Although section 6501(c)(8) has been in the Code for several years, many tax practitioners remain unaware of this exception to the general three-year statute of limitations for assessment of tax for delinquent foreign information returns. This exception can significantly influence a taxpayer's decision as to whether, and how, to correct past non-compliance. This article first discusses the exception, and then describes the alternative methods for late filing of foreign information returns.
The foreign information returns referenced include Form 8938, Statement of Specified Foreign Financial Assets, Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, and Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, among others. Although section 6501(c)(8) does not apply to the failure to file a Report of a Foreign Bank or Financial Account (FBAR), many taxpayers who have failed to file FBARs also have failed to file Form 8938 reporting their foreign accounts as specified foreign financial assets, and thus they still need to be concerned about section 6501(c)(8). For those uncertain about their responsibilities, the Service provides a helpful comparison of the filing thresholds for FBARs and Forms 8938.
Under section 6501(a), the Service generally has three years from the date a tax return is filed to assess additional tax, but there are numerous exceptions. Since the March 18, 2010 effective date of revised section 6501(c)(8), the time for assessment of tax does not expire until three years after the date that all required foreign information returns have been filed. The application of section 6501(c)(8) depends on the tax year at issue. For tax returns for which the general three-year statute of limitations for assessment had not yet expired before March 18, 2010 and for all returns filed after March 18, 2010, the statute of limitations for assessment is open for all items on the return until the delinquent foreign information return is filed, unless the failure to file the foreign information return was due to reasonable cause and not willful neglect. If the taxpayer establishes reasonable cause, the limitations period is extended only for the items related to the failure to provide the required information. For tax years for which the statute of limitations expired before March 18, 2010, the statute of limitations remains open with respect to any items related to the failure to furnish the required information. An example of an item related to the failure to file a foreign information return is subpart F income from a foreign corporation for which the taxpayer failed to file a required Form 5471.
Accordingly, for taxpayers who have not filed required foreign information returns, the statute of limitations remains open at best only for items related to those forms and at worst, for all items on the return. If the taxpayer files the foreign information returns, the statute of limitations begins to run and the Service has three years to assess additional tax, unless some other exception to the statute of limitations applies.
In Chief Counsel Advisory 200748006, the Service explained the standard for reasonable cause in the context of failure to file foreign information returns. The CCA specifically addresses penalties for failure to file Form 5471, but the same rationale applies to the failure to file other foreign information returns and for determining reasonable cause under section 6501(c)(8). The CCA stated that the Service will apply the reasonable cause standard for failure to file income tax returns under section 6651, which requires taxpayers to exercise ordinary business care and prudence. The Service has defined ordinary business care and prudence, as "making provisions for business obligations to be met when reasonably foreseeable events occur," and "taking that degree of care that a reasonably prudent person would exercise."
In deciding whether the taxpayer has met this standard, the Service considers the explanations for the failure to file the foreign information return, the taxpayer's compliance history, the length of time between the event cited as a reason for the noncompliance and the subsequent compliance, whether there were circumstances beyond the taxpayer's control, and, in some cases, the taxpayer's ignorance of the law or inability to get records. The Service has warned taxpayers with business and holdings offshore, however, that "[i]t is not reasonable or prudent for taxpayers to have no knowledge of, or to solely rely on others for, international transactions."
The indefinite and open-ended statute of limitations for assessment can be problematic. First, although there is a practical limit to how far back the Service is able to assess tax and penalties due to the difficulty of obtaining information with the passage of time, a taxpayer nonetheless remains vulnerable to audit and assessment of tax indefinitely, if the statute of limitations never closes. Second, a taxpayer's ability to present a reasonable cause defense decreases over time, because there may no longer be evidence in the taxpayer's possession to substantiate the claim and because the continuing failure to correct after learning about the error further weakens any reasonable cause defense.
Third, federal interest on underpayments is high: for non-corporate taxpayers, it is three points above the federal short-term rate and compounds daily, as indicated in fourth-quarter reports. A taxpayer who failed to report a foreign asset years ago may be unpleasantly surprised to receive a bill that includes more interest than the original tax would have been had it been paid when the error first occurred.
