IRS Approach on Closed Assessment Periods & FBAR Penalties
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- On December 13, 2023
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During a tax dispute, taxpayers have the advantage of time because the Internal Revenue Service (IRS) must identify a problematic return among millions, conduct an audit, and notify taxpayers of proposed changes before the assessment period ends. After the taxpayer files their tax return, the IRS typically takes three years to accomplish all of these actions.
There are exceptions, of course. In many cases, the Internal Revenue Code dictates that taxpayers who have committed some wrongdoing will be subject to extended assessment periods, sometimes indefinitely. Involuntary extensions are often used by the IRS because they allow them to impose larger amounts of taxes, FBAR penalties, penalties, and interest.
There are also situations in which taxpayers can extend assessment periods with the IRS on a voluntary basis, if they see a financial, tactical, or other benefit in doing so. A Form 872 (Consent to Extend the Time to Assess Tax) or similar document may be used to accomplish this.
Tax issues can be extended for a variety of reasons; however, the key is to extend while the assessment period is open. It cannot be revived once it lapses. In the context of tax issues, some taxpayers may be aware of the no-revival-of-closed-assessment-periods rule, but most likely aren’t aware of the IRS’s contrary position on undeclared foreign accounts, specifically regarding FBAR penalties. Due to a recent Freedom of Information Act request, the IRS was obligated to reveal its stance. The IRS is able to solicit and rely on extensions of time to impose penalties for FinCEN Form 114 (FBAR) violations from its perspective, even though the IRS obtained these extensions after the previous assessment period had expired.
This article discusses common ways taxpayers involuntarily extend assessment periods, the specific rules and obligations that apply to voluntarily extending assessment periods, and the IRS’ divergent views on the restoration of closed periods in relation to taxes and FBAR penalties.
Involuntary extensions of Assessment Periods
After a taxpayer files a return, the IRS generally has three years to assess additional taxes and penalties. A few of the situations when the IRS can extend the three-year period are as follows:
a. Incomplete, late, or unfiled information returns
Taxpayers with foreign assets and/or activities must generally file Form 8938 (Statement of Specified Foreign Financial Assets), as well as other foreign information returns. For taxpayers who own interests in foreign entities or have certain other ties to them, following disclosures are required as per the classification of the entities:
- Forms 5471 (Information Return of U.S. Persons with Respect to Certain Foreign Corporations)
- Forms 8865 (Return of U.S. Persons with Respect to Certain Foreign Partnerships)
- Forms 8858 (Information Return of U.S. Persons with Respect to Foreign Disregarded Entities and Foreign Branches)
- Forms 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts)
b. Substantial income omissions
Unreported income is subject to the IRS’s powers. According to the relevant provision,
- a taxpayer who omits income from their tax return and
- whose omitted income exceeds 25% of their gross income on their tax returns, or
- whose omitted income is greater than $5,000 and is related to one or more foreign financial assets covered by Form 8938, can be assessed income tax within six years of filing the relevant tax return by the IRS.
A primary result of this provision is that relatively minor amounts of omitted income can cause an assessment period to be extended to six years instead of three.
c. Fraudulent or false returns
The IRS may assess tax at any time if a taxpayer files a false or fraudulent return. A taxpayer’s fraudulent intent is determined when the taxpayer signs a tax return with the intention of filing it or when it is actually filed. Fraud allegations are decided on the basis of their individual facts, and no single factor is decisive. There are, however, several common indicators of fraud, referred to as ‘badges of fraud’, which are as follows:
- understatement of income,
- inadequate records,
- failure to file tax returns,
- implausible or inconsistent explanations of behavior,
- fictitious transactions and entities,
- concealment of assets,
- failure to cooperate with tax authorities,
- engaging in illegal activities,
- attempting to conceal such activities,
- dealing in cash, and
- not making estimated tax payments.
An important factor in determining fraud is the level of sophistication of the taxpayer.
d. Listed transactions that are undisclosed
Whenever a “participant” fails to enclose Form 8886 with a properly filed tax return in a matter that the IRS classifies as “listed transaction,” the assessment-period with respect to that return can remain open for a long time. It is worth noting that the IRS preserves its right to audit and modify the Form 8886 until one year has passed since either the participant files it, or a material advisor provides some data about the transaction. The IRS has the authority to assess any taxes, penalties, and interest during the prolonged assessment period, regardless of whether they are directly related to the listed transaction. Since reportable transactions (which include listed transactions) and “substantially similar” transactions are both subject to Form 8886 filing. The regulations emphasize that taxpayers should interpret the concept of substantially similar broadly for the purpose of filing tax returns.
2. Voluntary Extensions of Assessment Periods
If necessary, a taxpayer can grant the IRS an extension of time to complete its audit by executing Form 872 or the appropriate version of it. Below are some issues regarding voluntary extensions.
a. Extensions aren’t required, in theory
In the past, the IRS has claimed that its auditors, known as Revenue Agents, should complete their jobs within three years and should not request more time. However, the preceding statements of the IRS are not consistent with current reality. It is almost universal that the IRS requests Forms 872 from taxpayers in almost all audits today. It is therefore important to learn more about IRS duties and taxpayer rights.
b. IRS obligations while requesting extensions
According to the Internal Revenue Manual, the IRS must notify taxpayers of the following rights:
- the right to refuse to extend the assessment period,
- the right to request that the extension be limited to particular issues, and
- the right to request that the extension be limited to a specific period of time.
c. Taxpayers’ reasons for extension
In certain situations, taxpayers may benefit from voluntarily extending the assessment period.
As a prerequisite to reviewing any Protest Letter filed by taxpayers disputing unfavorable Examination Reports, the Appeals Office requires that at least 12 or 18 months remain open. Taxpayers may also extend the assessment period when the Revenue Agent has completed the audit.
d. A contrary view of revival
Many taxpayers and practitioners are unaware that the IRS has taken opposing positions regarding late extensions (i.e., extensions granted after the previous assessment period has expired). In regards to tax-related issues, the IRS believes that no penalties should be imposed, however FBAR penalties should be imposed. Below are details on this inconsistency.
3. The extension of tax-related issues
As previously explained, the IRS has three years from the date a taxpayer files a return to assess additional taxes and penalties, but taxpayers can agree to extend this period. However, such an agreement must be made before the current assessment period ends.
Additionally, the relevant regulations explicitly recognize that a “dead” assessment-period cannot be revived via agreements between taxpayers and the IRS.
4. Extensions for FBAR Penalties
The IRS has freely released certain information regarding its comprehensive voluntary disclosure program. According to the Voluntary Disclosure Practice Examiner Guide Paper (“Guide Paper”) obtained under the Freedom of Information Act, timing matters for FBAR penalties are significantly different. The IRS encourages Revenue Agents to secure taxpayers’ consent to extend the time for civil penalties to be assessed under 31 U.S.C. 5321 for FBAR violations (“FBAR Consent”). FBAR statutes that have expired can also be revived with taxpayer consent, according to the Guide Paper.
5. What is in the Taxpayer’s Interest?
There are certain situations where the taxpayer gains from declining an IRS request to extend the statute. However, for the majority, it works in taxpayer’s interest to extend the statute when requested. Deciding on whether to grant an extension request or not is specific to the taxpayer. Taxpayers considering extensions requests are advised to consult professionals with specialization in federal tax resolution.