Is Zwerner's 200% Penalty Excessive?

Let me ask you a hypothetical question.

Say you made a million dollars in 2013. Even in a worst-case, salt-the-fields scenario, what would be the most the government could take from you in taxes? 

I am thinking a million dollars. 

His facts are not attractive. There is a saying that “bad facts make bad law.” We have both in this case. 

His name is Carl Zwerner, is 86 years old and lives in the Miami area. For years 2004 through 2007, Zwerner maintained an account at ABN AMRO Bank in Switzerland. It is not (yet) illegal for an American to have a foreign bank account, but it is illegal not to report it. 

Somewhere in 2008 he had a change of heart. He filed a delinquent FBAR and amended his 2007 tax return to include the earnings from the account. In 2009 he decided to come clean on years 2004, 2005 and 2006 also.

There was a twist: Zwerner did not hold the bank account in his own name. The account was in the name of the “Bond Foundation” for a while, then in the name the “Livella Foundation.” At all times, though, Zwerner had control and was the beneficial owner of the funds. Those account names were just speed bumps.

Then he does the unbelievable. In a letter dated August 2010, he admitted to the IRS that he was aware that he should have reported both the existence of the account and the earnings from it.

Why, Carl, oh why?

The IRS, in yet another example of why people hate the IRS, decided that he “willfully” evaded his taxes, used regular gasoline in a high-octane-only car and failed to hold the door for an elderly woman at the grocery store. The IRS determined that the balances at the Swiss account were as follows over the years:

           

2004	$1,447,000
2005	$1,490,000
2006	$1,545,000
2007	$1,691,000

This did not take Sherlock-type powers by the IRS, by the way, as Zwerner had already reported the account.

The IRS then remembered that the penalty for willful failure to file an FBAR is 50% of the highest balance for each year.

NOTE: Did you pick-up on what the fifth-amendment-pleading crowd has done here? Two years worth of penalties and the account is depleted – essentially seized by the government. 

Well, Zwerner was facing 4 years. His penalty was almost $3.5 million, whereas his account had never exceeded $1.7 million.

Good thing he voluntarily filed amended returns! What would they have done to him had he not come clean? 

In the area of foreign accounts, Treasury and the IRS have decided that we are all guilty, and that the only way to salvation is through their disclosure program du jour. The fact that these programs may not be a fit for many (or most, in my opinion) is beside the point. Many tax practitioners, me included, have represented clients with foreign non-reporting issues. My clients have been “ordinary” – an expat who started a business in Scotland, another who had no idea what an “FBAR” was, much less that she had to file tax returns even though she had lived out of the U.S. for two decades. These are not tax desperados, and to lump them in with IRS programs designed to avoid criminal prosecution is bonkers.

And there is the rub. The IRS took Zwerner’s letter as an admission of “willfulness,” meaning that he is charged with tax fraud. This is a criminal charge, and Zwerner should have entered the Offshore Voluntary Disclosure Program if he wanted protection from criminal charges. The IRS would say this is not the same as my Aberdeen restaurateur. I in turn would ask the IRS: why don’t you have a program for people like my restaurateur? Do you think I enjoyed that phone call with an expat who is afraid to return to the United States to visit her mother? Why are you terrorizing ordinary people? We could probably put all the people with significant money hidden overseas into one hotel conference room. Why is it that attorneys and tax CPAs in 50 states have horror stories to tell? There cannot be that many overseas-money-hiding uber-wealthies to go around.

Zwerner amended his returns. He did not enter the disclosure program. The IRS calls this a “quiet disclosure,” and they do not like it. They assessed 200% penalties.

What choice did the IRS leave him? He filed a lawsuit against the government.  He has an interesting argument, as the Eighth Amendment prohibits “excessive fines.” 

What do you think? Is a penalty of more than 100% an “excessive fine?”

There is precedent. There is a 1998 case where someone tried to take $357 thousand overseas and got caught with the money in his luggage. The U.S. sought forfeiture of the entire amount. The Supreme Court ruled against the government, stating that forfeiture of all the money was “grossly disproportional to the gravity of the offense.” The Supreme Court ordered him to pay $20,000 instead.

We’ll be paying attention to Zwerner’s case as it goes through the courts.

