In recent months, the Internal Revenue Service (“the Service”) began the process of issuing follow-up letters to taxpayers who either requested preclearance to participate in the Offshore Voluntary Disclosure Program (“OVDP”) or who submitted a voluntary disclosure letter within the OVDP. For those that receive these letters – IRS Letter 5935 and IRS Form 15023 – and previously considered addressing offshore tax non-compliance (or thought that they had addressed offshore tax non-compliance), it is important that the proper response is made to avoid potentially dire consequences.
IRS Letter 5935 and IRS Form 15023 are issued to those who affirmatively contacted the Service regarding a potential offshore voluntary disclosure and did not conclude the process, at least based on the Service’s records. These affirmative contacts are generally made through a request for preclearance into the OVDP or through the submission of a voluntary disclosure letter. These contacts are fielded by, and notated by, the Criminal Investigation Division of the Service; however, a majority of the OVDP process, as well as the Streamlined Filing Compliance Procedures (“SFCP”) and other compliance procedures, are not handled by the Criminal Investigation Division. Therefore, if one was debating whether or not to enter the OVDP, it is likely that the Criminal Investigation Division’s records show that an examination or investigation should have occurred. It is likely that these letters are being generated in connection with the Service’s termination of the OVDP later this year.
If a taxpayer later decided to address non-compliance through the SFCP, Delinquent International Information Return Submission Procedures, the Delinquent FBAR Submission Procedures, or by some means other than the OVDP, the Service will not necessarily note these actions properly in its system and may assume that there are still unresolved offshore issues. These letters could also be issued if a taxpayer mistakenly believed they had unresolved offshore issues and ultimately ended up determining that they were in compliance. At this point, it is not clear if these letters are only issued to those later addressing noncompliance outside of an established program (e.g., SFCP) or if the Service’s existing systems are not sufficiently equipped to cross-reference cases that have actually been resolved through the SFCP or other established programs.
These letters should be taken seriously since offshore tax non-compliance can result in significant civil and criminal penalties. If the offshore non-compliance was not addressed within the OVDP, the Service is generally not precluded from opening an investigation and seeking assessment of civil penalties. In the case of non-willful non-compliance with FBAR requirements, penalties can be imposed at up to $10,000 per account per year. And, in the case of willful non-compliance with FBAR requirements, penalties can be imposed up to the greater of $100,000 or 50% of the highest account balance during the year, per account per year. On top of this, there are a number of other information reporting penalties and accuracy-related penalties that can be imposed for failure to report foreign income and assets. For certain taxpayers, these penalties can vastly exceed the amount of any unreported income taxes.
In addition, while many receiving these letters may think the issue is behind them, as too much time has passed, that assumption may be wrong. The Service has six years to make an assessment of FBAR penalties. This means that taxpayers with unreported foreign bank accounts from 2011 are still exposed to assessments until June 30, 2018. And, in the case of erroneous or unfiled tax returns, the window for assessment may be open even longer. Although the statute of limitations for assessment of tax and penalties is generally three years, the statute of limitations does not begin to run until a tax return has been filed. The same holds true for many information returns, including the Form 3520, Form 8865, Form 8621, Form 5471, and Form 8938. If a tax return was fraudulently filed (e.g., offshore income was intentionally omitted), the statute of limitations will never expire even if the issue was later corrected. The failure to report a foreign asset that generates more than $5,000 in tax can also extend the statute of limitations. In many cases, these statutes create potential exposure for tax years that taxpayers thought were long immune from additional assessments.
Similarly, in the context of criminal liability, the statutes of limitations can often be extended further into the future based on actions of the taxpayer. Therefore, even if an account was closed or some compliance action was taken, the government may be able to prosecute that person for more than five or six years after the perceived misconduct occurred. There may be other non-tax offenses or conspiracy-related charges that extend the timeframe for the government to prosecute. The Department of Justice is still working with the Service to prosecute individuals with offshore non-compliance and recent examples are published on their website.
Aside from the potential worst-case scenario of criminal prosecution, failure to respond or properly respond to IRS Letter 5935 or IRS Form 15023 can negate prior efforts to come clean and can expose one to a potentially protracted civil examination. Though few, if any, civil audits are enjoyed by taxpayers, audits involving offshore tax issues are frequently worse than the norm. Potential civil penalties can be exorbitant. Revenue agents are often not well-equipped to deal with these complex issues and, as a result, such cases frequently require administrative appeals. Even if everything is done correctly, the Service may request substantial documentation from a number of years to verify the accuracy of tax returns and FBARs. At a minimum, most taxpayers are more comfortable having an experienced professional deal with the Service; however, given the scope of these audits, that may come at a substantial financial cost. Given the ever-dwindling resources of the Service and the closing of the OVDP, those that are chosen for civil examination can expect the Service to seek penalties, spend their limited resources, and, likely, have their cases examined for quite some time. While a proper a response cannot eliminate this risk entirely, efforts should be taken to minimize this possibility.
Responding to IRS Letter 5935 and IRS Form 15023 requires careful consideration of many factors. The appropriate response (or, potentially, a lack of response) depends on the facts and circumstances of each case. If the letter indicates that the Service received a request to make a voluntary disclosure and the request was not eligible or was declined, there is likely significant exposure to civil and criminal penalties. Such voluntary disclosures are generally not permitted for those previously noted as being under civil examination or criminal investigation. This could indicate that the Service is still considering the case and may use any subsequent filings as evidence of civil or criminal non-compliance. It may not necessarily be in one’s best interest to provide further information. On the other hand, if the non-compliance was benign, simply a mistake, or has already been resolved, providing this information may prevent further follow-up and examination by the Service. Again, the best course of action will often depend upon individualized circumstances and judgment.
If the letter indicates that a request to participate in the OVDP was withdrawn or was based upon a decision to participate in the SFCP, a similar analysis should be performed. If a taxpayer has reasonable cause for failing to file returns or report accounts and has affirmatively addressed these issues, it is probably best to provide the requested information to the Service. This will allow the Service to update its records and may prevent further scrutiny. On the other hand, this may be another opportunity for taxpayers to review their prior submissions. Taxpayers may ensure everything was prepared accurately and that the submissions will withstand further review by the Service. For example, if a taxpayer provided information and the Service did not properly process it, the taxpayer may consider adding additional language to the submission to ensure it is not misprocessed and, further, to bolster arguments for reasonable cause.
Those receiving an IRS Letter 5935 or IRS Form 15023 should consult a tax professional immediately. Given the potential high stakes involved, it is paramount that taxpayers make appropriate considerations in responding to such letters to minimize their potential exposure to civil penalties, criminal penalties, and further entanglement with the Service through a drawn-out civil examination.