Good tax advice may avoid civil and criminal liability; bad advice can leave you broke, and land you in jail, Offshore Investment Magazine 217, (June 2011): 9-12.
Nathaniel K. MacPherson, Donald W. MacPherson, Howard Fisher, and Alexander Fisher

It is often said that advice is only worth what you pay for it. However, paying a substantial sum to the wrong advisor can be worse than no advice at all. For US taxpayers, reliance upon the legal analysis of competent counsel, may form the basis for a defence against criminal claims, and simultaneously allow taxpayers to avoid civil penalties.

The “old” IRS was often tolerant and forgiving of the poor ‘schnook’ who saw an advertisement in the back of a magazine which leads to the establishment of a maze of offshore entities. It was not unusual for the IRS and the Department of Justice to be more interested in prosecuting the promoter, than the ignorant taxpayer. In the new millennium, that is no longer true – federal and now even state tax authorities are looking to prosecute everyone they can, and recover the maximum penalties.

We are learning that often taxpayers have gone to offshore financial centres to receive advice from local professionals – sometimes lawyers, ‘trust officers’ or stockbrokers, who have no formal US tax training. Even if the foreign counsel is both US trained, and admitted to practice law in the US, care must be taken, for when the FBI or a US Marshall knocks on your client’s door in the US, the offshore advisor could be thousands of miles outside of the US, and may effectively be immune from US legal jurisdiction.

Who is subject to the US tax rules?

The US tax rules apply to “US Persons.” This includes citizens and ‘long term residents’ of the US. The rules also apply to anyone born in the US – even if they never lived in the US, and holders of a valid “green card,” even if the holder rarely comes to the US (a requirement of maintaining a valid green card is residing in the US).

Note that anyone born in the US is automatically a US citizen, and they are taxed on their worldwide income. If their parent crossed the border, gave birth in the US, and returned to their country of origin with their new baby – the child is a US citizen and taxpayer forever. This situation is more common than you think. For example, Chinese citizens come to UCLA for a few years of college, meet, marry and before they return to China, give birth. This child is a US citizen, even if they never come back to the US.

A green card holder is required to reside in the US or the green card is deemed invalid. This requirement holds that green card holder must spend at least one day a year in the US. If they do that, then they are considered a resident for income tax purposes, and all of the US tax rules apply. In the past, many people obtained a green card as a protection mechanism, in case there were problems in their home country – so they would have a place to go. However, this ‘pass’ comes with very real tax responsibilities.

What are the consequences of doing the wrong thing?

Below are some of the potential civil and criminal penalties that can apply to an ‘offshore’ structure used by a “US Person.” These lists are taken directly from the IRS’ questions and answers for the current (and former) offshore voluntary disclosure initiative.

In developing the lists of potential civil and criminal issues that can arise from improper offshore structures, the IRS was trying to educate taxpayers, rather than scare them into compliance. However even a cursory reading of the potential penalties should make it clear that going ‘offshore’ requires a great deal of thoughtful planning and implementation. Acting in a cavalier manner may result in the imposition of many of the penalties outlined below.

Question No. 5 – What are some of the civil penalties that might apply if I don’t come in under voluntary disclosure and the IRS examines me? How do they work? Depending on a taxpayer’s particular facts and circumstances, the following penalties could apply:

  A penalty for failing to file the Form TD F 9022.1 (Report of Foreign Bank and Financial Accounts, commonly known as an “FBAR”). United States persons must annually report their direct or indirect financial interest in, or signature authority over, a financial account that is maintained with a financial institution located in a foreign country if, for any calendar year, the aggregate value of all foreign accounts exceeded USD10,000 at any time during the year. Generally, the civil penalty for wilfully failing to file an FBAR can be as high as the greater of USD100,000 or 50% of the total balance of the foreign account per violation. Non wilful violations that the IRS determines were not due to reasonable cause are subject to a USD10,000 penalty per violation.

  A penalty for failing to file Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts. Taxpayers must also report various transactions involving foreign trusts, including creation of a foreign trust by a United States person, transfers of property from a United States person to a foreign trust and receipt of distributions from foreign trusts. This return also reports the receipt of gifts from foreign entities. The penalty for failing to file each one of these information returns, or for filing an incomplete return, is 35% of the gross reportable amount, except for returns reporting gifts, where the penalty is 5% of the gift per month, up to a maximum penalty of 25% of the gift.

