OVDP Penalty Refund – Setting Aside the Closing Agreement on the Theory of Duress
The first two segments of this series focused on the history of the Internal Revenue Service’s (IRS) targeted Offshore Voluntary Disclosure Program (OVDP) and the IRS’s position on disclosures made outside of an OVDP. The focus of the third section of our 4 part series examines the administrative procedure required before pursuing an OVDP penalty refund through tax litigation.
How does an individual who mistakenly paid an offshore penalty proceed with filing a civil action in federal court to obtain a refund of the penalty? With a few important distinctions, an individual seeking a refund of an OVDP penalty would proceed much the same as if that taxpayer was seeking a refund on an overpayment of a federal tax liability, and like a taxpayer seeking a claim for refund of an income tax liability, a taxpayer seeking a refund of an offshore penalty must first file an administrative claim for a refund with the IRS. The Internal Revenue Code (IRC) discusses the procedure regarding filing an administrative claim for refund, and IRC Section 7422(a) further explains that such a claim must be filed before bringing a lawsuit:
No suit or proceeding shall be maintained in any court for the recovery of any internal revenue tax alleged to have been erroneously or illegally assessed or collected, or of any penalty claimed to have been collected without authority, or of any sum alleged to have been excessive or in any manner wrongfully collected, until a claim for refund or credit has been duly filed with the Secretary, according to the provisions of law in that regard, and the regulations of the Secretary established in pursuance thereof.
The statute governing a claim for refund is contained in IRC Section 6401. IRC Section 6401(a) provides that the IRS may issue a refund for any overpayment of a tax, and continues by defining an overpayment of tax as a payment of any internal revenue tax that is assessed or collected. The United States Supreme Court has further clarified the term “overpayment of tax” by stating:
[W]e read the word “overpayment” in its usual sense, as meaning any payment in excess of that which is properly due. Such an excess payment may be traced to an error in mathematics or in judgment or in interpretation of facts or law. And the error may be committed by the taxpayer or by the revenue agents. Whatever the reason, the payment of more than is rightfully due is what characterizes an overpayment.1
At first glance, Section 6401 seems to foreclose a refund of the offshore penalty. This is because the offshore penalty is just that- a penalty and not a tax. Even though Section 6401 only authorizes a refund of a tax, the term “overpayment of tax” has been broadened by United States Supreme Court for purposes of Section 6401.
This broadened definition includes any penalties resulting from an assessment of a tax. In case of an OVDP penalty, the penalty is assessed under Title 26 (IRC) of the United States Code, the body of law that codifies all federal tax laws in the United States.2 Since the offshore penalty is an assessment under Title 26 of the United States Code, a penalty derived from Title 26 can easily be classified as income tax penalty. This means that the IRS has the legal authority to process a claim for refund of the offshore penalty.
Procedurally, the administrative claim for refund of an offshore penalty must set forth in detail each ground upon which the refund is claimed and facts sufficient to apprise the Commissioner of the exact basis thereof.3 Satisfying this requirement may be somewhat novel in these cases. This is because the offshore penalty is basically a creation of the IRS rather than Congress. Consequently, there are no statutory elements to the offshore penalty. Even though there is no statutory guidance defining an offshore penalty, there is some common sense guidance that may be utilized in filing an administrative claim for the refund of an OVDP penalty. First, a taxpayer seeking a refund of an offshore penalty must advise the IRS as to why he erroneously entered into the offshore voluntary disclosure program. Second, the taxpayer must put the IRS on notice as to why he should not be subject to the offshore penalty.
The Offshore Voluntary Disclosure Program’s Frequently Asked Questions and Answers (FAQ) publicized by the IRS sheds some light on how to proceed with a refund claim. In particular, FAQ Numbers 5 through 7 state that the miscellaneous offshore penalty is designed in lieu of any other penalties assessed for failing to timely file Form TD F 90-22.1, Form 8938, Form 3520, Form 3520-A, Form 5471, Form 5472, Form 926, and Form 8865. Additionally, Frequently Asked Question 7 provides that the miscellaneous penalty is designed to be in lieu of a civil fraud penalty.
Since the offshore penalty was designed to replace penalties that may be assessed in lieu of failing to file a number of informational returns, civil fraud penalties, and late filing penalties; a claim for an administrative refund must address the penalties the offshore penalty was designed to replace for each particular case. As an example, assume that the foreign-born elderly man discussed in part two of this series participated in the 2012 OVDP and paid the $27,500 offshore penalty. Let us also assume that this taxpayer would like to proceed with filing an administrative claim for the refund of his OVDP penalty. For the purpose of this example, the only offshore informational filings omitted by the elderly man were FBAR returns. This means, that in this case, the OVDP penalty was designed to be in lieu of FBAR penalties and potentially civil fraud penalties.
In order to “set forth in detail each ground upon which [the] refund is claimed to apprise the Commissioner,” an administrative claim filed for our hypothetical taxpayer must set forth in detail the reasons as to why he is not subject to willful and non-willful FBAR penalties. The administrative claim should also address any potential civil fraud penalty. Finally, the administrative claim for refund must state in detail the reasons why the taxpayer believes he erroneously entered into the 2012 OVDP.
In order to meet these required elements, an administrative claim could be drafted as follows:
Title 31 of United States Code Section 5314(a) provides in relevant part that:
Each person subject to the jurisdiction of the United States (except a foreign subsidiary of a U.S. person) having a financial interest in, or signature or other authority over, a bank, securities or other financial account in a foreign country shall report such relationship to the [IRS] for each year in which such relationship exists, and shall provide such information as shall be specified in a reporting form prescription by the Secretary to be filed by such persons.
