The 115th Congress is seriously considering imposing a beneficial ownership reporting regime on American businesses and other entities, including charities and religious congregations. Two House subcommittee chairmen recently released a discussion draft of legislation and legislation has been introduced in both the House and the Senate. Hearings have been held in both houses.
Under pressure from the Organisation for Economic Co-operation and Development’s Financial Action Task Force (FATF) and the EU, most OECD countries are moving to either a financial institution customer due diligence requirement, similar to the Treasury Department’s Financial Crimes Enforcement Network (FinCEN) Customer Due Diligence (CDD) rule discussed below, or a beneficial ownership reporting regime or sometimes both. As with anti-money laundering rules generally, there is little information available as to their effectiveness. Yet politicians continue to blithely enact ever more burdensome and intrusive rules.
The three proposals share three salient characteristics. First, they will impose a large compliance burden of the private sector, primarily on small businesses, charities and religious organizations. Second, they will create hundreds of thousands, and potentially more than a million, inadvertent felons out of otherwise law-abiding citizens. Third, they will do virtually nothing to achieve their stated aim of protecting society from terrorism or other forms of illicit finance. The proposals make lawful avoidance and unlawful evasion quite easy.
Furthermore, the creation of this expensive and socially damaging reporting edifice is unnecessary. The vast majority of the information that the proposed beneficial ownership reporting regime would obtain is already provided to the Internal Revenue Service (IRS). Simply creating a database based on information provided to the IRS and allowing the IRS to share this information with FinCEN would better meet the needs of law enforcement than would the proposed beneficial ownership reporting regimes.
The Corporate Transparency Act of 2017 (H.R. 3089) has been introduced in the House by Rep. Carolyn Maloney (D-NY). The True Incorporation Transparency for Law Enforcement Act (S. 1454) has been introduced by Sen. Sheldon Whitehouse (D-RI) in the Senate. Rep. Steve Pearce (R-NM), chairman of the Terrorism and Illicit Finance Subcommittee of the House Financial Services Committee, and Rep. Blaine Luetkemeyer (R-MO), chairman of the Financial Institutions and Consumer Credit Subcommittee of the House Financial Services Committee, recently released a discussion draft of legislation called the Counter Terrorism and Illicit Finance Act. Section 9 of the discussion draft would create a beneficial ownership reporting regime.
The discussion draft would require all newly formed corporations and limited liability companies to report to FinCEN the beneficial ownership of the firm and, among other things, the driver’s license or passport numbers of those owners. The firm would be required to update this information within 60 days of any change. All existing firms would be subject to these requirements within two years. Failure to comply would result in fines of up to $10,000 or three years in prison.
The proposed regime would then “exempt” from the beneficial ownership reporting regime those firms most able to engage in money laundering activities or otherwise facilitate illicit finance. Those exempt include (1) public companies, (2) government-sponsored enterprises, (3) banks and credit unions, (4) broker-dealers, (5) exchanges and clearing houses, (6) investment companies, (7) insurance companies, (8) commodities firms, (9) public accounting firms, (10) utilities, (11) most tax-exempt organizations, (12) firms with more than 20 employees and gross receipts greater than $5 million. Because the exemptions are not self-effectuating, even exempt firms are not truly exempt and must file with FinCEN.
They would not, however, be required to report their beneficial ownership. The only firms subject to the full reporting regime are corporations and LLCs with (1) 20 or fewer employees or (2) receipts under $5 million.
The reporting requirements do not define beneficial owner consistent with normal legal principles or an ordinary person’s conception of owner. Under the proposed regime, beneficial owners would include someone who (1) “… directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise exercises substantial control over a corporation or limited liability company …” or (2) “… receives substantial economic benefits from the assets of a corporation or limited liability company …”
The proposal contains poorly drafted “look through” rules, both explicit and implied, but the application of these rules is not clear. In the absence of such rules, the entire reporting regime could be easily avoided through the simple of expedient of having a corporation or LLC own a corporation or LLC. The discussion draft rules presumably require corporations and LLCs with owners that are also corporations or LLCs to report on the beneficial ownership (as defined) of the corporation or LLC that has a beneficial ownership interest in the reporting corporation or LLC. Thus, for example, a non-exempt firm that had an investment from a venture capital fund would presumably have to obtain information and report on the beneficial ownership of the venture capital fund and report any changes to the venture capital fund’s ownership. How the entrepreneurial firm would be able to secure regular updates from its venture capital investor so as to make new filings with FinCEN within the required 60 days regarding change of ownership in the venture capital firm is left unexplained even though failure to do so would be a felony. It is particularly unclear how this would be accomplished if the investing corporation (the venture capital firm, for example) is exempt and not required to report its beneficial ownership. In fact, exempt firms may not even know their beneficial ownership.
