The Internal Revenue Service (IRS) announced a recent third Offshore Voluntary Disclosure Program (OVDP) for U.S. taxpayers with unreported foreign income or financial accounts. The OVDP eliminates potential criminal penalties and greatly reduces the civil (monetary) penalties for U.S. taxpayers with previously undisclosed foreign income and assets. In most cases, U.S. taxpayers participating in the OVDP must pay a penalty equal to 27.5 percent of the highest aggregate balance of their foreign assets since the 2003 tax year. For those who mistakenly failed to disclose their foreign assets, the OVDP may not be necessary and they could be subject to unnecessarily paying 27.5%. This is not to say that these individuals do not need to disclose their previously undisclosed foreign income and assets to the IRS; however, these individuals may be able to get the benefits of OVDP without paying the 27.5%.
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 30th of the following year in which the account was held. 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 certain 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. A U.S. taxpayer may even have a filing requirement for foreign accounts in which he does not have a personal beneficial interest in the account. For example, a U.S. taxpayer serving as a power of attorney, nominee, or agent or an employee with signature authority on a foreign account could have a filing obligation.
The Basics of the 2012 OVDP
The 2012 OVDP program provides that participants will be subject to a penalty of 27.5 percent of the highest aggregate amount in all foreign accounts in which they had a financial interest from the 2003 through 2011 tax years. However, in some cases the penalty is reduced to 5 or 12.5 percent.
Participants of the OVDP 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. 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 OVDP 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 2011 tax years.
OVDP participants must file all 2003 through 2011 tax returns or amended tax returns. 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 liable 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 OVDP is not Necessary
Participation in the OVDP 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 delinquent FBAR returns are filed with the IRS, the IRS will not likely seek to impose a penalty for failing to timely disclose the foreign bank accounts. However, a persuasive argument must be made convincing the IRS why the FBAR returns were not timely filed. This exception also applies in cases where a Form 3520 annual return to report transactions with foreign trusts and receipt of certain foreign gifts was not timely filed. Form 3520 must be filed with the IRS when U.S. taxpayers received distributions from foreign trusts, foreign inheritances, or certain foreign 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 may 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.” In such cases, the IRS may defer foreign source income accrued in such account until it is paid to the U.S. taxpayer;
- A U.S. taxpayer resides, or resided, in a foreign country. While the U.S. taxpayer resided in a foreign jurisdiction he or she participated in a foreign pension trust that is considered to be a qualified plan for U.S. tax purposes. If the United States had a tax treaty in place with the foreign jurisdiction where the trust was located and the tax treaty contains language that provides relief with respect to the earnings of the pension trust, such treaty language may present a barrier to U.S. taxation in regards to distributions received from the foreign trust;
- 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. In such a case, a position could be taken that the foreign source taxable income should be assigned to the foreign alien and not the U.S. taxpayer.
Above is a partial listing of 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 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?
Above, we discussed an important exception to participation in the OVDP program. 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 27.5 percent OVDP penalty? And if this taxpayer does not participate in the OVDP, 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 the greater of 50 percent of the value of the undisclosed foreign account per year of omission or $100,000 for each year of omission.
Before we begin our discussion on this matter, it is important for all our readers to understand that the 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, per account. However, this penalty can be removed or abated for reasonable cause.
If a U.S. taxpayer deliberately established a foreign account to evade U.S. taxes, he or she could be subject to the willful penalty and harsh criminal penalties which include the possibility of a long prison sentence. In order to avoid these draconian penalties, U.S. taxpayers who established an undisclosed foreign bank account to avoid paying U.S. taxes and did not previously disclose the account should consider participation in the 2012 OVDP. In other cases, where a U.S. taxpayer has an undisclosed foreign account or accounts but the account(s) were not established to evade U.S. taxes, whether a taxpayer chooses to enroll in the 2012 OVDP may depend on a number of factors. By far, the most important factor to consider is whether the previously undisclosed accounts can be classified as “willful.” The test for willfulness is whether there was a voluntary, intentional violation of a known legal duty.
Willful is a legal concept, one which requires an affirmative act to evade or avoid a known legal requirement. Inadvertent negligence is not willfulness. In a recent case, United States v. Williams, 2010 Dist (ED VA 2010), a taxpayer sent $7 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 a willful penalty. The trial court disagreed that the Government’s case showed beyond a preponderance of the evidence standard that Williams’ conduct was willful.
The court stated the willfulness meant a knowing or reckless violation of a standard, not just a couple of 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 harsh 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 wrongfully extract money from U.S. taxpayers who established or inherited foreign accounts and did not know of the requirements to disclose the account. The government has appealed and the case is tentatively calendared for argument March 20 – 23, 2012 before the Court of Appeals.
The decision as to whether an individual should participate in the OVDP is difficult because there are many factors to weigh and consider, such as applying the willfulness standard(s) as discussed above. The individual should seek the assistance of a qualified tax attorney who can assist the individual in this process. In any case, whether or not the individual decides to enroll in the 2012 OVDP, the individual must amend his or her tax returns and report any previously undisclosed income and file all delinquent FBARs. The disclosure should report all foreign source income that was previously omitted and a compelling argument citing facts, circumstances and law 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.
Our tax law firm has substantial foreign tax experience in this highly complex area which is now a major government focus. In December of 2011, our law firm was recognized for our excellence in this area by honoring our senior partner, Stephen M. Moskowitz, Esq. when the government of South Korea invited Steve to speak to its National Congress and National Tax Service on U.S. Foreign Tax Compliance with Offshore Bank Accounts, FATCA and tax penalty assessment and collection procedures.
We have represented many clients in (and outside of) the 2009 and 2011 Foreign Amnesty Programs. Now with this 2012 Offshore Voluntary Disclosure Program we look forward to explaining all of your options, providing you with advice as to how to avoid criminal prosecution and legally minimize any payments to the government and make the best decision for you.