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Janice Eiseman

Deciding Whether to Opt Out of the IRS Voluntary Disclosure Program?

A difficult decision because it is not clear whether the IRS agents will apply maximum penalties regardless of mitigation guidelines and reasonable cause exceptions.

September 19, 2011
by Janice Eiseman, JD, LLM

Assume your client participated in the 2009 IRS Offshore Voluntary Disclosure Initiative (OVDI). The Internal Revenue Service (IRS) agent has informed you that the 20 percent required penalty under the OVDI is $151,359, a staggering amount in light of the facts.

For years your client has had a small bank account at the Swiss bank, UBS, which never exceeded $4,000. For 2003–2008, total interest and dividends were less than $2,000. Your client never reported this income on her Form 1040s. In 2006, she opened a second Swiss bank account. The amount in this account always exceeded $10,000. She timely filed Form TD F 90-22.1 (Report of Foreign Bank and Financial Accounts (FBAR)) for 2006 and 2007 reporting the second account, but not reporting the UBS account. She reported both accounts on her 2008 FBAR. The highest amount in the accounts from 2003–2008 was $756,796 in 2008 (UBS account $3,398; other account $753,398). Her failure to properly report income from the two accounts caused a total tax deficiency of $13,144. She can show that U.S. income tax was paid on the amounts used to open the accounts.

Opting Out of OVDI

Should you recommend opting out of the OVDI because of the large amount of the 20 percent penalty? The 20 percent penalty under the 2009 OVDI and the 25 percent penalty under the 2011 OVDI do not distinguish between those taxpayers, who acted “willfully,” and those taxpayers, who did not act “willfully.” The IRS answer to this problem is that the taxpayer can opt out of the OVDI under its Opt-Out and Removal Guide posted on its web site. The IRS emphasizes that upon “opting out” there may be a full scale audit and the taxpayer may be subject to any applicable penalty. When a taxpayer opts out, the list of potential penalties set forth in Frequently Asked Questions and Answers (FAQ) five of the 2011 OVDI is sent to the taxpayer. A memorandum must be submitted to the IRS agent with a statement of the facts and a recommendation plus rationale of the applicable penalties, if your client decides to opt out.

FBAR

In FAQ 51.1 & 51.2 of the 2011 OVDI, the IRS gives examples of when it may be advantageous or disadvantageous to opt out. As these examples illustrate, a major component of this decision is whether the IRS would assess the “willful” FBAR penalty. Assume only the FBAR penalty is applicable to your client.

After October 22, 2004, the maximum “willful” FBAR penalty is the greater of:

  1. $100,000 or
  2. 50 percent of the amount in the account at the time of the violation.

31 U.S.C. § 5321(a)(5)(C). The Statute of Limitations on assessment of the FBAR penalty is 6 years, which starts running from the date of violation of the failure to file the FBAR, not from when the form is filed. 31 U.S.C. § 5321(a)(7)(b)(1). Thus, if no extensions have been given, the Statute of Limitations for a 2004 FBAR, due on June 30, 2005, lapsed on June 30, 2011 even when no 2004 FBAR were filed. The maximum willful penalty your client could be assessed is $200,000 for her failure to include the UBS account on her 2006 and 2007 FBARs.

The government must prove “willfulness” by clear and convincing evidence that the taxpayer was aware of the FBAR filing requirement and consciously chose to violate the filing requirement — there was a “voluntary, intentional, violation of a known legal duty.” Internal Revenue Manual (IRM) 4.26.16.4.5.3; IRS Chief Counsel Advice (CCA) 200603026 (Sept. 1, 2005). “Willfulness” can be inferred where an entire course of conduct establishes the necessary intent. The government established “willfulness” in the case of U.S. v. Sturman, 951 F.2d 1466 (6th Cir. 1991). In that case, the defendant set up 150 domestic corporations and five foreign corporations in bank secrecy jurisdictions. The defendant used these corporations to take money from his business and deposit funds into several Swiss bank accounts. He admitted that he was aware of the question regarding foreign bank accounts on Schedule B, Form 1040, but failed to answer it.

The government was not able to prove “willfulness” in U.S. v. Williams, 2010 WL 3473311 (E.D. Va., 2010). The court held that the government’s case did not account for the difference between failing and “willfully” failing to report a foreign bank account. The defendant had pled guilty to tax evasion for the year the government asserted that he had “willfully” failed to file an FBAR. The government argued that his guilty pleas should stop him from arguing that his actions were not willful. The court held that intentionally failing to report income to evade tax is a separate matter from whether the taxpayer specifically failed to comply with filing the FBAR.

In many cases involving the failure to file an FBAR, the taxpayer has either answered the question on Schedule B of Form 1040 as “no” or has failed to answer it. This failure provides some evidence that the taxpayer was “willfully blind” to the FBAR filing requirement; however, it is not sufficient, by itself, to prove “willfulness.” Something more is required. IRM 4.26.16.4.5.3. Examples in Paragraph 8, IRM 4.26.16.4.5.3 illustrate IRS thinking on whether the facts indicate there may have been “willfulness.” Example (b) is somewhat similar to your client’s case — a taxpayer, who omitted one of three foreign bank accounts on its FBAR. Because no information surrounding the omitted account aroused suspicion, the example concludes that a willfulness penalty should not apply.

A 2004 amendment to Bank Secrecy Act (BSA) Section 5321(a)(5) added a “non-willful” penalty, not to exceed $10,000, for a violation after October 22, 2004. 31 U.S.C. § 5321(a)(5)(B)(i). The amendment provides for a “reasonable cause” exception if a delinquent FBAR is filed. Section 5321(a)(5)(B)(ii). The maximum non-willful penalty for your client is $20,000.

Since both the non-willful penalty and the willful penalty impose only maximum amounts, IRS examiners have the discretion to determine the actual amount of the penalty. To promote consistency by IRS employees, the IRS developed mitigation guidelines that set forth penalty amounts based upon the amount in the account causing the FBAR violation. IRM 4.26.16.4.6. The mitigation guidelines for the willful and non-willful penalty require the taxpayer to satisfy the following:

  1. No criminal tax history or BSA convictions for the 10 preceding years and no history of past FBAR penalty assessments.
  2. No money passing through any of its foreign accounts was from an illegal source or used to further a criminal purpose.
  3. Cooperation during the examination.
  4. No civil fraud penalty for the tax year in question due to failure to report income from foreign account.

For the non-willful penalty, the guidelines provide that if the maximum aggregate balance for all unreported accounts did not exceed $50,000 at any time during the year, there is a $500 penalty for each violation, not to exceed an aggregate penalty of $5,000. Under this provision, your client’s FBAR penalty for 2006 and 2007 would be $1,000. The guidelines provide higher penalties as the unreported amount increases.

Conclusion

Your client should probably opt out. Even though such decision is nerve-wracking, the facts indicate that the IRS could not successfully sustain an assessment of the maximum “willful” penalty ($200,000) and the maximum non-willful penalty ($20,000) is much less than the 20 percent OVDI penalty ($151,359).

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Janice Eiseman, JD, LLM, is a principal at Cummings & Lockwood in Stamford, Conn. office where she focuses on the taxation of closely held businesses and tax planning for owners and investors. Eiseman has broad-based experience counseling clients on the formation, ownership and structuring of various business entities, as well as drafting and negotiating tax-based and transactional documentation for both individual and business clients. She has also done controversy work before the Internal Revenue Service and the New York State Department of Taxation and Finance. Prior to joining Cummings & Lockwood, she served as senior tax and benefits counsel at the New York City-based  law firm Morrison & Cohen LLP.