Recent Changes By IRS Offshore Disclosure Less Painful For Many But More So For Others!
Last month, the IRS made sweeping changes to its 2012 Offshore Voluntary Disclosure Program (“2014 OVDP”) and Streamlined Filing Compliance Procedures (“Streamlined Disclosure Program” or “SDP”), which generally became effective July 1, 2014. Those changes both raise the penalty to 50% for some taxpayers who hold accounts at certain foreign financial institutions, as well as relax the penalty to a more taxpayer-friendly 5% for other non-compliant taxpayers who acted non-willfully in their failure to comply with reporting gross income from a foreign financial account to the IRS.
Background
The 2012 OVDP, a successor to the 2009 and 2011 offshore voluntary disclosure initiatives, generally imposed a Title 26, 27.5% miscellaneous penalty on taxpayers who entered the program to report their failure to report income for past years to the IRS, or a lower, 12.75% penalty for those with a highest aggregate account balance of less than $75,000 for each of the years covered by the OVDP. If accepted into the 2012 OVDP, the taxpayer would be required to file amended returns for each of the most recent eight tax years for which the due date has already passed, file FBARs if delinquent for those years, and pay the taxes, interest, and penalties for a failure to pay, failure to file, accuracy, information return, and FBAR penalties (whichever is applicable), in addition to the 27.5% miscellaneous penalty imposed on the highest aggregate value of the individual’s foreign assets related to the non-compliance.
Before the 2014 changes, the SDP was generally only available to a small group of taxpayers, namely non-US residents and those with small amounts of unpaid tax due for each year. No penalty was applied under this program to those eligible taxpayers.
2014 Changes to SDP
The good news is that the 2014 changes open up the availability of the SDP, by both removing the $1,500 threshold of unpaid tax per year that prevented so many taxpayers
from benefitting from such program, as well as making it available to US residents for the first time under its new “streamlined domestic offshore procedures.” For purposes of the SDP, a US resident is a person who
fails to meet the non-residency criteria set by the IRS, and has previously filed a US tax return for each of the most recent 3 years (if required) for which the U.S. tax return due date (or properly applied for extended due date)
has passed, and has failed to report gross income from a foreign financial asset and pay tax as required by U.S. law, and may have failed to file an FBAR and/or one or more international information returns with respect to the foreign
financial asset. Why are the 2014 changes to the SDP such good news? Because if accepted into this program, the taxpayer is subject to a 5% miscellaneous penalty, instead of a 27.5% miscellaneous penalty under the 2014 OVDP, with
no other penalties imposed (unlike the 2012 OVDP or the 2014 OVDP). The taxpayer would be required to file three years of amended income tax returns and six years of any required FBARs, in addition to paying the 5% miscellaneous
penalty, back-taxes and interest on those years. However, a taxpayer who applies under the SDP is still subject to possible audit by the IRS for any of the years reported under this program. The IRS has stated that taxpayers enrolled
in the SDP may be selected for audit under the existing selection processes applicable to any US tax return and may also be subject to verification procedures in that the accuracy and completeness of submissions may be checked against
information received from banks, financial advisors, and other sources. Thus, the IRS states that returns submitted under the streamlined procedures may be subject to IRS examination, additional civil penalties, and even criminal
liability, if appropriate.
U.S. persons living abroad may also benefit from the SDP (specifically, under the “streamlined foreign offshore procedures”), which also allows those US persons who are non-resident (and who are otherwise eligible) to file three years’ worth of tax returns, six years of FBARS, pay the back-taxes for those years (plus interest), and not be subject to any additional penalty.
2014 OVDP
While the revised SDP has been generally favorable to (and welcomed by) taxpayers, the 2014 OVDP may be seen as the IRS’ attempt to impose significant penalties on those taxpayers who are deemed willful in their non-compliance. The 2014 OVDP imposes a 50% penalty on those taxpayers with accounts held in a financial institution that is under investigation by or cooperating with the IRS or the Department of Justice. These institutions are currently listed on the IRS website. Whether subject to the 50% or 27.5% penalty, taxpayers in the 2014 OVDP will need to produce documentation for all foreign bank accounts regardless of the accounts’ value, as well as pay the penalty amount at the time of applying to the 2014 OVDP (unlike the 2012 OVDP). Those penalties, unlike the SDP, include penalties for failure to file, failure to pay, accuracy, information return, and FBARs (whichever is applicable).
