Some time ago, the Internal Revenue Service (IRS) announced a second Offshore Voluntary Disclosure Program (OVDI) for U.S. taxpayers with unreported foreign income or financial accounts. The OVDI eliminates potential criminal penalties for individuals with previously undisclosed foreign accounts. The catch is that the OVDI comes with a very steep price. Besides being subject to various penalties on not previously disclosing foreign source income, individuals participating in the OVDI must pay a penalty equal to 25 percent of the highest aggregate balance of their foreign accounts since the 2003 tax year. This is a very steep price to pay indeed. For those who willfully established foreign accounts offshore in the hope to avoid paying U.S. federal income taxes, the OVDI is a very fair program because it allows them to opportunity to avoid criminal prosecution with potential lengthy prison sentences. However, for those who mistakenly failed to disclose their foreign accounts, the OVDI may not be necessary and they could be subject to unnecessarily paying steep penalties. This is not to say that these individuals do not need to disclose their previously undisclosed foreign accounts to the IRS, however, these individuals may not need to enroll in the OVDI.

The Current Laws Governing the Disclosure of Foreign Accounts

U.S. taxpayers with foreign bank or financial accounts (totaling more than $10,000 at any time of the year) are required to file a Report of Foreign Bank and Financial Accounts (FBAR) by June 30, 2011 of the following year in which the account was held. (The FBAR must be received by the IRS by June 30 of the following year). When a taxpayer calculates the highest balance during the year, he or she must use the applicable exchange rate on the last day of the calendar year.

Almost every type of foreign financial account in which a taxpayer has signature authority must be disclosed. This includes annuities and life insurance products. In addition, as a general rule, U.S. citizens and residents are taxed on and must report all foreign income received from the foreign accounts.

The Basics of the 2011 OVDI

The 2011 OVDI program provides that participants will be subject to a penalty of 25 percent of the highest aggregate amount in all foreign accounts that they had a financial interest from the 2003 through 2010 tax years. However, in some cases the penalty is reduced to 5 or 12.5 percent.

Participants of the OVDI may only be subject to a reduced 5 percent penalty for accounts not opened by the participant. In addition, the taxpayer must have only had a minimal contact with the account. Minimal contact means that the taxpayer had withdrawn no more than $1,000 per year, and there was no untaxed principle in the account. Nonresidents who paid taxes in their foreign country and earned less than $10,000 of U.S. source income may also be eligible for the 5 percent penalty.

Participants of the OVDI may be subject to a reduced 12.5 percent penalty if the aggregate value of their previously undisclosed foreign accounts did not exceed $75,000 for the 2003 through 2010 tax years.

OVDI participants must file all 2003 through 2010 tax returns or amended tax returns by August 31, 2011. Participants must also pay all back federal taxes and interest on previously undisclosed foreign source income. Participants must also pay an accuracy related penalty of 20 percent of the outstanding tax liability. In addition, participants will be liability to pay delinquency penalties for failure to timely pay taxes which could reach as high as 25 percent of the tax liability owed per year.

When Participation in the OVDI is not Necessary

Participation in the OVDI may not be necessary if all foreign income had been previously reported on U.S. tax returns or foreign income is not reportable on a U.S. tax return, but FBARS have not been filed. In these cases, as long as all back FBAR returns are filed with the IRS by August 31, 2011, the IRS will not likely seek to impose a penalty for failing to timely disclose foreign bank accounts. However, a detailed statement advising the IRS why the FBAR returns were not timely filed must accompany the returns. This exception applies in cases where a Form 3520 was not timely filed. Form 3520 must be filed with the IRS when U.S. taxpayers received distributions from foreign trusts, foreign inheritances, or gifts.

Situations in which foreign income is earned, but is not reportable income on a U.S. tax return can be tricky. Examples were foreign income does not result in U.S. taxation are as follows:

  • A taxpayer establishes a foreign account in which the foreign government does not permit the individual to remove the funds for an extended period of time. These financial accounts are commonly referred to as blocked accounts;
  • If a U.S. taxpayer is also a citizen of a foreign country. The foreign country in which the U.S. taxpayer resides or resided provides for the deferral of income through a retirement plan. Income placed in such a retirement plan is not subject to taxation when placed in the plan or during the life of the retirement plan and the plan is treated similar to a U.S. Individual Retirement Account or 401(k) plan. If there is a provision under a tax treaty between the United States and the foreign country in which the plan was established the income generated within the plan may be deferred from U.S. taxation;
  • The U.S. taxpayer has a joint account with a foreign alien and the account is located in a foreign country. All the assets belonging in the account were provided by the alien.