  A penalty for failing to file Form 3520A, Information Return of Foreign Trust with a US Owner. Taxpayers must also report ownership interests in foreign trusts, by United States persons with various interests in and powers over those trusts. The penalty for failing to file each one of these information returns or for filing an incomplete return is 5% of the gross value of trust assets determined to be owned by the United States person.

  A penalty for failing to file Form 5471, Information Return of US Persons with Respect to Certain Foreign Corporations. Certain United States persons who are officers, directors or shareholders in certain foreign corporations are required to report. The penalty for failing to file each one of these information returns is USD10,000, with an additional USD10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of USD50,000 per return.

  A penalty for failing to file Form 5472, Information Return of a 25% Foreign Owned US Corporation, or a Foreign Corporation Engaged in a US Trade or Business and a ‘related person,’, or to keep certain records regarding reportable transactions, is USD10,000, with an additional USD10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency.

  A penalty for failing to file Form 926, Return by a US Transferor of Property to a Foreign Corporation is 10% of the value of the property transferred, up to a maximum of USD100,000 per return, with no limit if the failure to report the transfer was intentional.

  A penalty for failing to file Form 8865, Return of US Persons with Respect to Certain Foreign Partnerships, of interests in and transactions of the foreign partnerships, transfers of property to the foreign partnerships, and acquisitions, dispositions and changes in foreign partnership interests, is USD10,000 for failure to file each return, with an additional USD10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of USD50,000 per return, and 10% of the value of any transferred property that is not reported, subject to a USD100,000 limit.

  Fraud penalties – where an underpayment of tax, or a failure to file a tax return, is due to fraud, the taxpayer is liable for penalties that, although calculated differently, essentially amount to 75% of the unpaid tax.

  A penalty for failing to file a tax return is 5% of the balance due, plus an additional 5% for each month or fraction thereof during which the failure continues may be imposed. The penalty does not exceed 25%.

  A penalty for failing to pay the amount of tax shown on the return under IRC § 6651(a)(2) is half of 1% of the amount of tax shown on the return, plus an additional half of 1% for each additional month or fraction thereof that the amount remains unpaid, not exceeding 25%.

  An accuracy related penalty on underpayments of tax ranges from 20% to 40%.

Question No. 6. What are some of the criminal charges I might face if I don’t come in under voluntary disclosure and the IRS examines me?

  Possible criminal charges related to tax returns include tax evasion, filing a false return and failure to file an income tax return. Wilfully failing to file an FBAR and wilfully filing a false FBAR are both violations that are subject to criminal penalties.

  A person convicted of tax evasion is subject to a prison term of up to five years and a fine of up to USD250,000. Filing a false return subjects a person to a prison term of up to three years and a fine of up to USD250,000. A person who fails to file a tax return is subject to a prison term of up to one year and a fine of up to USD100,000. Failing to file an FBAR subjects a person to a prison term of up to ten years and criminal penalties of up to USD500,000. From the above, it should be clear that even a few hundred thousand dollars offshore, not properly structured and reported, can result in literally more than a million dollars in penalties and fines, as well as the very real prospect of imprisonment. The civil fines alone can greatly exceed the amount held offshore.

Hence, experienced, and independent counsel is a must. “Independent” is a must – you want advice from someone who does not benefit directly or indirectly from the advice.

Civil exculpation based upon advice

Reliance on the advice of a tax advisor, without wilful neglect is a basis for relief from civil penalties, such as negligence. Code Section 6664 in pertinent part provides that: “No penalty shall be imposed…with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.” The Treasury Regulations go on to state that: “Reliance on an information return, professional advice, or other facts, however, constitutes reasonable cause and good faith if, under all the circumstances, such reliance was reasonable and the taxpayer acted in good faith.”

In the old days, virtually any “opinion letter” from an attorney was adequate to qualify. However, a few years ago the IRS revised the rules applicable to tax professionals which now mandate that opinions be based upon a full legal and factual review, and cover all issues. Hence, fewer US attorneys are willing to write these so-called ‘get out of penalty’ opinions.

