Taking Tax Advice From Friends

 

I received a text message one night this past week.

I was researching living trusts on the internet. It sounds like it might work for my situation.

I had two immediate reactions:

First, excellent. I am a fan of doing your own research and understanding what an expert is recommending.

Second - and maybe more important – use the expert.

The problem with DIY tax research is that you may not know what you do not know. Granted, in many cases it might not matter as much (hey, can I deduct the mileage for my gig income?), but in other cases it might matter a lot.

Let’s talk about the Horowitz case from 2019.

Peter Horowitz was an anesthesiologist. Susan Horowitz was a PhD working as a public health analyst for the U.S. Department of Health of Human Services.

In 1984 they moved to Saudi Arabia. They lived mostly on Susan’s income while banking most of Peter’s salary.

They used U.S.-based accountants, so they knew to (and filed) federal taxes on their Saudi earnings.

One thing about a bank account in Saudi Arabia: it does not pay interest. After a couple of years, the Horowitzes got tired of that and opened a Swiss bank account. They were also concerned about untangling the Saudi account when the Saudi gig played out.

Makes sense.

The Horowitzes did not tell the U.S accountants about the Swiss account. This meant that they did not report the interest income nor did they report the existence of the foreign account to the Treasury or IRS.

Why?

Their friends in Saudi Arabia told them that they did not have to pay U.S. tax on interest earned on the Swiss account.

In 2001 they moved back to the U.S. That Swiss account had grown to $1.6 million. Peter called the bank every year or two to keep an eye on the account.

COMMENT:  I would too.

Fast forward to 2008, the year that UBS got in trouble with the (non)reporting on Swiss bank accounts. UBS notified the Horowitzes that they would be closing the account. Peter traveled to Switzerland and moved the funds to another bank. Susan travelled the next year to add her name to that account.

Peter opened a “numbered” account, which meant that a number rather than a name identified the account. He also requested the new bank to not send correspondence (termed “hold mail” - something the IRS did not like).

Why?

The bank explained:

… these services allowed U.S. citizens to eliminate the paper trail associated with undeclared assets and income they held … in Switzerland.”

This is going downhill.

In 2009 Peter started reading about IRS enforcement on foreign bank accounts. He and Susan decided to consult a tax attorney.

The Swiss account was now worth nearly $2 million.

They learned that they were supposed to – all along – have been reporting that account.

 In 2010 they closed the Swiss account, repatriated the funds and applied for a voluntary Treasury disclosure program.

Good idea.

They filed amended returns for the interest income, as well as filing FBARs disclosing the existence of the foreign account.

The interest income was not inconsequential: they sent the IRS more than $100 grand in back taxes.

Got it. It was going to hurt, so they might as well rip the band-aid.

In 2012 they opted out of the voluntary disclosure program (OVDP).

COMMENT:  The default ODVP penalty was 27.5%. I suspect - but do not know for certain - that they were hoping for a better penalty result during the audit process. Considering the Swiss account had neared $2 million, the penalty alone would have been around a half-million dollars.

In 2014 the IRS sent notices. The Horowitzes, their accountants and the IRS conferred but failed to reach an agreement.

The penalties now became an issue. The base FBAR penalty is $10 grand per instance. The IRS however saw the Horowitzes behavior as willful, meaning they wanted enhanced penalties. To muddy the waters further, the law had changed. What used to be a maximum $100 grand penalty was now the greater of $100 grand or 50% of the account.

COMMENT: You may also know the FBAR by its current name: FinCEN Form 114.

The Horowitzes protested. Their behavior was not willful, and - even if it was - the old penalty (maxed at $100 grand) should apply.

The Court was short on the willfulness issue.

The court acknowledged that the couple ‘insis[ed] that neither of them had actual knowledge on the FBAR requirement.’ But, relying on United States v. Williams …., it reasoned that willfulness in the civil context ‘covered not only knowing violations… but reckless ones as well’.”

In particular, the court pointed to the fact that the tax returns signed by the Horowitzes ‘included a question of whether they had foreign bank accounts, followed by a cross-reference’ to the FBAR filing requirement. It also found significant that, by their own account, the Horowitzes had ‘discussed their tax liabilities for their foreign accounts with their friends’ but failed to ‘have the same conversation with the accountants they entrusted with their taxes for years’.”

The Horowitzes appealed.

They argued that they messed up, but that mistake was not willful. The enhanced penalties should not apply.