Non-Willful Behavior
Perhaps most importantly, the taxpayer who wishes to apply for the SDP must have acted non-willfully in the taxpayer’s non-compliance and must certify (under penalties of perjury) that the taxpayer acted non-willfully (without intent to violate the law), and since there is little guidance as to what the IRS considers willful, there is some uncertainty as to how the 2014 OVDP and its related SDP will be applied. What we do know is that the IRS has stated that “non-willful conduct is conduct that is due to negligence, inadvertence, or mistake; or conduct that is the result of a good faith misunderstanding of the requirements of the law.” Although the IRS Internal Revenue Manual also explains that “the mere fact that a person checked the wrong box, or no box, on a Schedule B is not sufficient, by itself, to establish willfulness,” in cases under the 2012 OVDP where a taxpayer was contemplating opting out of the penalty regime, the IRS was generally taking the position that checking the “no” box on the question on Form 1040 Schedule B regarding ownership of offshore accounts constituted willfulness by the taxpayer. It is advisable to consult with counsel as to whether a person’s non-compliance would likely constitute willful or non-willful behavior.
Can I Apply for Both?
Since the SDP requires that the taxpayer certify as to nonwillfulness and the IRS upon review can reject such certification can I then enter the OVDP? The answer is no. Except for existing unclosed OVDP cases (see Transitioning From 2014 OVDP To SDP? below), the taxpayer must elect at the onset which program to participate in. A taxpayer who elects the SDP and is rejected cannot then enter the OVDP. It is unclear, however, what will happen to such taxpayer: will the IRS impose a 50% per year account penalty on FBAR failures or merely the $10,000 per year penalty for each offshore reporting failure?
If Eligible, is SDP for Everyone?
Even if eligible, the SDP may not be preferable over the OVDP for taxpayers who have extensive transactions involving foreign passive investment companies (“PFICs”). The taxation of PFICs is complicated and particularly onerous for taxpayers who have not made a mark-to-market or qualifying electing fund election. Taxpayers who participate in the OVDP are provided with a special simplified PFIC reporting regime for the amended return years covered by the OVDP which eliminates the interest charge on deferred taxes (except for a 7% charge in the first year) and reduces the tax rate from the maximum marginal ordinary income rate to the long term capital gain rate. Since taxpayers participating in the SDP merely amend the last three years of tax returns, such taxpayers are not eligible for the special PFIC reporting regime, although it is available to those who transition from the 2012 (or prior) OVDP to the SDP (see below).
Transitioning From 2014 OVDP To SDP?
A taxpayer who is under audit or has been contacted [1] by the IRS or government as to the taxpayer’s non-compliance may not participate in either the 2014 OVDP or the SDP. However, those taxpayers who have been accepted into the 2012 (or prior) OVDP (not including pre-clearance), are currently participating in the OVDP and have not yet received a Form 906 Closing Agreement may request to transition to the SDP. Before transitional treatment is given, the IRS must agree that the taxpayer is eligible for transitional treatment and must agree that the available information is consistent with the taxpayer’s certification of non-willful conduct. The taxpayer must also comply with submitting all documents requested under the applicable OVDP, certify to the taxpayer’s non-willfulness, and pay all tax, interest and penalties (other than the miscellaneous penalty) before transition treatment is granted. Each request for transitional treatment will be reviewed to determine whether the taxpayer is eligible for transitional treatment, the taxpayer’s certification of non-willfulness is complete, and the available information is consistent with the certification. If the IRS does not agree that the taxpayer is entitled to transitional treatment, the case remains governed by the terms of the OVDP in which the taxpayer is participating. If transition to the SDP is granted by the IRS, the taxpayer will be subject to a 5% miscellaneous penalty, rather than the OVDP’s miscellaneous penalty, for the prior six years, and must pay all unpaid taxes, interest and all other applicable penalties for the eight year period covered under the OVDP. Even with transition, the taxpayer must still execute a Form 906 Closing Agreement with the IRS. The alternative “MTM” PFIC method will continue to be available if a taxpayer transitions to the SDP.
[1] “Once the Service or the Department of Justice obtains information under a John Doe summons, treaty request or other similar action that provides evidence of a specific taxpayer's noncompliance with the tax laws or Title 31 reporting requirements, that particular taxpayer will become ineligible for OVDP and Criminal Investigation's Voluntary Disclosure Practice” FAQ 21, 2012 OVDP Frequently Asked Questions and Answers.
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