Remarks on Monday by John Koskinen, the Commissioner of Internal Revenue, indicate that the IRS is close to conceding to outside pressure to more clearly distinguish between Offshore Voluntary Disclosure Program (OVDP) filers whose past reporting failures were willful and those whose reporting failures do not rise to the traditional level of willfulness.
Specifically, speaking at the U.S. Council for International Business-OECD International Tax Conference in Washington, Koskinen noted with regard to the currently effective 2012 OVDP that “we [the IRS] are currently considering making further program modifications to accomplish even more. We are focusing on whether our voluntary programs have been too focused on those willfully evading their tax obligations and are not accommodating enough to others who don’t necessarily need protection because their compliance failures have been of the non-willful variety.”
As an example, Koskinen stated
We are well aware that there are many U.S. citizens who have resided abroad for many years, perhaps even the majority of their lives. We have been considering whether these individuals should have an opportunity to come into compliance that doesn’t involve the type of penalties that are appropriate for U.S.-resident taxpayers who were willfully hiding their investments overseas. We are also aware that there may be U.S.-resident taxpayers with unreported offshore accounts whose prior non-compliance clearly did not constitute willful tax evasion but who, to date, have not had a clear way of coming into compliance that doesn’t involve the threat of substantial penalties.
The Willfulness Standard
The most common federal tax crimes require the government to prove that the taxpayer acted “willfully” in violating the specific statute. For example, IRC § 7201 makes it a felony to “willfully attempt in any manner to evade or defeat any tax imposed by this title or the payment thereof…” Similarly, IRC § 7203 prohibits “willfully” failing to pay estimated tax, pay tax, make a return, keep required records, or supply required information.
In the criminal context willfulness is usually defined as the intentional violation of a known legal duty. Implied in this definition is a level of bad faith on the taxpayer’s part—the taxpayer knew the law but intentionally chose to violate it. The willfulness requirement is designed to prevent individuals who sincerely believe they are not violating the law from being convicted for actions that meet every other element of the subject criminal statute. Willfulness is based on the subjective state of mind of the defendant. One’s honest belief that he or she was acting lawfully, or one’s honest failure to be aware that he or she was acting unlawfully, is a defense to willfulness tax crimes. Cheek v. United States, 498 U.S. 192 (1991).
Willfulness in the civil context is defined by a lower standard. Generally actions that rise to the level of reckless disregard of, or willful blindness to, legal obligations are sufficient to establish civil willfulness. See United States v. Williams, 489 Fed. Appx. 655, 658-59 (4th Cir. 2012). The distinction between criminal and civil willfulness lies in the fact that a civil defendant does not have to be specifically aware of his legal obligation to willfully violate it. However, in both the civil and criminal context, willfulness requires a heightened level of misconduct by the defendant. Honest mistakes, or honest failures to become apprised of a legal obligation, should not give rise to a willful violation of the law, and the attendant penalties, in either the criminal or civil contexts.
The Problem: “Willfulness” Disregarded in the OVDP
To date, the willfulness requirement for most tax crimes and civil penalties has proven to be too nuanced for the OVDP. As a result, taxpayers who willfully violated tax laws, particularly the requirement to disclose the existence of foreign financial accounts when their aggregate balance exceeds $10,000 (generally known as the FBAR requirement), are given the same protections, and penalized in the same manner, as those who did not willfully violate the tax laws. In order to understand the practical effect of generally treating all OVDP filers the same way, it is helpful to understand how the OVDP works.
Generally speaking, the OVDP offers the chance for amnesty from criminal prosecution in exchange for making a full disclosure about past, offshore tax non-compliance. We have written about the OVDP here, here, and here. The OVDP is designed for taxpayers holding assets offshore who have failed to report the existence of those assets and the income generated by them. In return for the reduced risk of criminal prosecution, OVDP filers are generally required to pay all back taxes, interest, accuracy related penalties under IRC § 6662(a), and a single penalty of 27.5 percent of the highest average annual balance in their offshore accounts over an eight year look-back period (unreported offshore assets, such as real property or artwork, that are related to tax non-compliance must also be included in the base amount from which the 27.5 percent penalty is calculated).
In many circumstances, while the 27.5 percent penalty is significant, it is less than the total penalties the taxpayer would otherwise have to pay, which can include penalties for failure to file FBARs, fraud penalties, and penalties for failure to disclose ownership in foreign corporations or trusts. For instance, if a taxpayer’s failure to file an FBAR is determined to be willful, the penalty for each year can be up to 50 percent of the maximum account balance. If a taxpayer has an offshore account with a million dollars in it, the penalties imposed for willful FBAR violations over several years would dwarf the penalty imposed by the OVDP.
However, for many taxpayers, the failure to file FBARs or meet other disclosure or reporting requirements was not willful. Many U.S. citizens living abroad are honestly and justifiably unaware of their obligation to report their foreign accounts, or even pay U.S. tax. Many U.S. citizens are titled on, or have a beneficial interest in, foreign, interest bearing accounts without being aware of their status as to the account. For these taxpayers, their FBAR violations do not rise to the level of an “intentional violation of a known legal duty” or “reckless disregard” of a legal obligation and should therefore not be considered willful, either criminally or civilly. However, many taxpayers, when faced with any risk of criminal prosecution or a finding that their FBAR violations could be considered civilly willful and therefore give rise to massive penalties, choose to take the safe route and enter the OVDP.