Most of the reporting obligations are imposed on “applicants” but this term is not defined and who is actually to be treated as the applicant is quite unclear. Under state law, the person who forms a business entity is typically known as an incorporator, organizer or authorized person and they often are persons who have no continuing role in the business and do not exercise any degree of control or receive any economic benefit. For ongoing reporting purposes, it is even more unclear who would be responsible as the applicant.
The most important difference between the discussion draft and Whitehouse and Maloney bills is that the discussion draft contemplates FinCEN playing the primary administrative role while the latter contemplate the states playing the primarily administrative role and would provide federal funding to the states. Because most state laws treat corporate filings as public, the Whitehouse and Maloney bills would effectively make beneficial ownership reports public. The United Kingdom is one of the few countries where the information in the beneficial ownership database is currently publicly available. The FinCEN database in the discussion draft would not be accessible by the public. Fines of up to $1 million are permitted in the Whitehouse bill.
The problems with the proposed beneficial ownership reporting regime
The primary burden created by the proposed reporting regime is on firms with 20 or fewer employees or less than $5 million in gross receipts. These are the firms least able to absorb yet another increase in the regulatory burden imposed by the federal government. As should be evident from the brief description in the section above, determining who is and is not a “beneficial owner” under the proposal is complex, highly ambiguous and will often require hiring counsel or a compliance expert. In fact, it will probably take a decade or more of prosecutions and litigation before the meaning of “beneficial owner,” “substantial control as a practical matter,” “substantial economic benefit,” “an entitlement to the funds or assets,” and “directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise” are reasonably well established. Defending these cases will be expensive and often economically destroy the small business and business owner who must defend themselves against the federal government.
Once two years have elapsed, the requirements apply to all existing corporations and LLCs. Thus, for example, a local church or charity that is incorporated (most are) would be required to file with FinCEN. Under U.S. tax law, churches and most other religious organizations do not have to file a Form 990 annually with the IRS. But they would be required to file an exemption certification with FinCEN and update the relevant personnel changes within 60 days or face fines or imprisonment.
Roughly 12 million corporations or LLCs are likely to be subject to the new reporting regime. If even 10 percent are unaware of this new requirement and fail to file with FinCEN, two years after enactment there would be over a million small business owners, religious congregations and charities that will be in non-compliance, subject to fines and imprisonment.
These figures also give a sense of the scale of the compliance industry that would develop and the costs that would be incurred. Assuming, probably heroically, that a small business owner can, on average, read and familiarize him or herself with these rules and file the relevant form in one hour, then the number of compliance hours would be 12 million hours.
Monetized at $50/hr (which is a very low fully burdened rate for management), the compliance costs would be $600 million. If, more realistically, you assume a greater compliance time or a higher hourly rate or that they engage outside counsel or compliance experts (which is likely for many given the ambiguities discussed above), then the likely cost will be well over $1 billion annually and quite probably many billions of dollars.
The highly limited effectiveness of the proposed regime
Successful money launderers are typically sophisticated. They can lawfully avoid the requirements of the proposed reporting regime quite easily. It does not apply to partnerships and business trusts. So to avoid the application of these rules, they need only form a partnership or a business trust instead of a corporation or LLC. Alternatively, they could buy a business that met one of the exemption requirements (e.g. gross receipts over $5 million and 21 employees), file a certification of exemption with FinCEN and lawfully not report. As discussed above, the look-trough rules applicable when entities own entities are opaque, extremely unclear, potentially utterly unworkable and highly burdensome. But if it is ultimately determined that a non-exempt entity can have another entity own it without reporting on the beneficial ownership of the owning entity, then the requirements can be lawfully avoided by simply having a two-tier corporate structure.
