On June 26, 2012, the Internal Revenue Service (IRS) announced that its 2009 and 2011 offshore voluntary disclosure programs have generated more than $5 billion in revenue for the U.S. Treasury and released new FAQs with details regarding a new 2012 offshore voluntary disclosure program (OVDP) announced in January 2012, including tightening the eligibility requirements.
According to IRS Commissioner Doug Shulman, the IRS offshore voluntary disclosure programs have so far resulted in the collection of more than $5 billion in back taxes, interest and penalties from 33,000 voluntary disclosures made under the first two programs. In addition, another 1,500 disclosures have been made already under the new 2012 program announced in January.
The IRS also announced a plan to help U.S. citizens living abroad, including dual citizens, become compliant with their U.S. tax filing obligations and to provide assistance for people with foreign retirement plan issues.
The 2012 Offshore Voluntary Disclosure Program
Although many of the provisions of the 2009 and 2011 programs are included in the 2012 program, significant changes are implemented in the 2012 OVDP. Among these significant changes are:
Making a condition of eligibility for the 2012 OVDP notification to the U.S. Justice Department if a taxpayer appeals a foreign tax administrator's decision authorizing the providing of account information to the IRS.
Taxpayers' eligibility for OVDP can be terminated once the U.S. government has taken action in connection with their specific financial institution.
The OVDP is open for an indefinite period of time.
The IRS may change the terms of the OVDP at any time.
The offshore penalty has been raised to 27.5% from 25% in the 2011 program.
Taxpayers who do not submit a voluntary disclosure run the risk of detection by the IRS and the imposition of substantially higher penalties, including the 75% fraud penalty and foreign information return penalties, and an increased risk of criminal prosecution. The IRS states that it remains actively engaged in ferreting out the identities of those with undisclosed foreign accounts. Moreover, increasingly this information is available to the IRS under tax treaties, through submissions by whistleblowers, and will become more available under the Foreign Account Tax Compliance Act (FATCA) and Foreign Financial Asset Reporting (new IRC § 6038D).
The 2012 OVDP Requirements
Under the 2012 OVDP, taxpayers are required to:
Pay an accuracy-related penalty equal to 20% on the full amount of the offshore-related underpayments of tax for all years;
Pay a failure to file penalty, if applicable;
Pay a failure to pay penalty, if applicable;
Pay an offshore penalty (in lieu of all other penalties that may apply to undisclosed foreign assets and entities, including FBAR and offshore-related information return penalties and tax liabilities for years prior to the voluntary disclosure period), equal to 27.5% (or in limited cases 12.5% or 5%) of the highest aggregate balance in foreign bank accounts/entities or value of foreign assets during the period covered by the voluntary disclosure;
Submit full payment of any tax liabilities, applicable penalties and interest for years included in the offshore disclosure period or make good-faith arrangements with the IRS to pay, in full, such tax, interest and penalties;
Execute a Closing Agreement on Final Determination Covering Specific Matters, Form 906;
Agree to cooperate with IRS offshore enforcement efforts by providing information about offshore financial institutions, offshore service providers and other facilitators, if requested.
The Penalty Structure
The 27.5% offshore penalty
The offshore penalty applies to all of the taxpayer's offshore holdings that are related in any way to "tax non-compliance," regardless of the form of the taxpayer's ownership or the character of the asset. The penalty applies to all assets directly owned by the taxpayer, including financial accounts holding cash, securities or other custodial assets; tangible assets such as real estate or art; and intangible assets such as patents or stock or other interests in a U.S. or foreign business. If such assets are indirectly held or controlled by the taxpayer through an entity, the penalty may be applied to the taxpayer's interest in the entity or, if the IRS determines that the entity is an alter ego or nominee of the taxpayer, to the taxpayer's interest in the underlying assets. "Tax non-compliance" includes failure to report the existence of or income from the assets, as well as failure to pay U.S. tax that was due with respect to the funds used to acquire the asset.
The offshore assets to which the penalty applies must be related to "tax non-compliance." If offshore assets were acquired with funds that were subject to U.S. tax but on which no such tax was paid, the offshore penalty would apply regardless of whether the assets are producing current income. Assuming that the assets were acquired with after-tax funds or from funds that were not subject to U.S. taxation, if the assets have not yet produced any income, there has been no U.S. taxable event and no reporting obligation to disclose, the taxpayer will be required to report any current income from the property or gain from its sale or other disposition at such time in the future as the income is realized. However, because there has not been tax non-compliance, the 27.5% offshore penalty would not apply to those assets.
