Now, More than Ever, Taxpayers with Lingering Offshore Tax
Non-Compliance Must Seek Professional Assistance
On November 20, 2018, the Internal Revenue Service (“the Service”) released a memorandum containing important updates regarding its Voluntary Disclosure Practice (“the Memo”). Although the Memo provides significant guidance as a result of the closing of the Offshore Voluntary Disclosure Program (“OVDP”), which ended on September 28, 2018, it still leaves many issues unaddressed. Those with unaddressed issues relating to offshore activity should review the Memo and contact counsel to determine the best means for resolving remaining potential civil and criminal exposure.
Background of the OVDP
For the better part of the last decade, the Service has taken an aggressive and well-publicized stance against those who did not comply with their tax and reporting obligations with respect to foreign-sourced income, foreign bank accounts, and certain foreign entities. Aside from a significant number of criminal prosecutions, the Service addressed thousands of would-be offenders through several versions of the OVDP. While the Service did not have sufficient resources to civilly examine or criminally investigate all potential offenders, the threat of significant civil and criminal penalties caused many thousands of taxpayers to voluntarily disclose their misdeeds through the OVDP. The Service collected billions of dollars in revenue as a result of these efforts. As an offshoot of the OVDP, the Service also established programs aimed at addressing potential non-compliance of those with less criminal culpability. Those programs included the Streamlined Filing Compliance Procedures, Delinquent FBAR Submission Procedures, and Delinquent International Information Return Submission Procedures. Much like the OVDP, these programs offered a defined penalty structure for those that voluntarily came forward to the Service and met specific criteria. Although the latter programs are still in operation, the Service closed the OVDP on September 28, 2018 as the Service had provided significant opportunity for taxpayers to address non-compliance.
New Guidance from the Memo
Given the substantial opportunities already provided to those with potential criminal culpability to come forward through the now-closed OVDP, the revamped Voluntary Disclosure Practice (“the Practice”) discussed in the Memo provides much less favorable terms to those that come forward to the Service with offshore non-compliance. Even so, the terms may still be useful to those with a justified fear of criminal prosecution or substantial civil penalties. Some of the significant terms of the Practice include:
(1) Applies to all offshore voluntary disclosures submitted after September 28, 2018.
(2) All disclosures will be subject to initial review by the Criminal Investigation Division of the Service. As with prior programs, taxpayers may submit a request for preclearance and will be required to submit a narrative regarding non-compliance via Form 14457.
(3) If eligible for the Practice (e.g., no current civil or criminal investigation, no illegal-source income, etc.), the disclosure will be forwarded for examination within a civil examination unit.
(4) Voluntary disclosures will generally cover up to a six-year period. The disclosure may include less years if there are less years of non-compliance and more years if the taxpayer is deemed uncooperative or at the option of the taxpayer.
(5) Taxpayers must submit all required returns and reports for the disclosure period and must agree to resolve the disclosure by agreement.
(6) Although all applicable taxes, interest, and penalties will be determined by the civil examination unit, the following penalty structure applies:
a. In general, the civil fraud penalty under I.R.C. § 6663 or I.R.C. § 6651(f) will apply to the year with the highest tax liability. Taxpayers may request assessment of an accuracy-related penalty in lieu of the civil fraud penalty; however, such a request must be accompanied by compelling evidence and will only be granted in exceptional circumstances.
b. In certain circumstances, the civil fraud penalty will be expanded to more than one year in the six-year disclosure period (e.g., if no agreement as to the tax liability).
c. If the taxpayer fails to cooperate and resolve the exam by agreement, the civil fraud penalty may be applied beyond six years.
d. Willful FBAR penalties will be asserted in accordance with existing penalty guidance under the Internal Revenue Manual (e.g., IRM 4.26.16 and IRM 4.26.17).
e. Penalties for failing to file information returns will not be automatic and will be discretionary (with due consideration of any other penalties imposed by agreement).
f. Taxpayers retain the right to request an appeal with the Service’s Office of Appeals.
Some significant takeaways can be drawn from the Memo. First, assuming eligibility and cooperation with the Service, the Practice still provides a means to minimize criminal prosecution for taxpayers. Second, disclosures may be subject to increased tax penalties (e.g., fraud penalty at 75% versus accuracy-related penalty of 20% from prior versions of the OVDP). Third, the applicable FBAR penalties in a disclosure under the Practice will likely be higher than what was offered in the most recent version of the OVDP (i.e., 27.5% of the highest aggregate account balance versus 50% or more of the highest aggregate account balance). Fourth, penalties for failing to file information returns may be applied. Fifth, more discretion will be exercised by the Service in proposing penalties in the Practice than under the OVDP.
Remaining Issues and Takeaways Regarding the Practice
While these changes all appear to worsen the plight of those considering a disclosure, there are still a number of open issues and potential benefits. For example, a reduction of the disclosure period from eight years under the OVDP to six years under the Practice may benefit a discreet set of taxpayers. Further, the provision applying the civil fraud penalty to the year with the “highest tax liability” may benefit, at least in a relative sense, those with large amounts of unreported income and relatively small balances of unreported foreign accounts. (Relatedly, it is yet to be determined if the “highest tax liability” applies to the year with the largest amount of unreported tax or the year with the highest tax liability after combining previously unreported income with already reported income. It is similarly unclear what, if any, penalties apply to years in the disclosure not containing the “highest tax liability.”) Moreover, the Practice leaves open the opportunity to request lower FBAR penalties – at least compared to the OVDP – pursuant to the terms of the Internal Revenue Manual; however, it is not likely that the Service will exercise discretion to reduce penalties from the norm in most cases. It is similarly unclear as to the level of discretion that will be exercised by the Service with respect to information return penalties. Finally, the ability and scope of any available appeal rights remains unclear and untested.
All told, while the Memo outlines a new disclosure mechanism that will be less advantageous to most tax offenders than the OVDP and will result in higher penalties, it may still be preferable to other options (i.e., civil examination without guidance on application of penalties or criminal prosecution). Now more than ever, those with potential exposure from unreported offshore income and assets will need to consult with a skilled professional. Careful consideration of eligibility for the less onerous options, such as the Streamlined Filing Compliance Procedures and others, is more important than ever. Professional advice will also be necessary to address the many open issues in the Practice and to cogently present a case that minimizes the Service’s discretion to impose substantial penalties under the Practice or guidance in the Internal Revenue Manual. Those attempting to address significant non-compliance on their own may not choose the best available program for compliance or may be left arguing against substantial penalties in the Practice with little legal recourse. Worse yet, some who feel that they are treated unfairly by the Service may end up having their cases removed from the Practice altogether and could be exposed to further civil or criminal liabilities as a result.