A federal court recently addressed an individual's claim of illegal extraction by the IRS and the government's claims against the individual for over USD 1 million in penalties and interest. The court stated that the determinative issue common to both the individual's and the government’s claims is what standard should be applied to "willful" when assessing a civil tax penalty based on a willful violation of an individual's obligations.

Arthur Bedrosian, the individual in this case, opened a Swiss bank account with a USD 100 deposit during overseas business travel in the 1970s.

By 2005, Bedrosian had opened a second Swiss account and both accounts had balances exceeding the USD 10,000 Report of Foreign Bank and Financial Accounts (FBAR) filing threshold. For many years, Bedrosian did not tell his accountant about these accounts because "the accountant never asked." Bedrosian did eventually tell his accountant about these accounts in the 1990s, at which time he asked what he should do to rectify the situation. The accountant allegedly told him to "just leave it alone because the damage was already done."

That accountant passed away in 2007, at which time Bedrosian hired a new accountant. Under the guidance of the new accountant, Bedrosian reported on his 2007 federal income tax return for the first time that he had assets in a Swiss account and filed an FBAR for only one of his Swiss accounts. The account for which he made a disclosure had assets of approximately USD 240,000. The account that he did not disclose had assets totaling USD 2.3 million. Bedrosian also failed to report income earned on either account on his 2007 return.

In November 2008, Bedrosian asked the Swiss bank to close one of the accounts and transfer its assets to a different Swiss bank. In December 2008, he asked the first Swiss bank to close the remaining account and transfer all of its assets to a US bank account.

In August 2010, Bedrosian attempted to address the failure to disclose by filing an amended return for 2007 and an amended FBAR that included both accounts. The amended return reported approximately USD 220,000 in income from the Swiss accounts. By the time Bedrosian made these corrections, the IRS had already received information about these accounts from the Swiss bank, but had not yet opened an audit for the 2007 and 2008 tax years.

In September 2010, Bedrosian decided to enter the IRS Offshore Voluntary Disclosure Program (OVDP), but he claimed that an IRS agent advised him to opt out of OVDP. The government contends that this claim is incorrect, and that his OVDP application was rejected instead.

The government asserted that it is impossible to corroborate Bedrosian’s claims that his accountant advised him to not report the accounts because there is no written evidence of this advice and the accountant is deceased. The government also alleged that Bedrosian paid the Swiss bank to stop mailing information about his accounts to the US after reading an article about the US government trying to trace postage meter numbers to banks in Switzerland.

In July 2013, the IRS imposed a penalty for willful failure to file an FBAR against Bedrosian for the highest amount permitted by the regulations then in force, which was USD 975,789.17. Bedrosian filed suit against the government, alleging illegal extraction. The government filed a counterclaim for full payment of the penalty allegedly due with accrued interest, a late payment penalty, and other statutory additions. At this point of the case, the court was to determine whether the case should to proceed to resolve discrepancies over the facts.

Willfulness Is the Issue

Both parties to the suit agree that Bedrosian otherwise meets the other requirements of the relevant laws: (1) he is a US citizen, (2) he had an interest in a financial account during 2007, (3) the account had a balance exceeding USD 10,000 during that year, (4) that account was in a foreign country, and (5) he failed to disclose that account. On that basis, the court stated that the crux of the case is whether Bedrosian willfully failed to file an FBAR for the larger of his two Swiss accounts for 2007. The court explained that the "precise contours of the term 'willful' as used in … the civil penalty provision, have not been clearly established by statute or precedent."

Bedrosian's Interpretation of Willful

Bedrosian reasoned that the government must apply the same standard for the civil penalty as it does in the criminal context. Bedrosian asserted that the case law indicates that the government must show that his actions amounted to a voluntary, intentional violation of a known legal duty in order to assess a "willful" penalty.

The court explained that it was not necessary to ascertain the appropriate standard of willfulness at this point of the case but noted that it disagreed with Bedrosian's reasoning. The court opined further that the jurisprudential trend is towards one that would treat actions of recklessness as actions that amount to a willful violation of those rules.

The question facing the court at this juncture was whether there was a genuine dispute over the facts that will determine whether Bedrosian acted willfully, regardless of what standard is ultimately used. Specifically, the court noted that there were genuine disputes over what Bedrosian knew regarding his reporting requirements and when, and the extent to which Bedrosian’s statements regarding his prior accountant’s advice can be corroborated.

While it is yet to be determined what standard will be applied for "willfulness" here and whether Bedrosian will be found liable for the civil penalty under that standard, this case underscores the fact that many financial institutions have disclosed foreign account information to the US government and the IRS is intent on using that information to assess penalties—at the highest level permitted—against individuals who failed to fulfill their reporting obligations. This case also highlights that the IRS will not look sympathetically to an individual who has taken no or limited action to disclose all of his or her foreign accounts, or has engaged in selective disclosure at some point in the past. Importantly, the ultimate holding of this case may find that a lower threshold of a reckless disregard of reporting obligations permits an assessment of the highest penalties allowed. There is no “good cause” exception to this penalty. In other words, this case serves as another reminder to take action on undisclosed accounts before the IRS does.