TAXLITIGATOR – Tax Controversy (Civil & Criminal) Report

For years, the IRS has been pursuing – with mixed success – the disclosure of information regarding undeclared interests of U.S. taxpayers (or those who ought to be U.S. taxpayers) in foreign financial accounts. On January 9, 2012, the IRS announced yet another offshore voluntary disclosure program (the 2012 OVDI) following on the success of the 2009 Offshore Voluntary Disclosure Program (the 2009 OVDP) and the 2011 Offshore Voluntary Disclosure Initiative (the 2011 OVDI), which were announced many years after the 2003 Offshore Voluntary Compliance Initiative (OVCI) and the 2003 Offshore Credit Card Program (OCCP). Such initiatives typically offer reduced penalties in exchange for taxpayers voluntarily coming into compliance before the IRS is aware of their prior tax indiscretions. In part, the success of such initiatives often depends on the perception that they will be followed by strong government tax enforcement efforts.

The 2012 OVDI is patterned after the 2011 OVDI but increases the maximum “FBAR-related” penalty from 25% to 27.5% of the highest account value at any time between 2003 and 2010. The 2012 OVDI does not have a stated expiration date but can be terminated by the IRS at any time as to specific classes of taxpayers or as to all taxpayers. In all, the IRS has seen 33,000 voluntary disclosures from the 2009 and 2011 offshore initiatives. Since the 2011 program closed last September, hundreds of taxpayers have come forward to make voluntary disclosures. Those who have come in since the 2011 program closed last year will be able to be treated under the provisions of the new OVDP program. Participants must file all original and amended tax returns and include payment for back-taxes and interest for up to eight years as well as paying accuracy-related and/or delinquency penalties.

The IRS recognizes that its success in offshore enforcement and in the disclosure programs has raised awareness related to tax filing obligations. This includes awareness by dual citizens and others who may be delinquent in filing, but owe no U.S. tax. The IRS is currently developing procedures by which these taxpayers may come into compliance with U.S. tax law. More details will be available within the next month on IRS.gov. In addition, the IRS will be updating key Frequently Asked Questions (FAQs) and providing additional specifics on the offshore program.

Previous Offshore Initiatives. In 2003, following significant publicity regarding the use of foreign accounts and credit card arrangements by U.S taxpayers, the IRS offered significant penalty relief for taxpayers participating in the OVCI which coincided with strong tax enforcement efforts under the OCCP. Eligible OVCI taxpayers were required to file amended or delinquent returns for three tax years (1999-2001) but could choose to bring tax years 1996-1998 into the OVCI (and would not be examined for any earlier years). Approximately 1,321 taxpayers from 48 countries participated in the OVCI identifying approximately 400 offshore promoters. The IRS agreed to not assert any 75% civil fraud penalties and the Financial Crimes Enforcement Network (FinCEN) agreed to not assert any civil penalties for the failure to timely file a Report of Foreign Bank and Financial Accounts (FBAR).

Under the Bank Secrecy Act, U.S. residents or a person in and doing business in the United States must file a report with the government if they have a financial account in a foreign country with a value exceeding $10,000 at any time during the calendar year. Taxpayers comply with this law by noting the account on their income tax return and by filing Form 90-22.1, the FBAR. Willfully failing to file an FBAR can be subject to both criminal sanctions (i.e., imprisonment) and civil penalties equivalent to the greater of $100,000 or 50% of the balance in an unreported foreign account— for each year since 2004 for which an FBAR wasn’t filed.

The 2009 OVDP brought in at least 14,700 U.S. taxpayers (disclosing accounts in more than 60 countries) through the front door of IRS Criminal Investigation and untold thousands through a process of quietly amending returns and filing delinquent FBARs with the government. For eligible taxpayers who ventured through the front door, the OVDP provided the certainty of no criminal prosecution and civil penalty relief – they were required to pay back-taxes from 2003 to 2008, interest and a 20-25% penalty on the delinquent taxes. The IRS also imposed a 20% “FBAR-related” penalty equal to the highest aggregate value of the financial account between 2003 and 2008. In limited situations, the FBAR-related penalty could be reduced to 5% of the account value or $10,000 per tax year.

The 2011 OVDI, brought in an additional 12,000 eligible taxpayers who filed original and amended tax returns and agreed to make payments (or good faith arrangements to pay) for taxes, interest and accuracy-related penalties. The 2011 OVDI FBAR-related penalty framework required a 25% “FBAR-related” penalty equal to the highest value of the financial account between 2003 and 2010. Only one 25 percent offshore penalty is to be applied with respect to voluntary disclosures relating to the same financial account. The penalty may be allocated among the taxpayers with beneficial ownership making the voluntary disclosures in any way they choose. Potentially applicable penalties are identified in a series of Frequently Asked Questions available at irs.gov. Participants in the 2011 OVDI also had to pay back-taxes and interest for up to eight years as well as paying accuracy-related and/or delinquency penalties. Subject to certain limitations, financial transactions occurring before 2003 were generally irrelevant for those participating in the OVDI.