Above is a partial list in cases in which foreign source income derived from a foreign account may not be subject to U.S. taxation. It should be noted that just because foreign source income may not be taxable in the U.S., this does not mean that these sources of income should be excluded from a U.S. tax return. On the contrary, these sources of income must be reported on a U.S. tax return and a disclosure must accompany the tax return with an explanation as to why the foreign source income is excludable from U.S. taxation.

Can the IRS Automatically Assess a Penalty against a U.S. Taxpayer who Innocently or Mistakenly Failed to Disclose a Foreign Bank Account?

We discussed above the exception to participation in the OVDI program in cases where a U.S. taxpayer reported foreign source income or had foreign source income that was not subject to U.S. taxation. But what about cases where a U.S. taxpayer innocently or mistakenly failed to disclose a foreign account and mistakenly failed to report foreign source income? Is such a taxpayer doomed to pay the 25 percent OVDI penalty? And if this taxpayer does not participate in the OVDI, is this taxpayer subject to the more serious willful failure to report a foreign account penalty? The willful failure to disclose a foreign account penalty provides that a taxpayer could be penalized for 50 percent of the value of the undisclosed foreign account per year of omission. The statute of limitations on this penalty is six years. This means that the IRS could in theory assess a penalty that is three times the value of the foreign account or accounts against a U.S. taxpayer.

Before we begin our discussion on this matter, it is important for all our readers to understand that the 50 percent penalty for willfully failing to disclose a foreign account is not automatic. If a U.S. taxpayer innocently or mistakenly failed to properly disclose a foreign account, the maximum penalty is $10,000 per year starting in 2005, and there is a reasonable cause exception to remove or abate this penalty.

If a U.S. taxpayer deliberately established a foreign account to evade U.S. taxes, he or she could be subject to the 50 percent willful penalty or year. In order to avoid this draconian penalty, the taxpayer should elect to participate in the 2011 OVDI immediately. In other cases, whether a taxpayer chooses to apply for the OVDI may depend on whether there has been a willful violation of the law with respect to the non-filing of FBARS or failure to disclose and pay taxes on the foreign income. The decision on whether a taxpayer should or should not participate in the OVDI should be predicated for the most part on whether the failure to disclose the foreign account or accounts can be classified as willful.

Willful is a legal concept, one which requires an affirmative act to evade or avoid a known legal requirement. Inadvertence negligence is not willfulness. In a recent case, United States v. Williams, 2010 Dist (ED VA 2010), a taxpayer sent $7.0 million to a Swiss bank account, checked the box “no” on Schedule B of Form 1040 stating that he did not have an interest in a foreign bank account. The taxpayer pled guilty to one count of tax fraud. The IRS claimed the taxpayer willfully violated the FBAR filing requirement and attempted to assess the 50 percent penalty. The court disagreed.

The court stated the willfulness meant a knowing or reckless violation of a standard, not just a couple instances of inadvertent neglect. The lesson to be learned from Williams is the failure to report a foreign account does not necessarily mean a taxpayer will be subject to the 50 willful penalty even if the taxpayer specifically checked a box on a tax return denying the existence of a foreign account. The decision in Williams represents an important first step toward imposing discipline to a government seeking to wrongful extract money from hardworking U.S. citizens who established or inherited foreign accounts and did not know of the requirements to disclose the account. Williams offers important protections for these individuals. Now since the IRS can no longer simply assess a 50 percent penalty against taxpayers for merely not disclosing a foreign bank account, in certain cases it may not make much sense to participate in the OVDI.

The decision as to whether an individual should participate in the OVDI is difficult. The individual should seek the assistance of a qualified attorney who can assist the individual in this process. In any case, whether or not the individual decides to enroll in the 2011 OVDI, the individual must amend his or her tax returns and report any previously undisclosed income. The returns should not merely be filed with the IRS, but in cases where the individual decides against participating in the program, this individual should request a traditional voluntary disclosure through a local IRS criminal investigation division. The disclosure should report all foreign source income that was previously omitted and a detailed written statement as to why all applicable FBAR or offshore penalties should not be assessed. Finally, the U.S. taxpayer making such a disclosure should be prepared to immediately satisfy all tax, interest, and penalties from the failure to disclose foreign source income. Remember, the Williams case offers a compelling defense against penalties associated with not disclosing a foreign account. However, Williams does not excuse a U.S. taxpayer from disclosing foreign source income that is required to be disclosed and paying all applicable tax on the previously undisclosed income.

Also see, Offshore Banking, PFIC

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