The Unreported Offshore Account: Still Alive After Death & Plaguing Executors and Heirs

When someone dies owning an unreported financial account, the heirs and executors of the estate are faced with a serious problem. First, assuming there is undeclared income earned with respect to the account, such income will generate a tax liability for the decedent with respect to any tax years that remain open under the statute of limitations. Death will not erase that tax liability.

Statute of Limitations Issues

Individuals with potential tax problems always ask “How long can the IRS come after me?” The answer is, “It depends”. More precisely, it depends on the “statute of limitations” that is applicable to the case. A statute of limitations generally prescribes the length of time permitted to the IRS to enforce the tax rules. If the length of time runs out for a particular tax year, then the IRS is forever barred from claiming more tax is owed in that year. It is important to understand how the tax statute of limitations works, because in certain cases, the statute of limitations will be longer than others or it will not start to run at all.

If a tax return was not filed for the particular tax year in question, then, the statute of limitations will not start to run for that year until the tax return is filed. So, if the decedent had not filed tax returns, the IRS has “forever” to chase the taxes due. As relevant to an offshore account, under tax rules enacted in March 2010, the statute of limitations also does not begin to run until the taxpayer has complied with all mandatory foreign reporting. See IRC Section 6501(c)(8). Thus, even if tax returns were filed by the decedent, but required information reporting for the foreign account was not undertaken, for example, on a Form 8938 concerning ownership of “specified foreign financial assets”, then the statute of limitations “clock” will not start to “tick” until the IRS receives the required Form. Please see my blog posting here concerning special tax information reporting for “specified foreign financial assets”. Only when proper reporting is made will the statute of limitations begin. Furthermore, even though the statute starts to run once the information is provided, the entire tax return will remain open for IRS adjustments for a period of three years (rather than only for the portions of the return relating to the foreign reporting that had been missing).

Please see my blog post here for other statute of limitations rules.

IRS is On the Case

A recent IRS program manager technical assistance (PMTA) memorandum (PMTA 2014-018) is a stark reminder of the critical importance of complete filings for international information returns. As described in the PMTA, the taxpayer, an individual, owned certain specified foreign financial assets, which should have been reported on Form 8938. The taxpayer died during the tax year, and his executor was required to file the necessary tax returns including the Income Tax return for the decedent (Form 1040), Income tax return for the Estate (Form 1041) and the Estate tax return (Form 706). The executor filed all of these Forms 1040, 1041 and 706 in a timely manner; however the executor did not file the required Form 8938 with the decedent’s final income tax return on Form 1040.

The PMTA explained that the statute of limitations rule contained in Section 6501(c)(8) is very broad. It stated that an executor’s failure to report a foreign financial asset as required in any of the listed provisions of Section 6501(c)(8), “will hold open the period of limitations on assessment of any tax required to be shown on the individual’s Form 1040 or the estate’s Form 1041 or Form 706, to the extent that the unfurnished information ‘relates’ to such return.” The IRS stated that the question of whether the information “relates” to a return is a factual one”. Under the facts of the PMTA, each of the Forms 1040, 1041 and 706 omitted the foreign financial asset required to be reported under Section 6038D. This information would have identified “a likely source of income, during the relevant time period, and assets held at or near the time of death.” Accordingly, it was easy for the PMTA to conclude that the information “relate[d]” to each of these three returns, and that the extended statute of limitation under Section 6501(c)(8) would apply to those returns. In other words, the statute of limitations remained open for each of the Forms 1040, 1041 and 706 and the IRS could assess all taxes owed despite the passage of time.

Unpaid Income Tax Liabilities of the Decedent DO NOT Disappear at Death

Upon death, the decedent’s unpaid income tax liability becomes a liability of the estate. This liability cannot be ignored, because both the estate executors and heirs are at risk. The estate executors are personally liable for any unpaid claim of the United States, to the extent they make any distribution of the estate assets before paying the US government. Thus, the Estate executor will face fiduciary liability for unpaid taxes if he transfers assets from the estate prior to paying the IRS.

As for the heirs, they must not forget that the arm of the IRS is very long, indeed. In order to prevent taxpayers from avoiding their responsibilities to pay tax, the law has developed several theories under which the IRS can satisfy one party’s tax debts by following property that has been transferred by that party to another party. The theories vary, but fall into the general categories of “Nominee Liability”, “Alter-Ego Liability” and “Transferee Liability”. In the case of heirs receiving property from the estate, the unpaid taxes of the decedent might be collectible by the IRS on a theory of Transferee Liability. Special rules impose personal liability against the transferee of an estate (such as an heir) in cases when the estate did not pay estate taxes due. A special lien for estate tax automatically arises on the death of the decedent and attaches to property transferred from the estate. The transferee’s liability is generally limited to the fair market value of the property he or she received.

What to do?

In this type of situation, professional tax advice is absolutely required. It is best to engage the services of a US tax attorney to protect the Attorney-Client Privilege. An attorney is not treated the same as an accountant or other type of advisor. A special privilege is accorded when attorneys are consulted. Discussion with legal counsel may be protected by what is called the “attorney-client privilege.” Taxpayers with unreported income or assets must obtain a full understanding of the implications, their options for dealing with the matter and possible penalties under each option. Consultation with a non-attorney (for example, with the taxpayer’s accountant) is not protected by the privilege. If the IRS discovers the foreign financial account, the taxpayer’s accountant or other non-attorney could become a witness for the IRS against the taxpayer or be required to turn over records and documents. This would not be the case if an attorney had been consulted.

Streamlined? OVDP?

The relatively new and modified Streamlined procedure is a possibility to handle this type of problem. The modified streamlined filing compliance procedures are designed for individual taxpayers, but according to the IRS instructions for the procedure, eligibility specifically extends to the estates of individual taxpayers.

Significantly, taxpayers using the Streamlined procedure must certify that the tax noncompliance was “nonwillful”. According to the IRS, “Taxpayers using either the Streamlined Foreign Offshore Procedures or the Streamlined Domestic Offshore Procedures, will be required to certify, in accordance with the specific instructions, that the failure to report all income, pay all tax and submit all required information returns, including FBARs (FinCEN Form 114, previously Form TD F 90-22,1) was due to non-willful conduct.” What is very unclear is whether the nonwillfulness applies to the conduct of the decedent or to that of the executor who is now filing the returns and reporting the overseas account on behalf of the decedent’s estate. It would seem on the one hand, that the “nonwillfulness” relate to the conduct of the decedent in not properly reporting the foreign account. However, the decedent certainly cannot certify to this since he is dead! In addition, the executor cannot certify anything about whether the decedent himself was or was not “willful”.

My blog posting here analyzes how the Streamlined procedure can possibly be used in a situation involving an estate.

The Offshore Voluntary Disclosure Program (OVDP) is also an option. The OVDP FAQ’s specifically cover the scenario when the taxpayer is a decedent’s estate, or is an individual who participated in the failure to report an OVDP asset in a required gift or estate tax return, either as executor or advisor. As part of the OVDP process they will be required to provide complete and accurate amended estate or gift tax returns (or, original estate or gift tax returns if these had not previously been filed) for tax years included in the voluntary disclosure correcting the underreporting or omission of OVDP assets.

You can read more about both the Streamlined procedure and the OVDP here.