decreed, and the Supreme Court has largely agreed, that you don’t get off the hook just because your tax preparer made a mistake. So if you have any dealings overseas it is a legal presumption that you have memorized the relevant portions of the tax code. The penalty for not filing an obscure international form typically starts at $10,000 per year.
Passive Investments. Do you own shares in a mutual fund incorporated abroad? You must file Form 8621, report of Passive Foreign Investment Company. If the fund supplies you with the correct detail, you pay the same tax you would be paying if the same portfolio were run by a U.S. fund. If it doesn’t, you owe a punitive PFIC tax.
Note: These rules do not apply to U.S.-domiciled funds that own foreign stocks.
Personal Holding Company. You set up a corporation to hold, say, an Italian villa. File Form 5471, for a Controlled Foreign Corporation.
Bequests and Gifts. It’s hard not to know that foreign trusts, a classic means of hiding assets and dodging income taxes, must be reported on Form 3520; the form is advertised on the Schedule B attached to your income tax return. The surprise is that a gift or bequest from abroad counts as a “foreign trust” if it exceeds $100,000. The form is due at the same time as an income tax return but is sent off to a different IRS mail drop.
FBAR. File this form if you have $10,000 or more, combined, in international bank and brokerage accounts at any point during the year. You must file electronically.
Note: Disclosure is not required for foreign securities or currencies held by a U.S. bank or broker.
Fatca. The disclosure mandated by this anti-laundering law covers all manner of foreign financial assets, including insurance and retirement assets; it overlaps and often duplicates what’s on an FBAR. Under Fatca, however, the asset thresholds above which reporting is required are higher; they range from $50,000 for unmarried U.S. residents to $400,000 for couples residing abroad and filing joint returns.
The Fatca confession goes on Form 8938, filed with your income tax return.
Crypto. Do Fatca and FBAR rules apply to virtual currencies held abroad (such as in the Bahamas, if there’s anything left of your money there)? Probably not, at the moment. But the rules could change and you might not get the memo. Play it safe and file the reports.
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Source: https://www.forbes.com/sites/baldwin/2022/12/11/the-irs-versus-the-clumsy-taxpayer/