However, if the assets produced income subject to U.S. tax during the voluntary disclosure period that was not reported, the assets will be included in the penalty computation regardless of the source of the funds used to acquire the assets. If the foreign assets were held in the name of an entity such as a trust or corporation, there would also have been an information return filing obligation that may need to be disclosed.
The 5% offshore penalty
Taxpayers making voluntary disclosures who fall into one of the three categories described below will qualify for a reduced 5% offshore penalty, rather than the 27.5% penalty.
Taxpayers who meet all four of the following conditions: (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 for which the taxpayer was non-compliant; 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 will be presumed that they were.
Taxpayers who are foreign residents and who were unaware they were U.S. citizens.
Taxpayers who are foreign residents and who meet all three of the following conditions for all of the years of their voluntary disclosure: (a) taxpayer resides in a foreign country; (b) taxpayer has made a good-faith showing that he or she has timely complied with all tax reporting and payment requirements in the country of residency; and (c) taxpayer has $10,000 or less of U.S. source income each year. For these taxpayers only, the offshore penalty will not apply to non-financial assets, such as real property, business interests or artworks, purchased with funds for which the taxpayer can establish that all applicable taxes have been paid, either in the U.S. or in the country of residence. This exception applies only if the income tax returns filed with the foreign tax authority included the offshore-related taxable income that was not reported on the U.S. tax return.
The 12.5% offshore penalty
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 OVDP is less than $75,000 will qualify for a special reduced 12.5% offshore penalty.
Eight Tax Years Are Covered by the 2012 OVDP
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 tax non-compliance. Thus, for taxpayers who submit a voluntary disclosure prior to April 15, 2012 (or other 2011 return 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 and 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.
Alternatives for Reporting Passive Foreign Investment Company Income (PFIC)
A lack of historical information on the cost basis and holding period of many PFIC investments makes it a challenge for taxpayers to prepare statutory PFIC computations and for the IRS to verify them. Therefore, for purposes of the 2012 OVDP, the IRS offers taxpayers an alternative to the statutory PFIC computation that will resolve PFIC issues on a basis that is consistent with the mark-to-market (MTM) methodology of § 1296, but will not require complete reconstruction of historical data.
This is an extremely complex issue that will not be summarized here. Any taxpayer considering participation in the 2012 OVDP may want to consult a competent tax advisor with respect to the taxpayer's PFIC income and which alternative methodology for reporting income would be most advantageous.
New Eligibility Requirements
New rules regarding eligibility have been imposed in addition to the longstanding requirements that taxpayers must have met to satisfy the requirements of the IRS Voluntary Disclosure Practice and the 2012 OVDP civil penalty regime. The longstanding IRS voluntary disclosure practice requires that a taxpayer's disclosure is timely; that the taxpayer's disclosure is truthful and complete; that the taxpayer cooperates with the IRS in determining the taxpayer's correct tax liability; and that the taxpayer makes a good-faith arrangement with the IRS to fully pay all taxes, penalties and interest related to the taxpayer’s disclosure.
Generally, a taxpayer's disclosure is not timely if the taxpayer is under IRS examination or criminal investigation.
John Doe Summons and Treaty Requests
The fact that the IRS served a John Doe summons, made a treaty request or took similar action does not make every member of the John Doe class, or group identified in the treaty request or other action ineligible to participate. However, once the IRS or the Department of Justice obtains 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, that particular taxpayer will become ineligible for OVDP and Criminal Investigation’s Voluntary Disclosure Practice. (This is a key change to the 2009 and 2011 offshore voluntary disclosure programs, which provided that under these circumstances, the taxpayer "may become ineligible" for the programs.)
Accordingly, a taxpayer concerned that a party subject to a John Doe summons, treaty request or similar action will provide information about the taxpayer to the IRS should consider applying to make a voluntary disclosure as soon as possible.
Notice to attorney general required
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 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, the taxpayer will be ineligible to participate.
