Following the termination last fall of its immensely successful Offshore Voluntary Disclosure Program (OVDP), the Internal Revenue Service (IRS) has announced a new regime to govern all voluntary disclosures regarding tax noncompliance. These new procedures apply to both domestic and offshore voluntary disclosures, and in many ways they replicate the procedures under the now-shuttered OVDP.
In other ways, the new procedures are significantly different, particularly the new civil penalty framework. Taxpayers who now take advantage of the updated voluntary disclosure program will potentially face a 50 percent penalty on their undisclosed offshore financial assets, and a 75 percent civil fraud penalty on the unpaid taxes, and both of these penalties can, in certain circumstances, be applied for multiple years. In addition, the new procedures place greater emphasis on taxpayer cooperation during the voluntary disclosure process, and make clear that non-cooperative taxpayers may face greater penalty exposure. This significantly more stringent penalty framework may well cause some taxpayers to question whether the new program is worth the price of admission, especially when other voluntary disclosure options continue to exist.
Voluntary Disclosure Background
The IRS has for years maintained a self-disclosure regime whereby taxpayers can voluntarily disclose instances of noncompliance with the tax laws and in most cases avoid criminal prosecution. The critical underlying principal of voluntary disclosure is that the taxpayer must self-disclose before the IRS learns of the noncompliance; if the IRS already knows of the taxpayer’s noncompliance from whatever source (for example, from third-party reporting or a whistleblower), the taxpayer is ineligible to make a voluntary disclosure.
In March 2009, following the landmark agreement regarding offshore tax evasion struck by the United States with Switzerland’s largest bank, UBS AG, the IRS unveiled its now-famous “Offshore Voluntary Disclosure Program.” This was a specially-designed voluntary disclosure program – premised upon the IRS’s longstanding voluntary disclosure practice – for taxpayers with secret foreign bank accounts and other types of offshore financial assets. Participating taxpayers were required to file eight years of amended tax returns and to pay all back taxes, interest, and a “miscellaneous” offshore penalty calculated at 20 percent of the aggregate highest balance of undisclosed offshore financial assets. The IRS subsequently announced various modifications to the OVDP in 2011, 2012, and 2014, with the primary change each time consisting of an elevation of the penalty rate, which ultimately reached 27.5 percent in the 2014 iteration. In addition, under certain circumstances, the miscellaneous penalty could be elevated to 50 percent if the taxpayer maintained an account at a financial institution, or did business with an offshore service provider, identified on a list maintained by the IRS.
The OVDP was designed for taxpayers with exposure to potential criminal liability or substantial civil penalties due to a willful failure to report foreign financial assets and pay all tax due associated with those assets. The OVDP provided taxpayers with such exposure potential protection from criminal liability and terms for resolving their civil tax and penalty obligations. Taxpayers with unfiled returns or unreported income who had no exposure to criminal liability or substantial civil penalties due to willful noncompliance could come into compliance using other options, including the Streamlined Filing Compliance Procedures, the delinquent FBAR submission procedures, or the delinquent international information return submission procedures.
By the time the OVDP ended in September 2018, more than 56,000 taxpayers successfully completed the program, paying more than $11.1 billion in back taxes, penalties and interest. The total number of taxpayer disclosures under the OVDP peaked in 2011, when about 18,000 individuals came forward. In addition, more than 65,000 taxpayers took advantage of the Streamlined Filing Compliance Procedures, a related voluntary disclosure initiative unveiled in 2014 as an alternative to OVDP for taxpayers whose conduct was non-willful. Collectively, the OVDP and the Streamlined Filing Compliance Procedures represented the most successful voluntary disclosure program ever offered by the IRS, far eclipsing all prior initiatives. Participation in OVDP declined in recent years, however, with only 600 disclosures occurring during 2017, prompting the IRS to announce that the program would close as of September 28, 2018.
Highlights of the New Voluntary Disclosure Regime
On November 20, 2018, the IRS announced the new voluntary disclosure procedures by releasing publicly a five-page internal guidance memorandum. These new procedures are effective for all voluntary disclosures – both offshore and domestic – received after September 28, 2018. The objective of the new voluntary disclosure practice is to provide taxpayers concerned that their conduct is willful or fraudulent, and that may rise to the level of tax and tax-related criminal acts, with a means to come into compliance with the law and potentially avoid criminal prosecution. The guidance emphasizes that taxpayers who did not commit any tax or tax related crimes and do not need the voluntary disclosure practice to seek protection from potential criminal prosecution can continue to correct past mistakes using the Streamlined Filing Compliance Procedures or by filing an amended or past due tax return.
