One of the questions that taxpayers in the Offshore Voluntary Disclosure programs ask is should I “opt out” of the program if the penalty is unacceptable to me. The question often arises in the context of value of assets other than financial assets being added to the penalty base by the IRS.
In IRS Frequently Asked Question 36 the IRS takes the position that “if assets produced income subject to U.S. tax during the voluntary disclosure period (2003-2011) which was not reported, the assets will be included in the penalty computation regardless of the source of funds used to acquire the assets”. Translation, if you have offshore assets, like real property, or business interests on which you did not report income the VALUE OF THOSE ASSETS will be included in the penalty base.
Let’s take a simple example, assume a taxpayer has unreported foreign financial accounts with a balance of $100,000 and income from foreign owned real property of $5,000. Assume also that the real property is worth $1,000,000. The penalty base calculation for the 2012 Offshore Voluntary Disclosure Program (OVDP) is 27.5% of $100,000 PLUS 27.5% of the $1,000,000 for a total penalty of $302,500. If the taxpayer elects to “opt out” then assuming the act of failing to file a Report of Foreign Bank Account (FBAR) there are two possible results. First, if the the failiure to file the FBAR’s was based upon advise of a professional (reasonable cause) there is a possibilit of no penalty being imposed. Second, if the failure of file an FBAR was based upon “non-willful” conduct, like the taxpayer did not know of the obligation to file and FBAR, then the non-will penalty of $10,000 per account per year may be applied to one or more years. This example assumes that the taxpayer is otherwise able to get through an income tax audit with limited risk and has no other unfiled information returns.
If the taxpayer has unfiled information returns, as a result of unreported foreign gifts or bequests in excess of $100,000 or unreported foreign trust income or unreported controlled foreign corporations then the taxpayer needs to weigh “opting out” against the risk of the imposition of these penalties on audit.
For some taxpayers, an “opt out” decision makes sense and for others it will be very troublesome. This note is just an illustration of how to approach the problem. All cases are facts and circumstance driven and some may have criminal exposure in addition to civil penalties.