In addition to the statute of limitations issue addressed in this article, failure to file foreign information returns can lead to significant penalties. A full discussion of those penalties is available as part of the ABA Tax Section CLE Nuts & Bolts Series, titled "International Tax Enforcement: FBARs, FATCA, and More".
There are several options available for filing delinquent foreign information returns. As an initial matter, the foreign information returns referred to in section 6501(c)(8) are not stand-alone forms, but are attached to the taxpayer's income tax return. For example, if an individual taxpayer failed to file a Form 8938, the taxpayer would remedy by filing a Form 1040X Amended Individual Income Tax Return to which the delinquent Form 8938 would be attached.
In order to avoid or reduce penalties, as well as to start the statute of limitations on assessment, a taxpayer with delinquent foreign information returns may be eligible to use one of the Service's voluntary compliance procedures. Below is a brief description of each program, with hyperlinks to the applicable procedures on the Service's website. Although these programs are primarily directed to foreign bank account non-compliance, they also can be used to file information returns for other offshore assets and interests.
First, the taxpayer can file through the Service's procedures for delinquent international information returns. This procedure is appropriate for taxpayers who can establish reasonable cause for their failure to file or whose failure to file has caused no or nominal tax non-compliance. This procedure cannot be used, however, if the taxpayer is already under audit or investigation or has otherwise been contacted by the Service about the delinquent information returns. Under this procedure, the taxpayer files the delinquent returns with a statement of the facts establishing reasonable cause for the failure to file. In the "Frequently Asked Questions" section, the Service explains that taxpayers with tax noncompliance can use this procedure, but that the Service may impose penalties if it does not accept the taxpayer's reasonable cause explanation.
The next option, available only for taxpayers who are not under audit or investigation, is for the taxpayer to file amended returns through the Service's Streamlined Filing Compliance Procedures. Under the procedures for U.S. taxpayers who reside in the United States, U.S. residents must file amended returns for the preceding three tax years and FBARs for the preceding six tax years, pay any tax due with interest, and pay a penalty of 5% of the highest aggregate value of assets that should have been reported on the Form 8938—i.e., the value of their previously unreported specified foreign assets. Under the procedures for U.S. taxpayers who live abroad, the terms of this program are the same, except that the procedure may also be used to file original Forms 1040 as well as amended returns, and no penalties are imposed.
Both resident and non-resident U.S. taxpayers must submit a statement to the Service, using either Form 14653 or Form 14654, that explains the circumstances of their non-compliance and certifies that the failure to file was "non-willful." In this context, "non-willful" means that the taxpayer's conduct was "due to negligence, inadvertence, or mistake or conduct that is the result of a good faith misunderstanding of the requirements of the law." This is a less stringent standard than reasonable cause.
Finally, there is an option most likely to be used by taxpayers who are concerned that the Service may view their non-compliance as willful or fraudulent and impose steep civil penalties or prosecute them criminally. It is the Service's Offshore Voluntary Disclosure Program (the OVDP). Under the terms of the OVDP, the taxpayer must file amended returns, including all delinquent foreign information returns and FBARs for the preceding eight tax years, pay the tax due plus a 20% accuracy penalty and interest, and pay a penalty of 27.5% of the highest balance during that period of any unreported foreign accounts and other foreign assets related to tax non-compliance. This penalty will be increased to 50% of the highest balance during the period at issue for those taxpayers who had an undisclosed account with a foreign financial institution or facilitator identified by the Service as under criminal investigation or as having been served with a John Doe summons. The Service maintains an up-to-date list of these foreign financial institutions and facilitators. The OVDP is available to any taxpayer, regardless of whether they acted willfully or committed tax fraud, so long as (i) the taxpayer is not under audit or investigation and (ii) the income being reported is from a legal source.
Because the statute of limitations will not close on an income tax return with incomplete foreign information reporting, "waiting it out," is not a solution to the problem of non-compliance. Tax practitioners should assess their clients' unique circumstances and determine the best method for coming into compliance, keeping in mind the tax practitioner's own obligations under Circular 230. In the context of delinquent foreign information returns, tax practitioners should inform their clients about the extended statute of limitations as well as the potential penalties, and then discuss whether one of the Service's procedures is appropriate for them.
