Is Mental Incapacity a Defense to “Willful Behavior” Penalties?

By admin of MillarLaw A Professional Corporation On Sunday, December 1, 2019

By:  Sanford I. Millar ©

The Tax Crimes Handbook of the Office of Chief Counsel, Criminal Tax
Division of the Internal Revenue Service defines “Willfulness ” as
follows:

“[a] Willfulness is defined as the “voluntary, intentional
violation of a known legal duty.” Cheek v. United States, 498 U.S. 192,
200-01 (1991); United States v. Pomponio, 429 U.S. 10, 12 (1976); United States
v. Bishop, 412 U.S. 346, 360 (1973); United States v. Pensyl, 387 F.3d 456,
458-59 (6th Cir. 2004); United States v. George, 420 F.3d 991, 999 (9th Cir.
2005). 10

Subjective Test. A defendant’s good faith belief that he is not
violating the tax laws, no matter how objectively unreasonable that belief may
be, is a defense in a tax prosecution. Cheek v. United States, 498 U.S. 192,
199-201 (1991). See also, United States v. Grunewald, 987 F.2d 531, 535-36 (8th
Cir. 1993); United States v. Pensyl, 387 F.3d 456, 459 (6th Cir. 2004)”

Whether a taxpayer’s conduct is “willful” or not is particularly
complicated when dealing with individuals who suffer from mental impairment .
Recently, David Horton, acting deputy commissioner (international), IRS Large
Business and International Division illustrated an approach to documenting a
claim of “non-willfulness”

 . The approach suggests the use of
medical records to establish the taxpayer’s cognitive impairment by way of
third party circumstantial evidence.

According to the Alzheimer’s Association ” an estimated 5.3 million
Americans of all ages have Alzheimer’s disease in 2015.” These are the
diagnosed cases. Of those diagnosed cases the state of medical records will be
somewhat imperfect, meaning that the defense of “non-willful” behavior
might be difficult to sustain. This is particularly true when tax or foreign
bank account reporting issues arise. There are other forms of metal impairment
that can affect the determination of whether a person is
“non-willful”.  The other forms
of mental impairment include, but are not limited to dimentia, substance abuse,
physical brain injury and post-traumatic stress disorder (“PTSD”).  The burden is proof is on the taxpayer and
his or her representative to establish the failure to file or failure to properly
report income. assets or foreign accounts was the result of mental impairment
leading to the conclusion of non-willful action. This burden becomes
exaggerated when the taxpayer is in a Conservatorship or when the taxpayer is
deceased.

A Conservator is a fiduciary appointed by a state court judicial
officer.  A Conservator is charged with
taking care of the health and well being and/or the financial affairs of an
individual found no longer capable of doing so. 

Often a psychiatric report and medical report are required to convince a
court of the need for the appointment of a Conservator. The medical and
psychiatric reports will usually focus on the immediate health and state of
mind of the individual which is the issue before the court. But the immediate
moment is not the issue for tax and foreign account reporting purposes. The
state of mind that is at issue is what was the taxpayer’s intent when he or she
signed the income tax  return or failed
to file. In the case of a failure to file this  could be six-eight years earlier or more from
the court’s determination that that petition to appoint a Conservator should be
granted. Establishing the state of mind of a taxpayer years earlier when the
tax return, information return  or Report
of Foreign Financial Account (FBAR) was due or incorrectly filed, is or could
be critical to a decision about whether the individual was
“non-willful” and therefore qualifies for the Domestic Streamline
Procedure or whether the Conservator should use the formal Offshore Voluntary
Disclosure Program (OVDP). The financial difference to the Conservatorship
Estate is or can be quite substantial .

Example:  (1) Assume a U.S. resident
taxpayer is eligible for the Streamline Domestic Procedure because his/her actions
were “non-willful” due to mental incapacity.  The Streamline Domestic Procedure requires
the filing of three (3) years of amended or late original returns, six (6) of
late FBAR’s the payment of the underpaid income tax and a five (5%) percent
FBAR penalty calculated based upon the highest single year account  balances at the end of each calendar year for
 the aggregate offshore accounts.  If we assume a constant balance of $1 million
USD then the FBAR penalty would be $50,000 USD. 
Contrast this FBAR penalty with the situation in Example 2.

Example:  (2) Assume the same facts
except that the taxpayer cannot satisfy the “non-willful” criteria
due to an absence of medical evidence or third party statements.  Under these circumstances the taxpayer would
have to consider the Offshore Voluntary Disclosure Program (OVDP).  Under the OVDP the taxpayer would need to
file eight (8) years of amended or original income tax returns and FBAR’s and
pay an FBAR penalty of either twenty-seven and one half (27.50%) percent or
fifty (50%) of the highest single year account balances of the aggregate
offshore accounts and of the proceeds of those accounts (such as the value of
acquired art works or business interests). 
The determination of whether the FBAR penalty is 27.50% or 50% is based
upon whether the financial institution is a Department of Justice
“listed”   foreign financial
institution.  For simplicity purposes we
will assume that that the foreign financial account balances are a constant $1
million USD for all covered years.  Then
the FBAR penalty would be either $275,000 
USD or $500,000 USD versus $50,000 USD if the taxpayer qualified for the
Streamline Domestic Procedure.  If  the taxpayer used the proceeds of the
unreported account to purchase appreciating assets, the value of those assets
would have to be included in the penalty calculation. 

It is therefore very important for a the 
tax attorney  representing the
taxpayer  to obtain the most
comprehensive medical reports possible and statements from percipient third
party witnesses to  document the
taxpayer’s state of mind at the earliest possible date, not just the current
moment. A skilled forensic psychiatrist should be able to help in this regard.  The tax attorney needs to evaluate the
circumstantial evidence and then recommend which approach fits the facts.  The attorney will, in addition to reviewing
the medical evidence and third party statements, if any, need to do a
comprehensive review and analysis of the financial records to determine whether
the taxpayer was or was not using the foreign financial account, directly or by
use of a linked credit card or debit card or indirectly through the use of a
co-account signatory (such as a family member or fiduciary).

 The ability to use the Streamline
Prcedures or OVDP  assumes that the
taxpayer  or his/her Conservator,
Executor or Trustee,  has not yet been
contacted by the Department of Justice or the IRS.  If the taxpayer has been contacted, or has
received a FATCA letter from the foreign financial institution, then it may
already be too late to come forward.  If
it is too late to come forward, then the defense of mental impairment must be
raised in the IRS administrative proceeding or in the criminal investigative
phase with the Department of Justice or U.S. Attorney. 

The same basic process to establish “non-willfulness” applies if
the taxpayer is deceased and the Executor of the Estate or Trustee of the
decedents trust (whether created as a Living Trust or as a Testamentary Trust)
discovers unreported foreign financial accounts .  The case does become a bit more complicate,
however, because the ability to establish mental impairment is then virtually
dependent on medical records, third party declarations and forensic medical
testimony.  Once discovered, the estate
or trust fiduciary must come forward or risk personal liability for taxes and
FBAR penalties.  The heirs may attempt to
put pressure on the fiduciary to make a distribution of estate or trust assets,
but the fiduciary must exercise extreme caution in such cases and is best off
seeking court instructions to avoid or mitigate personal liability.

It is noteworthy to reiterate that a non-willful defense based upon mental
impairment is a complex defense to build and can be expensive in terms of
professional fees. But in the proper circumstances the time and effort are
justified if measured by potential savings to the taxpayer and/or  a Conservatorship estate.