Choices for Taxpayers with Unreported Foreign Assets: Voluntary Disclosure, Streamlined Submission, or Run Away and Hide?

By:
Bryan C. Skarlatos, Esq.
Published Date:
Apr 1, 2015

Recently, many tax return preparers have learned that a number of their clients failed to report their interest in a foreign bank account, corporation or trust to the IRS.  Because the Foreign Asset Tax Compliance Act requires foreign financial institutions to report their U.S. depositors to the IRS, the IRS is more likely to discover non-reporting taxpayers.  Furthermore, in light of more stringent reporting requirements, recent publicity and IRS enforcement action focused on non-reporters of foreign assets, all tax preparers should ask their clients whether they have failed to report foreign assets to the IRS.  When a practitioner learns of a client’s unreported foreign assets, what should he or she do? 

This article addresses four general options available to taxpayers with unreported foreign assets. 

Four Options For Taxpayers With Unreported Foreign Assets

 A taxpayer who has failed to report his or her foreign assets has four general options.  The first option is to do nothing.  This is not a good choice because by willfully failing to report foreign assets every April 15 and/or June 30 (the deadline for filing a Foreign Bank Account Report), the taxpayer will be continually non-complaint and subject to criminal penalties.  If a client decides not to report his or her foreign assets, the practitioner must fire the client because he or she cannot knowingly prepare inaccurate returns. 

A second option is to leave past non-compliance unresolved, but file accurate returns going forward.  Because a taxpayer who discovers that his or her prior returns were not accurate does not have a legal obligation to file amended returns, he or she can simply file accurate returns prospectively.  In this situation, a tax practitioner can prepare those returns for the client.  While a tax practitioner has an ethical obligation to advise the client to file amended returns, the ultimate decision belongs to the client.   The practitioner should advise the client of the consequences of filing and not filing amended returns.  A key part of this advice is the fact that the IRS audits past years’ returns -- not future returns.  Thus, filing accurate current and future year returns will do nothing to mitigate past non-compliance.   Additionally, a decision not to amend prior years’ returns leaves the taxpayer exposed to huge civil penalties, or even criminal prosecution, if the IRS discovers the past non-compliance. 

 A third option is to simply file accurate amended returns with the IRS Service Center together with the payment of delinquent tax and interest.  Some practitioners refer to this technique as a “quiet disclosure.”  Doing so will at least correct past non-compliance with the benefit of not requiring the taxpayer to voluntarily pay huge penalties.  On the other hand, this option does not protect the taxpayer against criminal prosecution or the proposed assessment of huge civil penalties in the event of an IRS audit of the quietly-filed returns.  In addition, filing amended returns reporting income from foreign assets increases the chance of an IRS audit that may ultimately result in the aforementioned criminal prosecution and/or significant penalties. 

A fourth option is voluntary disclosure by the taxpayer.  A voluntary disclosure is a way of filing amended returns and paying delinquent taxes that expressly notifies the IRS that the taxpayer is self-reporting non-compliance.  A voluntary disclosure provides the taxpayer with certain protections in exchange for expressly addressing his or non-compliance with the IRS.  For several decades, the IRS has implemented various types of voluntary disclosure policies.  These policies covered all types of non-compliance including domestic non-compliance such as failing to report cash receipts or claiming phony deductions as well as failing to report foreign assets.  More recently, the IRS has created special voluntary disclosure programs to deal with unreported foreign assets. 

The Offshore Voluntary Disclosure Program (OVDP)

The OVDP is the most recent voluntary disclosure program for unreported foreign assets.  (See http://www.irs.gov/uac/2012-Offshore-Voluntary-Disclosure-Program.) The OVDP provides the following benefits to qualifying taxpayers: 1) protection against criminal prosecution; 2) a limited look-back period of eight years; and 3) limited civil penalties.  To qualify, the taxpayer must meet the following conditions: 1) the disclosure must be timely, i.e., prior to the commencement of an IRS audit or investigation of the taxpayer; 2) the unreported income and/or assets must be derived from legal sources; 3) the disclosure and any related amended returns must be complete and truthful; and 4) the taxpayer must pay, or make good faith arrangements to pay, any tax, penalties and interest determined to be due. (See http://www.irs.gov/Individuals/International-Taxpayers/Offshore-Voluntary-Disclosure-Program-Frequently-Asked-Questions-and-Answers-2012-Revised.)