Under the 2011 OVDI, taxpayers who are foreign residents and who were unaware they were U.S. citizens may qualify for a reduced 5% FBAR-related penalty (FAQ 52). Others qualified for the 5% penalty if they: (a) did not open or cause the account to be opened (unless the bank required that a new account be opened, rather than allowing a change in ownership of an existing account, upon the death of the owner of the account); (b) have exercised minimal, infrequent contact with the account, for example, to request the account balance, or update account-holder information such as a change in address, contact person, or email address; (c) have, except for a withdrawal closing the account and transferring the funds to an account in the United States not withdrawn more than $1,000 from the account in any year covered by the voluntary disclosure; and (d) can establish that all applicable U.S. taxes have been paid on funds deposited to the account (only account earnings have escaped U.S. taxation). For funds deposited before January 1, 1991, if no information is available to establish whether such funds were appropriately taxed, it is presumed that they were.

Taxpayers whose highest aggregate account balance (including the fair market value of assets in undisclosed offshore entities and the fair market value of any foreign assets that were either acquired with improperly untaxed funds or produced improperly untaxed income) in each of the years covered by the 2011 OVDI is less than $75,000 qualified for a 12.5% FBAR-related penalty (FAQ 53). IRS examiners have no authority to negotiate a different FBAR-related penalty.

FBARs for 2011 are due on June 30, 2012, without extension. Taxpayers who reported and paid tax on all their taxable income but did not file FBARs, should not participate in the 2012 OVDI but should merely file the delinquent FBARs with the Department of Treasury, Post Office Box 32621, Detroit, MI 48232-0621 (and attach a statement explaining why the reports are filed late). Under the 2011 OVDI, the IRS agreed not to impose a penalty for the failure to file the delinquent FBARs if there were no underreported tax liabilities and the FBARs were filed by August 31, 2010 (FAQ 17). Presumedly, the IRS will follow the same course under the 2012 OVDI since those with no underreported tax liabilities are not truly within the range of taxpayers the IRS is trying to identify.

Under the 2011 OVDI, taxpayers were not to be required to pay a penalty greater than what they would otherwise be liable for under the maximum penalties imposed under existing statutes (FAQ 50). A similar provision in the 2009 OVDP has caused considerable frustration among taxpayers and their representatives. The understanding of potentially applicable penalties may differ greatly in the eyes of a taxpayer as compared to an examiner. Anyone considering an offshore voluntary disclosure submission must carefully examine all potential civil penalties and evaluate the risk of criminal prosecution.

Considerations re Coming into Compliance. There are many considerations before a taxpayer should determine whether to pursue a voluntary disclosure of prior tax indiscretions. When reviewing the OVDP and the OVDI, many made decisions based on whether they could be considered a  realistic candidate for a criminal prosecution referral by the IRS or prosecution by the Department of Justice? (If so, the determination to participate was relatively quick and easy). Was there a possibility of reducing that prospect by filing amended or delinquent returns and FBARs in lieu of a direct participation in the OVDP/OVDI? What would be the potentially applicable penalties upon a examination of such returns and FBARs? Could the government actually carry their burden of demonstrating that the taxpayer “willfully” violated the FBAR filing requirements? Since the OVDI asserted an offshore penalty based on foreign financial accounts and asset valuations, for many with smaller financial account values the aggregate offshore penalty determination, even for multiple years, was actually less outside the OVDI.

Information Flowing Into the United States. The ability of a U.S. taxpayer to maintain an undisclosed, “secret” foreign financial account is fast becoming nonexistent. Foreign account information is flowing into the IRS under tax treaties, through submissions by whistleblowers, from others who participated in the 2009 OVDP and the 2011 OVDI who have been required to identify their bankers and advisors. Additional information will become available as the Foreign Account Tax Compliance Act (FATCA) and Foreign Financial Asset Reporting (Form 8938 and new IRC § 6038D) become effective.

There are rumors regarding ongoing “John Doe” summons activity seeking to force foreign financial institutions to deliver account-holder information to the U.S. government as well as possible indictments of foreign financial institutions. Recently, several foreign institutions have advised their account holders to consult U.S. tax advisors regarding the IRS voluntary disclosure program and their U.S. tax reporting relating to their foreign financial accounts. It is reasonable to assume that such institutions will take whatever action is necessary to avoid being indicted, beginning with the delivery of information regarding account holders to the U.S. government.

It is likely that the U.S. will require foreign financial institutions doing business in the United States to disclose account holders having relatively small accounts and earnings. There have been rumors of discussions regarding accounts having a high balance of the equivalent of $50,000 at any time between 2002 and 2010. U.S. persons having interests in foreign financial accounts should not find comfort in a belief that their foreign financial institution will somehow refrain from disclosing very small accounts in the current enforcement environment. Those who think too long may be sorely surprised at the high level of ultimate cooperation of their institution with the U.S. government.

Waiting is NOT a Viable Option. Taxpayers having undisclosed interests in foreign financial accounts must consult competent tax professionals before deciding to participate in the 2012 OVDI. Others may decide to risk detection by the IRS and the imposition of substantial penalties, including the civil fraud penalty, numerous foreign information return penalties, and the potential risk of criminal prosecution. Although the 2012 OVDI penalty regime may seem overly harsh for many, the decision to participate should include an economic analysis of the taxpayers projected future earning power that could be generated from the funds held offshore. Participating taxpayers may well benefit by repatriating foreign funds with limited earning potential into a depressed U.S. economy with a suffering real estate market and business opportunities lurking behind every corner. “Cash is king” and the IRS has provided yet another opportunity for formerly non-compliant taxpayers to improve their future U.S. investment and business opportunities.

If a taxpayer is discovered before any voluntary disclosure submission, the results can be devastating. Waiting is simply not a viable option . . .