Once admitted to the OVDP, taxpayers are subject to a penalty regime that offers very little flexibility. That is, regardless of the level of willfulness involved in their tax non-compliance, the same 27.5 penalty is generally imposed and taxpayers are granted the same general reduction in the likelihood of criminal prosecution. For that reason, the OVDP in its current form unfairly favors individuals who willfully engaged in tax-noncompliance, i.e. those that knowingly violated or recklessly disregarded the tax and asset reporting laws. In other words, a taxpayer who willfully fails to file FBARs is subject to the same penalty rate as an individual who did not realize he had signatory authority over offshore bank accounts and thus had an FBAR filing obligation. Further, although the willfully acting taxpayer is much more likely to be subject to criminal prosecution absent the OVDP, both taxpayers will likely receive identical protection against criminal prosecution.
Right to Opt-Out Insufficient
The OVDP in its current form provides taxpayers with the option of “opting out” of the OVDP, and thereby remaining in the OVDP structure but choosing to bear the traditional penalties associated with their non-compliance, as opposed to the 27.5 percent penalty imposed by the OVDP. However, this is often little comfort to taxpayers. Once the opt-out election is made, it is irrevocable and the taxpayer faces the substantial risk that the IRS will undertake a full examination of the years included in the OVDP (as part of the OVDP submission, the taxpayer must agree to extend the statute of limitations to assess tax and FBAR penalties for all years covered by the taxpayer’s disclosure). If anything is uncovered in the examination that was not disclosed in the OVDP submission, the possibility of criminal prosecution reemerges.
Furthermore, the taxpayer again runs the risk of a determination that their FBAR violations were civilly willful, thus risking exposure to significantly higher penalties. This is a particularly strong concern because “willful blindness,” an extremely malleable and difficult to predict standard, is generally sufficient to give rise to a willful, civil FBAR violation which, as described above, can lead to a penalty of 50 percent of the highest balance in the subject account(s) each year for which there was a reporting failure. By opting out, taxpayers expose themselves to the risks they joined the OVDP to avoid in the first place.
Calls for Reform
These disparities have led to calls for the IRS to take a more exact approach in the application of penalties under the OVDP. Currently, there are only three possible penalty rates, 27.5 percent, 12.5 percent, and 5 percent. The 27.5 percent rate applies to the large majority of cases. The 12.5 percent applies only if the taxpayer’s undisclosed accounts and assets did not exceed $75,000 in any of the OVDP years, and the 5 percent rate applies only in narrow circumstances, such as for foreign residents who were unaware they were U.S. citizens, or where the taxpayer did not open the offshore account, had infrequent contact with the account, withdrew less than $1,000 per year from the account, and can prove that all income taxable by the U.S. in relation to the account has been paid. In short, the reduced penalties apply in very narrow circumstances and one misstep can cause a filer to lose the limited opportunity to take advantage of the reduced penalty.
This past January, the National Taxpayer Advocate issued scathing criticism of the current OVDP structure. In part, the Taxpayer Advocate stated:
The FBAR penalties are generally designed to apply to taxpayers who are intentionally evading U.S. tax by hiding significant untaxed assets in offshore accounts. But they are also affecting taxpayers with modest account balances and/or who did not intentionally evade tax, including those with assets in higher tax jurisdictions where no tax evader would reasonably plan to ide assets. In administering this law, the IRS needs to do a better job of recognizing this distinction, and a key part of what is needed is to remove the fear of opting out of the OVD programs.
The fundamental problem, as identified by the National Taxpayer Advocate and others, is that the willfulness requirement has been removed from the analysis of how to penalize non-compliant taxpayers. Whereas generally proving willfulness, either under the criminal or civil standard, is a burden the government must carry in order to convict taxpayers of serious tax crimes or impose significant penalties, once a taxpayer joins the OVDP willfulness is removed from the equation and all non-compliant taxpayers are treated equally.
To remedy this, the National Taxpayer Advocate proposed classifying OVDP filers in three categories:
The first category, applicable to taxpayers whose underpayment of tax is below a reasonable threshold, would be permitted to come forward and pay their back tax, interest, and penalty without the imposition of any information-reporting related penalties, such as the FBAR penalty.
The second category would cover OVDP filers that cannot meet the threshold of category one, but can provide an explanation as to why their actions were non-willful. They would be required to pay back tax, interest, penalties, and Title 26 information reporting penalties (i.e. failure to file Form 5471 disclosing an interest in a foreign corporation) but not FBAR penalties.
The third category would cover all others, and they would be subjected to the currently applicable OVDP penalties (i.e. payment of back tax, penalties, interest, and a single 27.5 percent penalty).
While the structure proposed by the National Taxpayer Advocate is not perfect, it does at least attempt to address the disparity between willful and non-willful non-compliance.
As Commissioner Koskinen’s comments seem to make clear, the IRS finally appears to be headed in that direction. As we have written before, past criticism of the OVDP by the National Taxpayer Advocate has been ignored by the IRS, so the Commissioner’s comments represent a significant step forward. While the Commissioner’s comments were vague, he stated that the IRS’s “goal is to ensure we have struck the right balance between emphasis on aggressive enforcement and focus on the law-abiding instincts of most U.S. citizens who, given the proper chance, will voluntarily come into compliance and remedy past mistakes.” This seems to be an indication that some modification of the current, one-size-fits-all treatment of OVDP filers will be forthcoming.
Moreover, the modification will likely be coming soon as the Commissioner noted “We believe that re-striking this balance between enforcement and voluntary compliance is particularly important at this point in time, given that we are nearing July 1, the effective date of FATCA.” FATCA is a law that generally requires foreign banks and financial institution to disclose their U.S. account holders or face a withholding tax on payments coming from U.S. sources. Its implementation, along with other efforts by the United States to acquire information about offshore accounts held by U.S. taxpayers has placed pressure on foreign banks to disclose their account holders’ identities which, in turn, has placed pressure on non-compliant account holders to address their past non-compliance. The IRS’s proposed modification of the OVDP could not come at a better time, and those contemplating making an offshore voluntary disclosure should give serious consideration to the current circumstances in deciding whether to proceed with a disclosure.