Preclearance by IRS-Criminal Investigation
As with the OVPD, IRS-Criminal Investigation will screen all voluntary disclosure requests (whether domestic or offshore) to determine if a taxpayer is eligible to make a voluntary disclosure. To do so, the IRS will require all taxpayers wishing to make a voluntary disclosure to submit a preclearance request on a forthcoming revision of Form 14457. Internal Revenue Manual section 188.8.131.52 will continue to serve as the basis for determining taxpayer eligibility. If IRS-CI determines that the taxpayer satisfies the voluntary disclosure requirements, it will issue a “preclearance letter” to the taxpayer.
For all cases where IRS-CI grants preclearance, taxpayers must then promptly submit all required voluntary disclosure documents using a forthcoming revision of Form 14457. This form will require information related to taxpayer noncompliance, including a narrative providing the facts and circumstances, assets, entities, related parties, and any professional advisors involved in the noncompliance. Once IRS-CI has received and preliminarily accepted the taxpayer’s voluntary disclosure, it will notify the taxpayer of preliminary acceptance by letter and simultaneously forward the voluntary disclosure letter and attachments to the IRS Large Business & International unit in Austin, Texas, for case preparation before examination. As with the OVDP, IRS-CI will not process tax returns or payments.
Civil Processing and Case Development
Once the LB&I Austin unit receives information from IRS-CI, it will route the case for audit. If a taxpayer or representative wishes to make a payment prior to case assignment with an examiner, payments may be remitted to the LB&I Austin unit. The LB&I Austin unit will select the most recent tax year covered by the voluntary disclosure for examination and then forward cases for case building and field assignment to the appropriate Business Operating Division and Exam function for civil audit. All voluntary disclosures will follow standard audit procedures. Examiners will be required to develop cases, use appropriate information-gathering tools (such as Information Document Requests and summonses, as appropriate), and determine proper tax liabilities and applicable penalties.
Six-Year Disclosure Period in Most Cases
In general, voluntary disclosures will include a six-year disclosure period, which means that participating taxpayers will be required to file corrected tax returns for the most recent six-year period, even if their tax noncompliance covered a greater period of time. However, IRS agents have the discretion to expand the disclosure period to cover additional years – including what the IRS calls “the full duration of the noncompliance” – if the taxpayer refuses to resolve the audit by agreement. In addition, cooperative taxpayers may be allowed to expand the disclosure period to include additional tax years in the disclosure period for various reasons (such as correcting tax issues with other tax authorities that require additional tax periods, correcting tax issues before a sale or acquisition of an entity, or correcting tax issues relating to unreported taxable gifts in prior tax periods).
Importance of Taxpayer Cooperation
The new voluntary disclosure procedures are notable for the emphasis they place on taxpayer cooperation, and perhaps more importantly, the consequences to taxpayers of non-cooperation. The IRS’s historical voluntary disclosure process has always required taxpayer cooperation, specifying that “[a] voluntary disclosure occurs when the communication is truthful, timely, complete, and when . . . the taxpayer shows a willingness to cooperate (and does in fact cooperate) with the IRS in determining his or her correct tax liability.” Similarly, the OVDP required taxpayer cooperation as a condition of participating in the program, which included making full disclosure of all offshore assets; agreeing to extend the applicable statutes of limitations; and fully paying all back taxes, interest, and penalties, or making satisfactory payment arrangements.
Under the new procedures, taxpayer cooperation takes on greater significance, and by “cooperation” the IRS means more than just making full disclosure of offshore assets, extending the time to assess, and arranging for payment. Rather, the extent of a taxpayer’s cooperation (or lack thereof) will have a direct bearing on the type and magnitude of penalties to be asserted. The new guidance states that the IRS expects that voluntary disclosures will be resolved by agreement with full payment of all taxes, interest, and penalties for the disclosure period. In other words, taxpayers are expected to assent to all adjustments that result from the audit, and not to exercise their legal rights to contest audit adjustments and seek review by IRS Appeals. In particular, taxpayers are warned that in cases that are not resolved by agreement (and the taxpayer exercises his or her right to take the case to Appeals), the agent “may assert maximum penalties under the law with the approval of management” and may expand the disclosure period beyond six years. Also, if a taxpayer fails to cooperate with the civil examination, the examiner may request that IRS-CI revoke preliminary acceptance, potentially triggering the opening of a criminal investigation.
The new voluntary disclosure procedures make clear that the nature and extent of penalties to be assessed will in large part be a function of the taxpayer’s cooperation during the process. As noted above, taxpayers whose cases that are not resolved by agreement can face “maximum penalties under the law.” On the other hand, taxpayers who provide “prompt and full cooperation during the civil examination of a voluntary disclosure” are entitled to civil penalty mitigation.
