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 June 26, 2012 the IRS released IR-2012-64/65 and updated Frequently Asked Questions (FAQs) providing updated guidance regarding the currently pending offshore voluntary disclosure program (the initial terms of the 2012 OVDP were set forth in IR-2012-5 released on January 9, 2012). The OVDP follows 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. 

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.

Generally, taxpayers who have undisclosed offshore accounts or assets and meet the requirements of IRM 9.5.11.9 are eligible to apply for IRS Criminal Investigation’s Voluntary Disclosure Practice and the 2012 OVDP penalty regime. The OVDP is available to taxpayers who have both offshore and domestic issues to disclose. The Voluntary Disclosure Practice requires an accurate, and complete voluntary disclosure. Consequently, if there are undisclosed income tax liabilities from domestic sources in addition to those related to offshore accounts and assets, they must also be disclosed in the OVDP. The 2012 OVDP 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 during the most recent eight tax years. The terms of the OVDP, are subject to change at any time. 

For calendar year taxpayers the voluntary disclosure period is the most recent eight tax years for which the due date has already passed. The eight-year period does not include current years for which there has not yet been non-compliance. Thus, for taxpayers who submit a voluntary disclosure prior to April 15, 2012 (or other 2011 due date under extension), the disclosure must include each of the years 2003 through 2010 in which they have undisclosed foreign accounts and/or undisclosed foreign entities. Fiscal year taxpayers must include fiscal years ending in calendar years 2003 through 2010. For taxpayers who disclose after the due date (or extended due date) for 2011, the disclosure must include 2004 through 2011. For disclosures made in successive years, any additional years for which the due date has passed must be included, but a corresponding number of years at the beginning of the period will be excluded, so that each disclosure includes an eight-year period. 

For taxpayers who establish that they began filing timely, original, compliant returns that fully reported previously undisclosed offshore accounts or assets before making the voluntary disclosure, the voluntary disclosure period will begin with the eighth year preceding the most recent year for which the return filing due date has not yet passed, but will not include the compliant years. For example, a taxpayer who had historically filed income tax returns omitting the income from a securities account in Country A, who began reporting that income on his timely, original tax and information reporting returns for 2009 and 2010 without making a voluntary disclosure, and who files a voluntary disclosure in January 2012, the voluntary disclosure period will be 2003 through 2008. 

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. On June 26, 2012, the IRS released FAQ #21 providing that taxpayers will become ineligible to participate in the OVDP when: (i) the IRS or the Department of Justice obtain information under a John Doe summons, treaty request or similar action that provides evidence of a specific taxpayer’s noncompliance with the tax laws or Title 31 reporting requirements, (ii) if a taxpayer appeals a foreign tax administrator’s decision authorizing the providing of account information to the IRS and fails to serve the notice as required under existing law, see 18 U.S.C. § 3506, of any such appeal and/or other documents relating to the appeal on the Attorney General of the United States at the time such notice of appeal or other document is submitted, or (iii) the IRS may announce that certain taxpayer groups that have or had accounts at specific financial institutions will be ineligible due to U.S. government actions in connection with the specific financial institution – in such announcements, the IRS will provide notice of the prospective date upon which eligibility for the specific taxpayer group terminates making the taxpayer ineligible to participate in the OVDI. 

Taxpayers under IRS criminal investigation are not eligible to participate in the OVDP. Also, if the IRS has initiated a civil examination, regardless of whether it relates to undisclosed foreign accounts or undisclosed foreign entities, the taxpayer will not be eligible to participate in the 2012 OVDP. 

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). 

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 2012 OVDP, 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 2012 OVDP 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. 

If a taxpayer has failed to file an FBAR to report an account over which the taxpayer has signature authority but no beneficial interest (e.g., an account owned by his employer), the IRS will not impose the offshore penalty (FAQ 38). The taxpayer may cure the FBAR delinquency for the account the taxpayer does not own by filing the FBAR with an explanatory statement before being contacted regarding an income tax examination or a request for delinquent returns. The answer might be different if: (1) the account over which the taxpayer has signature authority is held in the name of a related person, such as a family member or a corporation controlled by the taxpayer; (2) the account is held in the name of a foreign corporation or trust for which the taxpayer had a Title 26 reporting obligation; or (3) the account was related in some other way to the taxpayer’s tax noncompliance. In these cases, if the taxpayer is determined to have a direct or indirect beneficial interest in the account(s), the taxpayer will be liable for the 27.5% offshore penalty if there is unreported income on the account. On the other hand, if there is no unreported income with respect to the account, no penalty will be imposed. 