Now, even well-crafted opinions by the most reputable professionals are no longer adequate for relief from penalties if the opinion’s drafter is involved, directly or indirectly with the promoters of the structure. In the recent case of Canal Corp. v. Comm’r, 135 T.C. No. 9 (5 August 2010), the court held that the taxpayer could not rely upon the PricewaterhouseCoopers (PwC) opinion for which they paid USD800,000, because of PwC’s involvement with the underlying structure.

The only way to avoid civil penalties is to: (a) make full disclosure, to (b) an independent advisor, (c) who is experienced in the area of law, (d) receive, review and understand the advisor’s opinion, (e) the opinion and reliance must be ‘reasonable’ – no blind reliance, the ‘you should know better’ or ‘it’s too good to be true’ test, (f) the taxpayer must rely upon the opinion, and (g) the taxpayer must follow the plan and the opinion. Only then will the taxpayer have a chance of avoiding civil penalties for their offshore structure.

Criminal exculpation based upon advice

The rules to avoid criminal prosecution are very different than those for avoiding the civil penalties. Most tax crimes require an ‘intent’ to take a particular action – hence, if the taxpayer can show that he had a good faith belief that he did not owe tax, then he may be able to avoid a criminal conviction, but not necessarily avoid prosecution. Such belief does not require reliance upon a professional advisor.

Ignorantia juris non excusat! But there is the “Cheek defence!” Ignorance of the law is a defence in criminal tax cases. Cheek, an airline pilot, after attending courses, and self-study, developed a belief that wages did not constitute income, and therefore he failed to file his returns. In reversing the convictions for wilful failure to file, the Supreme Court held that Cheek was entitled to a good faith instruction to the jury; that is, the jurors were told that they could acquit him if they found that Cheek believed in good faith that he was not required to file. In other words, the prosecutor had to prove that Cheek did not rely in good faith on what he heard and read. The Court also noted that the jury is the final arbiter of a silly argument (Cheek v. US (1991) 498 US 192). Cheek represented himself at the original trial, was eventually convicted and served a year and a day. Although the good faith belief of a ‘crazy’ theory may negate the ‘intent’ element of the crime of tax evasion, it is rarely successful.

Hence, it is extremely difficult, absent a detailed professional opinion to demonstrate that the taxpayer’s belief was reasonable, although it is not impossible:

  Several years ago, federal prosecutors failed to convict a FedEx pilot, Vernice Kuglin of Memphis, who claimed she wrote to the Service enquiring what made her liable for taxes, and when no response was forthcoming, she didn’t file or pay tax on over USD920,000 in income. She successfully convinced a jury that the IRS’ failure to respond was proof she did not owe any tax, and that such belief was in good faith and reasonable.

  Similarly, in July 2007 Tom Cryer, an attorney in Louisiana was acquitted on charges of wilfully failing to file a tax return. The evasion charges were dropped. In part his defence was based on his repeated demand that the government explain why his theories were not viable – the government’s responses were that his positions were frivolous. Until Ms. Kuglin, the government did reply. Mr Cryer argued ‘imagine you receive a bill from someone you never heard from, and you called them to say ‘what’s this for’ – and they respond with ‘pay it’ – your request is frivolous. At trial Mr. Cryer convinced jurors that he genuinely believed he owed no tax for the years in question – and without proof of criminal intent, he was acquitted.

  Wesley Snipes’ defence followed in the path of Kuglin and Cryer. Snipes sincerely believed he didn’t have to pay tax. In early 2000 Snipes provided the IRS with a 600-page tome explaining that he was a ‘nontaxpayer’ and that the tax laws didn’t apply to him – he challenged the IRS to tell him if he was wrong, and of course the IRS ignored his tax protestor manifesto, Justice indicted him, and won partial convictions for failing to file, a misdemeanor – but not the more serious, felony charges of tax evasion. But Snipes was sentenced to three consecutive one year terms.

What Messrs. Kuglin, Cryer and Snipes have in common is that they were prosecuted, and because of the strength of their tax beliefs were willing to ‘go all the way’ and challenge their prosecution. There are very, very few successful defences based upon good faith belief. If the taxpayer couples his offshore endeavors with complex structures, it is even less likely that he will be able to convince a trier of fact of his good faith belief – however, that is not impossible. I have seen and heard brilliant individuals explain why they have offshore structures, which they believe are ‘perfectly legal.’ Often these structures were legal (e.g. pre-1970s foreign situs trusts with a US beneficiary), and avoided tax. Unfortunately no-one told the individuals concerned that the law had changed.