The IRS Is Looking For Hundreds of Thousands of Canadian Trust Returns

The IRS wants us to believe that there are hundreds of thousands of Americans who have failed to file required U.S. tax returns for their Canadian trusts.

Nonsense.

Let’s go over this, as it reflects a relentless demand by Treasury and the IRS for ever-more information on any financial transaction that may have –even remotely - an American connection. 

If an American funds or receives a distribution from a foreign trust, he or she is supposed to file tax Form 3520 with his/her Form 1040. If an American has a continuing interest in the trust (the likely reason is that he/she is a beneficiary), then he/she also has to file Form 3520-A annually. 

If one is so obstinate as to not file the 3520 or 3520-A, the IRS has a penalty of $10,000 they will gladly drop on you. You can get out of the penalty by showing “reasonable cause” for not filing, but the IRS reserves the right to define reasonable cause. 

  

The issue with reasonable cause is that it presumes both parties are reasonable, a presumption the IRS is near to abrogating. For example, whose brilliant idea was it to impose an automatic $10,000 penalty? The penalty for late filing of your personal tax return is 5% of the tax due per month – not $10,000. Late file a partnership return and the penalty is $195 per K-1 per month – not $10,000.  Why is this penalty different? Does the Treasury suspect that we are all hiding hundreds of thousands if not millions of dollars overseas? If so, where is mine?

Am I being heavy-handed? Let me give you three examples of what the IRS considers to be Canadian trusts:

• registered education savings plans (RESPs)
• tax free savings accounts (TFSAs)
• registered disability savings plans (RDSPs)

A RESP is a Canadian Section 529 plan, but with a twist. Like the American 529 plan, you open the account at a bank, broker or other financial institution. You or other family members can contribute. Unlike a 529, however, Canada will match your contribution, up to a certain percentage. Like a 529, there will be taxes when the child withdraws money to attend college.

There is no U.S. equivalent to a tax-free savings account. There is no deduction for the contribution, but there is no tax on withdrawals either. This aspect resembles an American Roth, but the Canadian TFSA is not limited to retirement savings. There are limits on how much one can contribute, of course, and for low-income taxpayers the government will contribute 500 hundred dollars Canadian.

Once again, there is no U.S. equivalent to a registered disability savings plan. The government will match one’s contribution, and for low-income taxpayers it will contribute up to 2 thousand dollars Canadian. Its purpose is self-descriptive.

The issue with the above three is that most people – even financially astute people – would not consider these vehicles to be trusts. We see savings vehicles, perhaps government-subsidized, but we do not see trusts. The problem however is that the IRS sees them as trusts. The IRS has defined a dog as a four-legged animal, and it now doesn’t know how to undefine any four-legged animal from being a dog. We are sitting ducks for that $10,000 penalty. 

What if you decide not to file prior IRS returns and just begin filing for the current year? One could easily come to this decision if there isn’t much money involved. This technique is known as “quiet disclosure.” Many practitioners, including me, have used it. The IRS does not care for it. The IRS has three reservations about quiet disclosures:

(1) Using quiet disclosures undermines the incentive to use government-approved disclosure programs, such as the most recent OVDP with its 27.5% penalty on the account’s highest balance over the last eight years. That is on top of any other applicable IRS penalties.

(2) Taxpayers using quiet disclosures may pay fewer penalties than those using the government-approved programs.

(3) Quiet disclosure is antithetical to general fairness, meaning that some taxpayers receive more favorable treatment than others do.

OBSERVATION: After the 501(c)(4) scandal, one will forgive my extreme cynicism on argument (3). Perhaps I will relent some when IRS bigwigs go to jail. It's only fair.

Reread (1) and (2) and you can see the real reason the IRS does not like quiet disclosures. It is not sufficient merely to bring someone back into compliance.

How is a reasonable person supposed to comply with the tax law, when the law is capricious? Consider that ignorance of the tax law is not defined as “reasonable cause” and you begin to see the box that the IRS is placing you in. They can pass any ludicrous demand – perhaps they want the napkin from your third lunch in the fifth week of alternating quarters – and then, with a straight face, say that your ignorance of their requirements is not an excuse.

It is also how they can say that hundreds of thousands of American citizens have failed to file for their Canadian trusts.