In the case of co-owners of an account, each taxpayer who participates in the OVDP will be liable for the penalty on their respective percentage of the highest aggregate balance in the account. The burden will be on the disclosing taxpayer claiming ownership of less than 100% of the account to establish the extent of their ownership. Their voluntary disclosure is effective as to their personal liability only – it does not protect the other co-owners. The IRS may examine any co-owner who does not make a voluntary disclosure. Co-owners examined by the IRS remain subject to all potential penalties. 

If there are multiple individuals with signature authority over a trust account, each person involved must file delinquent the FBARs. However, only one 27.5% offshore penalty will 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. 

FBARs for each year are due to be received by June 30 of the next year, without extension. Taxpayers who reported and paid tax on all their taxable income but did not file FBARs, should not participate in the 2012 OVDP 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 2012 OVDP, the IRS will not impose a penalty for the failure to file the delinquent FBARs if there were no underreported tax liabilities and the taxpayer has not previously been contacted regarding an income tax examination or a request for delinquent returns. (FAQ 17). 

Non-resident taxpayers should review the New Filing Compliance Procedures for Non-Resident U.S. Taxpayers set forth in IR-2012-65 released on June 26, 2012. Effective September 1, 2012, current non-residents including, but not limited to, dual citizens who have not filed U.S. income tax and information returns will be required to file 1) delinquent tax returns, with appropriate related information returns, for the past three years, (2) delinquent FBARs for the past six years, and (3) any additional information regarding compliance risk factors required by future instructions.  Payment of any federal tax and interest due must accompany the submission. More information about the application process including where submissions should be sent, will be provided prior to September 1, 2012. 

Retroactive relief for failure to timely elect income deferral on certain foreign retirement and education savings plans where deferral is permitted by a relevant treaty will be available for these nonresident taxpayers.  The proper deferral elections with respect to such arrangements must be made with the OVDP submission. Any taxpayer seeking relief for failure to timely elect deferral of income from certain retirement or savings plans where deferral is permitted by relevant treaty will be required to submit: (i) a statement requesting an extension of time to make an election to defer income tax and identifying the pertinent treaty position; (ii) for relevant Canadian plans, a Forms 8891 for each tax year and description of the type of plan covered by the submission; and a statement describing: (a) the events that led to the failure to make the election, (b) the events that led to the discovery of the failure, and (c) if the taxpayer relied on a professional advisor, the nature of the advisor’s engagement and responsibilities. 

IRS OVDP examiners do not have discretion to settle cases for amounts less than what is properly due and owing. However, because the 27.5% offshore penalty is a proxy for the FBAR penalty, other penalties imposed under the Internal Revenue Code, and potential liabilities for years prior to the voluntary disclosure period, there may be cases where a taxpayer making a voluntary disclosure would owe less if the special offshore initiative did not exist. The IRS has stated that under no circumstances will taxpayers be required to pay a penalty greater than what they would otherwise be liable for under the maximum penalties imposed under existing statutes. (see FAQ 50). For example, if a taxpayer had $100,000 in an offshore bank account in only one year and foreign income-producing real estate with a fair market value of $1,000,000, only the bank account would be subject to the FBAR penalty. Consequently, the maximum FBAR penalty would only be $100,000 (that is, the greater of $100,000 or 50% of the amount in the foreign account), which is substantially less than the offshore penalty of $302,500 (27.5% of $1,100,000). If this FBAR penalty, plus tax, interest and all other applicable penalties, are less than what is due under this offshore initiative, the taxpayer will only pay the lesser amount. 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. 

OVDP examiners will compare the amount due under the OVDP to the tax, interest, and applicable penalties (at their maximum levels and without regard to issues relating to reasonable cause, willfulness, mitigation factors, or other circumstances that may reduce liability) for all open years that a taxpayer would owe in the absence of the OVDP penalty regime. The taxpayer should only be obligated to pay the lesser amount. If the taxpayer disagrees with the result, the taxpayer may “opt-out” of the OVDP and the case be referred for an examination of all relevant years and issues. 

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.

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 with other countries, through submissions by whistleblowers, from others who participated in the 2009 OVDP, the 2011 OVDI or the 2012 OVDP 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 ongoing 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 in Europe, Israel, and Asia 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 2011. 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. 

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 receive the ability to use the previously undisclosed funds in any manner they desire. Many have benefitted by repatriating foreign funds with limited earning potential into a depressed U.S. economy with a suffering real estate market and numerous business opportunities. 

The IRS has provided yet another opportunity for formerly non-compliant taxpayers to come into compliance. If discovered before any voluntary disclosure submission, the results can be devastating. Waiting is simply not a viable option . . .