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Foreign Income & Taxpayers
Since 2009, the IRS has offered several formal offshore voluntary disclosure programs or initiatives. These programs have allowed qualifying taxpayers with previously undisclosed foreign accounts and assets to come forward and voluntarily disclose those accounts and assets in exchange for reduced penalty exposure and a promise that the IRS will not refer the taxpayers for criminal investigation. The Service announced in January that the current version of the program would remain open indefinitely.
In June 2014, the IRS announced several major changes to the Offshore Voluntary Disclosure Program (OVDP), including increasing the offshore penalty from 27.5% to 50% for certain accounts. At the same time, the IRS expanded its streamlined filing compliance procedures, which offer an alternative (and generally less expensive) route to disclosure for those taxpayers willing and able to certify that their failure to report the foreign assets and pay any resulting tax was not willful.
As part of its June 2014 announcements, the IRS clarified that it now offers four general options for taxpayers to address their prior failures to comply with U.S. tax-and-information-reporting obligations for foreign assets:
- The OVDP;
- Streamlined filing compliance procedures;
- Delinquent Report of Foreign Bank and Financial Accounts (FBAR, FinCEN Form 114) submission procedures; and
- Delinquent international information return submission procedures.
This item provides a synopsis of the steps and procedures involved in initiating and completing a successful voluntary disclosure through the OVDP. While the other options and procedures available to a taxpayer with previously undisclosed foreign assets should be considered (depending on the taxpayer’s circumstances), those initiatives’ procedures are beyond the scope of this item.
Qualifying for the OVDP
The OVDP is available to taxpayers who truthfully, timely, and fully disclose to the IRS the existence of their previously undisclosed funds from legal sources held in foreign jurisdictions, and who otherwise cooperate with the IRS. This cooperation includes making good-faith arrangements to satisfy the tax, interest, and penalties determined to apply.
Timeliness is important in evaluating whether a taxpayer qualifies to make a disclosure through the OVDP. For example, under Internal Revenue Manual Section 126.96.36.199, paragraph 4.A, a disclosure is not timely if the IRS has already initiated a civil examination or criminal investigation of the taxpayer or has notified the taxpayer that it intends to begin an examination or investigation. A disclosure is also not timely if the IRS has already received information from a third party (e.g., informant, other governmental agency, or the media) alerting it to the specific taxpayer’s noncompliance, or if it has acquired information directly related to the taxpayer’s specific liability from a criminal enforcement action (e.g., a search warrant or a grand jury subpoena).
Penalties for Noncompliant Taxpayers
Taxpayers with undisclosed foreign accounts and assets face a wide range of potential penalties for noncompliance with reporting obligations, depending on the circumstances. For instance, U.S. citizens, residents, and certain other persons must annually report their direct or indirect interest in, or signatory or other authority over, financial accounts in foreign countries if the aggregate value of the accounts exceeds $10,000, by filing an FBAR. Willful failure to file an FBAR can subject a taxpayer to a civil penalty equal to the greater of $100,000 or 50% of the total balance of the account for each year that the taxpayer willfully failed to file the form. For some taxpayers, the potential penalty can exceed the balance in the account. Criminal penalties may also apply, including imprisonment for up to 10 years and a fine of up to $500,000.
Other common potential civil penalties in this context include penalties for failing to file a tax return, accuracy-related penalties, and fraud penalties, as well as penalties for a failure to file:
- Form 8938, Statement of Specified Foreign Financial Assets;
- Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts;
- Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner (Under Section 6048(b));
- Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations;
- Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business;
- Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation; and
- Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships.
Taxpayers could also face a number of criminal charges, including for tax evasion, filing a false return, and failure to file an income tax return.
OVDP Penalty Structure
Taxpayers participating in the OVDP avoid the laundry list of potential penalties described above and, instead, submit to a standard, uniform penalty structure administered through the OVDP. Under the current OVDP, participating taxpayers generally agree to pay an “offshore penalty” equal to 27.5% of the highest year’s aggregate value of “OVDP assets” during a period that covers the past eight years, along with any applicable failure-to-file, failure-to-pay, and accuracy-related penalties.
Notably, however, the penalty is increased to 50% for certain taxpayers. The increased penalty applies to those taxpayers with undisclosed foreign financial accounts that are held at a foreign financial institution (FFI) (or that were established or maintained by a facilitator) that has been publicly identified as (1) being under investigation by the IRS or U.S. Department of Justice in connection with accounts that are beneficially owned by a U.S. person, (2) cooperating with the government in connection with those accounts, or (3) being named in a court-approved summons seeking information about those accounts. The IRS has published a list of FFIs and facilitators that it has identified as meeting these criteria. (The list is available at www.irs.gov.) While the list is not exhaustive, a tax practitioner can refer to it to gauge a taxpayer’s potential exposure under the OVDP.