Taxpayers with accounts at certain financial institutions
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. Such announcements will provide notice of the prospective date upon which eligibility for the specific taxpayer group ends and will be posted to the IRS website.
The risk of criminal prosecution
Following a longstanding practice, consistent with the Internal Revenue Manual voluntary disclosure practice, some taxpayers have made so-called "quiet" disclosures by filing amended returns and paying any related tax and interest for previously unreported offshore income, without otherwise notifying the IRS. These taxpayers are eligible for the 2012 OVDP penalty framework by submitting an application, along with copies of their previously filed returns (original and amended) to the IRS.
Without stating that these so-called "quiet" disclosures are not sanctioned voluntary disclosures, the IRS encourages such taxpayers to come forward under the 2012 OVDP to make timely, accurate and complete disclosures. The IRS also warns those taxpayers making "quiet" disclosures that they should be aware of the risk of their being examined and potentially criminally prosecuted.
Yet, what is the difference in the risk of criminal prosecution where a taxpayer makes a so-called "quiet" disclosure, as opposed to entering an offshore voluntary disclosure program?
The Internal Revenue Manual provides that: "It is currently the practice of the IRS that a voluntary disclosure will be considered along with all other factors in the investigation in determining whether criminal prosecution will be recommended. . . . A voluntary disclosure will not automatically guarantee immunity from prosecution. . . ." That is not exactly a guarantee of no criminal prosecution (although longtime practice supports the conclusion that few if any criminal prosecutions occur where the taxpayer complies with the practice).
The 2012 OVDP appears to be more comforting, stating: "When a taxpayer truthfully, timely, and completely complies with all provisions of the voluntary disclosure practice, the IRS will not recommend criminal prosecution to the Department of Justice."
Accordingly, the distinction appears to be that a voluntary disclosure in accordance with the provisions of the Internal Revenue Manual (and this may include a "quiet" disclosure) is merely a factor that the IRS will consider in determining whether a criminal prosecution will be recommended, as opposed to a disclosure under the 2012 OVDP, which if complete and accurate, is a guarantee that the IRS will not recommend criminal prosecution to the Department of Justice.
The civil risks
It appears that the IRS is attempting to ferret out taxpayers making "quiet" disclosures where the IRS would prefer that they make their disclosure in a "noisier" fashion. The IRS routinely reviews amended returns but makes a point in the 2012 OVDP FAQs discussion of "quiet" disclosures that it is reviewing amended returns and could select any amended return for examination. The IRS states that it has identified, and will continue to identify, amended tax returns reporting increases in income, presumably with attention to those returns reporting increases in income from foreign sources. The IRS will closely review these returns to determine whether enforcement action is appropriate. If a return is selected for examination, the 27.5% offshore penalty allowable under the 2012 OVDP would not be available.
Participation in the 2012 OVDP Unnecessary in Some Cases
Voluntary disclosure is not for everyone. It is not for persons who have reported all their income. Taxpayers who reported, and paid tax on, all their taxable income for prior years but who did not file FBARs should file the delinquent FBAR reports. No penalty will be imposed where the taxpayer has not been notified regarding an income-tax examination or a request for delinquent returns.
Similarly, a taxpayer who did not file tax information returns, such as Form 5471 (Information Return of U.S. Persons with Respect to Certain Foreign Corporations) for interests in foreign corporations, or Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts) for foreign trusts and gifts but who has reported, and paid tax on, all their taxable income with respect to all transactions related to the foreign corporations or foreign trusts or gifts, should file delinquent information returns and attach a statement explaining why the information returns are filed late. (The Form 5471 should be submitted with an amended tax return showing no change to income or tax liability.)
The IRS will not impose a penalty for the failure to file the delinquent Forms 5471 and 3520 if there are no underreported tax liabilities and the taxpayer has not previously been contacted regarding an income-tax examination or a request for delinquent returns.
