On January 9, 2012, the IRS announced a third Offshore Voluntary Disclosure program ("OVD") for taxpayers with undisclosed foreign assets. The IRS has collected approximately $4.4 billion from taxpayers who participated in the previous two OVDs in 2009 and 2011, and collections are expected to increase as the IRS continues to process applications under those programs. The IRS decided to launch a third OVD ("2012 OVD") in response to taxpayers who expressed an interest in coming forward after the closure of the previous programs.
Overview of the 2012 OVD
In general, U.S. taxpayers must report their worldwide income on an income tax return and disclose their ownership of foreign assets on an information return. However, many taxpayers have neglected to comply with these filing requirements and, as a result, face substantial penalties and criminal charges.
The 2012 OVD gives taxpayers the opportunity to come forward without the fear of criminal prosecution and the opportunity to take advantage of reduced penalties. The 2012 OVD is available for individuals and entities, including corporations and partnerships. However, a taxpayer who has already come under investigation by the IRS is not eligible to participate in the 2012 OVD.
To seek relief under the 2012 OVD, a taxpayer must:
- Pay all back taxes and interest for a period of eight full tax years prior to the disclosure ("Look-Back Period"); and,
- Pay a 20% accuracy-related penalty on the total amount of the back taxes for the Look-Back Period; and,
- Pay a 27.5% penalty on the highest aggregate account balance or value of foreign assets during the Look-Back Period (certain taxpayers may be eligible for a reduced penalty).
The IRS has indicated that it will release additional guidance in the future on how to take advantage of the 2012 OVD.
Unlike the prior two OVDs, the 2012 OVD does not have a set deadline and is open for an indefinite period. However, in an effort to encourage taxpayers to come forward soon, the IRS warns that the terms of the 2012 OVD could change (including an increase in penalties or termination of the program) without advance notice.
Importance of FBAR Compliance
In general, a U.S. taxpayer with either a financial interest in, or signatory authority over, foreign financial accounts with an aggregate value of more than $10,000 is required to file Form TD F 90-22.1 (Report of Foreign Bank and Financial Accounts) ("FBAR"). A foreign financial account includes a bank account, brokerage account, mutual fund, or trust. The form is filed separately from the taxpayer's income tax return and is due on June 30 of each year.
The FBAR is a significant tool used by the IRS to identify noncompliant taxpayers and the IRS has been focusing more of its attention on this filing requirement. Many taxpayers are unaware of the FBAR requirement, but ignorance is not a defense. The IRS can still impose penalties despite the taxpayer’s lack of knowledge of the tax rule.
The penalties for the failure to file an FBAR are severe. The taxpayer is subject to a $10,000 penalty for each year of noncompliance. If the IRS determines that a taxpayer has willfully failed to file the FBAR, the penalty is increased to the greater of $100,000 or 50% of the total balance of the undisclosed foreign accounts each year. In addition, accuracy-related penalties and criminal penalties can be imposed. The 2012 OVD can be an important source of relief for certain taxpayers who have failed to file an FBAR.
A simple example illustrates the severity of the penalty and the magnitude of relief potentially available under the 2012 OVD for a taxpayer who is determined to have willfully failed to file the FBAR.
Assume the Taxpayer deposits $1,050,000 into a foreign account in 2004 and earns $50,000 in interest income each year for seven years as follows:
|
Year |
Deposit |
Interest Income |
Account Balance |
|
2004 |
$1,050,000 |
$50,000 |
$1,100,000 |
|
2005 |
|
$50,000 |
$1,150,000 |
|
2006 |
|
$50,000 |
$1,200,000 |
|
2007 |
|
$50,000 |
$1,250,000 |
|
2008 |
|
$50,000 |
$1,300,000 |
|
2009 |
|
$50,000 |
$1,350,000 |
|
2010 |
|
$50,000 |
$1,400,000 |
Assume the interest is not compounded and the income is subject to a 35% tax rate. Therefore, the total tax on the interest income equals $122,500 (7 years x $50,000 in annual interest x 35%). Assume further that the taxpayer did not report the account or the income and the IRS determines that the taxpayer willfully failed to file an FBAR for tax years 2004-2010. In that case, in addition to having to pay the tax of $122,500, plus interest and other penalties, the taxpayer is subject to an FBAR penalty of $4,375,000, which is more than triple the amount of the account balance. The penalty of $4,375,000 is the sum of 50% of each year's account balance (2004-$550,000, 2005-$575,000, 2006-$600,000, 2007-$625,000, 2008-$650,000, 2009-$675,000, 2010-$700,000).
Under the 2012 OVD, the taxpayer would owe approximately $532,000, plus interest, and escape the risk of criminal prosecution. The tax liability of $532,000 is the total of the following amounts: (1) tax of $122,500; (2) accuracy-related penalty of $24,500 ($122,500 x 20%); and (3) OVD penalty of $385,000 ($1,400,000 x 27.5%).
By participating in the 2012 OVD, the taxpayer in the above example could save approximately $4 million.
Is the 2012 OVD Right for You?
One drawback of the OVDs is that penalties can apply regardless of whether the taxpayer made an honest mistake or intentionally attempted to evade paying taxes. Depending on the circumstances, the 2012 OVD may be too severe and a taxpayer may be better off by electing to resolve the issue outside of the 2012 OVD. For example, under general IRS rules, if the taxpayer can successfully demonstrate that the violation was due to "reasonable cause," the taxpayer would not be subject to a penalty. Therefore, taxpayers who did not act willfully and who have a strong "reasonable cause" argument for their failure to file may be better off to consider alternatives to the 2012 OVD.
Conclusion
The IRS’s ongoing foreign bank investigations, expanded reporting requirements, and whistleblower awards are making it more difficult for taxpayers with undisclosed foreign assets and income to remain anonymous. Therefore, it is not surprising that the IRS is increasing its efforts to identify those noncompliant taxpayers. The IRS warns that the consequences are going to be much worse for a taxpayer if the taxpayer is investigated before making a voluntary disclosure. However, taxpayers need to carefully evaluate their particular situation before determining whether the 2012 OVD is the best alternative for them.
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This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.
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