Full Analysis of Updated 2012 OVDP Program

The Internal Revenue Service announced on June 26, 2012 (IR-2012-64) that it is tightening eligibility requirements for the open-ended offshore voluntary disclosure program (2012 OVDP) that it announced in January 2012 for taxpayers with unreported income or assets, generally in the form of off-shore bank accounts. The IRS also added details to the compliance initiative by publishing 55 frequently asked questions and answers pertaining to the OVDP.

Also on June 26, the IRS announced (IR-2012-65) a plan to help US citizens who live overseas, including dual citizens, catch up with tax filing obligations and to provide assistance for those taxpayers with foreign retirement plan issues (the Current Nonresident Program). A new procedure will go into effect September 1, 2012, to help US citizens living abroad who have not been filing their tax returns to become current with their filing obligations if they owe little or nothing in back taxes. The Service has provided very little detail regarding the procedure for participating in this new disclosure program.

The Service’s announcement notes that a taxpayer challenging the disclosure of tax information by a foreign government is required under current law to notify the US Justice Department of the challenge. Failure to do so will mean the taxpayer is no longer eligible for the OVDP. The Service also notes that taxpayers may become ineligible for the OVDP once the US government has taken action with regard to the taxpayer’s financial institution.

The OVDP is aimed at bringing taxpayers back into the tax system, and will remain in place indefinitely. There is currently no set deadline for people to apply to the OVDP, though FAQ 1 states, “[T]he terms of this program could change at any time going forward.”

Background

The stated goal of the 2012 OVDP, like its predecessors, is to bring taxpayers with undisclosed foreign accounts or undisclosed foreign assets into compliance with US tax laws. This program follows and builds on the Programs before it, which convinced over 33,000 taxpayers to come forward to declare unreported income and pay taxes, interest and penalties totaling more than $5 billion. Since the closure of the 2011 OVDI, 1,500 more taxpayers have come forward to disclose unreported income. The high number of continued voluntary disclosures persuaded the IRS to create the 2012 OVDP. Similar to its predecessors, the 2012 OVDP provides a framework for determining penalties based on the value of a taxpayer’s foreign accounts and assets.

The Programs also provided an opportunity for taxpayers who had properly reported taxable income in prior years, but failed to file certain information returns, such as Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, and Treasury Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (FBAR), to file such late returns without penalties. The procedure required to participate in the 2012 OVDP depends on whether the disclosing taxpayer has previously unreported income or assets and missed information reporting. The first section below describes the procedure and additional information for taxpayers who have no unreported income, but need to remedy previously unfiled information returns such as Form 5471 or FBAR. The second section provides information for taxpayers who intend to disclose previously unreported income and assets.

Voluntary disclosure of missed information reporting returns (FAQs 17 and 18)

Like the prior Programs, the 2012 program offers the opportunity to remedy missed information returns, albeit with additional conditions for eligibility. If these conditions are met, the IRS will not assert penalties against taxpayers who reported and paid tax on all their taxable income from transactions reported on information forms such as Form 5471, and foreign bank accounts, so long as the taxpayer has not previously been contacted regarding an income tax examination or a request for delinquent returns. Taxpayers may be subject to penalties of up to $10,000 per foreign corporation per year (plus other sanctions) for failure to timely and correctly file Form 5471. Additionally, failure to comply with the FBAR reporting rules could result in a non-willful penalty of up to $10,000 per account per calendar year under 31 U.S.C. Section 5321(a)(5), for failure to file Form TD F 90-22.1 or report all foreign financial accounts, unless the violation was due to reasonable cause and income from the account was properly reported on the relevant income tax return (FAQ 5).

FAQs 17 and 18 indicate that some taxpayers may file these forms without penalty. The Service’s answer to FAQ 17 states that because the OVDP enables taxpayers who did not report taxable income to come forward voluntarily and resolve their tax matters, taxpayers who reported and paid tax on all of their taxable income, but did not file FBARs, should not use the voluntary disclosure process. Rather, they should file the delinquent FBAR reports according to the FBAR instructions (send to Department of Treasury, Post Office Box 32621, Detroit, MI 48232-0621) and attach a statement explaining why the reports are late. This statement should contain a positive statement that the filer meets all of the requirements of FAQ 17 of the current OVDP.

The IRS states that no penalty will be imposed for filing delinquent FBARs if the taxpayer has no unreported tax liabilities and files the returns before the IRS contacts the taxpayer requesting the delinquent returns or regarding an examination.

In FAQ 18, the Service states that a taxpayer who has failed to file Form 5471 or Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, but has reported and paid tax on all its taxable income from all transactions related to the controlled foreign corporations (CFCs) or foreign trusts, should file delinquent information returns with the appropriate IRS service center and attach a statement explaining why the information returns are late. Along with Form 5471, the taxpayer should submit an amended return showing no change to income or tax liability. The IRS states that it will not impose a penalty for late filing of Forms 5471 and 3520 if the taxpayer has reported and paid its tax liabilities. See the Implications section below for further information on FAQs 17 and 18.

