The Second Circuit recently joined the Fourth (United States v. Horowitz), Eleventh (United States v. Rum) and Federal Circuits (Norman v. United States) in holding that the 1987 regulation setting the maximum penalty for willful FBAR violations at $100,000 was invalid due to the 2004 statutory amendment that provides that Treasury may impose a maximum willful penalty in an amount equal to the greater of $100,000 or 50% of the aggregate amount in the accounts at the time of the violation.  But given that there was one dissent, I see that as a good sign in a generally bleak environment for people who are assessed willful FBAR penalties.

The case is United States v. Kahn, Dkt. No. 19-3920, 2021 WL 2931305 (July 13, 2021).  The parties in district court stipulated to the facts:

  • Harold Kahn had two accounts in Switzerland, each of which had more than $100,000;
  • He willfully failed to file an FBAR for 2008 that was due on June 30, 2009;
  • On that date, the aggregate balance in the accounts was $8,529,456;
  • The IRS assessed a $4,264,728 willful FBAR penalty against him for 2009; and
  • Kahn died after the penalty was assessed.

The United States sued the estate to reduce the assessment to judgment.  Cross motions for summary judgment were filed with the only issue being whether the 1987 Regulation, 31 C.F.R. §1010.820(g) limited the amount that could be assessed to a maximum of $100,000 per account, for a total of $200,000.  The district court ruled for the United States and a divided panel of the Second Circuit affirmed.

The majority began its analysis with a little bit of history.  In 1986 Congress enacted a civil monetary penalty for willful failure to file an FBAR.  The amount of the penalty that could be imposed was the greater of $25,000 or the “amount in the account (not to exceed $100,000) at the time of the violation.”  In 1987, Treasury promulgated the Regulation, which repeated the statute almost verbatim.

In 2002, Treasury gave FinCen authority to implement and administer the Bank Secrecy Act, including the promulgation and amendment of regulations “in effect or in use on the date of enactment of the USA Patriot Act of 2001, [which] shall continue in effect …  until superseded or revised….”  In 2003, FinCen delegated to the IRS authority to enforce the FBAR provisions, but not to promulgate or amend the regulations.

In 2004, Congress amended the FBAR penalty provisions at 31 U.S.C. §5321(a)(5) to add a nonwillful penalty and increase the maximum willful penalty that may be imposed to the greater of $100,000 or 50% of the amount in the account at the time of the violation.   The position of the Estate was that the 2004 statute was not inconsistent with the 1987 Regulation and, therefore, the Regulation remained in effect.  The majority did not buy this argument.

According to the majority, the 2004 amendment did not authorize the Secretary to set a maximum willful penalty level, since that was set by Congress.  The Secretary’s authority to issue regulations doesn’t mean that a regulation can be issued that contradicts a statutory provision.  Noting that the language of §5321(a)(5)(B) states that the Secretary may impose a non-willful penalty not to exceed $10,000 while §5321(a)(5)(C) states the maximum penalty under subparagraph (B)(i) shall be increased to the greater of $100,000 of 50% of the amount in the account, the majority stated that the use of “shall” in a statute is “mandatory.”  Thus, while the Secretary has the discretion in any given case to impose a penalty below the maximum, it does not mean the 1987 Regulation can forbid a penalty as high as the maximum set by the 2004 amendment.  As a result, the Regulation and the 2004 amendment do not “harmonize.”

The 1986 statute’s penalty was “plainly amended” in 2007 and a regulation that contravenes the statutory language is invalid.  Even where the regulation is not technically inconsistent with the statutory language, it is invalid if it is “fundamentally at odds with manifest Congressional design.”  That design was to increase the maximum penalty that could be imposed for a willful FBAR violation.  The majority thus said it wouldn’t read the 2004 amendment as being rendered superfluous by the 1987 Regulation.

According to the majority, Treasury has a “relaxed approach” to amending regulations to track the Code.  Since the 1987 Regulation does not implement Congress’s will as expressed by the 2004 amendment, it is “a mere nullity.”  The majority rejected the Estate’s argument that the rule of lenity applies so that any ambiguity should be read in its favor, stating that there was no ambiguity in the 2004 amendment regarding the maximum willful penalty.  The Second Circuit thus affirmed the district court.

Circuit Judge Menashi dissented.  Before getting to his dissent, let us analyze the language of §5321(a)(5)(B) and (C), which provides in pertinent part:

(B) Amount of penalty. —

(i) In general. — Except as provided in subparagraph (C), the amount of any civil penalty imposed under subparagraph (A) shall not exceed $10,000.

*****

(C) Willful violations. — In the case of any person willfully violating, or willfully causing any violation of, any provision of section 5314—

(i) the maximum penalty under subparagraph (B)(i) shall be increased to the greater of—

                                    (I) $100,000, or

(II) 50 percent of the amount determined under subparagraph             

As I interpret this provision, for purposes of a willful violation the maximum penalty that the Secretary may impose shall not exceed the greater of $100,000 or 50 percent of the amount in the account at the time of the violation.  It is left to the Secretary’s discretion on the amount of a willful penalty as long as it does not exceed the statutory cap.  So let us turn now to the dissent.

Judge Menashi begins by quoting Ft. Stewart Schs. v. Fed. Lab. Reels. Auth., 495 U.S. 641 (1990): “It is a familiar rule of administrative law that an agency must abide by its own regulations.”  According to the dissent, this principle (termed “the Accardi principle”[1]) requires that the district court be reversed.  The reason: while the governing statute authorizes penalties greater than $100,000, “it nowhere mandates that the Secretary impose a higher fine.”  Since the regulation and the statute don’t conflict, the Treasury must adhere to the regulation, which was issued following notice and comment rule making.

The dissent notes that the Accardi principle applies in the tax context as well as the non-tax context.  The regulation limits the amount of the maximum willful penalty to the greater of the amount in the account (not to exceed $100,000) or $25,000.  There is nothing in the 2004 amendment that conflicts with the regulation.  The statute provides that the Secretary “may impose a penalty” and in the case of a willful violation, the maximum amount of the penalty is the greater of $100,000 or 50% of the maximum amount in the account at the time of the violation.  The imposition of any penalty and the maximum amount of any penalty is left to the Secretary.  Thus, the Secretary can promulgate a regulation establishing a maximum penalty at anywhere from zero to the statutory maximum. 

Contrary to the majority, there is no requirement that the Secretary ensure that violators are exposed to a maximum penalty of up to 50% of the account balance.  Further, nothing in the statute “manifests a Congressional purpose to suspend the rule that an agency may constrain its discretion through regulation.” 

The dissent points out that the cases relied on by the majority were all pre-Chevron and under Chevron if the text is clear, then extra-textual evidence (such as legislative history) is not to be considered.  The statutory language gives the Secretary “discretion to impose any penalty beneath the statutory language and contains no language indicating that this discretion is constrained.”  It is thus improper to read such constraints into the statute or to ignore the Accardi principle.

The dissent concluded that Treasury can amend its regulation if it desires a different outcome and that, in affirming the district court, the majority “departs from basic administrative law and unjustifiably accommodates the Treasury’s relaxed approach to amending its regulations.”  [Internal quotation marks and citation omitted.]

