On May 15, 2018, the United States District Court for the Western District of Texas issued an important ruling concerning the application of willful FBAR penalties under 31 U.S.C. § 5321. In United States v. Colliot, Case No. AU-16-CA-01281-SS (W.D. Tex. 2018), the court held that the Internal Revenue Service (“the Service”) could not assess penalties in excess of the threshold set by 31 C.F.R. § 1010.820 notwithstanding the higher penalties authorized by statute. In so holding, the court severely reduced the penalty exposure for many with undisclosed offshore accounts.
Background. In December 2016, the Service initiated a lawsuit to obtain a judgment for certain penalties against Colliot for willful failure to timely file multiple Forms TD F 90-22.1 (“Report of Foreign Bank and Financial Accounts” or “FBAR”) for 2007 to 2010. For 2007, the IRS had assessed penalties of $548,773 for four separate FBAR violations and for 2008 had assessed $196,082 for another four FBAR violations. Smaller penalties were also assessed for 2009 and 2010. The Service had stated that such penalties were authorized pursuant to 31 U.S.C. § 5321(a)(5) and 31 C.F.R. § 1010.820(g)(2).
Legal Analysis. Colliot argued that, although statutorily authorized to assess the penalties at issue, the assessments in the case were not valid as they were contrary to, and exceeded the amounts authorized by, the regulations then in effect. As background, a predecessor statute had only permitted assessment up to the greater of the balance in the account at the time (not to exceed $100,000) or $25,000. The regulations promulgated at the time expressly capped the penalty at $100,000, in accordance with the statute in effect at that time. Subsequently, the statute concerning FBAR penalties was revised to provide that the maximum willful FBAR penalty could not exceed the greater of 50% of the account balance or $100,000. Though the penalty structure was revised (and increased) from a statutory perspective, the regulations were never changed from their initial language to reflect the statutory change.
Even though the statute itself permitted the assessment of the penalties at issue, Colliot stated that the Service acted “arbitrarily and capriciously” in assessing the penalties because they exceeded the amounts permitted by regulation. The Service, on the other hand, argued that the change in statute implicitly superseded or invalidated these regulations. The court ultimately found in favor of Colliot, holding that:
Rules issued via notice-and-comment rulemaking must be repealed via notice-and-comment rulemaking…Section 1010.820 has not be so repealed and therefore remained good law when the FBAR penalties in question were assessed against Colliot. Consequently, the IRS acted arbitrarily and capriciously when it failed to apply the regulation to cap the penalties assessed against Colliot.
Accordingly, the court ruled in favor of Colliot in finding the penalties were not validly assessed. As a result, Colliot may establish a maximum willful FBAR penalty threshold lower than what the Service is seeking in many past and pending FBAR-related cases.
Effect of Colliot. As this ruling is likely to be appealed by the Department of Justice, it will likely be some time before there can be any conclusion as to its effect. For those with unreported foreign financial accounts, Colliot may establish a new upward limit for FBAR penalties whether in the context of an audit or the Offshore Voluntary Disclosure Program (“OVDP”). For example, by its language, 31 C.F.R. § 1010.820(g)(2) states that a civil penalty may be assessed in an amount “not to exceed the greater of the amount (not to exceed $100,000) equal to the balance in the account at the time of the violation, or $25,000.” For those in an audit where willfulness is asserted by the Service, this could substantially reduce the amount of exposure for FBAR penalties.
For instance, if an account was opened from 2014 through 2016 and had a constant value of $1,000,000, the Service could theoretically seek to collect $1,500,000 in penalties under the current statute. Pursuant to previously issued guidance, that proposed penalty would likely be limited to 50% of the account balance, or $500,000. See IRS SBSE Memo 04-0515-0025 (May 13, 2015) (regarding mitigation policy for FBAR penalties). However, pursuant to Colliot, the maximum penalty that could be proposed would be $300,000 – equal to a $100,000 penalty for each year. In cases where the Service has relied on this policy and has not obtained further statute extensions for assessment, the holding in Colliot could further reduce the maximum penalty exposure. While guidance is not yet available, it is likely that the Service will continue with its present position until appeals are exhausted in Colliot. Accordingly, to obtain these reduced penalties, individuals may be required to pursue the matter through appeals and subsequent litigation.
As for individuals still participating in the OVDP, it is unclear what effect this ruling may have. Pursuant to the Frequently Asked Questions of the OVDP (“the FAQ”), the Service indicates that:
Under no circumstances will taxpayers be required to pay a penalty greater than what they would otherwise be liable for under the maximum penalties imposed under existing statutes for the years included in the disclosure period. Examiners will compare the amount due under this offshore program to the tax, interest, and applicable penalties (at their maximum levels and without regard to issues relating to reasonable cause, willfulness, mitigation factors, or other circumstances that may reduce liability) for all years within the disclosure period that a taxpayer would owe outside of the OVDP. The taxpayer will pay the lesser amount.
FAQ 50. The FAQ provides that the Service will only consider issues relating to reasonable cause, willfulness, mitigation factors, and other circumstances that may reduce liability in the context of an opt-out – not in the OVDP; however, all of those items relate to factual considerations. It is not clear if the impact of Colliot, which could set a legal maximum on the penalties involved, may be up for consideration in the OVDP. At the least, taxpayers should consider making their case to the examiner and, if the Service does not consider the ruling, should analyze whether an opt-out is appropriate. If this ruling holds, many taxpayers could see a reduction in the penalties being pursued by the Service.