The IRS countered: “willfulness” in this context includes recklessness, which standard was met by:    

The Horowitzes never asking their tax preparer whether they had to report the Swiss bank accounts,

The Horowitzes asking their friends about international tax matters demonstrated their awareness of potential issues,

The Horowitzes knew to report their Saudi earnings and U.S.-based interest income from domestic banks, and

The Horowitzes signed their tax returns without reviewing them with any care.

Here is the Court:

… their only explanation for not disclosing foreign interest income related to some unspecified conversations they had with friends in Saudi Arabia in the late 1980s. Yet, if the question of whether they had to pay taxes on foreign interest income was significant enough to discuss with their friends, they were reckless in failing to discuss the same question with their accountant at any point over the next 20 years.”

Taking all of these circumstances together, the record indisputably establishes not only that the Horowitzes ‘clearly ought to have known’ that they were failing to satisfy their obligation to disclose their Swiss accounts, but also that they were in a ‘position to find out for certain very easily’.”

How much are we talking about across the years?

Including interest and penalties, it was close to $1 million.

Our case this time was Horowitz v US, No. 19-1280 (4^th Cir. 2020)

Owing A Million Dollar Penalty

What caught my attention was the size of the penalty.

The story involves Letantia Russell, a dermatologist from California who has been in the professional literature way too much over too many years. The story started with her attorneys reorganizing her medical practice into a three-tiered structure and concealing ownership through use of nominees. Then there was the offshore bank account.

Let’s talk about that offshore account.

Back when I came out of school, one had to report foreign accounts above a certain dollar balance. The form was called the “TD 90-22.1.” I remember accountants who had never heard of it. It just wasn’t a thing.

The requirement hasn’t changed, but the times have.

If you have an overseas bank account, you are supposed to disclose it. The IRS has a question on Schedule B (where you report interest and dividends) whether you have a foreign bank account. If you answer yes, you are required to file that TD 90-22.1. The form does not go to the IRS; it instead goes to the Treasury Department. Mind you, the IRS is part of Treasury, but there are arcane rules about information sharing between government agencies and whatnot. Send to Treasury: good. Send to IRS: bad.

The rules were fairly straightforward: bank account, balance over $10 grand, own or able to sign on the account, required to file. There was no rocket science here.

Don’t play games with account types, either. A checking account is the same as a savings account which is the same as a money market and so on. Leave that hair-splitting stuff to the lawyers.

About a decade or so ago, the government decided to pursue people who were hiding money overseas. Think the traditional Swiss bank account, where the banker would risk jail rather than provide information on the ownership of an account. That Swiss quirk developed before the Second World War and was in response to the unstable Third Republic of France and Weimar government of Germany. Monies were moving fast and furious to Switzerland, and Swiss bankers made it a criminal offense to break a strict confidentiality requirement.

Thurston Howell III joked about it on Gilligan’s Island.

Travel forward to the aughts and the UBS scandal and the U.S. government was not laughing.

Swiss banks eventually agreed to disclose.

The IRS thundered that those who had … ahem, “underreported” … their foreign income in the past might want to clean-up their affairs.

The government dusted-off that old 90-22.1 and gave it a new name: FinCen 114 Report of Foreign Bank and Financial Accounts.

The IRS was still miffed about that government-agency-sharing thing, so it came up with its own form: Form 8938 Statement of Foreign Financial Assets.

So you had to report that bank account to Treasury on the FinCen and to the IRS on Form 8938.  Trust me, even the accountants were trying to understand that curveball.

Resistance is futile, roared the IRS.

Many practitioners, me included, believed then and now that the IRS went fishing with dynamite. The IRS seemed unwilling to distinguish someone who inherited his/her mom’s bank account in India from a gazillionaire hedge-fund manager who knew exactly what he/she was doing when hiding the money overseas.

And you always have … those people.

Letantia Russell is one of those people.

The penalties can hurt. Fail to fail by mistake and the penalty begins at $10,000. Willfully fail to file and the penalty can be the greater of

·      $100,000 or

·      ½ the balance in the account

Letantia dew a $1.2 million penalty on her 2006 tax return. I normally sympathize with the taxpayer, but I do not here. One has to be a taxpayer before we can have that conversation.

It went to District Court. It then went to Appeals, where her attorneys lobbed every possible objection, including the unfortunate trade of Jimmy Garappolo from the New England Patriots to the San Francisco 49ers.

It was to no avail. She gets to pay a penalty that would make a nice retirement account for many of us.