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Today in Tax: Foreign Account Reporting Requirements and Divisive Tax-Free Reorganizations

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Brief commentary on cases, rulings, notices, and related federal tax guidance as of December 29, 2021.

FBAR Noncompliance Leads to More Severe Penalties in the 5th Circuit

Penalties for FBAR violations can be severe if applied on a per-account basis, as opposed to a per-form basis. However, a taxpayer with “reasonable cause” can avoid these penalties altogether. First, identify all foreign bank and financial accounts in which you have an interest or for which you have signature authority. Then be sure to talk with a tax professional about any reporting requirements you may have. Be open with that professional to make sure they have enough information to properly guide you through any reporting requirements. Any attempt to conceal accounts or any inadvertent omission can bear significant penalties.

Under the “Report of Foreign Bank and Financial Accounts” (FBAR) rules, taxpayers are required to report certain transactions and accounts with foreign financial institutions. Non-willful violations of these rules will result in a maximum penalty of $10,000, adjusted for inflation. This penalty, however, can be abated if the taxpayer has reasonable cause for the violation.

Recently, the U.S. Court of Appeals for the Fifth Circuit held that the $10,000 penalty for a violation of the FBAR rules to report a qualifying account applies for each account, not each form. Thus, the untimely filing of a single form with multiple accounts will produce multiple penalties. This decision from the Fifth Circuit differs from the findings of the Ninth Circuit in a March 2021 decision. In the earlier case, the Ninth Circuit held that one penalty applies for the untimely filing of a single accurate FBAR that includes multiple foreign accounts.

While this holding creates an unfavorable precedent for taxpayers who may have penalties due to non-willful violations of the FBAR rules, the Court’s discussion of reasonable cause is instructive of what is required of taxpayers who want to avoid any penalties. The Fifth Circuit concluded that the taxpayer did not exercise ordinary business care and prudence in failing to fulfill his reporting obligations. In reaching this conclusion, they focused on the taxpayer’s sophistication. Even though the taxpayer was a naturalized U.S. citizen that had only lived in the U.S. for approximately 8 years before returning to Romania, the taxpayer was a successful business person with dozens of bank accounts in several European countries. Due to this business savvy, the taxpayer’s failure to inquire about his reporting obligations was unreasonable despite the fact that the taxpayer was unaware that, as a U.S. citizen, he had to report his interests in certain foreign financial accounts.

Taxpayers who want to avoid penalties should talk with a tax professional about any reporting requirements they may have. To gain the most benefit from this discussion, the taxpayer must be transparent about their holdings and ensure that the tax professional knows all the facts in order to property advise the taxpayer on any reporting requirements.

IRS Releases Numerous Rulings Relating to Divisive Reorganizations

The Internal Revenue Service issues rulings to taxpayers requesting specific guidance relating to particular aspects of proposed transactions. Although the IRS won’t rule on every aspect of tax-free divisive reorganizations, a number of criteria that must be satisfied to achieve tax-free status are eligible for ruling. The rulings outlined below are a reminder that divisive reorganizations can carry a significant tax cost if improperly structured, and that every transaction is unique. Particularly, transactions involving the division of domestic and foreign businesses, recapitalization or retirement of debt, or spin-offs in nascent or R&D intensive industries may warrant obtaining the additional comfort of an IRS ruling.

In PLR 202151004 (a supplement to PLR 202139006), the IRS determined that service by a key employee of the parent corporation as a director of the subsidiary corporation would not cause the proposed spin-off transaction to become taxable. In this ruling the employee would be a minority of the directors of the subsidiary and would only serve as a director during the period in which the parent corporation held subsidiary stock.

In PLR 202151001 the IRS ruled that a series of interrelated transactions, including the reallocation of assets among related parties, spin-off of a subsidiary corporation, and debt retirement in exchange for debt or equity, would constitute a “reorganization” for purposes of qualifying as a tax-free reorganization.

In PLR 202150012 the IRS addressed three successive transactions. The first two transactions involved distributions of subsidiary stock and debt through a chain of affiliated corporations, while the third distribution effected the spin-off of the domestic activity of the taxpayer (which retained certain domestic and foreign business lines).

In PLR 202150009 the IRS ruled that the creation of a subsidiary corporation, the contribution to that subsidiary of all the equity of a disregarded entity operating a historic business, and the subsequent distribution of the subsidiary corporation was a “reorganization” for purposes of qualifying as a tax-free reorganization, and that post-reorganization consummation of certain agreements (transition services, tax matters, employee matters, and so on) would be treated as occurring immediately before the reorganization rather than after the corporations parted ways.

In PLR 202150004 the IRS ruled that a business with ongoing operational expenses, employees, and research and development activity would be treated as an active business, and therefore eligible to be spun-off in a tax-free manner, even though the business did not generate income in each of the five preceding years.

Access the previous installment here.