The Internal Revenue Service ended its Offshore Voluntary Disclosure Program (“OVDP”) effective September 28, 2018. Since then the IRS has made its Voluntary Disclosure Practice (“VDP”) available to willfully-noncompliant taxpayers. VDP offers such taxpayers the prospect of avoiding criminal prosecution, and of mitigating civil penalties.
VDP does not apply to the great majority taxpayers whose failure to comply with U.S. laws concerning foreign financial accounts, foreign income, or foreign entities is nonwillful. Such taxpayers can become compliant by means of the IRS’ Delinquent FBAR Submission Procedures, its Delinquent International Information Return Submission Procedures, or its Streamlined Filing Compliance Procedures. The taxpayer incurs little or no penalty under such procedures.
VDP proceeds from a longstanding U.S. Treasury policy enabling willfully noncompliant taxpayers to avoid criminal prosecution in becoming compliant. A voluntary disclosure does not automatically guarantee immunity from prosecution, but may result in prosecution not being recommended. VDP is not available to a taxpayer with illegal-source income.
“Willfulness” for this purpose means the voluntary, intentional violation of a known legal duty. The quintessential willful taxpayer is a U.S. person who transfers funds overseas and invests them there without reporting the resulting investment income on a U.S. income tax return.
In any voluntary disclosure case, whether Delinquent FBAR Submission Procedures, Delinquent International Information Return Submission Procedures, Streamlined Filing Compliance Procedures, or VDP, the very first thing the client should do is file delinquent or amended FBARs as needed for the preceding six years—the period of the statute of limitations on assessment of FBAR penalties.
A voluntary disclosure occurs when the communication is truthful, timely, complete, and when (1) the taxpayer shows a willingness to cooperate (and does in fact cooperate) with the IRS in determining his correct tax liability, and (2) the taxpayer makes good faith arrangements with the IRS to pay in full the tax and interest and any penalties determined by the IRS to be applicable.
A disclosure is timely if it is received before (1) the IRS has initiated a civil examination or criminal investigation of the taxpayer, or has notified the taxpayer that it intends to commence such an examination or investigation, (2) the IRS has received information from a third party (e.g., informant, other governmental agency, or the media) alerting the IRS to the specific taxpayer’s noncompliance, (3) the IRS has initiated a civil examination or criminal investigation which is directly related to the specific liability of the taxpayer, or (4) the IRS has acquired information directly related to the specific liability of the taxpayer from a criminal enforcement action (e.g., search warrant, grand jury subpoena).
A VDP case begins with the filing of a Form 14457, Voluntary Disclosure Practice Preclearance Request and Application, with Part I completed. The IRS takes upwards of 60 days to reply to a preclearance request.
If the IRS grants preclearance, the taxpayer must promptly complete the voluntary disclosure by completing Form 14457 Part II and submitting it to the IRS. Form 14457 Part II asks the estimated amount of the taxpayer’s unreported income, and the taxpayer’s estimated highest aggregate balance of foreign financial accounts, for each of the preceding six years. Part II also asks whether anyone, including a foreign government or a foreign financial institution, advised the taxpayer that his offshore account records, which are the subject of the voluntary disclosure, which were susceptible to being turned over to the U.S. Government pursuant to an official request. Part II also asks information about all entities which the taxpayer owned or controlled, or was the beneficial owner of, directly or indirectly, for which the taxpayer reported noncompliant financial accounts in Part I.
Form 14457 Part II also requires a narrative, organized under three headings: (1) Noncompliance; (2) Taxpayer Background; and (3) Professional Advisors. “Noncompliance” must include a complete and thorough discussion of failure to report income or information or to pay tax in violation of the Internal Revenue Code (U.S. Code Title 26) or the Bank Secrecy Act (U.S. Code Title 31). The taxpayer must address the source of unreported income, and explain the use of nominees, alter egos, and other methods used to conceal his noncompliance. The taxpayer must completely identify all entities involved in his noncompliance. “Taxpayer background” must include all aspects of the taxpayer’s personal and professional history. “Professional advisors” must include complete details on attorneys, accountants, financial planners, private bankers, etc. who rendered services to the taxpayer from inception of the noncompliance to the present, regardless of their connection to or knowledge of the noncompliance. The narrative must include a complete explanation of the taxpayer’s foreign financial assets.
The IRS will conduct a full-scope audit of the taxpayer’s income tax liability for the years included in the disclosure. It is important that the taxpayer cooperate in the audit. If the taxpayer does not cooperate, the examining IRS agent has the discretion to expand the scope of the audit to cover the full duration of noncompliance, including years earlier than the last six years. The IRS could also revoke a noncooperative taxpayer’s acceptance into the VDP. Cooperation is also important in mitigating civil penalties. Noncooperation is counterproductive.
A VDP applicant is subject to civil penalties under the Bank Secrecy Act Penalty and the Internal Revenue Code. The Bank Secrecy Act penalty is the penalty for will failure to file FBARs, equal to 50% of the taxpayer’s highest aggregate balance of foreign financial accounts over the preceding six years, or $100,000, whichever is greater. The examining agent has the discretion to assess less than the maximum penalty, upon good cause shown. Many of the reasons a taxpayer may advance for assessment of a lesser penalty, such as that the taxpayer was not aware of the obligation to file FBARs, or that the taxpayer relied upon a professional advisor who failed to address FBARs, go to willfulness. If the taxpayer was not willful, he should not be in VDP in the first place.
The income tax penalty is the Internal Revenue Code (“IRC”) § 6663 penalty for filing a false, fraudulent tax return, or the IRC § 6651(f) penalty for fraudulent failure to file a tax return. Under either statute the penalty equals 75% of the tax deficiency. In lieu of these penalties the taxpayer can request an IRC § 6651(a) negligence penalty equal to 25% of the tax deficiency. But again, if the taxpayer’s position is that he was not willful, he should not be in VDP in the first place.
Civil penalties for failure to file information returns will not automatically be imposed in a VDP audit.
Early payment of tax is sensible in mitigating interest. But interest does not accrue on penalties until they are assessed. So it does not make sense to pay penalties until they are assessed, at the end of the audit. Taxpayers with unresolved issues on audit may request IRS Appeals Office review of the case.
What of a taxpayer whose is preclearance application is denied? I have only seen it once. As soon as possible the taxpayer should file amended income tax returns correcting misinformation in prior tax returns, and let the chips fall where they may. Correcting prior tax returns undermines willfulness, and generally improves the taxpayer’s position.
Other articles of interest: