By Anthony Diosdi
Just about anyone considering disclosing a previously undisclosed foreign financial asset to the Internal Revenue Service (“IRS”) has heard about the Offshore Voluntary Disclosure Program or the Streamlined Procedures Compliance Filing Procedures. However, few individuals with delinquent international information returns, such as Form 5471, Form 8938, or Form 3520,
know about the Delinquent International Information Return Submission Procedures (“DSP”), also referred to as Option 4 among the Options Available for U.S. Taxpayers with Undisclosed Foreign Financial Assets. See Options Available For U.S. Taxpayers with Undisclosed Foreign Financial Assets, IRS last accessed Apr. 23, 2018, https://www.irs.gov/individuals/international-taxpayers/options-available-for-u.s-taxpayers-with-undisclosed-foreign-financial-assets.
Offshore Penalties
U.S. persons with foreign interests have been a focus of an expanding universe of miscellaneous reporting requirements and enforcement. Specific civil sanctions, sometimes referred to as “International Penalties,” may be assessed against any person for failing to comply with certain reporting requirements. For example, Internal Revenue Code Section 6038(a) imposes an obligation on U.S. persons to submit annual reports disclosing interests in and transactions with controlled foreign corporations. These reports are required to be submitted on Forms 5471 attached to the person’s annual federal income tax return. Under Section 6038(b), a substantial monetary penalty may be assessed against the U.S. shareholder if the Form 5471 is determined to be untimely, substantially inaccurate, or income. The IRS may assert a $10,000 penalty for each failure for each applicable annual accounting period, plus an additional $10,000 for each month the failure continues up to a maximum of $60,000.
Several code sections away, the monetary reporting penalty provided in Internal Revenue Code Section 6048(a) provides another example of an international penalty. Section 6048 requires responsible parties to provide written notice to the IRS upon the occurrence of certain events involving transfers of property interests to a foreign trust by a U.S. person, either through the initial settlement of a foreign trust or a subsequent grant. A disclosure is made on an IRS Form 3520. If the responsible party fails to submit a timely, complete, and accurate report of the event, a penalty up to 35 percent of the gross reportable amount; i.e., the value of the property interest involved may be assessed a penalty. The Internal Revenue Code allows a reasonable cause defense to be asserted by a person to potially avoid the assessment of an international penalty.
Individuals with offshore assets may not only have a legal obligation to file Forms 5471 and 3520, depending on the foreign financial assets, individuals with offshore assets may also have an obligation to disclose the foreign financial asset(s) on Form 8938, Form 926, Form 8865, or Form 8858. The IRS may assess an international penalty (similar to the penalties discussed above) for each form not filed. Obviously, these penalties can be substantial. For some, the DSP can be utilized to avoid the assessment of international penalties. Below, I will discuss the DSP in more detail.
The DSP is Available to U.S. Persons with Exposure to International Penalties
The DSP is available for taxpayers who do not need to use the Voluntary Disclosure Program or Streamlined Procedures to file delinquent or amended tax returns to report and pay additional tax, but who have not filed one or more international returns, have reasonable cause for not filing the information returns, are not under civil examination or criminal investigation, and have not already been contacted by the IRS about the delinquent information returns.
Under DSP, participants file delinquent international forms, such as Forms 5471 or 3520, with an amended income tax return, such as a Form 1120X or 1041X, and include a reasonable cause statement and certification that the entity for which an information return is being filed was not engaged in tax evasion. Unfortunately, the DSP is not available to taxpayers who have not filed the original income tax returns. The DSP is also not available to individuals which the IRS has automatically assessed international penalties on late-filed international forms. The IRS has issued some guidance regarding who may utilize the DSP. The FAQs issued for the DSP clarify that taxpayers who have unreported income or unpaid taxes are not precluded from using the DSP. See Delinquent International Information Return Submission Procedures Frequently Asked Questions and Answers, IRS, last accessed Apr. 23, 2018, https://www.irs.gov/individuals/international-taxpayers/deliquent-international-information-return-submission-procedures-frequently-asked-questions-and-answrs.
Many tax practitioners have been reluctant to advise taxpayers to utilize the DSP. This is because of the uncertainty over the amount of acceptable unreported income or unpaid taxes. It is also my understanding that some tax practitioners have advised taxpayers to utilize the Streamlined Compliance Procedures when they could have utilized the DSP. This is because some practitioners believe that proving the non willful standard through the Streamlined Compliance Procedures is an easier standard to satisfy than the reasonable cause standard. Whether or not this is a correct assumption is debatable. With that said, in 2015, officials at the IRS affirmed that non-willful taxpayers with de minimis unreported income and tax due could use the DSP. See Lee A. Sheppard, Did You Really Mean to Hide Those Foreign Accounts?, 78 TAX NOTES INT’L (TA) 1018 (June 15, 2015). (Public comments made by government officials helps to understand IRS enforcement priorities. At the June 5, 2015 New York Tax Controversy Forum, a senior IRS attorney provided insight on the taxpayer’s burden of proof of demonstrating non-willfulness in the context of the Streamlined Program. The senior attorney also noted it might be possible to file delinquent information forms such as Forms 5471 and 3520 and attach reasonable cause statements if the Streamlined procedure is viewed as being too complex and not a good match to the taxpayer’s individual facts and circumstances).
In a perfect world, the IRS would readily issue “frequently asked questions” dealing with specific issues of “reasonable cause” and “unreported income” in the context of the DSP. This is somewhat perplexing because in so many other contexts, the IRS issued guidance not only in the varied voluntary disclosure programs, but also in other areas.
Although the IRS has not issued formal guidance guidance defining who can participate in the DSP, it appears the individuals who innocently failed to disclose a foreign asset on an information return with a small amount of unreported income can utilize the DSP. What constitutes the terms “innocently” and “small amount of unreported income,” at this point, appropriate legal judgment is required. Like the Streamlined Compliance Procedures, the IRS has not defined the parameters of the DSP. However, for certain individuals facing the prospect of significant international penalties, the DSP should at least be considered. The DSP may not only offer the participant substantial savings from the assessment of international penalties, but the DSP can also result in a substantial savings in the form of not having to pay the five percent Streamlined Compliance Procedures penalties.
Diosdi Ching & Liu, LLP represents clients through IRS Offshore and Domestic Voluntary Disclosure Programs, Streamlined Compliance Procedures, and Delinquent International Information Return Submission Procedures.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi represents clients in federal tax controversy matters and federal white-collar criminal defense throughout the United States. Anthony Diosdi may be reached at 415.318.3990 or by email: adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.