By Anthony Diosdi
Since the Internal Revenue Service (“IRS”) has launched the initial Offshore Voluntary Disclosure Program (“OVDP”) in 2009, more than 56,000 people have disclosed their foreign financial accounts to the IRS. At last count, the IRS has collected over $10 billion dollars in tax, interest, and penalties from various targeted offshore voluntary disclosure programs.
The OVDP is a subset of the IRS Criminal Investigation Division’s longstanding Voluntary Disclosure Practice. The Voluntary Disclosure Practice is a longstanding practice of IRS Criminal Investigation (“CI”) whereby CI takes timely, accurate, and complete voluntary disclosures into account in deciding whether to recommend to the Department of Justice that a taxpayer be criminally prosecuted. It enables noncompliant taxpayers to resolve their tax liabilities and minimize their chance of criminal prosecution. When a taxpayer truthfully, timely, and completely complies with all provisions of the voluntary disclosure practice, the IRS will not recommend criminal prosecution to the Department of Justice. The OVDP addresses the civil side of a taxpayer’s voluntary disclosure of foreign accounts and assets by defining the number of tax years covered and setting the civil penalties that will apply.
In 2009, the IRS opened the initial OVDP to provide a uniform mechanism to U.S. citizens and tax residents who had not otherwise disclosed foreign bank accounts, foreign situs assets, and the income that was used to pay for such assets. After the expiration of the 2009 OVDP, the IRS created the 2011 Offshore Voluntary Disclosure Initiative. After expiration of the 2011 Offshore Voluntary Disclosure Initiative, the IRS opened another version of the program, the 2012 OVDP, which was significantly modified in July of 2014. The OVDP ended on September 28, 2018; however, it was recently revived again with modifications.
All of the aforementioned programs required participants to amend or file tax returns disclosing previously undisclosed foreign accounts or assets. In addition, each participant was subject to a miscellaneous offshore penalty based on the highest aggregate of undeclared foreign assets. Depending on the program, the miscellaneous offshore penalty ranged from 20 to 50 percent of the highest aggregate of undeclared foreign assets. Depending on the value of the foreign financial accounts and assets previously not disclosed, the miscellaneous penalty can be substantial. As a result, many of the participants have criticized the targeted offshore voluntary disclosure programs for being harsh and inflexible. Since 2009, I assisted hundreds of clients with undisclosed foreign financial assets. Many who elected to participate in a targeted offshore voluntary disclosure program often have buyer’s remorse and many believe that they entered into an offshore voluntary disclosure program with a full understanding of the program or as a result of poor advice. I have been asked a number of times is there a way to obtain a refund of the miscellaneous offshore penalty paid through a targeted offshore voluntary disclosure program? This article explores if there are any circumstances in which a participant who paid a miscellaneous offshore penalty can potentially obtain a refund of that penalty and the hurdles involved with prosecuting such a case.
The Miscellaneous Offshore Penalty is Classified as a Tax and is Subject to the Anti-Injunction Act
The vast majority of individuals that participate in a targeted offshore voluntary disclosure program are assessed a so-called miscellaneous offshore penalty. The penalty is assessed once a participant executes a closing agreement with the IRS. The closing agreement requires that a participant of a voluntary disclosure program to agree to be assessed the offshore penalty under Title 26 of the United States Code. Since the miscellaneous offshore penalty is classified as a Title 26 penalty, the penalty will likely be treated as a tax. This is an important characterization because penalties treated as a tax are subject to the Anti-Injunction Act.
The Anti-Injunction Act says that “no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person.” 26 U.S.C. Section 7421(a). Among other things, the Anti-Injunction Act generally bars pre-enforcement challenges to certain tax statutes and regulations. The Anti-Injunction Act requires plaintiffs to instead raise such challenges in refund suits after the tax has been paid, or in deficiency proceedings. This means all demands for refunds of a miscellaneous offshore penalty must treat it as if it were a refund claim of the overpayment of taxes.
The Internal Revenue Code discusses the procedure regarding filing a claim for refund of taxes. Internal Revenue Code Section 7422(a) explains that such a claim must be filed before bringing a lawsuit:
No suit or proceeding shall be maintained in any court for the recovery of
any internal revenue tax alleged to have been erroneously or illegally assessed or collected, or of any penalty claimed to have been collected without authority, or of any penalty claimed to have been collected without authority, or of any sum alleged to have been excessive or in any manner wrongfully collected, until a claim for refund or credit has been duly filed with the Secretary, according to the provisions of law in that regard, and the regulations of the Secretary established in pursuance thereof.
