Recently, many tax return preparers have learned that a number of their clients failed to report their interest in a foreign bank account, corporation or trust to the IRS. Because the Foreign Account Tax Compliance Act (FATCA) requires foreign financial institutions to report their U.S. depositors to the IRS, the IRS is more likely to discover nonreporting taxpayers. Furthermore, in light of more stringent reporting requirements, recent publicity and IRS enforcement action focused on nonreporters of foreign assets, all tax preparers should ask their clients whether they have failed to report foreign assets to the IRS.
When a practitioner learns of a client’s unreported foreign assets, what should he or she do?
A taxpayer who has failed to report his or her foreign assets has four general options. The first option is to do nothing. This is not a good choice because by willfully failing to report foreign assets every April 15 or June 30 (the deadline for filing a Report of Foreign Bank and Financial Authority, or FBAR), the taxpayer will be continually noncomplaint and subject to criminal penalties. If a client decides not to report his foreign assets, the practitioner must fire the client because he cannot knowingly prepare inaccurate returns.
A second option is to leave past noncompliance unresolved, but file accurate returns going forward. Because a taxpayer who discovers that her prior returns were not accurate does not have a legal obligation to file amended returns, she can simply file accurate returns prospectively. In this situation, a tax practitioner can prepare those returns for the client. While a tax practitioner has an ethical obligation to advise the client to file amended returns, the ultimate decision belongs to the client. The practitioner should advise the client of the consequences of filing and not filing amended returns. A key part of this advice is the fact that the IRS audits past years’ returns— not future returns. Thus, filing accurate current and future year returns will do nothing to mitigate past noncompliance. Additionally, a decision not to amend prior years’ returns leaves the taxpayer exposed to huge civil penalties, or even criminal prosecution, if the IRS discovers the past noncompliance.
A third option is to simply file accurate amended returns with the IRS Service Center, together with the payment of delinquent tax and interest. Some practitioners refer to this technique as a “quiet disclosure.” Doing so will at least correct past noncompliance, with the benefit of not requiring the taxpayer to voluntarily pay huge penalties. On the other hand, this option does not protect the taxpayer against criminal prosecution or the proposed assessment of large civil penalties in the event of an IRS audit of the quietly filed returns. In addition, filing amended returns reporting income from foreign assets increases the chance of an IRS audit that may ultimately result in the aforementioned criminal prosecution and significant penalties.
A fourth option is voluntary disclosure by the taxpayer. A voluntary disclosure is a way of filing amended returns and paying delinquent taxes that expressly notifies the IRS that the taxpayer is self-reporting noncompliance. A voluntary disclosure provides the taxpayer with certain protections in exchange for expressly addressing his noncompliance with the IRS. For several decades, the IRS has implemented various types of voluntary disclosure policies.
These policies covered all types of noncompliance including domestic noncompliance such as failing to report cash receipts or claiming phony deductions as well as failing to report foreign assets. More recently, the IRS has created special voluntary disclosure programs to deal with unreported foreign assets.
Offshore Voluntary Disclosure Program
The Offshore Voluntary Disclosure Program (OVDP) is the most recent voluntary disclosure program for unreported foreign assets. (See www.irs.gov/uac/2012- Offshore-Voluntary-Disclosure-Program.)
The program provides the following benefits to qualifying taxpayers:
• Protection against criminal prosecution
• A limited look-back period of eight years
• Limited civil penalties.
To qualify, the taxpayer must meet the following conditions:
1) the disclosure must be timely, i.e., prior to the commencement of an IRS audit or investigation of the taxpayer
2) the unreported income and/or assets must be derived from legal sources
3) the disclosure and any related amended returns must be complete and truthful
4) the taxpayer must pay, or make good faith arrangements to pay, any tax, penalties and interest determined to be due.
(See www.irs. gov/Individuals/International-Taxpayers/ Offshore-Voluntary-Disclosure-ProgramFrequently-Asked-Questions-andAnswers-2012-Revised.)