The following penalty terms will be applied to taxpayers who make timely voluntary disclosures and who fully cooperate with the IRS during the voluntary disclosure process:
Civil Fraud Penalty
The civil penalty under I.R.C. § 6663 for fraud or the civil penalty under I.R.C. § 6651(f) for the fraudulent failure to file income tax returns will apply to the one tax year with the highest tax liability. In limited circumstances, the IRS may apply the civil fraud penalty to more than one year in the six-year scope (up to all six years) based on the facts and circumstances of the case, for example, if there is no agreement as to the tax liability. The IRS may assert the civil fraud penalty beyond six years if the taxpayer fails to cooperate and resolve the examination by agreement. The new procedures provide that taxpayer may request imposition of accuracy-related penalties under I.R.C. § 6662 instead of civil fraud penalties, although granting such requests is expected to be exceptional. Where the facts and the law support the assertion of the civil fraud FBAR penalty, a taxpayer must present convincing evidence to justify why such penalty should not be imposed.
Willful FBAR penalties will be asserted in accordance with existing IRS penalty guidelines contained in the Internal Revenue Manual, which include mitigation guidelines that permit the IRS to reduce FBAR penalties if certain criteria are met. Taxpayers may request that the IRS impose non-willful FBAR penalties, but granting such requests is expected to be exceptional, and taxpayers must present convincing evidence to justify lower penalties.
Information Return Penalties
The new voluntary disclosure procedures provide that penalties for failure to file information returns will not be automatically imposed. This is a positive development for taxpayers, as the penalties for not filing information returns such as Forms 5471 (requiring disclosure of ownership of foreign corporations), Forms 8938 (requiring disclosure of foreign financial assets), and Forms 3520 (requiring disclosure of information regarding foreign trusts), can be significant, especially if the taxpayer’s noncompliance spans multiple years. The procedures provide that agents will exercise discretion as to these types of penalties and will take into account the application of other penalties (such as the civil fraud penalty and the willful FBAR penalty) and the extent of the taxpayer’s cooperation.
Other types of penalties, such as those relating to excise taxes, employment taxes, and estate and gift taxes, will be handled based upon the facts and circumstances with IRS agents coordinating with appropriate subject matter experts.
Ability to Request an Appeal
In a break from prior practice under the OVDP, the new voluntary disclosure procedures provide that taxpayers retain the right to request an appeal with the IRS Office of Appeals. Taxpayers accepted into the OVDP were not permitted to request an appeal under any circumstances; the only recourse for taxpayers who did not wish to accept the OVDP civil resolution terms was to “opt-out” of the program and face a full-scope audit. The ability to take an appeal is another positive development for taxpayers under the new voluntary disclosure procedures, but this is a double-edged sword. It appears that taxpayers who exercise their appeal rights – one of the fundamental rights enumerated in the “Taxpayer Bill of Rights” – will be deemed non-cooperative and can face imposition of greater penalties than taxpayers who agree to resolve their voluntary disclosure cases and do not appeal.
Application of the New Civil Penalty Framework
As noted, the new voluntary disclosure procedures are described in a five-page internal guidance memorandum released in November. The IRS has not yet published any additional guidance on how the new program will work in practice, such as Frequently Asked Questions which were a large part of the OVDP and largely helpful to taxpayers and practitioners.
At the American Bar Association’s National Institute on Criminal Tax Fraud and National Institute on Tax Controversy in December 2018 – held only a few weeks after the IRS issued the new voluntary disclosure guidance – an attorney from the IRS Office of Chief Counsel presented the following three scenarios to illustrate how the new voluntary disclosure penalty framework will be applied to various fact patterns.
Taxpayer 1 is a US citizen who lives in California, but he was born in Italy and lived in Italy for parts of his adult life. Taxpayer 1 has several bank accounts in Italy and a Swiss bank account established by his grandfather’s estate for Taxpayer l’s inheritance. Taxpayer 1 accessed the Swiss account and never informed the Swiss bankers of his US citizenship. Taxpayer 1 had no interests in or control over any foreign entities. He intentionally did not tell his return preparer about his foreign bank accounts and checked “no” to the question about having foreign bank accounts on Schedules B filed with his tax returns.
Taxpayer 1 fully cooperates with the civil examination. The examiner asserts the civil fraud penalty for one year and a willful FBAR penalty totaling 50% of the highest aggregate balance in all foreign bank accounts.
This scenario represents what appears to be a relatively straightforward case of willful conduct by the taxpayer, as evidenced by the taxpayer’s deliberate concealment of his offshore accounts from his return preparer and his “no” answer to the question about foreign bank accounts on Schedule B. The taxpayer is cooperative during the examination, and presumably resolves the audit by agreement (and does not request an appeal). Because the taxpayer’s conduct was willful, the IRS revenue agent asserted a one-year civil fraud penalty and a one-year willful FBAR penalty.