Unfortunately, the IRS takes the same strict position in the 2012 OVDP with persons evading millions as it does with persons who have not reported very small amounts in income. As stated by the IRS, taxpayers who have reported and paid tax on all taxable income should not use the voluntary disclosure process. One may ask, shouldn’t this also be the case if the taxpayer failed to report a few dollars of interest income from a foreign account? It is unlikely that the IRS would recommend criminal prosecution of a taxpayer who innocently underreported a few dollars of income from a foreign account. Unfortunately, there appears to be no "de minimis" rule when it comes to tax compliance, at least in the context of computing the "offshore penalty." As stated by the IRS, "[n]o amount of unreported income is considered de minimis for purposes of determining whether there has been tax non-compliance with respect to an account or asset and whether the account or asset should be included in the base of the 27.5 percent penalty." Accordingly, those taxpayers who omitted small amounts of income and who cannot meet the stiff (and stingy) requirements for the 5% penalty (discussed above) will be left with the choice of being treated the same as persons evading millions of dollars of tax (who would be going to jail if they were discovered before participating in the 2012 OVDP) or facing the uncertainty of an opt-out examination (discussed below).
Full Payment of the Liability May Not Be Required
The terms of the 2012 OVDP require the taxpayer to pay the tax, interest and accuracy-related penalty and, if applicable, the failure to file and failure to pay penalties with their submission. However, it is possible for a taxpayer who is unable to make full payment of these amounts to request the IRS to consider other payment arrangements.
If the taxpayer cannot pay the total amount of tax, penalties and interest (this does not include the offshore penalty), the taxpayer is instructed to submit certain financial information regarding the taxpayer’s assets, liabilities, income and expenses.
The burden will be on the taxpayer to establish inability to pay, to the satisfaction of the IRS, based on full disclosure of all assets and income sources, domestic and offshore, under the taxpayer's control. Assuming that the IRS determines that the inability to fully pay is genuine, the taxpayer would have to work out other financial arrangements, acceptable to the IRS, to resolve all outstanding liabilities, in order to be entitled to the penalty relief under the 2012 OVDP.
Pre-clearance Before Disclosure
Before making a voluntary disclosure that will contain great detail and admissions about the taxpayer's failure to comply with U.S. tax laws, it is essential to secure "pre-clearance." Taxpayers who do not secure pre-clearance before making a voluntary disclosure run the risk of admitting their non-compliance, not being admitted to the program and facing a full civil examination and possibly criminal prosecution.
Pre-clearance is secured by the taxpayer's representative contacting IRS – Criminal Investigation Lead Development Center (LDC) with the following identifying information: name, date of birth, Social Security number and address. Criminal Investigation will then provide notification by facsimile whether the taxpayer is cleared to make an offshore voluntary disclosure. Taxpayers not pre-cleared are probably already the focus of the IRS. The denial of pre-clearance is typically cryptic, simply stating that pre-clearance has been denied due to "lack of timeliness or completeness." This is IRS shorthand for "the taxpayer is already under investigation" or that information submitted to date is incomplete. Mistakes in this process have occurred, and taxpayers who believe they have been improperly denied pre-clearance may want to reach out to IRS Criminal Investigation.
Pre-clearance does not guarantee a taxpayer's acceptance into the 2012 OVDP. Taxpayers are still required to truthfully, timely and completely comply with all provisions of the 2012 OVDP.
Securing Preliminary Acceptance
Taxpayers must mail their offshore voluntary disclosure letter and attachments to the Internal Revenue Service Voluntary Disclosure Coordinator in Philadelphia, Pa.
The offshore voluntary disclosure letter provides basic identifying information, asks for the source of the funds at issue and whether the taxpayer has been contacted by the IRS or is under investigation and requires disclosure of the value of the offshore assets and the amount of unreported income.
The attachment to the offshore voluntary disclosure letter is a four-page document that must be completed for each foreign financial account over which the taxpayer has control or is the beneficial owner. The attachment asks for account/institution identifying information, the names of the individuals/entities who advised the taxpayer in opening and using the account, how funds in the account were deposited/withdrawn, whether other people or entities were affiliated with the account and the advice received from the financial institution concerning communications with the institution.
The disclosure letter serves the function of quickly apprising the IRS on whether the taxpayer qualifies for voluntary disclosure. The attachment efficiently alerts the IRS to the conduct and identity of other individuals/entities, including family members, attorneys, accountants, bankers, trustees and others, who may be of interest to the U.S. government in its pursuit of promoters of non-compliant foreign financial arrangement.
Criminal Investigation will review the offshore voluntary disclosure letter and notify taxpayers by mail or facsimile whether their offshore voluntary disclosure have been preliminarily accepted or declined. It is intended that Criminal Investigation will complete its work within 45 days of receiving a complete offshore voluntary disclosure letter.