Voluntary disclosure of unreported foreign income or assets

Eligibility and compliance

Generally, all taxpayers with undisclosed foreign accounts or assets who are not under civil or criminal examination are eligible to participate in the 2012 OVDP. See FAQ 21 for other, limited exceptions. To confirm eligibility and enter the 2012 OVDP, a taxpayer should submit a pre-clearance request in accordance with FAQ 23. Taxpayers who are accepted will receive a letter from the IRS Criminal Investigation unit indicating that they have 90 days to complete and submit all voluntary disclosure materials. Under certain conditions, FAQ 25.1 indicates that a taxpayer may request an additional 90 days to complete and submit the voluntary disclosure package.

To comply with the 2012 OVDP, FAQ 25 requires the taxpayer to provide the following:

• Incorrect or incomplete originally filed US income tax returns (if any) or amended US income tax returns (if applicable)
• Complete and accurate amended or original US income tax returns, including all information returns for the disclosure period
• A completed Foreign Asset or Foreign Account statement indicating all previously undisclosed foreign assets and/or accounts
• A properly completed and signed Taxpayer Account Summary and Penalty Calculation
• A check for the total amount of the tax, interest and penalties
• An agreement to extend the period for assessment of tax and penalties by the original or extension deadline.
• Copies of the compliant US income tax returns (for taxpayers who began filing timely, compliant US income tax returns prior to submitting their 2012 OVDP material)
• Copies of offshore account statements for the entire disclosure period (for taxpayers disclosing offshore accounts with more than $500,000 in aggregate highest balance in any given year)

For calendar year taxpayers, the disclosure period covers the eight most recent calendar years for which the filing deadline has already passed. See FAQ 9 for information regarding the disclosure period for fiscal-year taxpayers and for taxpayers who have begun filing timely, compliant federal income tax returns reporting all offshore accounts and assets.

Spousal Participation

A new FAQs 24.1, asks: What should I do if my spouse also wishes to make a voluntary disclosure under OVDP? This one is a surprise, as many advisers thought joint tax returns meant joint participation in the OVDP was mandatory. However, it is evidently optional.

The IRS recommends that both spouses enter the program where joint returns were filed during the disclosure period. However, the representative said the IRS could in its discretion accept the signature of only one spouse on amended joint returns, as long as full payment of the tax, interest and penalties is made. Thus, it is conceivable that one spouse could enter the OVDP and amend joint returns without the other spouse’s knowledge.

Where spouses both want to participate in OVDP, the FAQs state clearly that they may do so jointly or separately. If they enter jointly, they should be sure to include all required information and documents for each spouse and clearly indicate their intention to disclose jointly. If they do it separately, each spouse should separately complete and submit all required information and documents. See FAQs 22 through 25.

Opt-out procedure

At any time prior to signing a closing agreement, a taxpayer may choose to opt out of the 2012 OVDP. The election to opt out must be made in writing and is irrevocable. Additionally, a taxpayer who opts out of the 2012 OVDP is electing to have his or her case handled under the traditional IRS audit process. A taxpayer may choose to opt out when the result reached under the 2012 OVDP penalty framework (see next section) appears too severe given the taxpayer’s facts. The Service provides examples of when a taxpayer may find it preferable to opt out of the 2012 OVDP in FAQ 51.1 and examples of when a taxpayer may benefit from remaining in the 2012 OVDP in FAQ 51.2. Finally, the Service has posted the procedures for opt out in an Opt Out and Removal Guide on its website.

Penalty framework

The most critical factor necessary to make the decision to opt out of the 2012 OVDP in favor of the traditional disclosure and audit process is to understand the differences between the potential penalties available to the IRS under the traditional disclosure and audit process and the 2012 OVDP penalty framework. For the 2012 OVDP, the revenue agent administering the taxpayer’s case cannot exercise any discretion and has no authority to negotiate the penalties prescribed under the 2012 OVDP. Under the 2012 OVDP, the 20% accuracy-related penalty for all years for which the taxpayer is making a disclosure and the failure to file and failure to pay penalties may apply. Additionally, in lieu of all other penalties, including information return reporting penalties and the FBAR penalties, the revenue agent is required to assess a 27.5% offshore penalty (in some circumstances, described in the next paragraph, the penalty can be reduced to 12.5% or 5%). The 27.5% offshore penalty is applied to the highest aggregate value of all of the taxpayer’s undisclosed foreign accounts or assets in the years at issue. FAQ 35 states that the penalty is to be assessed against the highest fair market value of the taxpayer’s assets, if the assets generated unreported income or were purchased with unreported income during the disclosure period. Therefore, in addition to assessing the offshore penalty against the taxpayer’s financial accounts, the IRS will assess the 27.5% offshore penalty against the taxpayer’s real and personal property, including the value of any stock, from which the taxpayer earned unreported income.

