OVDP Penalty Refund – Setting Aside the Closing Agreement on the Theory of Duress
In this second segment of our 4 part series on Offshore Voluntary Disclosure Program (OVDP) penalty refunds, we will look at the IRS’s position on disclosures made outside of OVDP and break down the threats faced by non-compliant taxpayers. For more information on OVDP, see our previous segment on the OVDP’s history.
Four part series on OVDP Penalty Refund: Setting Aside the Closing Agreement on the Theory of Duress
Since the 2009 calendar year, the IRS’s position has been that all taxpayers who are not compliant with FBAR filing requirements and failed to disclose foreign source income, no matter how small, must participate in an offshore voluntary disclosure program.1 This has been reflected in the IRS’s frequently asked questions section for each of the targeted offshore voluntary disclosure programs.2 For example, in the IRS 2011 Frequently Asked Questions published by the IRS, they state that “quiet” filings do not constitute valid disclosures and could subject the taxpayer not only to a civil challenge, but also criminal treatment.3 The IRS’s position was echoed at the American Bar Association Section of Taxation meeting in Washington, D.C. on May 8, 2010 where IRS officials Ronald Schultz and Rick Raven explained that taxpayers were either “in or out” of the targeted offshore voluntary disclosure program and that “quiet disclosures” are not part of the program. Ronald Schultz further stated that the IRS will not allow taxpayers to become compliant through the “back door” via an amended return. They additionally went on to advise that taxpayers will find quiet disclosures may result in the worst possible outcome because noncompliant taxpayers will have flagged their unreported foreign income for the IRS to review without any protection from criminal charges.
Given the threats discussed above, the IRS’s position regarding individuals who are not compliant with a FBAR filing requirement should not surprise anyone; if you are a taxpayer with a previously undisclosed foreign financial account, enroll in a targeted offshore voluntary disclosure program or face severe consequences such as a lengthy prison sentence. Obviously, an individual who sent untaxed U.S. business receipts to an offshore account in Switzerland held in the name of a Panamanian corporation would not be well served by making a “quiet disclosure.” However, is making a disclosure outside of OVDP a grave mistake for a taxpayer who innocently or mistakenly failed to disclose a foreign bank account? Whether or not an individual can safely make a disclosure outside of OVDP is heavily dependent on the facts of each individual case.
For example, suppose a foreign-born elderly man accidently failed to disclose on his U.S. tax returns a foreign account established in his home country valued at $100,000. Let us assume that this same elderly taxpayer relied on a certified public accountant (CPA) to prepare his tax returns, and despite the fact that the elderly taxpayer advised his tax return preparer of his interest in the foreign financial account, the tax return preparer failed to advise this individual of his legal obligation to disclose the foreign account on his U.S. tax returns and an FBAR. If this taxpayer entered into the 2012 OVDP, he would be liable for a 27.5 percent miscellaneous or offshore penalty. In this example, the penalty would be $27,500 (27.5% x $100,000 = $27,500). If the taxpayer were to make a “quiet disclosure” to the IRS, is this particular individual really exposed to any criminal or civil penalties? By making a “quiet disclosure,” the elderly man in our example would amend all returns open for assessments as the result of the statute of limitations, late file his FBARs, pay all applicable taxes on foreign source income, and pay all applicable interest on previously undisclosed foreign source income. However, since this individual is not participating in the 2012 OVDP, he is not bound to the unforgiving penalty structure of the program.
When the IRS receives the elderly man in our example’s amended returns and late filed FBARs, they will likely be audited because he elected not to participate in the 2012 OVDP. During such an audit, the biggest risk that any taxpayer faces in making a disclosure outside of an OVDP is the risk of criminal prosecution for the willful failure to file an FBAR. Under Title 31 United States Code (U.S.C.) Section 5322(a), a person who is convicted of willfully failing to file an FBAR potentially faces up to five (5) years in prison. Willfulness in the criminal context has been defined by federal courts as the “voluntary, intentional violation of a known legal duty.”4 Given that the taxpayer in our example knew nothing about a legal duty to disclose foreign financial accounts on an FBAR and retained the services of a certified public accountant to prepare his tax returns, it is extremely unlikely that the IRS could criminally prosecute this individual.
The IRS has also threatened to civilly challenge any disclosure made outside of an OVDP. The most severe penalty the IRS may assess against our hypothetical taxpayer is a willful failure to file an FBAR under Title 31 U.S.C. Section 5314. In the case of a willful penalty, the IRS can impose a penalty equal to $100,000 or 50 percent of the amount of the financial “transaction,” whichever is greater.5 In order to impose the willful penalty under Title 31 U.S.C. Section 5314, the IRS must demonstrate the taxpayer knew that he had a duty to disclose his foreign account on an FBAR, yet intentionally ignored the duty. This standard was defined in Cheek v. United States, 498 U.S. 192, 201 (1991). In Cheek, the U.S. Supreme Court stated that the government must overcome a significant legal hurdle to prove willfulness:
Willfulness … requires the Government to prove that the law imposed a duty on the defendant, that the defendant knew this duty, and that he voluntarily and intentionally violated that duty… “[c]arrying this burden requires negating a defendant’s claim of ignorance of the law or a claim that because of the misunderstanding of the law, he had a good-faith belief that he was not violating any provisions of the tax laws.”6
In our example, the taxpayer’s failure to disclose his foreign financial account was not an act undertaken intentionally or in deliberate disregard for the law. Instead the failure to disclose the account constituted an understandable omission. Thus, the IRS could not successfully assert a willful civil penalty under Section 5314 against the taxpayer in our example.
Finally, the IRS could attempt to assess a non-willful penalty under Title 31 U.S.C. Section 5321 against our example taxpayer. In the case of a non-willful FBAR violation, the IRS may assess a penalty of up to $10,000 per violation. With that said, under Section 5321, no non-willful penalty shall be imposed if the violation was due to “reasonable cause.”7 At first glance, the defense against a non-willful penalty seems relatively straightforward; all a taxpayer has to demonstrate is that there was a “reasonable cause” for not filing an FBAR informational return in order to satisfy the test provided under Section 5321. Although the term “reasonable cause” is not addressed in Section 5321, the concept of “reasonable cause” is referred to in the Internal Revenue Manual (IRM).
The IRM includes the following statements to this effect8:
- The [non-willful] penalty should not be imposed if the violation was due to reasonable cause.
- If the failure to file the FBAR is due to reasonable cause, and not due to the negligence of the person who had the obligation to file, [a penalty should not be assessed].
- Reasonable Cause and Good Faith Exception to Internal Revenue Code Section 6662 may serve as useful guidance in determining the factors to consider [in assessing FBAR penalties].
- Although tax regulation[s] for Section 6662 does not apply to FBARs, the information it contains may still be helpful in determining whether the FBAR violation was due to reasonable cause.
In summary, the IRM indicates that an examiner could consider defenses to the Section 6662 penalty in determining whether a taxpayer should be liable for a non-willful penalty. Internal Revenue Code (IRC) Section 6662 imposes a 20 percent accuracy related penalty to an underpayment of tax due to negligence, while IRC Section 6664(c) states that no penalty shall be imposed if it is shown that there was a reasonable cause for such underpayment. Therefore, if a taxpayer can show reasonable cause, the Section 6662 penalty will not be imposed. The reasonable cause exception in a Section 6662 penalty has been generally interpreted to mean the exercise of ordinary business care and prudence.9 When an individual exercises ordinary business care and prudence, the individual will not be liable for the Section 6662 penalty where the understatement results from a mistake of law or fact in good faith and on reasonable grounds.10 In our example, the taxpayer exercised ordinary business care and prudence by retaining the services of a certified public accountant to prepare his tax returns. As a result of the tax return preparer’s neglect, the taxpayer omitted his foreign financial account from an FBAR.
Since the taxpayer in our example exercised ordinary business care and prudence by retaining the services of a CPA and through disclosing his foreign financial account to his tax return preparer, this taxpayer should survive an IRS audit without the assessment of a non-willful penalty or for that matter, the assessment of any offshore penalties. Despite the IRS’s dire warnings, the taxpayer in our example is far better off making a disclosure outside the 2012 OVDP instead of agreeing to a penalty structure under that program.
There are many other examples in which it may be advantageous for noncompliant taxpayers to make a disclosure to the IRS outside of a targeted offshore voluntary disclosure program. Take for example a taxpayer that failed to disclose a foreign financial account on an FBAR because of poor English skills or a taxpayer who was too ill to timely file FBAR informational returns to disclose an interest in a foreign financial account. In these cases, instead of entering into an OVDP, these taxpayers may (by filing amended tax returns and late filing FBARs) potentially make a qualifying voluntary disclosure with the IRS outside of the targeted offshore voluntary disclosure program. Certainly, taxpayers that innocently or mistakenly failed to timely disclose a foreign financial account could enter into an OVDP to buy “peace” and avoid the hassle of a tax audit. But taxpayers who innocently or mistakenly failed to disclose a foreign financial account should not feel compelled to enter into OVDP out of an irrational fear of criminal prosecution or the assessment of massive civil penalties.
But where does this leave the taxpayer that innocently or mistakenly failed to disclose a foreign financial account and paid a penalty associated with an offshore voluntary disclosure program? Part three of this series continues by examining the process of obtaining an OVDP penalty refund prior to starting litigation. However, as will be discussed in the conclusion of this series, the possibility of tax litigation is severely limited by the closing agreement executed by each participant of an offshore voluntary disclosure program.
- The IRS provides an exception to taxpayers that paid tax on all taxable income for prior years but did not file FBARs. In these situations, the taxpayer will not be assessed a penalty as long as the delinquent FBAR is filed and a statement is attached explaining why the FBAR was filed late. See IRS 2011 FAQ, note 17.
- See Id. at note 4, 5, and 6.
- See Id. at note 16.
- United States v. Pomponio, 429 U.S. 10 (1976).
- 31 U.S.C. Section 5321(a)(5)(C)(i).
- Cheek v. United States, 498 U.S. 192, 201 (1991).
- 31 U.S.C. Section 5321(B)(i).
- IRM 188.8.131.52.3.1 (07-01-2008).
- United States v. Boyle, 269 U.S. 241, 246 (1985).
- Scott v. Commissioner, 1 T.C. 654 (1974).