The IRS is working hard to ensure U.S. persons report their foreign accounts. That's commendable. But let's make sure the rules make sense
The Internal Revenue Service's recent efforts to enforce the reporting of foreign bank accounts has created a lot of confusion for many people. This is particularly true for beneficiaries of trusts, as well as for holders of interests in foreign hedge funds and private equity funds. In fact, during the past four months, the IRS has offered taxpayers several different extensions of time to file the “Report of Foreign Bank and Financial Accounts” (FBAR) in an attempt to encourage taxpayers to sort out the filing requirements and submit their FBAR forms. As a result, the number of FBAR filers has skyrocketed, despite the significant effort and cost associated with filing current and past FBAR reports. Clearly, further guidance from the IRS is sorely needed. In the meantime, certain measures can be taken that might help minimize the impact of the FBAR filing requirements.
The federal Bank Secrecy Act, which was enacted in 1970, requires U.S. persons who have a financial interest in, or signature authority over, any foreign accounts in any calendar year to report these accounts if the aggregate value of all such accounts exceeded $10,000 on any day during such year.
The accounts must be reported on the FBAR — that is to say, Form TD F 90-22.1. Failure to file a required FBAR may be a crime. Failure to file also is subject to substantial civil penalties, currently as high as the greater of $100,000 or 50 percent of the value of an unreported account for each year of failure. These disclosure requirements apply both to foreign financial accounts held by U.S. persons directly, as well as accounts held by entities such as trusts in which U.S. persons have an interest.
Recently, the IRS has pushed hard to enforce the reporting and payment of U.S. tax on income earned in foreign accounts owned by U.S. taxpayers.
Witness the IRS' highly publicized investigation of U.S. taxpayer accounts at UBS AG in Switzerland. UBS AG agreed on Feb. 18, 2009 to pay $780 million to defer prosecution for aiding tax evasion and gave data to the IRS on 250 clients. Then on Aug. 19, 2009, it was announced that the U.S. government forced UBS AG to disclose the names of 4,450 U.S. clients suspected of hiding assets in Swiss accounts. To further encourage reporting, in March 2009, the IRS offered limited amnesty to certain taxpayers who voluntarily disclosed unreported foreign accounts.
Less publicized was the IRS' issuing in October 2008 a new version of Treasury Form 90-22.1 and an accompanying set of instructions that expand not only the amount of information that must be reported, but also the types of connections with foreign accounts that will be treated as financial interests or signature authority.
Four times this past year, the IRS extended deadlines for filing FBARs.
The first extension was announced in March 2009 as part of the limited amnesty program. Typically, the FBAR due date is June 30 of the year following the calendar year being reported. The IRS provided the extension to individuals who were obliged to file an FBAR in calendar years before 2008 but had failed to do so. Taxpayers were eligible only if they had reported all of their past income from foreign accounts. They would not be subject to any failure-to-file penalties if they filed six years of prior FBAR returns by Sept. 23, 2009 and if they had “reasonable cause” for filing late.
In June 2009, the IRS extended the deadline for filing 2008 calendar year FBARs from June 30, 2009 to Sept. 23, 2009 for those U.S. persons who timely reported all 2008 income with respect to foreign financial accounts but who learned of their 2008 FBAR filing obligations just before the normal June 30 filing deadline and had insufficient time to gather the information necessary to complete their FBARs.
Then, in August 2009, the IRS issued Notice 2009-62, further extending from Sept. 23, 2009 until June 30, 2010 the deadline for filing FBARs for 2008 and earlier years. This later deadline was for:
- persons with signature authority over, but no financial interest in, a foreign financial account; and
- persons with a financial interest in, or signature authority over, a foreign commingled fund. Foreign commingled funds generally are understood to include foreign hedge funds, foreign mutual funds and foreign private equity funds.
Finally, on Sept. 21, 2009, the IRS issued its fourth and final pronouncement to date (IR-2009-84), further extending the deadline for 2008 and past FBAR forms from Sept. 23, 2009 to Oct. 15, 2009. This extension applies to all persons other than those granted additional time under Notice 2009-62 (who still have until June 30, 2010 to file).
FBAR's Trust Issues
In the past several months, the application of the FBAR rules has caused a considerable amount of confusion in the context of trusts and trust beneficiaries. If a trust, foreign or domestic, is the owner of a foreign financial account, any U.S. trustee of this trust most likely has an obligation to file an FBAR to report the account as a result of having “signature authority” over the account. (See “Key Definitions,” p. 26.)
But should the trust's ownership of a foreign financial account be attributed to its U.S. grantors, beneficiaries and/or power holders? As mentioned, a U.S. person has a financial interest in a foreign account owned by a foreign or domestic trust if such U.S. person has a present beneficial interest (directly or indirectly) in more than 50 percent of the trust's assets or receives more than 50 percent of the trust's current income. While on its surface this rule seems clear, its application raises a number of questions:
- Is there an FBAR filing obligation for a U.S. beneficiary of a discretionary trust (that is to say, a trust over which the trustees have complete discretion to distribute any amount of trust income and principal to any one or more of the beneficiaries, and in which no beneficiary has a fixed right to receive any trust income or assets) that holds a foreign financial account?
- If such discretionary trust has more than one U.S. beneficiary, do all such U.S. beneficiaries have the obligation to report the same interests on multiple FBARs?
