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Window of Opportunity is Closing for Taxpayers with Unreported Foreign Financial Accounts to Take Advantage of Favorable IRS Guidance

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Each taxpayer who has a financial interest in or signature authority over a foreign financial account generally is required to file the Report on Foreign Bank and Financial Accounts (FBAR) by June 30 for the previous year. For the 2008 tax year, the IRS recently announced that it will accept, without penalty, late filing of an FBAR for those taxpayers that recently learned of their obligation to file and that reported all of their 2008 income on their tax returns. For most taxpayers, the filing deadline has been extended until September 23, 2009. Individuals who have signature authority over, but no financial interest in, a foreign financial account or commingled fund may file until June 30, 2010.

Investments in Foreign Hedge Funds, Private Equity Funds, and Private Investment Funds Now Reportable on FBAR

These filing extensions followed changes to the FBAR and its instructions, and an announcement in mid-June that the IRS expects taxpayers holding investments in foreign hedge funds or foreign private equity funds to report these interests as foreign accounts. Prior to this announcement, few taxpayers or tax professionals believed that these investments were subject to FBAR reporting requirements. Because of the confusion following the June announcement, the IRS announced that it will not impose civil and criminal penalties on certain taxpayers that file an FBAR by the appropriate extended deadline.

During a June teleconference with the American Bar Association and the American Institute of Certified Public Accountants, IRS representatives stated that investors that hold an equity interest in a foreign hedge fund must report this interest by filing an FBAR, also known as Form TD F 90-22.1. This announcement surprised most tax professionals, but an IRS spokesperson later confirmed the new interpretation. According to the IRS, these and other offshore private investment funds qualify as “foreign accounts” for FBAR reporting purposes. The IRS has provided little other guidance on this matter, except to say that any interest in a foreign partnership or corporation used by investors to commingle funds must also be reported.

Previous Assumptions about “Foreign Accounts” for FBAR Reporting Purposes

Prior to this announcement, most taxpayers assumed that these types of private investments did not qualify as “foreign accounts” for FBAR purposes.  The IRS does not consider certain other types of investments in foreign entities to be “accounts.”  For example, taxpayers are not required to file an FBAR to report bonds, notes or stock certificates issued by foreign corporations. Instead, “foreign accounts” have historically included and still include any savings, demand, checking, deposit, time deposit, securities or other accounts maintained with a financial institution. Assets held in a commingled fund or any equity interest in a commingled fund are also considered “foreign accounts.”  Equity interests in foreign business entities, however, were not believed to be “foreign accounts” by most taxpayers.

Since October 2008, the revised instructions to Form TD F 90-22.1 have listed mutual funds as an example of “accounts” because they are commingled funds. The June announcement indicated the IRS believes that hedge funds, private equity funds and other private investment funds are similarly commingled funds.  The IRS has yet to clarify what other types of entities or investment structures will qualify as foreign commingled funds and, in turn, as “accounts” for FBAR purposes.

Expansion of Individuals with FBAR Filing Obligation

This new interpretation of “foreign accounts” was not the only change that the IRS made to the Form TD F 90-22.1 instructions. For the first time, individuals with signature, or other similar authority over foreign accounts, are now required to file an FBAR if the total value of the accounts exceeds $10,000 at any point during the calendar year. A person with such authority has control over the disposition of the funds in an account. As a result of this change, executives and other employees with control over foreign accounts held by their organizations may be required to file an FBAR on their own behalf. The IRS has just announced that individuals with signature authority have until June 30, 2010 to file FBARs for tax years 2003 through 2009.

The IRS also expanded the scope of the filing requirements to include any persons or entities “in and doing business in” the United States.  Previously, only citizens, residents, domestic entities or domestic trusts were required to file an FBAR. This new requirement, however, for persons who are not United States citizens, residents or domestic entities has been temporarily suspended. The IRS plans to clarify this change to the FBAR instructions in subsequent years.

Significant Penalties for Failure to File

These broader FBAR filing requirements create greater potential for civil and criminal penalties for taxpayers with foreign investments.  Failure to file an FBAR can lead to civil penalties of up to $100,000 or fifty percent of the amount of the account. It can also lead to criminal penalties of up to $500,000 or ten-years imprisonment. Taxpayers that remain unaware of their obligation to file under the FBAR reporting requirements will be at risk of incurring significant penalties.

What Action to Take

Because of this risk, taxpayers should review their offshore investments and determine whether to take advantage of the IRS’s September 23, 2009 or June 30, 2010 filing date extensions. If taxpayers choose to file, they must follow special filing instructions that require taxpayers to provide a statement explaining why the FBAR filing is delinquent. Taxpayers should also consider whether other changes in the IRS’s general instructions affect their filing obligations.

Only taxpayers that reported all of their income but failed to file an FBAR can take advantage of the September 23, 2009 or June 30, 2010 deadlines without penalty. These delinquent FBAR filing procedures are not available to taxpayers that did not report income on foreign investments on their 2008 tax returns. Instead, these filers must follow the IRS’s voluntary disclosure procedures.

This advisory was prepared by the Tax Department at Nutter McClennen & Fish LLP. For more information, please contact Melissa McMorrow or your attorney at Nutter at 617-439-2000.

This update is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising.

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