For several years, I have been advocating that the regulation in question limits the maximum penalty and that if the Treasury doesn’t like the result it can easily fix it.  It was heartening to read an opinion (even if a dissenting one) that agrees.

Robert S. Horwitz is a Principal at Hochman Salkin Toscher Perez P.C., former Chair of the Taxation Section, California Lawyers’ Association, a Fellow of the American College of Tax Counsel, a former Assistant United States Attorney and a former Trial Attorney, United States Department of Justice Tax Division.  He represents clients throughout the United States and elsewhere involving federal and state administrative civil tax disputes and tax litigation as well as defending clients in criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.


[1] After United States ex.rel. Accardi v. Shaughnessy, 347 U.S. 260 (1954), which established the principle that federal agencies must abide by their regulations, rules and procedures.

We are pleased to announce that Dennis Perez and Michel Stein will be speaking at the upcoming CalCPA webinar, Tax Practice and Procedures Update: Laws and Lessons Learned” on Monday, July 28, 2021, 1:00 p.m. – 2:30 p.m. (PST).


Dennis and Michel will be speaking on important practice and procedural issues facing practitioners, including IRS priorities and the new emphasis on fraud investigations and referrals to the criminal investigation division. The procedure presentation covers important changes in Federal and California tax law, IRS new guidance and pronouncements. They will cover key developments from the IRS, FTB and Courts, along with compliance and planning lessons learned from these rulings.

Click Here for more information.

On May 20, 2021, the U.S. Treasury published a report entitled “The American Families Plan Tax Compliance Agenda.”[1]  The 22-page report reiterates previously-announced proposals by the Biden administration focused on increasing and improving tax compliance, including increasing information reporting by banks with respect to cryptocurrencies and additional financial transactions, and increasing the budget of the IRS for modernization, security and to help detect tax evasion and to narrow the tax gap.

Tax Gap

The tax gap is the difference between the amount of tax owed by taxpayers for a given year and the amount that is actually timely paid for that same year.[2]  As of 2019, the  tax gap reached nearly $600 billion and is anticipated to  rise to close to $7 trillion over the course of the next decade if left unaddressed – leaving roughly 15% of taxes owed going uncollected.[3]

The tax gap has three distinct elements:

  1. Taxpayers who fail to file returns in a timely manner (the “nonfiling” tax gap);
  2. Those who underreport income or overclaim deductions (the “underreporting” tax gap); and
  3. Those who underpay taxes despite reporting obligations in a timely manner (the “underpayment” tax gap)

Those who fall within the “underreporting” category account for almost 80% of the overall tax gap problem.[4]

American Families Plan Initiatives

The American Families Plan proposes initiatives that are estimated to raise $700 billion in additional tax revenue over the next decade and $1.6 trillion in the second decade trillion.[5] 

There are four categories in the agenda focused on efforts to increase tax compliance.

  1. Increase the resources of the IRS to pursue noncompliant taxpayers and better serve those who are fully compliant;
  2. Increase the information reporting, including leveraging information that financial institutions already collect to shed light on those taxpayers who misreport income derived from opaque categories;
  3. Overhauling antiquated technology to help leverage data analytic tools; and
  4. Regulate paid tax preparers and increasing penalties for those who intentionally commit malfeasance.

Increasing IRS Resources

It is no secret that the IRS’s overall budget declined by 18.5% between FY 2010 and FY 2021,[6] and its enforcement budget decreased by 15% over this time period, leading to a 20% decline in the IRS workforce.[7]  These losses have been most significant for revenue officers who collect taxes (50% decrease) and revenue agents who audit complex returns (35% decrease). 

The share of audited returns declined by nearly 45% between 2010 through 2018.  There has also been a steep decline in audit rates across all filing categories.  The share of corporate income tax, individual income tax, estate tax, and employment tax returns examined by auditors have all dropped in the last decade.

The Biden administration proposes providing the IRS with nearly $80 billion in additional resources over the next decade.  As noted in the report, the additional funding is intended, along with other things, to enable the IRS to hire new “specialized enforcement staff” and “revitalize the IRS’s examination of large corporations, partnerships, and global high-wealth and high-income individuals.”  Specifically, the proposed budget increase will enable the IRS to focus its enforcement scrutiny on high-income taxpayers and their businesses – arguably, significant contributors to the overall tax gap.

Increasing Information Reporting: Form 1099-INT and Cryptocurrency

Increased third-party information reporting is one of the more efficient and resource savings way to increase the overall tax reporting compliance rate as existing empirical evidence has confirmed.[8]

 One proposal is for financial institutions to report additional data to the IRS regarding its customers’ financial accounts on already existing information returns, such as the Form 1099-INT, that would provide the IRS with specifics as to gross inflows and outflows on all business and personal accounts from financial institutions, including bank, loan, and investment accounts but carve out exceptions for accounts below a low de minimis gross flow threshold.[9]

Another proposal is to expand tax compliance to cover cryptocurrency reporting requirements for investors, cryptocurrency exchanges, and payment service accounts that accept cryptocurrencies.  Businesses that receive cryptocurrency with a fair market value of more than $10,000 would be required to report these transactions.

Overhauling Outdated Technology

The IRS still relies on Individual and Business File Systems that date back to the 1960s.[10]  Modernizing the IT would not only be more efficient, secure and cost effective, but is also intended to enable the IRS to better identify suspect tax filings.[11]  For example, by comparing returns to similarly situated taxpayers and historical filings in a way that the current IRS IT system does not allow.  These resources would also support efforts to meet threats to the security of the tax system like the 1.4 billion cyberattacks the IRS experiences annually.

Regulating Paid Tax Preparers

With the IRS’s focus on “enablers” which can often reach large swaths of taxpayers in one investigation rather than a single taxpayer at a time, the report also identifies proposals intended  to provide the IRS with the authority to regulate and establish minimum competency standards for all paid tax preparers.[12]

Increased Tax Enforcement

While we may not see all of the above proposals enacted into law, the message of the American Families Plan agenda is clear.  The IRS is focused on increased enforcement of high-net-worth individuals.  Increased audits, heightened scrutiny, and a closer look at non-compliance by those who are viewed as contributors to the tax gap is the clear message.

Steven Toscher is a Principal at Hochman Salkin Toscher Perez P.C., and specializes in civil and criminal tax litigation. Mr. Toscher is a Certified Tax Specialist in Taxation, the State Bar of California Board of Legal Specialization and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation.

Sandra R. Brown is a Principal at Hochman Salkin Toscher Perez P.C., and former Acting United States Attorney, First Assistant United States Attorney, and the Chief of the Tax Division of the Office of the U.S. Attorney (C.D. Cal). Ms. Brown specializes in representing individuals and organizations who are involved in criminal tax investigations, including related grand jury matters, court litigation and appeals, as well as representing and advising taxpayers involved in complex and sophisticated civil tax controversies, including representing and advising taxpayers in sensitive-issue audits and administrative appeals, as well as civil litigation in federal, state and tax court. 


[1] https://home.treasury.gov/news/press-releases/jy0188

[2] U.S. Department of Treasury, “The American Families Plan Tax Compliance Agenda,” May 20, 2021, at 1.