The Jobs Act of 2004 provides that the Secretary (and by extension the IRS pursuant to delegation of authority) “may” impose penalties on any person who violates United States Code Section 5314.
During the 2003 through 2011 tax years the taxpayer had an interest in a financial account located in a foreign country. This financial account should have been disclosed on FBAR information returns for the 2003 through 2011 tax years. However, the taxpayer’s FBAR non-filing for the 2003 through 2011 tax year was inadvertent and caused by the unfamiliarity of both the taxpayer and his accountant with the existence of the FBAR form. Since the taxpayer and his accountant were unfamiliar with the FBAR forms, the taxpayer’s failure to file the FBAR forms for the 2003 through 2011 tax years was due to error rather than willfulness. Therefore, the taxpayer should not be assessed any willful FBAR penalties for the 2003 through 2011 tax years.
Not only should the taxpayer not be assessed willful FBAR penalties for the 2003 through 2011 tax years, the taxpayer should not be assessed non-willful penalties for any of the tax years such a penalty could be assessed. Title 31 of United States Code Section 5321(a)(5)(B)(ii) states in relevant part that the non-willful penalty should not be imposed if the violation was due to “reasonable cause.” The IRS’s own Internal Revenue Manual states that where an individual exercises ordinary business care and prudence, an individual will not be liable for the non-willful penalty. In the present case, the taxpayer exercised ordinary business care and prudence by retaining the services of a certified public accountant. The taxpayer also provided to his certified public accountant all of his documentation regarding the foreign account for the 2003 through 2011 tax years. The taxpayer believed that his interest in the foreign account was property disclosed for U.S. tax purposes. The only reason the taxpayer failed to timely disclose his interest in his foreign financial account was through the result of an error by his accountant. Given the facts and circumstances of the present case, the taxpayer should not be liable for the non-willful penalty for any of the applicable tax years.
Any omitted tax liability from the foreign financial account was inadvertent and not the result of a willful attempt to avoid paying taxes. Therefore, the taxpayer should not be liable for a civil fraud penalty for any of the years that he had an interest in the foreign financial account.
According to Question Two of the Frequently Asked Questions & Answers promulgated by the IRS, the objective of the OVDP is “to bring taxpayers that have used undisclosed foreign accounts and undisclosed foreign entities to avoid or evade tax into compliance with United States tax laws.” In the present case, the taxpayer did not purposely utilize undisclosed foreign accounts and undisclosed foreign entities to avoid or evade compliance with United States Tax laws. The taxpayer erroneously believed that the 2012 OVDP was his only option to become compliant with his IRS filing requirements. The taxpayer now realizes that he was not legally required to enter into the 2012 OVDP and that he mistakenly paid an Offshore Penalty through the voluntary disclosure program. The taxpayer respectfully requests a refund of the Offshore Penalty that he paid.
The sample claim for refund discussed above should meet all the requirements stated in the Income Tax Regulations. The administrative claim for refund apprises the Commissioner of the Internal Revenue that the taxpayer in our example erroneously entered into the 2012 OVDP. Furthermore, the administrative claim for refund puts the Commissioner of the Internal Revenue on notice that the taxpayer is not liable for any penalties that the offshore penalty was designed to replace. The example above provides guidance on how a claim for refund may be drafted for a taxpayer with a relatively simple set of facts. Obviously, the complexity of a claim for refund of an offshore penalty will increase as the facts of each case warrant.
In addition to correctly filing a claim for refund, any participant of a voluntary disclosure must keep in mind that there are strict statutory limitations regarding when a claim for refund can be filed. In particular, IRC Section 6511 details the period of limitation allowed for a refund claim:
(a) Claim for credit or refund of an overpayment of any tax imposed by this title in respect of which tax the taxpayer is required to file a return shall be filed by the taxpayer within 3 years from the time the return was filed or 2 years from the time the tax was paid, whichever of such periods expires the later, or if no return was filed by the taxpayer, within 2 years from the time the tax was paid…..
(b) (1) No credit or refund shall be allowed or made after the expiration of the period of limitation prescribed in section (a) for the filing of a credit or refund, unless a claim for credit or refund is filed by the taxpayer within such period.
As written, Section 6511 imposes a strict two year limitation on a claim for an offshore penalty. This means that a claim for refund must be filed within two years of the date the penalty was satisfied. Any individual seeking a refund of the offshore penalty must carefully keep the date the penalty was paid in mind. The administrative claim for refund must also be filed with the service center serving the Internal Revenue district in which the penalty was paid.4 Once the IRS receives the claim for a refund, they will likely review and act on the claim. Should the IRS reject the administrative claim or fail to act on it more than six months from the date of submission, the taxpayer may proceed with litigating the claim before either the Court of Federal Claims or a United States district court. In the conclusion of this series, we will look at the limitations placed on litigation by the OVDP closing agreement, examine setting aside the closing agreement utilizing the theory of duress, and discuss the importance of selecting the proper forum to litigate your OVDP refund.
For more information, contact Moskowitz, LLP.
- Jones v. Liberty Glass Co., 332 US 524, 531 (1947).
- See Subparagraph 4 of Form 906 entitled Closing Agreement on Final Determination Covering Specific Matters which states the “Taxpayer agrees to pay, and the Internal Revenue Service may assess under Title 26 of the United States Code a miscellaneous [offshore] penalty.
- Treas. Reg. Section 301.6402-2(b).
- Treas. Reg. Section 301.6402-2(a)(2).