Preliminary acceptance into the 2012 OVDP is conditioned upon the information provided by the taxpayer being—and remaining—truthful, timely and complete.
Taxpayers making both an offshore voluntary disclosure and a domestic voluntary disclosure should follow the process for offshore voluntary disclosures, but should indicate on the offshore voluntary disclosure letter that they are also making a domestic voluntary disclosure.
Post Preliminary Acceptance Requirements
The preliminary acceptance letter from Criminal Investigation will instruct the taxpayer to submit the full voluntary disclosure submission to the IRS Austin Campus within 90 days of the date of the letter. The voluntary disclosure submission must be sent in two separate parts.
Copies of previously filed original (and, if applicable, previously filed amended) federal income-tax returns for tax years covered by the voluntary disclosure;
For taxpayers who began filing timely, original, compliant returns that fully reported previously undisclosed offshore accounts or assets before making the voluntary disclosure for certain years of the offshore disclosure period, copies of the previously filed returns for the compliant years;
Complete and accurate amended federal income-tax returns for all tax years covered by the voluntary disclosure, with applicable schedules detailing the amount and type of previously unreported income from the offshore account or entity or domestic source;
A completed foreign account or asset statement for each previously undisclosed foreign account or asset during the voluntary disclosure period;
Properly completed and signed taxpayer account summary with penalty calculation;
If a taxpayer cannot pay the total amount of tax, interest and penalties as described in Part 1 above, submit a proposed payment arrangement and a completed collection information statement;
For those applicants disclosing offshore financial accounts with an aggregate highest account balance in any year of $500,000 or more, copies of offshore financial account statements reflecting all account activity for each of the tax years covered by the voluntary disclosure. For those applicants disclosing offshore financial accounts with an aggregate highest account balance of less than $500,000, copies of offshore financial account statements reflecting all account activity for each of the tax years covered by the voluntary disclosure must be readily available upon request; and
Properly completed and signed agreements to extend the period of time to assess tax (including tax penalties) and to assess FBAR penalties.
Part 1. A check payable to the Department of Treasury in the total amount of tax, interest, accuracy-related penalty and, if applicable, the failure to file and failure to pay penalties, for the voluntary disclosure period must be sent along with information identifying the taxpayer name, taxpayer identification number and years to which the payment relates. (This payment does not include payment of the offshore penalty.)
Part 2. Provide the following documents:
After submission of the foregoing, the taxpayer may be contacted by an IRS examiner with a request for specific additional information. The examiner will certify that the voluntary disclosure is correct and accurate. The examiner will also verify the tax, interest and civil penalties owed.
A "Certification," Not an "Examination," of the Tax Returns
Normally, no examination will be conducted with respect to an offshore voluntary disclosure, although the IRS reserves the right to conduct an examination. The normal process is to assign the voluntary disclosure to an IRS examiner to certify the accuracy and completeness of the voluntary disclosure. The certification process is less formal than an examination and does not carry with it all the rights and legal consequences of an examination. For example, the examiner will not send the usual taxpayer notices, the certification process will not constitute a "second examination" if one or more years in the voluntary disclosure have previously been examined, and the taxpayer will not have appeal rights with respect to the IRS's determination. However, the examiner has the right to ask any relevant questions, request any relevant documents and even make third-party contacts, if necessary, to certify the accuracy of the amended returns, without converting the certification to an examination.
Offshore Assets Held by Entities
A taxpayer who holds assets through a foreign entity he or she controls, such as a corporation or a trust, is required to file information returns for that entity (e.g., Form 5471 for a foreign corporation and Forms 3520 and 3520-A for a foreign trust), regardless of whether the taxpayer honored the form of the entity in his or her dealings with the assets. However, in 2012 OVDP cases where the taxpayer certifies (by filing a Statement of Dissolved Entities) that the entity had no purpose other than to conceal the taxpayer's ownership of the assets, and where the taxpayer dissolves the entity, the IRS may not require the filing of these forms.
There Is No Discretion to Reduce Penalties.
