Taxpayers who fail to disclose overseas accounts with more than $10,000 face hefty penalties under the Bank Secrecy Act. For willful violations the IRS can impose a penalty of up to the greater of $100,000 or 50% of the balance in each undisclosed account at the time of the violation (for a discussion of whether the non-willful penalty is computed per account or per form, see The Fifth Circuit Parts Ways with the Ninth Circuit Regarding the Non-Willful FBAR Penalty).
For people with multiple accounts and multiple years of willful violations, the maximum willful penalty can be crippling. The draconian impact has led to 8th Amendment excessive fine challenges, as well as arguments that its punitive nature should lead to the penalty not surviving the death of the violator.
All this leads to United States v Schwarzbaum, a case that has generated a great deal of attention. The case involves a wealthy German-born naturalized U.S. citizen who starting in the early 2000’s had multiple bank accounts in Costa Rica and Switzerland. Schwarzbaum self-filed an FBAR in 2007 and listed only one account. He did not file any FBAR in 2008, and in 2009 he filed an FBAR that only listed three accounts. IRS assessed over $12 million in penalties, and brought suit to collect.
There is a lot to the case, including a discussion of the appropriate willfulness standard and the possible impact of the opinion on the statute of limitations when an original penalty assessment is timely but a court finds that the IRS computed the penalty improperly and needs to start over. My colleague Jack Townsend, who, in addition to writing a terrific blog on criminal tax matters, is the principal author of the criminal penalties chapter and FBAR subchapter in Saltzman and Book IRS Practice and Procedure, covers the case in 11th Cir. Remands For IRS To Re-Determine FBAR Penalties After Affirming Original Calculation Was Arbitrary And Capricious.
For purposes of this post, I just want to highlight one aspect of the opinion: the relationship of the Administrative Procedure Act (APA) to the appropriate amount of willful penalty.
On appeal, Schwarzbaum argued that the IRS’s actions in calculating the penalties were “not in accordance with the law” under 5 U.S.C. § 706(2)(A). This inquiry into what and why the IRS did in computing the penalty differs from what courts do in reviewing Title 26 penalties; for the most part, in IRC-based tax penalty cases the APA does not provide the means to examine the IRS’s conduct. In typical tax penalty cases, courts can take a fresh look at both the propriety of imposing the penalty and the amount of the penalty, assuming that they conclude that the penalty is warranted in the first instance.
Title 31 FBAR penalties differ. The APA shines a light on agency conduct, and reviewing courts are generally empowered to examine whether the agency acted rationally and provided a reasoned contemporaneous explanation based on the record at the time of the original agency action. (for an early discussion of the intersection of APA and FBAR see District Court Punishes IRS For Failing to Justify or Explain Itself in FBAR Case )
All of this gets back to the IRS actions in assessing over $12 million in willful FBAR penalties on Schwarzbaum. As Jack notes, to soften the possible impact of the FBAR penalty the IRS in the Internal Revenue Manual “has a formula that determines the maximum willful penalty that it will assess at 50% of the highest amount in the accounts in all willful years. The IRM then allocates that penalty in equal portions over the willful years.”
The problem with that IRM is that the statute itself pegs the maximum penalty to each account’s balance as of the date that the taxpayer failed to file the FBAR, a date that IRM formula neglects and one that the IRS did not use in calculating Schwarzbaum’s penalty.
As Jack discussed, Schwarzbaum “held that, since the allocation formula was based on the high amounts during the reporting year rather than the amounts on the reporting dates, the allocation was arbitrary and capricious and could not be sustained.” (my emphasis).
In the words of the Eleventh Circuit, the IRS botched its calculations from the start:
In calculating Schwarzbaum’s FBAR penalties, the IRS took a wrong fork in the road by starting with the wrong numbers. Recall that, for each tax year and for each account, the statutory maximum penalty for a willful FBAR violation is the greater of $100,000 or 50% of the account’s June 30 balance. See 31 U.S.C. § 5321(a)(5)(C)(i), (D)(ii); 31 C.F.R. § 1010.306(c). By using the wrong account balances, the IRS calculated the wrong statutory maximums for Schwarzbaum’s penalties, and from there, mitigated the penalties across the board. The IRS’s error, it appears, flowed through its calculations from beginning to end.
This led the Eleventh Circuit to conclude that the district court should have remanded the matter back to the IRS to determine the appropriate penalty amount:
When a party challenges agency action under the APA, “the district court does not perform its normal role but instead sits as an appellate tribunal.” Cnty. of L.A. v. Shalala, 192 F.3d 1005, 1011 (D.C. Cir. 1999) (quotation omitted). And when an agency action is unlawful, the APA directs a reviewing court to “hold [it] unlawful and set [it] aside.” 5 U.S.C. § 706(2). The APA does not, however, direct the court to do the agency’s job for it.
The opinion goes on to cite the the Supreme Court in SEC v. Chenery Corp for the principle that a reviewing court is to examine the grounds that the agency used in making its determination, and it is not the court’s role to “affirm the administrative action by substituting what it considers to be a more adequate or proper basis.”
Conclusion
In vacating the district court’s judgment, the Eleventh Circuit instructed the district court to remand the matter back to the IRS to recalculate the penalties.
While I have problems with the draconian nature of the FBAR penalty (an issue that Congress should take up or perhaps one that can have an impact on courts considering the survivability of the FBAR penalty at death), the Eleventh Circuit’s approach seems formalistic.
As Title 31 gives IRS discretion to impose a penalty up to the maximum of 50% of the account balance as of the violation date, it seems that the IRS approach in the IRM, and any mitigated penalty it wishes to impose on Schwarzbaum or anyone else for that matter, should likely just start with a new first step in its calculations. That step should take into account half of the highest account balance and allocate it across all willful years, with any amount in a given year capped at 50% of that year’s aggregate account balances on the reporting date. Once that step is taken, documented internally, and communicated to taxpayers clearly, I suspect that it will be difficult to mount an APA challenge to the penalty.