Key distinction between civil and criminal liability based upon “advice”

The civil courts will, no doubt, continue to make taxpayers toe the line with respect to demonstrating the key elements necessary for a penalty defence of reasonable reliance on counsel. And, while in the criminal courts the elements are the same for reliance on counsel or other professional, such as an accountant or tax preparer, the criminal courts give wide latitude with respect to a wilfulness defence of reliance on just about anything, including what the defendant read or heard. This is because the prosecutor must prove beyond reasonable doubt wilfulness, or specific criminal intent, which means that the defendant: (a) knew and understood the law; and (b) intentionally set out to violate it, that is, with the purpose of, e.g. evading the assessment or collection of taxes.

To this required element of wilfulness, the defendant is entitled to present a good faith defence, including good faith belief and reliance, where reliance includes all that the defendant read and heard. In fact, the US Supreme Court held what many lower courts had already held: good faith is a defence, no matter what the belief.

Which brings us full circle to the need for reliance on the advice of competent counsel. Not to mention the jury instruction of wilful blindness: on the element of “knowingly,” often included with wilfully, the jury can find that the defendant intentionally concealed from himself the truth. As with the Three Stooges: “I can’t see, I can’t see.” – “What’s wrong?” – “My eyes are closed.” This argument might be made if, for example, the defendant hears or reads something, but fails to consult a professional. As clients should be asked, “if you have a toothache, do you go to a plumber or a dentist? Both have a pair of pliers.”

A very recent example of a taxpayer’s apparent failure to obtain the advice of independent, competent counsel for use of an offshore limited liability company and trust in Nevis is the federal indictment against Jimmie Ross filed on 5 April 2011 in Knoxville, Tennessee. In that case the grand jury charges Mr. Ross with five counts of tax evasion. Ross failed to report income received from a Nevis based trust services provider which was totally exonerated by the US government. The tax evasion charge against Ross is based on his use of offshore entities and an offshore bank account.

On the other end of the spectrum is the recent case of US v. Lindsey Springer and his attorney Oscar Stilley for conspiracy to defraud the US and evasion of Springer’s taxes by use of the attorney’s trust account to funnel client funds, and from which account client expenses were paid. Each received a sentence of 15 years (Case No. 09 CR 043 JHP, Northern District of Oklahoma).

Finally, in considering reliance on counsel, and the lack thereof, compare the close cousin case of Jim and Pamela Moran with that of Kris Smith, all of whom were extensively involved in the offshore scam operation of “Anderson’s Ark and associates.” The Morans’ tax convictions were reversed by the Ninth Circuit because the trial judge would not allow evidence of the defendants’ reliance upon their accountant. On retrial, the reliance defence was presented, resulting in acquittals. US v. Moran, 493 F 3d 1002 (9th Cir. 2007).

Smith, on the other hand, rejected the opinion of her long term tax preparer and instead accepted the opinion of the promoters, an opinion which, in the short run saved her hundreds of thousands of dollars in taxes, but in the long run cost her: (a) additional taxes, plus penalties and interest; (b) attorney fees to pay for her defence at trial, on appeal, and on a habeas corpus action in the district court and on appeal; plus (c) a prison term of 28 months. For this reward, she paid the promoter USD50,000. For free she could have listened to her preparer who advised against Smith’s involvement because the programme “appeared designed to create fictitious deductions,” and because the promoters would not give additional information to the preparer unless he joined their organisation. US v. Kris Smith, _F 3d_ (10th Cir. 2011 [Case No. 10-1117]).

Note that although the good faith belief and reliance arguments may be viable as a defence in a criminal tax case, often these offshore situations involve money laundering (i.e. disguising the nature or origin of the funds) – where, again, there is available to the government the principal of ‘intentional blindness’ – or simply ignoring what is reasonably available to you as a basis for conviction. So one way or the other, if the government wants you, they will get you. “Forewarned is forearmed;” obtain a specific opinion letter from an independent, competent professional.

Concluding comment

There is a new world order in which non-payment of tax, especially if facilitated with structures outside of the home country, is often viewed as tax evasion. It is absolutely critical before implementing any structure that the taxpayer engages and obtains the counsel of an independent, competent professional.