Congress and IRS increasing scrutiny of off-shore bank accounts

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Brian C. Bernhardt

In early July, a federal court in Miami authorized the IRS to issue a “John Doe Summons” to the Swiss bank UBS. Despite Swiss laws protecting the confidentiality of people who bank in Switzerland, the IRS asked UBS to identify American citizens with UBS accounts who did not complete forms necessary to report their income to the IRS.

The fall-out from the court’s decision has been fierce. UBS has announced that it will no longer provide confidential private banking and private wealth services to American citizens in Switzerland. Congress has begun to hold a series of hearings investigating the role foreign banks play in helping their American customers avoid U.S. taxes.

The Senate is considering new bills that would give the IRS expanded authority to identify American citizens with off-shore bank accounts, further examine the accounts and collect taxes and penalties from account holders. Americans with off-shore bank accounts, especially bank accounts at UBS in Switzerland, are wondering how these rules, and the summons the IRS issued to UBS, will affect them.

The rules that apply to American citizens holding off-shore bank accounts are fairly straightforward. Off-shore accounts are allowed, so long as they are properly reported.  Individuals must report their off-shore accounts in three main ways.  First, the owner of an off-shore account must report all interest earned on the account on Parts I and/or II of Schedule B on the owner’s Form 1040. Second, the owner of the off-shore account must complete Part III of Schedule B on Form 1040, which acknowledges that the off-shore account exists. Third, the owner of the off-shore account must complete and file a Form TD F 90-22.1 report of foreign bank accounts.

The problem, of course, is that many taxpayers use off-shore accounts for nefarious reasons: to hide cash receipts from the government, vendors or creditors to whom they owe money, plaintiffs who are suing them, or, of course, spouses trying to obtain large divorce settlements.  These taxpayers do not want anyone, especially the IRS, to know about the off-shore money.  So they don’t report the interest income, acknowledge they own an off-shore bank account on their income tax return, or complete and file a report of the foreign bank account.

Problems arise, however, when someone such as the IRS discovers the account, which brings us back to the UBS summons issued by the IRS.  When UBS, or any off-shore bank, responds to a summons asking for the identity of account holders, it is not difficult for the IRS to cross-check that list with tax returns and reports of foreign bank accounts to see who has reported the accounts and who has not done so. 

If the IRS finds a taxpayer’s undisclosed off-shore bank account, there are typically three responses. Most likely, one of these three things will happen to the account holders that UBS identifies for the IRS.

First, the IRS could do nothing.  This result is unlikely, but could happen if the list of people discovered is large, it identifies many other people who were engaged in more active acts of evasion, the statute of limitations is expiring soon (keep in mind that if a tax return or report foreign bank account is not filed, the statute of limitations will never start, much less expire), or the IRS just makes a mistake. 

Second, the IRS could launch a criminal investigation. This result is also unlikely in most cases, but could happen if the taxpayer actively engaged in evading taxes and reporting requirements.  For instance, the IRS believes that some of the people included in UBS’s summons response have actively worked with UBS to change the owner of their off-shore bank account. This would allow the original owner to maintain control over the off-shore account but no longer have any reporting requirement to the IRS.  That type of active conduct is more likely to rise to the level of criminal than when a taxpayer simply does not report the off-shore account or its income.

Third, the IRS could begin a civil audit. This result is the most likely result. The IRS would do an examination of the number and locations of the off-shore accounts, the interest earned, and whether any penalties should apply. Taxpayers would likely owe tax and interest on the interest they did not report to the IRS, as well as penalties. The penalty might be a 20 percent “accuracy related” penalty or the much higher 75 percent fraud penalty, depending on the facts.  In addition, there are penalties for failing to file the foreign bank account report or for filing it incorrectly by leaving off one or more off-shore bank accounts.

While the focus on off-shore bank accounts may seem a little over the top, keep in mind that the IRS is worried about more than taxpayers not reporting interest income — there is a lot of cash that floats around our economy that is almost impossible for the IRS to trace, cash that often ends up overseas. So while existing off-shore accounts may only mean that taxpayers have unreported interest income, the missing cash that created the off-shore accounts in the first place represents a large amount of unreported income and uncollected tax.

As a result, it should be no surprise that the IRS is looking to foreign banks such as UBS for the names of American citizens hiding money in secret Swiss bank accounts. And it should not be surprising that Congress will soon be considering laws that widen the scope of taxpayers treated as owning and/or controlling an off-shore bank account, mandate additional reporting requirements for those people, and give the IRS more authority to enforce the reporting requirements.

Remember, it’s not that having an off-shore bank account is bad, wrong, or illegal — it’s what you do, or do not do, with an off-shore bank account that matters.

Brian Bernhardt is a partner in the Richmond office of McGuireWoods LLP. He practices in the areas of Federal tax controversies, Federal tax litigation, and nonprofit and tax-exempt organizations, focusing on their administrative relationships with the Internal Revenue Service.

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