A claim for refund is governed by Internal Revenue Code Section 6401. Internal Revenue Code Section 6401(a) provides that the IRS may issue a refund for any overpayment of a tax. However, the claim for refund must be filed within the time prescribed by law. Internal Revenue Code Section 6511 explains the period of limitations for filing an administrative claim for refund:
(a) Claim for credit or refund of an overpayment of any tax imposed by this title in respect of which the taxpayer is required to file a return shall be filed by the taxpayer within 3 years from the time the return was filed or two years from the time the tax was paid, whichever of such periods expires the later, or if no return was filed by the taxpayer, within 2 years from the time the tax was paid….
(b)(1) No credit or refund shall be allowed or made after the expiration of the period oflimitation prescribed in section (a) for the filing of a credit or refund, unless a claim or refund is filed by the taxpayer within such period.
Section 6511 imposes a strict two year limitation on a claim of the miscellaneous offshore penalty. This means that a refund claim of a miscellaneous offshore penalty must be paid in full and the claim for refund must be completed no later than two years from the date of the payment of the penalty.
Procedurally, the administrative claim for refund of a miscellaneous offshore penalty must set forth in detail each ground upon which the refund is claimed and facts sufficient to apprise the IRS of the exact basis thereof. Satisfying this requirement would be somewhat novel in these cases. This is because the miscellaneous offshore penalty is basically a creation of the IRS rather than Congress. Consequently, there are no statutory elements to a miscellaneous offshore penalty. Even though there is no statutory guidance defining a miscellaneous offshore penalty, there is some common sense guidance that may be utilized in filing an administrative claim for refund of such a penalty.
First, anyone seeking a refund of a miscellaneous offshore penalty must advise the IRS as to why you erroneously entered into the OVDP. Second, we should put the IRS on notice as to why he or she should not be subject to the penalty. The Offshore Voluntary Disclosure Frequently Asked Questions and Answers promulgated by the IRS in previous offshore voluntary disclosures sheds some light on how to proceed with a refund claim. In particular, Frequently Asked Questions and Answers Numbers 5 through 7 states that the miscellaneous offshore penalty is designed in lieu of any other penalties for failing to timely file Form TD F 90-22.1, FinCen 114, Form 8938, Form 3520, Form 3520-A, Form 5471, Form 5472, Form 926, and Form 8865. Frequently Asked Questions and Answer 7 also provides that the miscellaneous penalty is designed to be in lieu of the civil fraud penalty.
Since the miscellaneous penalty was designed to replace penalties that may have been assessed in lieu of failing to disclose foreign financial assets or financial accounts on a number of informational returns and civil fraud penalties, the claim for refund must address each of these possible penalties.Should the IRS reject or ignore the claim for refund, the individual seeking the refund may bring suit before either the United States Court of Federal Claims or a United States district court with proper venue.
Limitation a Closing Agreement Will Place on Litigation
On a civil action commences in federal court, the first challenge a litigant will face is the daunting task of setting aside the closing agreement that he or she executed with the IRS. All participants completing a disclosure through a targeted offshore voluntary disclosure program must execute an IRS Form 906 entitled “Closing Agreement on Final Determination Covering Specific Matters.”
By signing this closing agreement, [the participant] consents to the assessment and collection of the liabilities for tax, interest, additions to tax, and penalties determined by or resulting from the determination of this agreement, including any defenses based on the expiration of the period of limitations on assessment or collection.
By executing the Form 906, a participant has entered in a closing agreement with the IRS. A closing agreement is written agreement between an individual and the Commissioner of the IRS which settles or “closes” the liability of that individual with respect to any internal revenue tax for a taxable period. The Internal Revenue Code provides that if a closing agreement is signed and accepted by the Commissioner or his delegate, the agreement is not final and conclusive if there is a showing of “fraud or malfeasance, or misrepresentation of a material fact.” On its face, it appears the only method to invalid a Form 906 is claim the agreement was entered into by fraud, malfeasance, or misrepresentation. Establishing such a claim would be extremely difficult if not impossible. However, as discussed below, fraud, malfeasance, or misrepresentation may not be the only method to invalidate a closing agreement. In some cases, closing agreement can be challenged on contractual type theories.
Can a Closing Agreement be Attacked under Contractual Theories?
Closing agreements with the IRS are analyzed in a manner similar to contract law. Although closing agreements are governed by federal contract principles rather than state contract law, closing agreements under Internal Revenue Code Section 7121(a) “are contracts and generally are interpreted under ordinary contract principles.”
