Taxes and Penalties on Unreported Foreign Assets: Who Foots the Bill?

Abstract

Brian and Helena are getting divorced. Brian has a successful electronics company that sells products around the world. Several years ago, a European customer owed a lot of money to Brian’s company and Brian instructed the customer to divert part of the payment to a numbered bank account in the Channel Islands controlled by Brian. The account now has a little over one million dollars. Helena has always known about the account and now she is threatening to tell the judge, or worse, call the Internal Revenue Service, unless Brian agrees to her settlement proposal.

What can Brian do? What are the tax consequences? Could there be penalties? More importantly, does Brian have criminal exposure? And who bears the cost of all the taxes and penalties associated with the unreported foreign account: is it all Brian’s burden; or is Helena jointly responsible?

Matrimonial lawyers often think of tax issues in terms of who is an “innocent spouse,” but that does not fully capture the proper analysis required when dealing with unreported foreign assets. When such assets surface in a divorce, the most important issue is whether either of the spouses “willfully” failed to report the foreign assets because “willfulness” could trigger a criminal prosecution, or huge civil penalties, either of which could wipe out the marital estate. Secondarily, there are issues relating to innocent spouse treatment under the Internal Revenue Code (I.R.C.) and separate issues relating to how a matrimonial court will allocate any tax liabilities relating to the unreported foreign account.

This article is not about how to find foreign assets. That is a question for a good forensic accountant, though it is important to understand that foreign accounts often can be traced through a careful review of bank statements and financial transactions. In addition, new laws are requiring foreign financial institutions around the world to report foreign accounts held by their U.S. customers to the Internal Revenue Service (IRS), making it easier for the IRS, creditors, and spouses to uncover such accounts.

This article is about what to do when unreported foreign assets come to light in a divorce and will help practitioners evaluate the available alternatives and associated risks and costs. Part I outlines many of the various reporting requirements for foreign assets and the related civil penalties. Part II discusses the willfulness standard and when huge penalties, or even criminal prosecution and potential imprisonment, must be considered. Part III reviews the options available to a taxpayer who has foreign assets, including the voluntary disclosure programs that can be used to minimize the civil penalties and avoid criminal prosecution. Part IV addresses strategies for dealing with taxes and penalties when unreported foreign assets surface in a divorce case. The conclusion summarizes an analytical framework for approaching issues involving unreported foreign assets.

Keywords: taxes, penalties, foreign assets