Since 2009, the IRS has offered taxpayers with undisclosed foreign financial accounts the opportunity to “come clean” under its Offshore Voluntary Disclosure Initiative (OVDI). According to the Internal Revenue Service, more than 38,000 U.S. taxpayers have entered the program. They have paid more than $5.5 billion to resolve issues, with an estimated $5 billion yet to come.
What is OVDI? It is a program of limited duration that offers significant benefits to taxpayers who may have engaged in conduct that could be viewed as criminal. Benefits include immunity from criminal prosecution and avoidance of the full brunt of civil penalties that otherwise could far exceed amounts concealed in offshore accounts. The OVDI program can end at any time. But considering its recent success, many practitioners expect it to continue well into the foreseeable future.
Before viewing OVDI as a panacea or a solve-all, it is important to know that there is a heavy price to pay in order to get the peace of mind that comes from a clear assurance that the government will not come after the taxpayer with its guns blazing. An OVDI disclosure is made by doing the following:
(1) Filing both the original returns and amended returns for the prior eight years that report all income and disclose the foreign accounts;
(2) Filing all missing FBAR reports;
(3) Cooperating fully in the OVDI process;
(4) Signing agreements to extend the statutes of limitation; and
(5) Paying penalties.
Penalties can be quite substantial. For starters, there is a one-time FBAR penalty. The FBAR penalty is based on the highest aggregate balance in a taxpayer’s offshore account over the eight-year period. Typically, the penalty assessed is 27.5% of that amount, although a limited number of taxpayers may qualify for a 12.5% or 5% penalty rate.
While the FBAR penalty, alone, may appear to be punitive, it is not the only penalty. Taxpayers must also pay a 20% accuracy-related penalty based on the total underpayment for all eight years and failure-to-pay or failure-to-file penalties, if applicable.
Once the filing package is submitted to the IRS, the waiting game begins. The IRS will notify the taxpayer or his representative if additional information is required. If not, then the IRS will issue its proposal and request that the taxpayer agree.
The taxpayer has two options. The first is to agree with the IRS’s conclusions and pay the amount due. And the second is not to agree. If the taxpayer agrees, that will end the case once and for all with no further civil or criminal penalties being assessed on the foreign account. The one caveat to that is if the taxpayer fails to disclose all relevant information.
What if the taxpayer does not agree with the IRS’s conclusions? The taxpayer always has the option of “opting out” of the program. An opt out means that the taxpayer rejects the IRS penalty proposal. What are the consequences of opting out? The most significant consequence of an opt out is a withdrawal from the IRS of any assurances that it will forgo prosecution. Another consequence of an opt out is that it is irrevocable, meaning that if the taxpayer wakes up the following morning and has buyer’s remorse, it’s too late.
The procedure following an opt out is relatively simple, but nothing short of nerve-racking. The IRS sends the taxpayer a letter requesting that he or she submit a proposed penalty, a counter-offer if you will, to the IRS’s penalty. If the IRS agrees to the proposal, the matter will be settled. If not, then it might as well be Armageddon for the taxpayer. In that case, the IRS will conduct a full audit of the taxpayer’s returns for the eight-year look back period.
Most troubling is what could happen in the event that the IRS discovers information during the audit that is inconsistent with prior OVDI submissions made by the taxpayer. First, criminal proceedings could be initiated. And second, civil FBAR penalties far in excess of OVDI penalties could be assessed.
To say that the OVDI has its share of critics would be an understatement. Indeed, many innocent taxpayers are being targeted and forced to pay large penalties for minor infractions in order to resolve their potential tax liability.
However, for clients who have undisclosed foreign financial accounts, the OVDI program might be just what the doctor ordered. One need look no further than the criminal penalties to see why. Criminal penalties associated with failure to report a foreign financial account are a maximum fine of $250,000 and up to five years in prison.
Moreover, if the failure to file an FBAR is part of a pattern of illegal activity, the penalties double to a maximum $500,000 fine and up to ten years in prison. 31 U.S.C. § 5322. The penalty for a non-willful civil violation is up to a $ 10,000 fine. However, if the violation is deemed willful, then the penalty is the greater of $ 100,000 or 50% of the account balance at the time of the violation. 31 U.S.C. § 5321(a)(i).
Recent statistics show that this is no laughing matter. Since 2009, when UBS paid $780 million and turned over the names of more than four thousand account holders to avoid criminal charges, more than 120 U.S. taxpayers and advisers have been criminally charged in connection with offshore accounts, many of which were based in Switzerland.
Last August, a Zurich attorney pleaded guilty to helping clients evade U.S. taxes using Swiss bank accounts. And last October, Italian authorities arrested Raoul Weil, the former No. 3 official at UBS, based on an Interpol notice requested by U.S. authorities. Me. Weil was indicted in 2008 in connection with encouraging U.S. tax evasion.
While OVDI might make sense for many taxpayers who have undisclosed foreign bank accounts, it is not right for everyone. What class of taxpayers might it not be right for? Those with defenses or explanations. Why? Because OVDI is a one-size-fits-all “package” deal. Once the taxpayer enters the program, these tax, interest, and penalty assessments are automatically imposed. In other words, OVDI does not include the expectation of a full audit to determine a taxpayer’s correct tax liability and appropriate penalties. Very simply, a taxpayer is barred from offering mitigating evidence in support of a defense.
That can be particularly harsh, especially when the taxpayer has evidence that the prior failures to report were not willful but caused by inadvertence, negligence, or mistake. Similarly, evidence such as reasonable cause and good-faith reliance on the advice of others will not be considered. Therefore, to the extent that the taxpayer has mitigating evidence, voluntary disclosure under OVDI is problematic.
Not surprisingly, many taxpayers are indecisive and apprehensive about making a voluntary disclosure. Some are willing to “take their chances” and avoid entering the OVDI. Before going down that road, it is important to understand the IRS’s enforcement initiatives.
The government has launched investigations of foreign banks believed to have helped U.S. taxpayers hide money abroad. In most cases, these banks are located in countries that have tax treaties with the United States. Notwithstanding the reputation that these countries have for solid bank secrecy laws, many banks in these countries have agreed to disclose account-holder information and to pay penalties based on the amount of assets they helped hide.
What would motivate a foreign bank to disclose such information? A guarantee of immunity from prosecution by the United States government. While it might be surprising to learn that these banks have turned a blind eye to the very same bank secrecy laws that have become enshrined in the culture of the countries in which they operate, there is something even more surprising. And that is that these banks have gone one step forward and have begun prodding their account holders to disclose. Why? Because they could avoid owing penalties on undeclared assets if their account holders disclose.
The U.S. government has not stopped there. It also has at its disposal a major enforcement tool: the recently enacted Foreign Account Tax Compliance Act (FATCA). Signed into law in 2010, the FATCA allows for the exchange of information regarding foreign accounts between the U.S. and other countries. As of this writing, the U.S. has agreements with France, Spain, Germany, Italy, the United Kingdom, and Switzerland.
The foregoing Government enforcement initiatives make it much more likely that the IRS will become aware of undeclared foreign accounts of U.S. taxpayers. And once they become aware, the OVDI is no longer an available option.
The takeaway is this: a taxpayer should give careful consideration before entering the OVDI. Most important, a determination should be made whether the underlying circumstances reflect past criminal behavior. Is there evidence that the taxpayer was aware of the duty to report the offshore accounts? Is there a pattern of misconduct extending over several years? Is there a significant unreported tax liability? Are there mitigating circumstances, including mistaken or negligent reliance on others? Because the IRS may view the circumstances as a criminal matter, this analysis should be made by an attorney, so that it remains privileged.
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