The Tax Crimes Handbook of the Office of Chief Counsel, Criminal Tax Division of the Internal Revenue Service defines "Willfulness” as follows:
"[a] Willfulness is defined as the "voluntary, intentional violation of a known legal duty." Cheek v. United States, 498 U.S. 192, 200-01 (1991); United States v. Pomponio, 429 U.S. 10, 12 (1976); United States v. Bishop, 412 U.S. 346, 360 (1973); United States v. Pensyl, 387 F.3d 456, 458-59 (6th Cir. 2004); United States v. George, 420 F.3d 991, 999 (9th Cir. 2005). 10
[b] Subjective Test. A defendant's good faith belief that he is not violating the tax laws, no matter how objectively unreasonable that belief may be, is a defense in a tax prosecution. Cheek v. United States, 498 U.S. 192, 199-201 (1991). See also, United States v. Grunewald, 987 F.2d 531, 535-36 (8th Cir. 1993); United States v. Pensyl, 387 F.3d 456, 459 (6th Cir. 2004)"
Whether a taxpayer's conduct is "willful" or not is particularly complicated when dealing with individuals who suffer from mental impairment. Recently, David Horton, acting deputy commissioner (international), IRS Large Business and International Division illustrated an approach to documenting a claim of "non-willfulness"
The approach suggests the use of medical records to establish the taxpayer's cognitive impairment by way of third party circumstantial evidence.
According to the Alzheimer's Association “an estimated 5.3 million Americans of all ages have Alzheimer's disease in 2015." These are the diagnosed cases. Of those diagnosed cases the state of medical records will be somewhat imperfect, meaning that the defense of "non-willful" behavior might be difficult to sustain. This is particularly true when tax or foreign bank account reporting issues arise. There are other forms of metal impairment that can affect the determination of whether a person is "non-willful". The other forms of mental impairment include, but are not limited to dementia, substance abuse, physical brain injury and post-traumatic stress disorder ("PTSD"). The burden is proof is on the taxpayer and his or her representative to establish the failure to file or failure to properly report income. Assets or foreign accounts was the result of mental impairment leading to the conclusion of non-willful action. This burden becomes exaggerated when the taxpayer is in a Conservatorship or when the taxpayer is deceased.
A Conservator is a fiduciary appointed by a state court judicial officer. A Conservator is charged with taking care of the health and wellbeing and/or the financial affairs of an individual found no longer capable of doing so.
Often a psychiatric report and medical report are required to convince a court of the need for the appointment of a Conservator. The medical and psychiatric reports will usually focus on the immediate health and state of mind of the individual which is the issue before the court. But the immediate moment is not the issue for tax and foreign account reporting purposes. The state of mind that is at issue is what the taxpayer’s intent was when he or she signed the income tax return or failed to file. In the case of a failure to file this could be six-eight years earlier or more from the court's determination that that petition to appoint a Conservator should be granted. Establishing the state of mind of a taxpayer years earlier when the tax return, information return or Report of Foreign Financial Account (FBAR) was due or incorrectly filed, is or could be critical to a decision about whether the individual was "non-willful" and therefore qualifies for the Domestic Streamline Procedure or whether the Conservator should use the formal Offshore Voluntary Disclosure Program (OVDP). The financial difference to the Conservatorship Estate is or can be quite substantial.
Example: (1) Assume a U.S. resident taxpayer is eligible for the Streamline Domestic Procedure because his/her actions were "non-willful" due to mental incapacity. The Streamline Domestic Procedure requires the filing of three (3) years of amended or late original returns, six (6) of late FBAR's the payment of the underpaid income tax and a five (5%) percent FBAR penalty calculated based upon the highest single year account balances at the end of each calendar year for the aggregate offshore accounts. If we assume a constant balance of $1 million USD then the FBAR penalty would be $50,000 USD. Contrast this FBAR penalty with the situation in Example 2.
Example: (2) assume the same facts except that the taxpayer cannot satisfy the "non-willful" criteria due to an absence of medical evidence or third party statements. Under these circumstances the taxpayer would have to consider the Offshore Voluntary Disclosure Program (OVDP). Under the OVDP the taxpayer would need to file eight (8) years of amended or original income tax returns and FBAR's and pay an FBAR penalty of either twenty-seven and one half (27.50%) percent or fifty (50%) of the highest single year account balances of the aggregate offshore accounts and of the proceeds of those accounts (such as the value of acquired art works or business interests). The determination of whether the FBAR penalty is 27.50% or 50% is based upon whether the financial institution is a Department of Justice "listed" foreign financial institution. For simplicity purposes we will assume that that the foreign financial account balances are a constant $1 million USD for all covered years. Then the FBAR penalty would be either $275,000 USD or $500,000 USD versus $50,000 USD if the taxpayer qualified for the Streamline Domestic Procedure. If the taxpayer used the proceeds of the unreported account to purchase appreciating assets, the value of those assets would have to be included in the penalty calculation.
It is therefore very important for a the tax attorney representing the taxpayer to obtain the most comprehensive medical reports possible and statements from percipient third party witnesses to document the taxpayer's state of mind at the earliest possible date, not just the current moment. A skilled forensic psychiatrist should be able to help in this regard. The tax attorney needs to evaluate the circumstantial evidence and then recommend which approach fits the facts. The attorney will, in addition to reviewing the medical evidence and third party statements, if any, need to do a comprehensive review and analysis of the financial records to determine whether the taxpayer was or was not using the foreign financial account, directly or by use of a linked credit card or debit card or indirectly through the use of a co-account signatory (such as a family member or fiduciary).
The ability to use the Streamline Procedures or OVDP assumes that the taxpayer or his/her Conservator, Executor or Trustee, has not yet been contacted by the Department of Justice or the IRS. If the taxpayer has been contacted, or has received a FATCA letter from the foreign financial institution, then it may already be too late to come forward. If it is too late to come forward, then the defense of mental impairment must be raised in the IRS administrative proceeding or in the criminal investigative phase with the Department of Justice or U.S. Attorney.
The same basic process to establish "non-willfulness" applies if the taxpayer is deceased and the Executor of the Estate or Trustee of the decedents trust (whether created as a Living Trust or as a Testamentary Trust) discovers unreported foreign financial accounts. The case does become a bit more complicate, however, because the ability to establish mental impairment is then virtually dependent on medical records, third party declarations and forensic medical testimony. Once discovered, the estate or trust fiduciary must come forward or risk personal liability for taxes and FBAR penalties. The heirs may attempt to put pressure on the fiduciary to make a distribution of estate or trust assets, but the fiduciary must exercise extreme caution in such cases and is best off seeking court instructions to avoid or mitigate personal liability.
It is noteworthy to reiterate that a non-willful defense based upon mental impairment is a complex defense to build and can be expensive in terms of professional fees. But in the proper circumstances the time and effort are justified if measured by potential savings to the taxpayer and/or a Conservatorship estate.