[3] Id. at 3.

[4] Id. at 4.

[5] Id. at 2.

[6] IRS Statistics of Income, “Table 31: Collection Costs, Personnel, and US Population,” IRS Databook, 2019.

[7] Supra note 1 at 11.

[8] GAO, “Multiple Strategies are Needed to Reduce Noncompliance: Statement of James R. McTigue, Jr. Director, Strategic Issues,” 2019.  Dina Pomeranz, “No Taxation Without Information: Deterrence and Self-Enforcement in the Value Added Tax,” American Economic Review, 105(8), 2015.

[9] Supra note 1 at 19.

[10] GAO, “IRS Needs to Take Additional Actions to Address Significant Risks to Tax Processing,” GAO-18-298, 2019.

[11] Id. at 2.

[12] Id. at 21.

We are pleased to announce that Michel Stein, Robert Horwitz and Jonathan Kalinski will be speaking at the upcoming CalCPA webinar, “Partnership Examinations: What You Need to Know About New Partnership Rules” on Tuesday, July 27, 2021, 9:00 a.m. – 10:00 a.m. (PST).


This webinar will cover practical considerations for partners and advisers to partnerships now operating under the new partnership audit regime. Our panel of experts will review the latest guidance, explain partnership audit adjustments, and make recommendations for steps to take in light of the implementation of this new regime.


The centralized partnership audit regime (CAR) is effective now. The Bipartisan Budget Act of 2015 (BBA) included a new audit regime for partnerships effective for audits of partnership returns for years beginning in 2018.


Under the new rules, the partnership itself remits the underpayment (or receives the overpayment) resulting from an IRS examination at the end of an IRS review and pays the additional tax due at the highest income tax rate available (37% currently). Alternatives include making a push-out election taxing the individual partners owning interests during the year examined and showing that partners have amended their returns to account for the adjustments, the amended return adjustment. The Corrections Act in 2018 reduced the burden of filing amended returns by allowing partners to pay the amount of tax due and adjust any related tax attributes without the burden of filing amended tax returns, the pull-in procedure.

Click Here for more information.

At one point or another, you may have heard that California has an $800 per year tax for businesses in California. But what is this tax and to which business does it apply to?

California has an annual franchise tax. Every corporation that:

  1. is incorporated under the laws of California;
  2. is qualified to transact intrastate business in California pursuant to Chapter 21 of Division 1 of Title 1 of the Corporations Code (this chapter applies to foreign corporations who register with the Secretary of State to transact intrastate business); and
  3. is doing business in California[1]

is subject to the minimum franchise tax and shall pay annually to the state a minimum franchise tax of eight hundred dollars.[2]

Beginning in 1997, limited liabilities companies (“LLC”) doing business in California were also required to pay annually to the state “a tax for the privilege of doing business” in California in the amount specified in Cal. Rev. & Tax. Code § 23153.[3]

The first two categories of corporations required to pay the annual franchise tax is straightforward – a corporation is or is not incorporated under the laws in California, or a corporation is or is not qualified to transact intrastate business in California.

But what does that mean for corporations not incorporated in California or not transacting intrastate business in the state? And for LLCs? When are those corporations or LLC’s “doing business” in California?

Generally, “’doing business’ means actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.”[4] A taxpayer does business in California if any of the following conditions have been satisfied:

  1. The taxpayer is organized or commercially domiciled in this state;
  2. Sales in the state exceed the lesser of $500,000 or 25% of the taxpayer’s total sales;
  3. The real property and tangible personal property of the taxpayer in California exceed the lesser of $50,000 or 25% of the taxpayer’s total real property and tangible personal property; and
  4. The amount paid in California by the taxpayer for compensation exceeds the lesser of $50,000 or 25% of the total compensation paid by the taxpayer.[5]

The Office of Tax Appeals recently issued an opinion about the threshold limits of R&TC 23101(b)(3).

In the Matter of Consolidated Appeals of LA Hotel Investments

On May 13, 2021, the Office of Tax Appeals issued an opinion about whether two LLCs, La Hotel Investments #3, LLC (“Hotel #3”) and La Hotel Investments #2, LLC (“Hotel #2”), organized in the state of Louisiana were doing business in the state of California.[6]

Hotel #3 had a 5.41% interest in Irvine Center Hotels, LLC (“Irvine Center”), in 2013. Hotel #2 had a 2.56% interest in Tustin Gateway SPE LLC (“Tustin Gateway”), in 2013 and a 5.13% interest in both 2014 and 2015.  Both Irvine Center and Tustin Gateway were California LLCs that owned hotel properties in Orange County, California.  Hotel #2 paid the $800 franchise tax for 2013 and Hotel #3 paid the $800 franchise tax for 2013, 2014 and 2014.  Both LLCs filed refund claims for the franchise tax paid, stating that they were not doing business in California in those tax years and, therefore, were not subject to the annual $800 LLC tax.

The LLC’s pursued their refund claims based on the decision in Swart Enterprises, Inc. v. Franchise Tax Bd. (2017) 7 Cal.App.5th 497, which held that an out-of-state corporation’s passive holding of a 0.2 percent ownership interest in a manager-managed LLC doing business in California, with no right of control over the business affairs of the California LLC, was not itself doing business in California under R&TC section 23101(a).

The Franchise Tax Board argued that the LLCs were doing business in California because the LLC’s respective distributive share of the real and tangible property of Irvine Center Hotels and Tustin Gateway exceeded the thresholds stated in R&TC section 23101(b)(3).

For 2013, Irvine Center reported assets in California of $25,349,626. Based on Hotel #3’s 5.41% interest in Irvine Center, Hotel #3’s distributive share of Irvine Center’s property was $1,371,415, which exceeded the $50,000 threshold set forth in R&TC section 23101(b)(3).

For 2013, Tustin Gateway reported assets of $50,947,674. Based on Hotel #2’s 2.56% interest in Tustin Gateway, Hotel #2’s distributive share of Tustin Gateway was $1,304,260. In 2014 and 2015, Tustin Gateway reported assets of $51,434,471, and based on Hotel #2’s 5.13% interest in those years, Hotel #2’s distributive share for 2014 and 2015 was $2,638,588. Thus, Hotel #2’s distributive share of Tustin Gateway’s property for the three years at issue exceeded the $50,000 threshold as well.

The Hotel LLCs did not dispute the calculations discussed above, but rather argued they were not doing business in California within the meaning of R&TC section 23101(b) because Swart did not address R&TC section 23101(b).  They also argued that they were passive investors in Irvine Center and Tustin Gateway and “it seems a ’stretch’ to try to allocate a prorated percentage of

income and assets to passive investors.”  However, the Office of Tax Appeals found Swart inapplicable because the dispute in Swart concerned a tax year before enactment of R&TC section 23101(b) in 2010.

Based on the Hotel LLC’s distributive shares of property in Irvine Center and Tustin Gateway, the OTA found the two LLCs were doing business as defined by R&TC section 23101(b)(3) and were not entitled to a refund of the $800 LLC taxes paid.