Taxpayer 2 owns a restaurant in Dallas as a sole proprietorship. Taxpayer 2 reports all credit card receipts, but only 20% of cash receipts. Taxpayer 2 kept a second set of books tracking his actual income. Taxpayer 2 had no other tax or information reporting noncompliance. Taxpayer 2 used the unreported cash to pay various personal expenditures and to buy gold bullion. Taxpayer 2 accumulated $2 million in gold bullion in his personal safety deposit box over the last 10 years with his cash skimming scheme. In Taxpayer 2’s voluntary disclosure letter to CI he expresses willingness to sell his bullion to pay all outstanding tax liabilities if he doesn’t have sufficient liquid assets to pay his taxes. Taxpayer 2 fully cooperates including providing his second set of books tracking his actual income to the examiner. The examiner asserts the civil fraud penalty for one tax year.
This scenario, which involves solely domestic conduct, demonstrates the value that the IRS will place on taxpayer cooperation during the voluntary disclosure process. The scenario presents numerous examples of fraudulent conduct by the taxpayer, including a typical “cash skim,” maintaining a second set of books, payment of personal expenses, and accumulation of a “cash hoard” (albeit in the form of gold bullion). Outside of the voluntary disclosure process, an IRS agent would undoubtedly assert the civil fraud penalty for multiple years. Because this is a voluntary disclosure case, the civil fraud penalty is limited to a single year, a significant concession to the taxpayer.
Taxpayer 3 is a US citizen who lives in New York. Taxpayer 3, through nominees, owned 100% of a Panamanian corporation that held several foreign financial accounts in Singapore and interests in two businesses in China. Taxpayer 3 willfully and fraudulently failed to disclose his ownership of the CFC and his control over the foreign financial accounts. Taxpayer 3 actively traded securities and held mutual funds in one of the foreign financial accounts. During the course of the examination, Taxpayer 3 and the IRS cannot agree on the proper PFIC tax calculations for the last three years of the six-year disclosure period and transition tax under Section 965. Taxpayer 3’s positions on the issues are made in good faith and are non-frivolous. The examiner and her manager coordinated the issues internally and disagree with Taxpayer 3. Although agreement is not reached on those years, Taxpayer 3 fully cooperates throughout the examination including providing all documents requested and answering questions in an interview. Taxpayer 3 requests review by the Office of Appeals. The examiner asserts the civil fraud penalty for the last three years of the disclosure period and a willful FBAR penalty totaling 65% of the highest aggregate balance in all foreign bank accounts.
This scenario presents the most objectionable application by the IRS of the new voluntary disclosure penalty framework. The taxpayer’s conduct in this hypothetical is unquestionably willful, as evidenced by the taxpayer’s use of nominees to hold offshore accounts in tax haven countries and deliberate concealment of ownership of a controlled foreign corporation and control over foreign accounts. During the audit, the taxpayer fully cooperates but cannot reach an agreement with the agent as to a technical issue relating to application of the highly complex passive foreign investment company (PFIC) rules. The audit is resolved on an unagreed basis, and the taxpayer exercises his legal right to review by IRS Appeals. Despite the taxpayer’s assertion of a good faith, non-frivolous position regarding the PFIC issue, the IRS agent asserts a whopping array of penalties consisting of three years of civil fraud (a 225-percent penalty in total) and multiple willful FBAR penalties that total 65 percent in the aggregate. Taxpayers should not be punished for asserting good-faith legal positions and seeking review by IRS Appeals, but this scenario makes clear that taxpayers who do so will face what can only be described as retaliatory penalty assertions by IRS agents.
Other Voluntary Disclosure Options Still Exist
It is important to note that the new voluntary disclosure regime unveiled in November is not the only pathway for noncompliant taxpayers. Other viable, and less expensive, voluntary disclosure options still remain available depending, of course, on individual facts and circumstances. As noted, the highly-popular Streamlined Filing Compliance Procedures may still be used by taxpayers whose conduct was non-willful. For taxpayers whose only noncompliance was omission of certain information returns, the Delinquent FBAR Submission Procedures and the Delinquent International Information Return Submission Procedures are good options. Finally, although the IRS discourages the practice, taxpayers may still make so-called “quiet” disclosures by filing amended tax returns and following the procedures described in section 184.108.40.206 of the Internal Revenue Manual.
The new IRS voluntary disclosure regime is a mixed bag for taxpayers and practitioners. On the one hand, they should be welcomed by taxpayers and practitioners because they make clear that voluntary disclosure practice for both domestic and offshore issues is alive and well despite closure of the OVDP. On the other hand, the new procedures dramatically increase the range of available penalties as compared to OVDP and authorize IRS revenue agents ostensibly to punish non-cooperating taxpayers by significantly ratcheting up the potential penalty exposure, even when taxpayers assert good faith positions and/or seek to exercise their appeal rights. The increased price of admission may well discourage taxpayers from making formal voluntary disclosures and instead drive taxpayers into using other options, such as the Streamlined Filing Compliance Procedures or quiet disclosures.