Offshore Voluntary Disclosure Initiative: Time is of the Essence

Peter D. Anderson
Director, Litigation Department
Richard M. Stone
Of Counsel, Tax Department
Published: NH Society of CPAs' newsletter and MA Society of CPAs' SumNews
March 25, 2013

Since 2009, the IRS has been offering taxpayers with undisclosed foreign financial accounts the opportunity to “come clean” under its Offshore Voluntary Disclosure Initiative (OVDI), and thousands of individuals have done so. The OVDI program has been slightly revised over the last three years, but it basically allows taxpayers who are not under audit or criminal investigation, and who are not on IRS lists of offshore account holders (obtained from foreign banks), the opportunity to gain clearance from criminal prosecution and civil penalties by paying a one-time FBAR penalty based on the foreign account balances, and accuracy and failure to file penalties based on the tax underpayment for the prior 8 years.

The IRS explains why it thinks that a voluntary disclosure should be made:

Taxpayers with undisclosed foreign accounts or entities should make a voluntary disclosure because it enables them to become compliant, avoid substantial civil penalties and generally eliminate the risk of criminal prosecution. Making a voluntary disclosure also provides the opportunity to calculate, with a reasonable degree of certainty, the total cost of resolving all offshore tax issues. Taxpayers who do not submit a voluntary disclosure run the risk of detection by the IRS and the imposition of substantial penalties, including the fraud penalty and foreign information return penalties, and an increased risk of criminal prosecution.  The IRS remains actively engaged in ferreting out the identities of those with undisclosed foreign accounts. Moreover, increasingly this information is available to the IRS under tax treaties, through submissions by whistleblowers, and will become more available as the Foreign Account Tax Compliance Act (FATCA) and Foreign Financial Asset Reporting (new IRC §6038D) become effective.

The “increased risk” that the IRS refers to is dramatic, as thousands of names are being disclosed to the IRS by foreign banks and cooperating tax authorities. The IRS is using these lists for both criminal prosecutions and civil audits and is aggressively pursuing information exchange agreements with other countries.

For calendar year taxpayers the voluntary disclosure period is the most recent 8 tax years for which the due date has already passed. The OVDI disclosure is made by filing both the original returns and amended returns for the prior 8 years that report all income and disclose the foreign accounts, file all missing FBAR reports, cooperate fully in the OVDI process, sign agreements to extend the statutes of limitations, pay a penalty of 27.5% (reduced in only very limited cases) of the accounts’ highest balance over the 8 year period, pay a 20% accuracy penalty based on the total underpayment for the 8 years, pay failure to pay penalties, and pay failure to file penalties, if appropriate.

The filing package is submitted to the IRS after a preliminary determination is made that the taxpayer is eligible for the program. Several months after the package is submitted, the IRS will contact the taxpayer or the representative and let them know if additional information is required. When all information has been submitted by the taxpayer, the IRS will issue its proposal and request that the taxpayer agree.

If the taxpayer agrees with the IRS conclusions, and pays the appropriate amount due, the case is closed and no further civil or criminal penalties will be assessed for the foreign accounts unless the taxpayer has failed to fully disclose all relevant information.

If the taxpayer does not agree with the IRS conclusions, “opting out” of the program is an option.  An opt out means that the taxpayer rejects the IRS penalty proposal. If the taxpayer decides to do this and notifies the IRS in writing, then a letter is sent by the IRS accepting the opt out decision and stating that the opt out is irrevocable. That letter requests that the taxpayer submit a proposed penalty that the taxpayer is willing to pay. If the IRS agrees to the proposal, the matter will be settled. If not, a full audit of the taxpayer’s returns for the 8 years will occur, and if any information is discovered that is inconsistent with the prior OVDI submissions by the taxpayer, criminal proceedings could be initiated. Also, civil FBAR penalties far in excess of the OVDI penalties can be assessed.

The OVDI program is evolving and has many critics. Many innocent taxpayers are being targeted and forced to pay large penalties for minor infractions in order to resolve their potential tax liability. However, the IRS has had tremendous success in raising revenue—as of June 2012, it collected more than $5 billion in back taxes, interest and penalties from 33,000 voluntary disclosures made under the first two programs in 2009 and 2011.

The OVDI program can end at any time determined by the IRS, but considering its success, practitioners expect it to continue for the next several years.

From the perspective of practitioners with clients having undisclosed foreign financial accounts, the OVDI program makes sense in most cases. 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).

Many clients are indecisive and apprehensive about making a voluntary disclosure in view of the hefty penalties imposed by the OVDI. Some clients are willing to “take their chances” and avoid entering the OVDI. For these clients, it is important to make them aware of the IRS enforcement initiatives.

The Government has launched investigations of foreign banks which have resulted in disclosures of account holder information to the IRS. The Government has also been actively pursuing treaty requests with countries with which the United States has tax treaties.  Finally, the Government has at its disposal the recently enacted Foreign Account Tax Compliance Act (FATCA). 26 U.S.C.§1471, et seq. While the intricacies of FATCA are beyond the scope of this article, it represents a major enforcement tool for the Government. FATCA was signed into law in 2010 and already the United States has agreements with France, Spain, Germany, Italy, the United Kingdom and Switzerland to implement information exchange regarding foreign accounts. As of this writing, the Government is aggressively pursuing agreements with other countries.

The foregoing Government enforcement initiatives make it much more likely that the IRS will become aware of undeclared foreign accounts of U.S. taxpayers. Once the IRS is aware of undeclared foreign account information, the OVDI is no longer an option available to a client and much more severe penalties, civil and/or criminal, will likely be imposed.