Section 23101(b)(3) provides that a corporation or LLC is doing business in California if the “real and tangible personal property of the taxpayer in this state exceed the lesser of fifty thousand dollars ($50,000) or 25% of the taxpayer’s total real property and tangible personal property.”  Under California law, a partnership and an LLC is distinct from its partners and a member of an LLC or a partner in a partnership is not considered to own the real or tangible personal property of the business.[7]  Many non-residents own minority interests in California businesses and real estate partnerships through LLCs.  The OTA’s construction of the statute will have a major impact on these non-resident investors.  Will the FTB and the OTA push this decision to its logical limits and argue that out-of-state LLCs that own an interest in a California corporation are subject to the franchise tax if their proportionate share of the assets of the corporation exceed the $50,000 threshold?  If the LLC’s only asset is an interest in a California business, will it be subject to the franchise tax because the assets in California exceed 25% of its total property?  It seems that may be where we are heading.

Robert S. Horwitz is a Principal at Hochman Salkin Toscher Perez P.C., former Chair of the Taxation Section, California Lawyers’ Association, a Fellow of the American College of Tax Counsel, a former Assistant United States Attorney and a former Trial Attorney, United States Department of Justice Tax Division.  He represents clients throughout the United States and elsewhere involving federal and state administrative civil tax disputes and tax litigation as well as defending clients in criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

Gary Markarian is an Associate Attorney at Hochman Salkin Toscher Perez P.C., and a graduate of the joint JD/LL.M. Taxation program at Loyola Law School, Los Angeles. While in law school, Mr. Markarian served as an intern at the Tax Division of the U.S. Attorney’s Office (C.D. Cal) and Internal Revenue Service Office of Chief Counsel’s Large Business and International Division.


[1] Cal. Rev. & Tax. Code § 23153(b)(1-3)

[2] Cal. Rev. & Tax. Code § 23153(d)(1)

[3] Cal. Rev. & Tax. Code § 17941(a)

[4] Cal. Rev. & Tax. Code § 23101(a)

[5] Cal. Rev. & Tax. Code § 23101 (b)(1-4)

[6] In the Matter of the Consolidated Appeals of: La Hotel Investments #3, LLC and La Hotel Investments #2, LLC, 2021 WL 2930331, at *1

[7] Cal. Corporations Code §§16201, 16203, 17300.

It was refreshing to read a Ninth Circuit decision that states in its opening paragraph that “the Tax Court erred by invoking substance-over-form principles to effectively reverse that Congressional judgment and disallow what the statute plainly allowed.”  The decision is Mazzei v. Commissioner, 998 F.3d 1041 (9th Cir. 2021), rev’g 150 T.C. 138 (2018).  The case involves the interaction of the Roth IRA provisions of the Internal Revenue Code (“I.R.C.”) with the since-repealed I.R.C. provisions for Foreign Sales Corporations (“FSC”), I.R.C. §§921-927.  In its opinion, the Ninth Circuit provides an overview of the rules governing the tax treatment of FSCs, Roth IRAs and Domestic International Sales Corporations (“DISCs”), so that is where we will begin.

          IRAs have been authorized by the I.R.C. since the 1970s.  In the traditional IRA, the contributions (up to a statutory cap) are not taxable in the year paid to the IRA.  Earnings in an IRA accumulate tax free.  The beneficiary of the IRA pays tax when distributions are paid out.  In 1997, Congress authorized the Roth IRA.  Like a traditional IRA, earnings in a Roth IRA accumulate tax free.  Unlike traditional IRAs, however, the contributions to Roth IRAs are not deductible and distributions are not taxed.  There are strict rules limiting the amount contributed to Roth IRAs and excess contributions are subject to a 6% excise tax. 

          DISCs and FSCs were both statutorily authorized vehicles to allow U.S. corporations with foreign trade income to compete more effectively with foreign businesses.  DISCs were authorized in 1971 and carved out an exception to the transfer pricing provisions of I.R.C. §482.  Under the DISC provisions, a U.S. corporation that sold product overseas could set up a DISC and sell product to the DISC at a hypothetical transfer rate that produced a profit for both the corporation and the DISC when it resold the product.  The transfer price was fixed under a statutory formula that allowed part of the corporation’s export income to be reallocated to the DISC and not subject to corporate income tax.  The corporation could also pay commission to the DISC for export services, with the commissions computed under a formula.  All commissions paid the DISC would be tax deductible by the corporation and were unrelated to the services actually provided by the DISC.  The DISC was generally exempt from corporate income tax on its commission income.  Thus, neither the corporation nor the DISC would pay tax on the export income allocated to the DISC.  Tax would only be paid the IRS on DISC income when dividends were paid or deemed paid under the statute.  The I.R.C. allows tax-exempt entities to own shares of a DISC, but dividends received by an exempt organization from a DISC are treated as unrelated business income subject to tax under I.R.C. §511 at corporate income tax rates.

In 1984, due to disputes over DISCs under the General Agreement on Trade and Tariffs, Congress enacted legislation authorizing the formation of FSC by U.S. corporations with foreign trade income.  Unlike DISCs, FSCs must be formed under the laws of a foreign country or a U.S. possession.  The FSC would be a shell corporation.  The U.S. corporation would cycle part of its foreign trade income through the FSC in the form of tax deductible “commissions.”  The commissions paid the FSC would be computed under a statutory formula and the FSC did not have to perform any services for the commissions; instead it could contract with the U.S. corporation or a related party to perform the services for which the commissions were ostensibly paid.  Part of the “commissions” would be treated as foreign source income not effectively connected to a U.S. trade or business.  The FSC would pay federal income tax on the rest of the “commissions.” The U.S. corporation would get to deduct the entire amount of “commissions” paid.  The FSC would return the “commissions” back to the U.S. corporation or a related party as dividends, usually tax free.  “As a result, the FSC’s taxable income was largely generated through related-party transactions that lacked meaningful economic substance, and the FSC taxation rules thus reflected a sharp departure from the normal principle that taxation is based on economic substance rather than on legal form.” 

          Due to the dividends received deduction for corporations, dividends paid by a FSC to its parent corporation are not subject to corporate income tax.  If a shareholder of the FSC is an individual, dividends paid the individual are taxable income.  If an IRA is a FSC shareholder, dividends paid to the IRA are exempt from tax since, unlike DISC dividends paid to an exempt shareholder, they are not treated as unrelated business taxable income.  This meant that where a Roth IRA owned shares in a FSC:

  • The U.S. corporation deducts from its income the “commissions” paid the FSC;
  • The FSC pays a reduced federal income tax on the “commissions” it receives from the U.S. corporation;
  • The Roth IRA pays no income tax on dividends it receives from the FSC; and
  • The individual owner of the IRA pays no tax on authorized distributions.

So much for the overview of Roth IRAs, DISCs and FSCs.  What does all this have to do with the Mazzies?  The Mazzies patented an injector to add fertilizer to water used in agricultural irrigation systems in 1977 and set up Mazzie Injector Corp.  The corporation grew rapidly and by the mid-1980s it was exporting to foreign distributors.  In 1998, through a farmers’ trade association to which they belonged, the Mazzies set up a FSC and Roth IRAs that were shareholders in the FSC.  The FSC entered into various agreements with a partnership formed by the Mazzies.  Under these agreements, the FSC received commissions between 1998 and 2002 of $558,555 and paid dividends to the Roth IRAs of $533,057.  The Roth IRAs did not pay tax on the dividends.