The penalty framework for the offshore voluntary disclosure and the agreement to limit tax exposure to an eight-year period are package terms under the 2012 OVDP. If any part of the offshore penalty is unacceptable to the taxpayer, the case will be examined and all applicable penalties will be imposed. After a full examination, any tax and penalties imposed by the IRS may be appealed.
Offshore voluntary disclosure 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. 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. 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 pay only the lesser amount.
Examiners will compare the amount due under this offshore initiative 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 will pay the lesser amount. If the taxpayer disagrees with the result, the taxpayer may request the case to be referred for an examination of all relevant years and issues.
If the offshore penalty is unacceptable to a taxpayer, that taxpayer must indicate in writing the decision to withdraw from or opt out of the 2012 OVDP. Once made, this election is irrevocable. An opt out is an election by a taxpayer to have the matter handled under the standard audit procedure. The IRS recognizes that the penalty structure of the 2012 OVDP may be too stiff under the taxpayer's particular circumstances. However, the taxpayer must be certain the returns filed in compliance with the 2012 OVDP are complete in all respects, both as to foreign and domestic issues. If the taxpayer omitted items that should have been reported, and those items are discovered during the course of the post opt-out examination, the taxpayer risks exposure to criminal prosecution.
The opt-out procedure is set forth in a detailed Opt Out and Removal Guide published in June 2011 and applicable to the 2009, 2011 and the 2012 OVDPs. The procedure provides for a series of letters and information gathering by the IRS before termination in participation in the program occurs.
The scope of the opt-out examination
One thing the IRS will request of the taxpayer is a recommendation of the penalties that should apply in the taxpayer's case. It is vital for the taxpayer to make a complete and compelling argument supporting the taxpayer's reasonable cause for not being compliant, especially with respect to not filing the FBAR. Once the taxpayer has provided this and other information, the examiner will prepare a summary of the case. The summary will document whether the examiner agrees with the taxpayer's statement of facts and recommendation of the penalties that should apply. If the examiner disagrees with either, the examiner will document the disputed facts (or note the lack of evidence in a given area) and penalty recommendations as well as any other facts or circumstances of which the reviewing committee should be aware. The examiner's summary will also include a recap of the income-tax and accuracy-related penalties for each of the years, the case history notes and the examiner's recommendation on applicable penalties and whether or not the opt out would likely result in a determination of a non-willful FBAR penalty and the dollar amount of that penalty if known. Finally, the examiner's summary will include a recommendation regarding the scope of the examination.
After the IRS examiner has completed this task, the examiner will forward the taxpayer's statement of facts, penalty recommendation and rationale along with the examiner’s summary of the case and the examiner's case history notes to the IRS centralized review committee, which will be composed of IRS managers.
The IRS centralized review committee will review the taxpayer's statement of facts and recommendation of the penalties that should apply and the rationale for the penalty recommendations along with the examiner's statement and case history notes in order to determine how the examination will proceed. The committee will decide on the appropriate level of examination, keeping in mind that the taxpayer is not to be punished (or rewarded) for opting out. The committee will determine whether to reassign the case for a normal examination along with a determination of the likely scope of such examination, to reassign the case to a Special Enforcement Program agent, or to assign the case for other treatment. In making this determination, the committee will consider whether the results under the applicable voluntary disclosure program appear too excessive given the facts of the case. The committee will also consider the cooperation of the taxpayer and the representative during the certification process, including whether removal was under consideration at the time of opt out. The decision of the committee is final.
Even after opting out, the taxpayer remains subject to the Criminal Investigation voluntary disclosure program requiring the taxpayer to fully cooperate with the IRS in determining the taxpayer's tax liability; and the taxpayer must make arrangements to fully pay the tax, interest and penalty determined to be due. Failure to cooperate/pay may result in criminal prosecution.
Is opting out the right approach?
Whether opting out is the preferred route depends on the taxpayer's particular facts and circumstances. Questions that should be considered in advance include:
What years will be open under the examination? Unless the IRS can prove fraud, the taxpayer is unlikely to be subject to examination for a full eight years as is the case in the 2012 OVDP. The normal statute of limitations on assessment of additional tax is three years from the date the return was filed. If this is the case, the statute of limitations for assessment of additional taxes for 2008 and prior years has expired (2008 return filed April 15, 2009, plus three years = expiration of statute of limitations on April 15, 2012). If there is significant underreporting of "gross receipts" (not taxable income), the statute is open for six years from the date of filing, resulting in the year 2006 and subsequent years being open for additional assessment. If no returns were filed, the statute of limitations remains open.