The benefit of the OVDP is certainty. In the end, the amount of tax, penalty and interest will be ascertained and the underlying problem will be resolved, once and for all, with no risk of criminal prosecution. Conversely, the detriment of the OVDP is the cost of filing eight years’ worth of amended returns, paying the underlying tax, a penalty equal to 20 percent of the unpaid tax, plus interest on the tax and penalty. In addition, the taxpayer must pay a miscellaneous penalty equal to 27.5 percent of the amount of the unreported foreign accounts plus certain other foreign assets related to the tax noncompliance. If the taxpayer’s unreported foreign accounts were held in a financial institution identified by the government as being involved in offshore tax evasion, the penalty can increase to 50 percent. (For the current list of such institutions, see http://www.irs.gov/Businesses/InternationalBusinesses/Foreign-Financial-Institutionsor-Facilitators.)
Over time, the IRS realized that there were many innocent taxpayers with unreported foreign assets who wanted to correct their prior noncompliance but did not want to pay the relatively large penalties associated with the OVDP. OVDP penalties are intentionally large because, in exchange for participating in the OVDP, the taxpayer is protected from criminal prosecution, as well as much larger civil penalties based on the willful failure to report foreign assets. However, there are millions of taxpayers—most of them living abroad—who really have no idea that foreign assets and income are reportable to the IRS. To encourage these “nonwillful” taxpayers to become compliant, the IRS created streamlined disclosure procedures as a way for these innocent taxpayers to report previously undisclosed foreign assets and income.
The two types of streamlined disclosure procedures are the Streamlined Foreign Offshore Procedures and the Streamlined Domestic Offshore Procedures. Both are considerably more lenient than the OVDP because the former procedure imposes no penalties and the latter procedure imposes only a 5 percent penalty. Because neither procedure is part of the OVDP, however, they provide no protection against criminal investigation or the huge willful FBAR penalties. This is because streamlined procedures are not for taxpayers who willfully failed to report foreign assets. In fact, to qualify for either streamlined procedure, a taxpayer must certify under penalty of perjury that he or she did not willfully fail to report the foreign assets or income.
To participate in the Streamlined Foreign Offshore Procedures, a taxpayer must meet the nonresidency requirement and provide the required nonwillful certification. A taxpayer meets the nonresidency requirement, if, in any of the preceding three years, the taxpayer did not 1) have a place of abode in the United States and 2) physically spend more than 35 days in this country. A qualifying taxpayer can participate in the streamlined procedures by filing original or amended tax returns for the preceding three years, and original or amended FBARs for the preceding six years. The taxpayer’s liability is limited to the resulting tax and interest, with no penalties imposed. (See www.irs.gov/Individuals/InternationalTaxpayers/U-S-Taxpayers-ResidingOutside-the-United-States.)
If a taxpayer does not meet the nonresidency requirement, the Streamlined Domestic Offshore Procedures are available to taxpayers who live in the United States, have an abode in United States or spend a significant amount of time in this country. These procedures, however, are not available to taxpayers who have not filed U.S. tax returns—considered to be domestic noncompliance—because they apply only to taxpayers with foreign asset-related noncompliance. A qualifying taxpayer must file amended income tax returns for the preceding three years, and original or amended FBARs for the preceding six years. In addition to the tax and interest triggered by the foreign asset income, the taxpayer must pay a miscellaneous penalty equal to 5 percent of any foreign asset (i.e., a bank account) that was not properly reported on the original returns. (See http://www.irs. gov/Individuals/International-Taxpayers/ U-S-Taxpayers-Residing-in-the-UnitedStates.)
Ultimately, the taxpayer’s best option depends on whether he or she willfully failed to report the foreign assets. A truly innocent taxpayer who did not willfully fail to report foreign assets may qualify for one of the streamlined programs and pay little or no penalties.
Bryan C. Skarlatos, Esq., LL.M. (Taxation), represents clients in tax audits, civil tax litigation, sensitive tax issues, criminal tax investigations, voluntary disclosures and IRS whistleblower matters. He is also an adjunct professor at New York University School of Law, where he teaches a course on tax penalties.
Article taken from Trusted Professional May 2015. This story originally appeared in the Tax Stringer, the NYSSCPA’s electronic tax newsletter. To sign up for this free membersonly publication, go to nysscpa.org.