The IRS did not look favorably on the Mazzies’ use of a Roth IRA as shareholders of the FSC.  It therefore issued notices of deficiency determining that the amounts paid by the FSC to the Roth IRAs should be deemed contributions in excess of the statutory limits and asserted excise taxes and penalties against the Mazzies.  By a 12-4 vote, the Tax Court upheld the excise tax deficiencies but not penalties.  The majority reasoned that the Roth IRAs put nothing at risk in the FSCs, that the Mazzies were the true owners of the FSCs and that the payments to the Roth IRS should be recharacterized as dividends to the Mazzies and as contributions to the Roth IRAs. 

The Ninth Circuit noted that the IRS did not contend (a) that the Mazzies failed to follow any formalities of the I.R.C regarding either the FSC or the Roth IRAs or (b) that the commissions paid the FSC were improperly calculated under the statute.  While the IRS tried to recharacterize the entire transaction, the Tax Court only recharacterized one transaction: the purchase of FSC stock by the Roth IRAs.  The Ninth Circuit viewed the issue before it as “whether the Tax Court properly concluded that, under the substance-over-form doctrine, the Mazzies, rather than their Roth IRAs, were the owners of the FSC for federal tax purposes.”

The Ninth Circuit’s analysis of the Tax Court’s opinion begins by recognizing that a general principal in construing tax laws is that form should be disregarded for substance and that the emphasis should be on economic reality.  This is “the formula within which all statutory provisions are to function.”  But there is an exception to every rule so the substance over form doctrine “can be negated by Congress in express statutory language.”  The Ninth Circuit viewed this as a case where statutory provisions elevate form over substance:

Put simply, the FSC statute expressly contemplates that, without itself performing any services, a FSC can receive “commissions” from a related entity and then (after paying a reduced level of tax) the FSC can pay the remainder as dividends to the same or another related entity. Under the scheme that Congress devised in the FSC statute, the taxation rules in certain respects plainly follow the form of the matter and not its substance. 

The Tax Court’s reliance on substance-over-form rules was an “extremely restrictive view of the exemption reflected in the FSC statute” that “cannot be reconciled with what Congress has decreed with respect to FSCs.”  The holding that the Roth IRAs were not the true owners of the FSC because they did not have the risks and benefits of ownership overlooked the fact that the statute allows FSCs to be set up to eliminate any risk from owning FSC stock: FSCs are shell companies with no operations and they generate value only because of the reduced tax rate on money “funneled through it” in accordance with strict statutory formulas.  Such a shell corporation presents little risk to the owner because it will only be used if and when taxes can be saved by funneling funds through it:

The statute clearly envisions that the parties who pay money into the FSC and the parties who receive dividends out of it will be related. Given that reality, it would not make much economic sense to “capitalize” the FSC with more than a nominal amount of capital. As the dissenters noted, taking the Tax Court’s analysis seriously would lead to the illogical conclusion that “no one could ever own an FSC” because no owner would ever “put capital at risk” in the FSC.

The Ninth Circuit also castigated the Tax Court’s reliance on the anticipatory assignment doctrine. The FSC regime explicitly departs from that tax law doctrine, since it allows the U.S. corporation to assign part of its foreign sales income to the FSC in the form of “commissions” that the FSC did not earn.

Two “textual clues” supported the Ninth Circuit’s determination: since the FSC provisions exempt FSCs from §482, the provisions apply regardless of who the related party is that owns an FSC.  Although Congress was aware that a tax-exempt entity can own shares in a FSC, unlike the DISC provisions, Congress did not make payments from a FSC to a tax-exempt entity like an IRA subject to taxation. 

To end its analysis, the Ninth Circuit noted that its decision was supported by the decisions of the First, Second and Sixth Circuits in the Summa Holdings, Inc. v. Commissioner cases.  The three cases, Summa Holdings v. Commissioner, 848 F.3d 779 (6th Cir. 2017), Benenson v Commissioner, 887 F.3d 511 (1st Cir. 2018), and Benenson v. Commisisoner, 910 F3d 690 (2nd Cir. 2018), involved a transaction where Roth IRAs owned stock in a corporation that, in turn, owned a DISC.  The Tax Court, relying on substance-over-form principals, held that the payments to the DISC were not commissions but deemed dividends to Summa’s shareholders followed by contributions to their Roth IRAs.  All three circuits reversed the Tax Court, ruling against the IRS.  The Ninth Circuit joined “our sister circuits here in concluding that, when Congress expressly departs from substance-over-form principles, the Commissioner may not invoke those principles in a way that would directly reverse that congressional judgment.”

As noted at the beginning of this blog, it’s refreshing to see appropriate limits put on the Commissioner’s use of the substance over form doctrine and  a Court reject the application of substance-over-form principles where the transaction is one that was contemplated by the statute. The lesson to be learned here is while the Commissioner’s power to apply judicial doctrines to protect the treasury is broad, it is not without its limits.

Robert S. Horwitz is a Principal at Hochman Salkin Toscher Perez P.C., former Chair of the Taxation Section, California Lawyers’ Association, a Fellow of the American College of Tax Counsel, a former Assistant United States Attorney and a former Trial Attorney, United States Department of Justice Tax Division.  He represents clients throughout the United States and elsewhere involving federal and state administrative civil tax disputes and tax litigation as well as defending clients in criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

Background

Last year, our partner, Robert Horwitz, blogged about United States v. Schwarzbaum[1], and detailed Mr. Schwarzbaum’s willful failure to file FBARs for his Swiss and Costa Rican offshore bank accounts.[2] The Court in that case entered a judgment against Mr. Schwarzbaum of approximately $15.8 million in FBAR penalties, interest, and late-payment penalties. This blog now turns to subsequent proceedings- the effort to collect those penalties from someone who resides outside the United States. We are moving into uncharted waters.

After the Court entered the judgment, Mr. Schwarzbaum sold his Florida residence and moved to Switzerland, or in the words of the government, gave “up on the United States”. Asserting that Mr. Schwarzbaum has de minimis assets remaining in the United States and that he had failed to satisfy the judgment prior to leaving, the government, believing that he has over $49 million deposited in Swiss bank accounts, has taken formal steps to repatriate those foreign assets in collection of Mr. Schwarzbaum’s outstanding FBAR judgment.

Motion to Repatriate Foreign Assets

On June 3, 2021, we saw a new development in the Schwarzbaum case when the U.S. government filed a post-judgment Motion to Repatriate Foreign Assets, specifically, Mr. Schwarzbaum’s Swiss bank accounts.

In its motion, the government referenced the District Court’s “inherent authority to ensure that prevailing parties can enforce money judgements in their favor,” citing Pfizer, Inc. v. Uprichard.[3]

The government also cited to the Federal Debt Collection Procedures Act (“FDCPA”)[4] and the All Writs Act,[5] stating that “the Court can issue a writ or other order requiring Schwarzbaum to bring sufficient assets back onshore to satisfy the judgment.” The government argued that the FDCPA and All Writs Act grants the court “the power to order judgment debtors to repatriate foreign assets … where a judgment debtor maintains large amounts of money or assets abroad and has insufficient money or assets within the United States to satisfy the judgment.” Additionally, the government noted that although many repatriation orders are connected with income tax enforcement and this case involved an FBAR penalty, which is found under Title 31 of the U.S.C., that shouldn’t be a limiting factor in the court’s powers to enforce the judgment like a tax. The judgment sought in this case represents a remedial civil penalty, and thus, the government asserted, this situation is really “a distinction without a difference.”