The benefit of the OVDP is certainty.  In the end, the amount of tax, penalty and interest will be ascertained and the underlying problem will be resolved, once and for all with no risk of criminal prosecution.  Conversely, the detriment of the OVDP is the cost of filing eight years of amended returns, paying the underlying tax, a penalty equal to 20% of the unpaid tax, plus interest on the tax and penalty.  In addition, the taxpayer must pay a miscellaneous penalty equal to 27.5% of the amount of the unreported foreign accounts plus certain other foreign assets related to the tax non-compliance.  If the taxpayer’s unreported foreign accounts were held in financial institution identified by the government as being involved in offshore tax evasion, the penalty can increase to 50%.  (For the current list of such institutions, see http://www.irs.gov/Businesses/International-Businesses/Foreign-Financial-Institutions-or-Facilitators.)

The Streamlined Programs

 Over time, the IRS realized that there were many innocent taxpayers with unreported foreign assets who wanted to correct their prior non-compliance but did not want to pay the relatively large penalties associated with the OVDP.  The OVDP penalties are intentionally large because, in exchange for participating in the OVDP, the taxpayer is protected from criminal prosecution as well as much larger civil penalties based on the willful failure to report foreign assets.  However, there are millions of taxpayers, most living abroad, who really have no idea that foreign assets and income is reportable to the IRS.  To encourage these “non-willful” taxpayers to become compliant, the IRS created the streamlined disclosure procedures as a way for these innocent taxpayers to report previously undisclosed foreign assets and income. 

The two types of streamlined disclosure procedures are the Streamlined Offshore Procedures and the Domestic Streamlined Procedures.  Both are considerably more lenient than the OVDP because the former procedure imposes no penalties and the latter procedure imposes only a 5% penalty.  Importantly, because neither procedure is part of the OVDP, they provide no protection against criminal investigation or the huge willful FBAR penalties.  This is because streamlined procedures are not for taxpayers who willfully failed to report foreign assets.  In fact, to qualify for either streamlined procedure, a taxpayer must certify under penalties of perjury that he or she did not willfully fail to report the foreign assets or income. 

To participate in the Streamlined Offshore Procedures, a taxpayer must meet the non-residency requirement and provide the required non-willful certification.  A taxpayer meets the non-residency requirement, if, in any of the preceding three years, the taxpayer did not 1) have a place of abode in the U.S.; and 2) physically spend more than 35 days in the U.S.  A qualifying taxpayer can participate in the streamlined procedures by filing original or amended tax returns for the preceding three years and original or amended FBARs for the preceding six years.  The taxpayer’s liability is limited to the resulting tax and interest with no penalties imposed.  (See http://www.irs.gov/Individuals/International-Taxpayers/U-S-Taxpayers-Residing-Outside-the-United-States.)

If a taxpayer does not meet the non-residency requirement, the Streamlined Domestic Procedures is available to taxpayers who live in the U.S., have an abode in the U.S. or spend a significant amount of time in the U.S.  However, these procedures are not available to taxpayers who have not filed U.S. tax returns (considered to be domestic non-compliance) because it applies only to taxpayers with foreign asset-related non-compliance.  A qualifying taxpayer must file amended income tax returns for the preceding three years and original or amended FBARs for the preceding six years.  In addition to the tax and interest triggered by the foreign asset income, the taxpayer must pay a miscellaneous penalty equal to 5% of any foreign asset (i.e., bank account) that was not properly reported on the original returns.   (See http://www.irs.gov/Individuals/International-Taxpayers/U-S-Taxpayers-Residing-in-the-United-States.)

Conclusion

Taxpayers with unreported foreign assets must choose among the four options described above.  Ultimately, the taxpayer’s best option depends on whether he or she willfully failed to report the foreign assets.   A truly innocent taxpayer who did not willfully fail to report foreign assets may qualify for one of the streamlined programs and pay little or no penalties. 

scarlatosBryan Skarlatos, Esq., represents clients in tax audits, civil tax litigation, sensitive tax issues, criminal tax investigations, voluntary disclosures and IRS whistle-blower matters. He is also an adjunct professor at NYU School of Law where he teaches a course on tax penalties and he has taught several courses on tax procedure, penalties and ethics to various offices of the IRS. Mr. Skarlatos is co-chair of the annual NYU Tax Controversy Forum and chair of the annual Practicing Law Institute program on "Nuts and Bolts of Tax Penalties." Mr. Skarlatos regularly speaks and publishes articles on the topics of civil tax litigation, tax penalties and criminal tax prosecutions. He has been the chair of several tax committees at the American Bar Association, New York State Bar Association and New York City Bar Association and he is an elected Regent in the American College of Tax Counsel. He can be reached at bskarlatos@kflaw.com.

 
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