Under certain circumstances, the offshore penalty may be reduced to either 12.5% or 5% of the highest annual aggregate value of taxpayer’s accounts and assets. The offshore penalty will be reduced to 12.5% if the aggregate value of all of the taxpayer’s accounts is less than $75,000 for each of the years covered by the disclosure period.

The offshore penalty may be reduced to 5% for taxpayers who:

• Did not open or cause the account to be opened; has exercised minimal, infrequent contact with the account (e.g., to request the balance or update account holder information); has, except for a withdrawal closing the account to transfer the funds to a US account, not withdrawn funds in excess of $1,000 from the account; and can establish that all applicable US taxes have been paid on funds deposited to the account (i.e., only account earnings have escaped taxation
• Is a foreign resident and is unaware that he or she is a US citizen
• Is a foreign resident and meets all three of the following conditions for all disclosure years: (1) taxpayer resides in a foreign country; (2) taxpayer makes a good faith showing that he or she has timely complied with all tax reporting and payment requirements in the country of residency; and (3) taxpayer has $10,000 or less US-source income each year

Furthermore, for the third category of taxpayers only, the offshore penalty will not apply to non-financial assets. Again, in the 2012 OVDP, the IRS will not negotiate this penalty framework and, absent the specific circumstances listed above that reduce the offshore penalty to 12.5% or 5%, the offshore penalty will be 27.5%.

If the taxpayer opts out of the 2012 OVDP, the IRS may assert all penalties in the Internal Revenue Code, including, but not limited to, the accuracy-related penalty, failure to file and failure to pay penalties, willful and nonwillful FBAR penalties, penalties for failure to file various information returns, civil fraud penalties, and even criminal penalties. However, outside the 2012 OVDP, the revenue agent has some discretion regarding whether to apply these penalties based on the taxpayer’s unique facts and circumstances. Therefore, unlike with the 2012 OVDP, in the traditional IRS audit process, facts and circumstances matter and penalties may be abated for reasonable cause. On the other hand, the IRS is not barred from asserting additional penalties outside the 2012 OVDP disclosure period if the circumstances warrant such penalties and the statute of limitations has not run.

Miscellaneous

The new 2012 OVDP FAQs also provide information regarding eligibility for the 2012 OVDP if the Service has filed a John Doe summons or made a treaty request seeking information to identify the taxpayer (FAQ 21); providing information to the IRS Criminal Investigation unit (FAQs 6 and 51.3); an alternative resolution method for reporting PFIC income (FAQ 7); whether penalties will be owed on funds transferred from one unreported foreign account to another during the voluntary disclosure period (FAQ 37); under what circumstances the IRS may propose adjustments to tax for more than three tax years (FAQs 42 and 43); and a procedure for making a late election to avoid recognizing income earned on Canadian retirement savings plans or retirement income fund and to file late Forms 8891 reporting these Canadian accounts.

The proposed Current Nonresident Program

While the final details of this program have not yet been announced, the IRS has described the proposed program as a potential alternative for low-compliance-risk taxpayers to become compliant. Based on the limited detail provided the notice, eligible taxpayers will file three years of tax returns and six years of FBARs. If their filings are considered to represent a low compliance risk, the review will be expedited and penalties will not be asserted. Submissions representing higher compliance risk will not be eligible for the expedited procedure and could be subject to a full examination covering more than three years. The Notice defines a low risk as a taxpayer with simple returns with little or no US tax due. The IRS warned that taxpayers concerned about the risk of criminal prosecution should be advised that this new procedure does not provide protection from criminal prosecution, and such taxpayers should consult our law firm about the 2012 OVDP.

Implications

Voluntary disclosure of missed information reporting returns (FAQs 17 and 18)

Unlike the prior voluntary disclosure Programs, it does not appear the new program will be available for taxpayers receiving penalty notices pursuant to the IRS Automated 5471 Late Filing Penalty program. Additionally, the penalty relief provided may be limited for taxpayers who are subject to continuous IRS examination.

Although the IRS announced the program in January as “open-ended,” the announcement indicated that the IRS may end the 2012 program at any time in the future.

Although only Forms 5471 and 3520 are specifically mentioned, the answer to FAQ 18 seems to imply that other information returns may be filed without penalty.

As FAQ 18 points out, the IRS requires an omitted form or schedule to be submitted with an amended return; it cannot be filed alone. This requirement does not apply to taxpayers filing late FBARs pursuant to FAQ 17.

Voluntary disclosure of unreported foreign income or assets

The IRS releases and FAQs clarify the details of the previously announced 2012 offshore voluntary disclosure program. The prior lack of detail regarding the mechanics of the new program rendered many taxpayers hesitant to enter the program. The FAQs provide a framework for taxpayers to weigh the costs/benefits of entering the program by quantifying the applicable penalties. Taxpayers with prior-year unreported income or unfiled information forms should review the effect of entering the 2012 program in conjunction with our law firm.

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