Mr. Schwarzbaum’s judgment debt, as of as of May 31, 2021, already exceeds $16.5 million. Nonetheless, the government in this post-judgment proceeding is also pursuing a surcharge of 10% of the debt owed for a total repatriation of $18,227,465.89, plus any penalties and interest continuing to accrue.

On June 17, 2021, Mr. Schwarzbaum, through counsel, responded to the United States’ Motion to Repatriate Foreign Assets. The response argued that (1) the government’s motion is a disguised attempt to compel Mr. Schwarzbaum to post an appeal bond and frustrate his appeal; (2 the majority of Mr. Schwarzbaum’ liquid assets were always kept outside of the United States and therefore Mr. Schwarzbaum could not repatriate funds which never left Switzerland to begin with; and (3) repatriation orders are reserved for tax liabilities or disgorgement of ill-gotten gains – neither of which is applicable here. Mr. Schwarzbaum’s response asked the Court to deny or abate the government’s claim pending the results of Mr. Schwarzbaum’s appeal.

On June 24, 2021, the United States submitted its reply to Mr. Schwarzbaum’s response. The government’s introduction stated “Defendant Isac Schwarzbaum’s response can be distilled to ‘I don’t want to pay the judgment, and no one can make me.” The government argued that (1) Mr. Schwarzbaum can pay the judgment voluntarily, post a bond, or face forced collection, but that none of these options will frustrate his appeal because “if he prevails, the Government will return the money collected to the extent required by the appellate decision.”; (2) repatriation can be applied to funds that were not previously in the United States as in United States v. McNulty, 446 F. Supp. 90, 92 (N.D. Cal. 1978); and (3) repatriation orders are not reserved solely for tax liabilities or disgorgement cases. The government also offered to call their requested relief “’bringing in’ foreign assets instead of ‘repatriating’ them” if it would appease Mr. Schwarzbaum. The government’s conclusion told the court that Mr. Schwarzbaum “is snubbing the judicial process and this Court’s authority” and requested he be ordered to repatriate assets sufficient to pay the judgment.

On June 30, 2021, United States Magistrate Judge Bruce Reinhart filed his Report and Recommendation on the government’s repatriation motion and recommended that the government’s motion be granted, and that Mr. Schwarzbaum be ordered to repatriate $18,227,465.89 in addition to any additional interest.

The Government’s Post-Judgment Collection Efforts

Presuming the government prevails in obtaining the relief sought, here is a summary of just a few civil remedies the United States might be considering in its efforts to collect from Mr. Schwarzbaum.

            Writ of Ne Exeat Republica

If Mr. Schwarzbaum were to return to the United States, the government could pursue a writ of ne exeat republica. Awrit of ne exeat republica (Latin for “let him not leave the republic”) is a writ issued by a court to restrain a person from leaving the jurisdiction of the court until the person has complied with a court order. If Mr. Schwarzbaum was in the United States, the writ would restrain him from leaving the country until he has fully paid his outstanding liabilities.

We saw the government use this tool in 2010 in United States v. Barrett, when Mr. and Mrs. Barrett, who owed the IRS $326,421, left the United States and moved to Ecuador rather than pay their outstanding liability.[6] The government sought and was granted a writ of ne exeat republica. In 2013, when the Barretts decided to attend their daughter’s wedding in the United States, they were greeted by U.S. Marshals, detained, ordered to turn over their passports, and remain in the country. The writ would not be discharged – meaning the Barretts would be unable to leave the U.S. — unless they paid over $16,000 the IRS knew they had in Ecuador.

However, absent Mr. Schwarzbaum’s presence in the United States, this writ would be ineffective.

            Civil Contempt

A U.S. District Court has inherent authority to hold someone in civil contempt for failing to comply with a court order.[7] An aggrieved party, e.g., in this case, the government, may file a motion for civil contempt of court when the other party to the case disobeys a court order. The remedy for civil contempt can include incarceration, in an effort to coerce the disobedient party to do that which the court has ordered him or her to do.

However, a finding of civil contempt would only be effective if Mr. Schwarzbaum were in the United States since a finding of civil contempt is not a criminal offense. It is, therefore, not an extraditable offense under the United States’ extradition treaty with Switzerland.[8]

            U.S. Request for Recognition and Enforcement in Switzerland

The U.S. government may also try to seek Switzerland’s assistance to enforce the judgment in this situation.

Enforcement proceedings in Switzerland are subject to the Swiss Debt Collection and Bankruptcy Act (DCBA) and the recognition and enforcement of a U.S. judgment is governed by the Swiss Private International Law Act (PILA).

Under these laws, a creditor who seeks recognition and enforcement of a U.S. judgment against a debtor’s assets in Switzerland must first secure its claim by attaching the debtor’s assets. The attachment proceedings enable the creditor to freeze the debtor’s Swiss assets. To attach the debtor’s assets, the creditor must make a prima facie showing that (1) he or she has a claim against the debtor; (2) one of the statutory grounds for attachment is met; and (3) the debtor has assets in Switzerland.[9] The DCBA provides a list of statutory grounds for attachment. Relevant to this discussion is Article 272 (1) (6) of the DCBA, which states that to qualify as a ground for attachment, the judgment must be enforceable in the country where it was issued.

In the present matter, the U.S. government would need to show that: (1) it has a claim against Mr. Schwarzbaum; (2) the judgment is enforceable in the United States; and (3) the debtor has assets in specified Swiss bank accounts.

If the request for attachment is granted, the Debt Collection Office of the Canton where the assets are located will execute the attachment and freeze the debtor’s property. The debtor will then be informed of the execution and have the right to file an objection. If the Swiss court confirms the attachment, the creditor must then initiate enforcement proceedings within 10 days.

Enforcement proceedings require the creditor show (1) the foreign country had jurisdiction; (2) the decision is final; and (3) there are no grounds for denial as provided in Article 27 of the PILA.[10] Grounds for denial include (1) the debtor did not receive proper service of process;[11] (2) the debtor was not duly notified and given an opportunity to present its defense before the foreign country’s courts;[12] or (3) public policy arguments where the debtor must show a great injustice which reaches the level of being intolerable.[13]

The U.S. government must ensure there are no grounds for denial per Article 27 of PILA and this is where they are likely to run into trouble. It appears that the government will satisfy the requirements for service of process and an opportunity to present a defense before a court in the U.S, but there would appear to be strong public policy arguments against enforcement that would be attractive to a Swiss Court.