Will the opt out examination result in any adjustment to the return? If the taxpayer has carefully prepared an amended return and corrected all errors on the originally filed return, then there should be no additional adjustment. The issue with many OVDP filings is that the taxpayer thinks about correcting the "foreign" problem and does not give consideration to correcting other aspects of the originally filed return, such as domestic sources of unreported income, the deduction of personal expenses and the deduction of business expenses that cannot be substantiated, etc.
Can the taxpayer assert a strong reasonable cause argument for underreporting income or not filing an FBAR? Will the IRS penalty mitigation provisions provide the taxpayer with any relief? It may be worthwhile to read the Internal Revenue Manual. The IRS Penalty Handbook contained in The Manual provides a road map for taxpayers trying to eliminate or reduce penalties. The FBAR penalty mitigation provisions counsel examiners to use discretion in asserting penalties. The options for the FBAR penalty run from the massively confiscatory greater of $100,000 or half the value of the account, to the non-willful penalty of "no more than $10,000" per account, all the way down to a letter of warning. Not every case warrants the maximum penalty available. Also, is it realistic to think that the U.S. government will bring a civil lawsuit in federal court to collect every assessed FBAR penalty? Further, "hazards of litigation" is a basis for settling controversies, and should be considered when negotiating any IRS/FBAR penalty.
New Filing Compliance procedures for Non-Resident U.S. Taxpayers
On June 26, 2012, the IRS announced a new procedure for current non-residents, including dual citizens, who have not filed U.S. income-tax and information returns to file their delinquent returns. This procedure will go into effect on September 1, 2012.
Taxpayers utilizing the new procedure will be required to file delinquent tax returns for the past three years and to file delinquent FBARs for the past six years. All submissions will be reviewed with varying degrees of intensity. Taxpayers presenting low compliance risk will receive an expedited review, and no penalties will be asserted. Submissions that present higher compliance risk are not eligible for the procedure and will be subject to a more-thorough review and possibly a full examination that in some cases may include more than three years, in a manner similar to opting out of the 2012 OVDP.
Tax, interest and penalties, if appropriate, will be imposed; and payment of tax and interest is due at the time of the submission.
In addition, retroactive relief for failure to timely elect income deferral on certain retirement and savings plans where deferral is permitted by relevant treaty will be available through this process. The proper deferral elections with respect to such arrangements need to be made with the submission.
The IRS will determine the level of compliance risk presented by the submission based on certain information provided on the returns filed, as well as certain additional information that will be required as part of the submission. Low risk will be predicated on simple returns with little or no U.S. tax due. Absent high risk factors, if the submitted returns and application show less than $1,500 in tax due in each of the years, they will be treated as low risk. In general, the risk level will rise as the income and assets of the taxpayer rise, if there are indications of sophisticated tax planning or avoidance, or if there is material economic activity in the United States. Additional risk factors include any additional history of noncompliance with U.S. tax law and the amount and type of U.S. source income.
Any taxpayer claiming reasonable cause for failure to file tax returns, information returns or FBARs will be required to submit a dated statement, signed under penalties of perjury, explaining why there is reasonable cause for previous failures to file. 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:
a statement requesting an extension of time to make an election to defer income tax and identifying the pertinent treaty position;
for relevant Canadian plans, a Form 8891 for each tax year and description of the type of plan covered by the submission; and
a statement describing:
the events that led to the failure to make the election,
the events that led to the discovery of the failure and
if the taxpayer relied on a professional advisor, the nature of the advisor's engagement and responsibilities.
Taxpayers who are in a situation where they are concerned about the risk of criminal prosecution should be aware that this new procedure does not provide protection from criminal prosecution if the IRS and Department of Justice determine that the taxpayer's particular circumstances warrant such prosecution. Taxpayers concerned about criminal prosecution because of their particular circumstances should consider the 2012 OVDP. However, once a taxpayer makes a submission under this new procedure described here, 2012 OVDP is no longer available. Taxpayers who are ineligible to participate in 2012 OVDP are also ineligible to participate in this procedure.