Criminals can also illegally evade the system rather easily by simply filing partial but false beneficial ownership reports or not filing at all. Unless FinCEN is going to start routinely auditing firms (expending a great many federal tax dollars and imposing large costs on law-abiding firms), then this is a low risk evasion strategy. The maximum of $40 million in funding contemplated in the legislation is vastly too low to support non-trivial audit rates on roughly 12 million entities. The bulk of the $40 million will not be spent on enforcement but on simply administering the system and maintaining the database. Thus, unless the FinCEN budget is dramatically increased, the chance of FinCEN detecting inaccurate filings would be extremely low.
To the author’s knowledge, there is no actual evidence, as opposed to bare assertions or anecdotes, that the beneficial ownership reporting regimes in other countries have had any material effect on money laundering or terrorism. But the relevant question for the U.S. is not whether they have had any impact but whether they have they improved non-tax law enforcement in a cost-effective manner. The tax information is already available to the IRS. Thus, the only gain to be had for the U.S. from the proposed regime is with respect to non-tax law enforcement.
The existing anti-money laundering regime (AML) is extraordinary expensive. As detailed in a September 2016 Heritage Foundation report, Financial Privacy in a Free Society, the current AML regime costs at least an estimated $4.8 billion to $8 billion annually. It costs at least $7 million per conviction and potentially many times that. There is a need to engage in a serious cost benefit analysis of the AML regime and its constituent parts before adding yet another poorly conceived requirement that burdens the smallest businesses in the country. Yet a serious cost-benefit analysis of the AML has never been undertaken by the U.S. government.
FinCEN’s CDD Rule
In 2016, FinCEN finalized its “Customer Due Diligence Requirements for Financial Institutions” rule with which covered financial institutions must comply by May 11, 2018. Covered financial institutions must identify and verify the identity of the major beneficial owners of all legal entity customers (other than those that are excluded, generally other financial institutions and public accounting firms) at the time a new account is opened. Thus, unlike the Congressional proposals, it would apply only to new accounts. The identification and verification procedures for beneficial owners are very similar to existing rules for individual customers under a financial institution’s customer identification program. Financial institutions may generally satisfy this requirement by having the customer fill out a form specified in FinCEN regulations.
One of the stated reasons for the proposed beneficial ownership reporting regime is to alleviate the burden on financial institutions caused by the FinCEN Customer Due Diligence (CDD) regulation. The objective is to shift the costs imposed on financial institutions caused by the CDD rule onto small firms and, to a lesser extent, government. Yet, the only definite cost savings for financial institutions from section 9 of the legislation is from the temporary suspension of implementation of the CDD rule until a revised rule is promulgated. Beyond that, the magnitude of savings to financial institutions would be a function of what FinCEN chose to do in its revised rule. Given FinCEN’s history, a minimal consideration of private costs incurred is to be expected as the regulation is revised. The justified concern about the costs and inadequate benefits of the FinCEN rule could better be addressed simply by placing a permanent moratorium on the rule. Countering FinCEN’s overreach does not require imposing large costs on small firms and civil society.
An alternative approach
The alternative approach would require the Internal Revenue Service to compile a beneficial ownership database based on information already provided to the agency in the ordinary course of tax administration and to share the information in this database with FinCEN. The database would be compiled from information provided on six Internal Revenue Service forms: (1) SS-4, (2) 1065 (Schedule K-1), (3) 1120S (Schedule K-1), (4) 1041 (Schedule K-1), (5) 1099 DIV [Dividends and Distributions], and (6) 8822-B. With this information, the ownership of every business in America and each business’ responsible party would be available to FinCEN, with the exception of non-dividend paying C corporations.
This alternative approach would also enable FinCEN to look through entities that had ownership in other entities. It would provide more comprehensive information to FinCEN than the proposed reporting regime. Furthermore, the social cost of this approach – creating a database based on information already provided to the IRS – would be a very small fraction of the approach contemplated in the proposed reporting regime. The increase in private compliance costs would be negligible since the information is currently reported for tax purposes and the alternative approach outlined here would not create a large class of inadvertent felons out of small business owners and church treasurers or pastors. It almost certainly would reduce federal administrative costs compared to those contemplated in the discussion draft. Reformatting and sharing existing information should require dramatically fewer resources than creating, administering and enforcing an entirely new reporting system.
To implement this approach, Internal Revenue Code §6103(i) governing the privacy of tax information would need to be amended to allow the IRS to share the information with FinCEN and to govern what FinCEN could then do with the information. The revised approach should also place a moratorium on implementation of FinCEN’s CDD rule.
This piece originally appeared in Cayman Financial Review on 4/19/18