The 50% FBAR penalty has punitive elements and reaches the level of being intolerable. Swiss courts have refused to enforce judgments with excessive punitive damages intended to punish an individual for their actions or deter the party from repeating the same behavior and have reasoned that punitive damages must be in reasonable relation to the damage or loss actually suffered.[14]

Additionally, a Swiss Court would also consider whether enforcement violated the so-called Revenue Rule. Although the present matter is an FBAR case, the Swiss Court may liken it to a tax case and apply the principals of the “Revenue Rule.”[15] The Revenue Rule is the rule that prevents revenue authorities of one country from initiating a legal proceeding to claim or enforce its revenue in another country.

Conclusion

We’ll have to wait and see what happens next in the matter of United States v. Schwarzbaum, but one message is clear from the government’s latest motion: The U.S. government is looking to not only continue its FBAR enforcement and that its reach for foreign assets to satisfy FBAR penalty debts continues to expand.

Steven Toscher is a Principal at Hochman Salkin Toscher Perez P.C., and specializes in civil and criminal tax litigation. Mr. Toscher is a Certified Tax Specialist in Taxation, the State Bar of California Board of Legal Specialization and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies, and tax litigation.

Sandra R. Brown is a Principal at Hochman Salkin Toscher Perez P.C., and former Acting United States Attorney, First Assistant United States Attorney, and the Chief of the Tax Division of the Office of the U.S. Attorney (C.D. Cal). Ms. Brown specializes in representing individuals and organizations who are involved in criminal tax investigations, including related grand jury matters, court litigation and appeals, as well as representing and advising taxpayers involved in complex and sophisticated civil tax controversies, including representing and advising taxpayers in sensitive-issue audits and administrative appeals, as well as civil litigation in federal, state and tax court.

Gary Markarian is an Associate Attorney at Hochman Salkin Toscher Perez P.C., and a graduate of the joint JD/LL.M. Taxation program at Loyola Law School, Los Angeles. While in law school, Mr. Markarian served as an intern at the Tax Division of the U.S. Attorney’s Office (C.D. Cal) and Internal Revenue Service Office of Chief Counsel’s Large Business and International Division.


[1] United States v. Schwarzbaum, No. 18-CV-81147, 2020 WL 1316232 (S.D. Fla. Mar. 20, 2020), appeal dismissed (Nov. 25, 2020)

[2] See Robert S. Horwitz, “It Still Lives!! Recent Opinions in Two Willful FBAR Penalty Cases” June 1, 2020 https://taxlitigator.me/2020/06/01/it-still-lives-recent-opinions-in-two-willful-fbar-penalty-cases-by-robert-s-horwitz/

[3] Pfizer, Inc. v. Uprichard, 422 F.3d 124, 131 (3d Cir. 2005).

[4] 28 U.S.C. §§ 3001–3308,

[5] 28 U.S.C. § 1651(a)

[6] United States v. Barrett, Case No. 10-cv-02130 (D. Colo. Aug. 13, 2013).

[7] 28 U.S.C. § 636

[8] See Extradition Treaty Between the Government of the United States of America and The Government of the Swiss Confederation, Article 2 (An offense must be criminal to be an extraditable offense). https://www.congress.gov/104/cdoc/tdoc9/CDOC-104tdoc9.pdf

[9] Article 271 (1) DCBA

[10] Article 25 PILA

[11] Article 27(2)(a) PILA

[12] Id.

[13] Article 27(1) PILA

[14] Martin Bernet & Nicolas C. Ulmer, Recognition and Enforcement of Foreign Civil Judgments in Switzerland, 27 Int’l Law. 317, 328 (1993). 

[15] Pasquantino v. United States, 125 S. Ct. 1766, 1768, 161 L. Ed. 2d 619 (2005) (The revenue rule “prohibited the collection of tax obligations of foreign nations.”)

We are pleased to announce that Michel Stein, Sandra Brown along with Lois Dietrich will be speaking at the upcoming Strafford webinar, “IRS Promoter Investigations, Enforcement Actions, and Penalties: Syndicated Conservation Easements, Micro-Captives” on Tuesday, July 20, 2021, 10:00 a.m. – 11:30 a.m. (PST).


This CLE/CPE webinar will guide tax professionals through new IRS enforcement actions focused on promoters of syndicated conservation easements and micro-captive arrangements. The panel will discuss recent IRS investigations of promoters of what they determine as abusive tax avoidance transactions, navigating the processes involved for examinations, new procedures of the IRS Office of Promoter Investigation, penalties, and key strategies for tax professionals. The panel will also discuss structuring micro-captives and conservation easement transactions to minimize IRS assessments and audits.


Recently, the IRS announced the new Office of Promoter Investigations to combat abusive tax avoidance transactions. As the IRS expands its operations and enforcement actions, tax professionals and advisers must prepare to defend targeted taxpayers on syndicated conservation easements and micro-captive insurance arrangements.
Over the past year, the crackdown on conservation easement transactions has forced taxpayers, tax counsel, and advisers to recognize critical tax issues in structuring these transactions. Conservation easements are legally enforceable perpetual land preservation agreements between a landowner and either a government agency or a qualified land protection organization (such as a land trust) to conserve land and its resources. Grantors within these transactions enjoy significant tax benefits if the easement meets IRS approval for a donation.


In addition, the use of captive insurance companies, particularly Section 831(b) “micro-captives,” has come under increased IRS scrutiny as well. The IRS has explicitly recognized micro-captives as a legitimate form of risk protection but has expressed concern that these vehicles are being used more as a wealth transfer device than legitimate insurance.


The popularity of conservation easement transactions and micro-captive arrangements makes them prime targets for promoters and investors seeking to take advantage of their tax benefits. However, the IRS may consider these transactions to be abusive tax avoidance schemes based on their structure, leading to potential IRS audits and investigations.


Furthermore, although the IRS has focused investigations on promoters of syndicated conservation easements and micro-captive insurance arrangements, the Service will investigate other transactions that they deem abusive tax avoidance practices.Listen as our panel discusses recent IRS enforcement actions on promoters, navigating the processes involved in abusive tax avoidance transaction cases, and key tax professionals’ strategies.


We are also pleased to announce that we will be able to offer a limited number of complimentary and reduced cost tickets for this program on a first come first serve basis. If you are interested in attending, please contact Sharon Tanaka at sht@taxlitigator.com. 

Click Here for more information.

Posted by: Robert Horwitz | July 11, 2021

Death and the Non-Willful FBAR Penalty by ROBERT HORWITZ

Causes of action based on penal statutes do not survive the defendant’s death while those based on remedial statutes survive death.  In this context, a remedial statute is one meant to compensate the victim for a harm suffered, while a penal statute is meant to impose damages upon a defendant for a general wrong.  Given the magnitude of the civil FBAR penalty ($10,000 for a non-willful violation and the greater of $100,000 or 50% of the amount in the account for willful violations), most people would conclude that an action to collect the civil FBAR penalty is a “penal” rather than a “remedial” cause of action and that it does not survive the death of the person assessed.  If you have kept track of willful FBAR penalty cases, you’d know that the district courts that have addressed the issue have held that a willful FBAR penalty survives the death of the defendant.  See, United States v. Estate of Garrity, 304 F. Supp. 3d 267 (D. Conn. 2018); United States v. Estate of Schoenfield, 344 F. Supp. 3d 1354 (M.D. Fla. 2018); United States v. Park, 389 F. Supp. 3d 561 (N.D. Ill. 2019); United States v. Green, 457 F. Supp. 3d 1262 (S.D. Fla. 2020); United States v. Wolin , 489 F. Supp. 3d 21 (E.D. N.Y. 2020).