How to Make a Voluntary Disclosure
Once a taxpayer decides to make a voluntary disclosure through the OVDP, four steps must generally be taken to complete a successful disclosure: (1) a preclearance request; (2) submission of the offshore voluntary disclosure letter and attachments; (3) completion of the voluntary disclosure submission; and (4) execution of a closing agreement. After completing the first three steps, the taxpayer may still decide to “opt out” of the uniform penalty structure and submit his or her case to the standard audit process.
Before making a voluntary disclosure, a taxpayer’s representative should generally first submit a preclearance request to determine whether the taxpayer is eligible for the OVDP. While obtaining preclearance is not a required step and does not guarantee acceptance into the OVDP, it helps mitigate the risk that a taxpayer, in attempting to enter the program, will make substantial incriminating admissions only to find out that he or she was not eligible for the program in the first place.
To obtain a preclearance, the representative submits the taxpayer’s name, date of birth, Social Security number, address, and telephone number, along with identifying information for the financial institutions and foreign and domestic entities (other than those traded on a public stock exchange) at issue, to the IRS Criminal Investigation Lead Development Center. The IRS will subsequently notify the representative—generally within 30 days—whether the taxpayer has been precleared to make a voluntary disclosure.
Offshore Voluntary Disclosure Letter
Once a taxpayer obtains preclearance to enter the OVDP, the next step is to submit Form 14457, Offshore Voluntary Disclosure Letter. The taxpayer should also submit a Form 14454, Attachment to Offshore Voluntary Disclosure Letter, for each financial institution at which an account is being disclosed. These forms are submitted to the IRS’s voluntary disclosure coordinator in accordance with the preclearance notification and require the taxpayer to disclose, among other things, information about the taxpayer’s eligibility for the program, the source of the funds, the FFI and the taxpayer’s interaction with that institution, and an estimate of the value of the funds and associated unreported income.
Once this information has been submitted, IRS Criminal Investigation reviews the offshore voluntary disclosure letter and attachments and notifies the taxpayer or representative whether the voluntary disclosure has been preliminarily accepted as timely or declined.
Voluntary Disclosure Submission Package
If a taxpayer’s disclosure is preliminarily accepted, the taxpayer must next complete the voluntary disclosure submission package and cooperate with the IRS in resolving the matter. The voluntary disclosure submission package must include the following:
- Copies of previously filed original and amended tax returns for the years covered by the voluntary disclosure;
- Complete and accurate amended or original tax returns for the years covered by the voluntary disclosure, along with schedules detailing the amount and type of previously unreported income;
- A copy of the previously submitted offshore voluntary disclosure letter;
- A completed foreign account or asset statement for each previously undisclosed OVDP asset during the voluntary disclosure period;
- A penalty calculation worksheet;
- Signed agreements to extend the period of time to assess tax, tax penalties, and FBAR penalties;
- Copies of filed FBARs; and
- Copies of statements for all financial accounts for each tax year covered by the voluntary disclosure.
Additional disclosures may be required for those taxpayers disclosing a foreign entity or for disclosures that involve estate or gift tax issues or certain other circumstances.
The disclosing taxpayer is also required to separately submit payment to Treasury for the total amount of tax, interest, offshore penalty, accuracy-related penalty, and any failure-to-file and failure-to-pay penalties for the voluntary disclosure period. However, those taxpayers who cannot pay the total amount of tax, interest, and penalties should, instead, submit a proposed payment arrangement and a completed collection information statement (Form 433-A, Collection Information Statement for Wage Earners and Self-Employed Individuals, or 433-B, Collection Information Statement for Businesses, as appropriate).
Once the taxpayer has submitted the voluntary disclosure package, he or she must cooperate with the assigned IRS examiner on any follow-up questions or requests for information. The examiner determines whether the voluntary disclosure is correct, accurate, and complete and verifies the tax, interest, and civil penalties owed.
As the final step, once the IRS completes its review, the examiner presents the taxpayer with a Form 906, Closing Agreement on Final Determination Covering Specific Matters, memorializing the terms of the disclosure. The taxpayer’s execution of the closing agreement completes the voluntary disclosure if the taxpayer has satisfied his or her other obligations under the program.
Some taxpayers, however, may be unwilling to agree to the uniform penalty under the OVDP set forth in the proposed closing agreement. If the offshore penalty is unacceptable to a taxpayer, that taxpayer, at this point, may make an irrevocable election to “opt out” of the OVDP’s penalty structure and submit his or her case to the standard audit process for a determination of the appropriate penalty, if any. Taxpayers who opt out of the civil settlement structure remain in the IRS’s voluntary disclosure practice, and thus maintain protection against criminal referral so long as they continue to fully cooperate. However, those taxpayers forgo the certainty of the uniform penalty structure and, although they are free to argue for a lower penalty, run the risk that a higher penalty may ultimately apply.
Taxpayers with undisclosed foreign assets now may have several options available to address prior compliance failures. The OVDP is available to taxpayers who truthfully, timely, and completely disclose those assets and otherwise cooperate with the IRS. Using the procedures outlined above, taxpayers could benefit from reduced penalty exposure and a promise that the IRS will not refer the taxpayer for criminal investigation.
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