The San Francisco Bay Area is a focal point for international business. It is common for individuals to start a business, and later expand operations overseas to Europe or Asia. There is no prohibition in expanding overseas, but U.S. persons (a defined term that means U.S. citizens and residents of the United States) are required to report their foreign business activities on “information returns” filed with the Internal Revenue Service. While there may be no tax due, the returns report information that is used to satisfy the reporting requirements of sections 6038 and 6046, and the related regulations. A trap for the unwary, taxpayers who fail to consult their accountants or tax professionals before operating abroad, can find themselves facing steep civil penalties for failing to file the forms.
Unbeknownst to some, the Internal Revenue Service has an on-going enforcement effort in the San Francisco Bay Area, focusing on individuals who fail to report their ownership interest in foreign entities, namely corporations and partnerships. Typically, the revenue agents working the cases are from the Special Enforcement Program (SEP). SEP is a specialized compliance program within the IRS and is directed to taxpayers that derive substantial income and intentionally understate their tax liability. IRM 18.104.22.168 (06-14-2011).
In many cases, the IRS agent has reasonable indications that a likelihood of unreported income exits before any contact with the taxpayer. Id. The IRS may receive this information from informants/whistleblowers, Criminal Investigation, banks filing suspicious activity reports, federal, state or local law enforcement, and the IRS’ Information Reporting Program. Id. Taxpayers should think twice about “talking their way out” of the problem in an IRS interview. There are no off the record conversations with the agent, and cases can we won and lost at IRS interviews.
Unlike a standard or routine audit, SEP investigations proceed simultaneously in three distinct areas. First, there is an income tax examination under Title 26 probing for unreported income (income that the taxpayer should have reported and paid tax on). Second, there a Foreign Bank Account and Financial Account (FBAR) investigation under Title 31 that focuses on whether the individual has failed to report foreign financial accounts (there is a $10,000 threshold reporting obligation). Third, the IRS conducts an information return investigation (e.g., Form 5471 or Form 8865), which looks at whether the individual has a reportable interest in a foreign entity. The cases are complex and fast-moving, as the agent works all three parts in parallel. The agent also may seek to assert the civil fraud penalty under Internal Revenue Code 6663.
Information return audits are some of the most complex audits faced in recent years. Despite this, a taxpayer can mount a successful strategy to eliminate or minimize civil penalties.
In some cases, a taxpayer will take the position that “I don’t own the foreign company.” However, the defense “I don’t own it” does not work standing alone. The taxpayer must work in conjunction with tax counsel to build documentary evidence proving that the taxpayer does not own the entity. The IRS is a document-driven agency, and this means that the taxpayer’s self-serving testimony, standing alone, will not win the case. Often, information return cases involve understanding the laws of the foreign jurisdiction, translating international documents, interviewing witnesses located overseas, and untimely presenting a sold proof package to the agents. A taxpayer may have to contact a person in a foreign country (or local counsel) to obtain the needed documents to win the case. The IRS likely has some information in the file suggesting that the taxpayer has an ownership interest in the foreign entity, and the IRS will not disclose the document. The IRS also will not explain why the agency believes the taxpayer has a reporting obligation. Unfortunately, the taxpayer must prove a negative. Although this is not an easy task, a taxpayer can successfully defend the case.
Finally, the IRS does not like taxpayers who make false statements. Unfortunately, taxpayers make statements either during an IRS interview or in response to an Information Document Request that may be misunderstood by the IRS as a false or misleading statement. An inaccurate statement can be challenging to unwind later in the case when working with the agent to reach a field closure and minimize civil penalties. Consequently, it is essential to engage with tax counsel early in the case. Taxpayers facing an information return audit would be wise to consult with experienced tax counsel, who can effectively represent them before the Internal Revenue Service.