Given the number of district court cases over the past three years holding that the willful FBAR penalty survives the defendant’s death, why a blog now on death and the FBAR penalty?  Because a recent opinion by the United States District Court for the Southern District of Texas, United States v. Gill, Dkt. No. H-18-4020, contains an in-depth analysis of whether the non-willful FBAR penalty was remedial or penal in the context of a motion to dismiss and concluded that it was remedial and survived death. 

First, just the facts: Gill was a naturalized U.S. citizen who had an interest in or signatory authority over numerous foreign bank accounts.  He failed to report foreign income on his 2005-2010 income tax returns and failed to file FBARs for those years.  The IRS assessed $740,848.00 in non-willful FBAR penalties against Gill and $55,304 in non-willful FBAR penalties against his wife.  The Government filed separate collection actions against Gill and his wife.  Gill answered and moved to consolidate the two cases. The motion was granted.  Shortly afterwards Gill died and his wife was appointed representative of his estate.  The estate then moved to dismiss the case against Gill under Fed. Rule Civ. Pro. 12(b)(6), failure to state a claim upon which relief can be granted, arguing that the FBAR penalty was penal and, thus, the Government’s claim did not survive Gill’s death.

The Court got down to analyzing the law by first stating the ground rules under Rule 12(b)(6):  on a motion to dismiss for failure to state a claim all questions of fact and all legal ambiguities are to be resolved in favor of the plaintiff, in this case the Government. 

The first question was whether under 28 U.S.C. sec. 2404 the claim against Mr. Gill survived his death.  That section provides that a civil action for damages brought by or on behalf of the United States survives the defendant’s death.  To answer this question requires a determination of whether the claim is primarily remedial or penal.

The general rule is that causes of action that seek remedial damages survive the defendant’s death while those that are penal do not.  A remedial action seeks damages for a specific harm suffered by a person while a penal action seeks damages for “a general wrong to the public.”  A three-part test (termed the In re Wood factors) is normally applied to make this determination: (1) is the purpose of the statute to address individual wrongs or a more general wrong to the public; (2) does the recovery go to the harmed individual or the public; and (3) is the recovery authorized by the statute “wholly disproportionate to the harm suffered.”  My initial reaction to this three-part test is that the civil FBAR penalty is a penal statute.  But there’s more. 

Under Hudson v. United States, 522 U.S. 93 (1997), when the Government is the plaintiff, the courts additionally consider whether the legislature labeled the “penalizing mechanism as civil or penal” and the seven-factor Kennedy test:

  1. Does the sanction involve an affirmative disability or restraint;
  2. Has it been regarded historically as punishment;
  3. Does it only come into play upon a finding of scienter;
  4. Does it promote the traditional aims of punishment — retribution and deterrence;
  5. Is. the behavior to which it applies already a crime;
  6. Is there an alternative, non-punitive purpose to which it may be rationally connected; and
  7. Is it excessive in relation to the alternative purpose.

Finally, if the claim does not fall neatly into either category, you look to the primary purpose of the statute.

          The statute (31 U.S.C. Sec. 5324) and regulations impose a duty to report foreign accounts if the aggregate balance in the accounts exceed $10,000.  The penalties for violating the reporting requirement are $10,000 if the violation is not willful or the greater of $100,000 or 50% of the balance in the accounts where the violation is willful.  The Senate Report states the non-willful penalty “that applies without regard to willfulness will improve compliance with this [reporting] requirement.”   The Court saw this statement as supportive of the non-willful penalty having a deterrent purpose, which is usually associated with punishment, but noted that deterrence may serve both civil and criminal goals:

Since the penalties imposed are for non-willful violations, the deterrent purpose is towards a broader audience who will want to make sure they are following tax regulations to avoid steep penalties as opposed to punishing the individual upon whom the penalty is assessed — who obviously did not willfully fail to file.

Since a person acts willfully if he knows about the reporting requirement and intentionally fails to file an FBAR, to be non-willful a person would have to be ignorant of the reporting requirement.  Thus, to be deterred by the non-willful penalty a person would have to know about the reporting requirements.  But if a person knows of the filing requirement the failure to file would be willful, so people who are non-willful would not be deterred by the non-willful FBAR penalty.  Or is my reasoning faulty?

Moving on, the Estate pointed to a provision of the IRM stating that the FBAR penalties are to “promote compliance with FBAR reporting and record keeping requirements” and urged that this further supported the claim that the penalty was penal.  The Court readily brushed this aside since the IRM is not law, although it can provide guidelines “to assess the propriety of IRS actions.”  In any event, the Court found that this provision of the IRM does not indicate that the civil FBAR penalties are “primarily punitive such that the court should dismiss the claim at this time.”  In summation “The text of the statute, Congressional Record, and the IRS Manual inform the court’s analysis, and they indicate that the statute has some deterrent purpose but do not preclude a potential remedial purpose.”

The Court then looked at the cases cited by the parties.  The Government cited cases holding that the willful FBAR civil penalty is remedial and thus survives a defendant’s death and is enforceable against the estate.  All of these cases relied on the multi-factor Kennedy test.  Several of these cases stated that the civil FBAR penalty in part reimburses the Government for the “heavy expense” of investigation.

The Estate relied on United States v. Bajakajian, 524 U.S. 321 (1998), which noted that a civil forfeiture for violating the reporting requirement for taking cash out of the country was punishment.  Civil forfeiture required a finding of criminal conduct and thus the case was inapposite, as were the other cases relied on by the Estate: United States v. Simonelli, which dealt with whether the civil FBAR penalty was a tax that was discharged in bankruptcy or “a civil money penalty” that was not discharged; and cases dealing with whether the non-willful penalty was imposed per account or per form.

The Court found the Government’s cases more persuasive.  As a result, at this stage of the proceedings, it held that the non-willful FBAR penalty was remedial and survived the defendant’s death.  It denied the motion to dismiss.  The Court concluded:

Since at the motion to dismiss stage and ambiguities must be resolved in favor of the non-movant, the court finds that given the “close call” nature of this question, the doubt should be resolved in favor of the Government.

This may be a sign that the Court at a later stage of the proceeding may reach a different conclusion.  But maybe I am grasping at straws.

Robert S. Horwitz is a Principal at Hochman Salkin Toscher Perez P.C., former Chair of the Taxation Section, California Lawyers’ Association, a Fellow of the American College of Tax Counsel, a former Assistant United States Attorney and a former Trial Attorney, United States Department of Justice Tax Division.  He represents clients throughout the United States and elsewhere in federal and state administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

We are pleased to announce that Sandra Brown and Steven Toscher along with Marty Schainbaum, Damon Rowe, and Richard Hassebrock will be speaking at the upcoming USD Sixth Annual USD School of Law – RJS Law Tax Controversy Institute webinar, “The IRS New Office of Fraud Enforcement—What Practitioners Can Expect, the Consequences and Best Practices” on Friday, July 16, 2021, 1:30 p.m. (PST).


Click Here for more information.

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