- If under these rules a U.S. person who is a discretionary beneficiary of a trust is deemed to own a financial interest in the trust's foreign accounts, what should the U.S. beneficiary report on the FBAR if the U.S. beneficiary has no specific information regarding the trust's investments because the trustees of the trust are prohibited from disclosing such information to the trust's beneficiaries? Similarly, if a U.S. beneficiary is unaware of his discretionary interest in a trust (perhaps because no distributions have ever been made to such U.S. beneficiary), will such U.S. person be penalized for failure to file an FBAR?
- If a U.S. person is not a current beneficiary of a trust that holds a foreign financial account, but is a remainder beneficiary of the trust, does that U.S. person have a current FBAR filing obligation?
- Does a U.S. person who could be a potential appointee of a power of appointment over a trust that holds a foreign financial account have a current FBAR filing obligation?
- Does a U.S. person who is not a beneficiary of a trust but who has a power of appointment over trust assets have “signature authority” over the trust?
Taxpayers and their advisors need the IRS to issue guidance on the application of the FBAR rules to trusts that own foreign financial accounts. It would make sense for this guidance to incorporate one or more of these principles:
- A U.S. person won't be deemed to have a financial interest in a foreign financial account held by a trust solely because of his status as a discretionary beneficiary of such trust, unless he is the trust's only beneficiary.
- A U.S. person will not be deemed to have a current financial interest in a foreign financial account held by a trust solely because of his status as a remainder beneficiary of the trust.
- Multiple filings in connection with a foreign account held by a trust will not be required. If a trust has a U.S. trustee, the U.S. trustee, who most likely already has an obligation to file an FBAR to report all of the foreign account, should file one FBAR to report all of the trust's foreign accounts, as well as information regarding the U.S. beneficiaries. Each U.S. beneficiary won't have an independent filing obligation.
- If a trust does not have a U.S. trustee, the non-U.S. trustee will file the FBAR reporting these trust accounts. Alternatively, if the trust is a grantor trust for U.S. income tax purposes and has a U.S. grantor who is treated as the “owner” of the trust's income for federal income tax purposes, the U.S. grantor can file the FBAR.
- A potential appointee of a power of appointment over a trust does not have an obligation to report foreign financial accounts held by the trust.
- The holder of a limited power of appointment does not have signature authority over the trust's accounts solely because he holds such power.
In the absence of clarifying guidance from the IRS, practitioners can take certain steps to minimize the impact of the FBAR requirements on their clients. If the agreement governing a client's trust permits amendments, consider amendments that:
- Minimize the obligation — If the trust has multiple U.S. beneficiaries, the trust agreement can be amended to provide that, notwithstanding the trustee's discretion over the trust fund, the trustee cannot distribute more than 50 percent of the trust's assets or more than 50 percent of the trust's current income to any one U.S. beneficiary. While this provision may limit the trustee's future flexibility to make distributions, it also should minimize the FBAR reporting obligations in connection with the trust's foreign accounts.
- Empower the trustee to disclose — Another possible trust amendment is a provision permitting the trustees to disclose financial information for purposes of complying with government obligations. This power will make it easier for those U.S. beneficiaries who do have an obligation to file FBAR reports to satisfy that obligation. Similarly, a trust amendment requiring the trustees to notify the U.S. beneficiaries (or the parents of those U.S. beneficiaries who are minors) of their status as beneficiaries at least will give the U.S. beneficiaries the opportunity to comply with the FBAR reporting obligations and avoid ongoing penalties.
- Clarify that there is no signature authority — It may make sense to amend the trust agreement to spell out the exact procedures for the exercise of a power of appointment. If, for example, the trust agreement provides that the holder of a power of appointment could exercise the power only by delivering the instrument of exercise to the trustee, and that the trustee, and only the trustee, would communicate with the foreign financial institution at which the trust's account is held regarding the transfer of assets, it would be hard for the IRS to argue that the power holder had “signature authority” over the account.
U.S. investors also have faced significant uncertainty regarding their FBAR filing obligations in connection with their interests in foreign hedge funds and private equity funds. The new FBAR form issued in October 2008 expanded the definition of “financial account” to include “any accounts in which the assets are held in a commingled fund, and the account owner holds an equity interest in the fund (including mutual funds).”
In a June 12, 2009 telephone conference sponsored by the American Institute of Certified Public Accountants and the American Bar Association Section of International Law, Committee on International Taxation and Section of Real Property, Probate and Trusts, the IRS' representatives publicly stated that the definition of foreign financial account includes offshore hedge fund and private equity investments. That means every U.S. investor in such a fund (either directly or through an entity such as a trust) must file an FBAR, whether or not the fund itself has any offshore bank or securities accounts, and regardless of the ownership percentage the U.S. person holds in the fund.
These statements caused a significant amount of confusion, even panic among tax practitioners who work in the hedge fund area, as they seemed to contradict the advice given by tax practitioners in the past. It's because of this confusion that the IRS extended the filing deadline to June 30, 2010 for persons with a financial interest in a foreign commingled fund.
Hopefully, with this extra time the IRS will be able to issue balanced guidance that satisfies its goal of increasing disclosure of foreign accounts without requiring unnecessary paperwork and costly and duplicative filings.
Elyse G. Kirschner is a partner at Weil Gotshal & Manges in New York