The most common reason participants enter into a targeted offshore voluntary disclosure program is the fear of criminal prosecution or large civil penalties. We have to remember that for many years that IRS took a very tough stance with individuals with undisclosed foreign financial assets. The IRS basically gave taxpayers with undisclosed foreign financial assets a choice: 1) enter into a targeted offshore voluntary disclosure program and pay the miscellaneous offshore penalty; 2) take your chances through the uncertainty of the Streamlined Procedures; or 3) face criminal charges and/or serious civil penalties by the government.
These threats probably resulted in number of individuals needlessly entered into an offshore voluntary disclosure program and paying the miscellaneous offshore penalty. Some of these participants may have mistakenly failed to disclosure for assets on their tax returns as a result of bad advice, age, or because of poor English comprehension. Could these threats amount to duress to set aside a closing agreement? Federal courts have recognized the doctrine of duress as a defense to the enforce of a contract with a government agency. However, the Court of Claims and the district courts have applied the doctrine of duress to contracts with the government differently.
The Contractual Concept of Duress as Applied by the Court of Claims
I will begin by discussing discussing Fruhauf Southwest Garment Co. v. United States, 111 F.Supp. 945, 951 (Ct.Cl. 1953). Although it is an older case, Fruhauf is a terribly important case for anyone considering attacking a government contract on the theory of duress. In Fruhauf, the Court of Claims has stated that duress exists where: 1) one side involuntarily accepted the terms of another; 2) that circumstances permitted no other alternative; and 3) that said circumstances were the result of coercive acts of the possite party. The Court of Claims has also determined an agreement is voidable on grounds of duress if a party’s manifestation of assent was induced by an improper threat which left the recipient with no reasonable alternative but to agree. It is important to note that the Court of Claims tests duress by an objective, not subjective standard.
In deciding whether the IRS’ threats of criminal prosecution and/or severe civil liability against participants of an offshore voluntary disclosure program amounted to duress, the Court of Claims will not inquire whether these threats are indeed actions that the IRS could pursue. Instead, the Court of Claims must measure, from an objective standpoint, whether the IRS’ overt or subtle threats would be enough to “defeat…the will of the party coerced.” It is important to note that threats made against individuals who willfully or recklessly failed to disclose foreign financial assets are justified. In these cases, “[i]t is not duress for a party to do or threaten to do what it has a legal right to do.” Whether or not IRS threats of criminal prosecution or severe civil penalties can be so overpowering as cause certain individuals to needlessly enroll a targeted offshore voluntary disclosure program and pay the miscellaneous offshore penalty will depend upon the facts and circumstances of each individual case. As a preliminary observation, incompetent, unsophisticated, or eldery indivuals will have a stronger case to invalidate a closing agreement for duress or other contractual theories than other individuals. With that said, a comprehensive definition of the circumstances constituting duress is impossible; in Fruhauf, the Court of Claims has pointed out that each case must be decided on its own facts. However, the fact that there is some authority in this area should offer some hope to participates who paid the miscellaneous offshore penalty out of the errounuous fear of criminal prosecution or enormous civil penalties.
The Concept of Duress Applied to Closing Agreements in District Courts
Similar to the Federal Court of Claims, district courts in jurisdictions throughout the United States recognize that the threat of severe penalties may constitute duress. With that said, district courts typically do not employ the three part test for duress enunciated by the Court of Claims. Instead, district courts seem to review the facts and circumstances of each case to determine if duress existed. With that said, in exercising discretion in applying the concept of duress to contracts with the IRS, district courts weigh public interest in the enforcement of these contracts heavily in favor of the government. This means that a district court will likely find a closing agreement unenforceable on the grounds of duress only in cases of extraordinary circumstances. The fear of criminal prosecution or severe civil penalties will not likely convince a district court that a closing agreement was entered into under duress.
For example, in one older case, a criminal investigator also told two taxpayers that his intentions were to put them in jail. Although these individuals were apparent targets of a criminal investigation, they were never indicted by a grand jury. These individuals executed a settlement with the IRS based on these threats. The two taxpayers ultimately filed suit before a United States district court and sought to have the settlement agreement set aside. These individuals argued that they were forced to choose between a certain sum forfeited to the IRS and their reputations and, potentially millions of dollars. The district court stated that:
“while [the taxpayers’] choice was difficult and painful, it is far from unique. All parties to potential litigation, when offered a settlement, must weigh the odds of prevailing upon a claim and potential gains against possible liabilities. The choice is never easy, but it is not unfair or inequitable.”
Similarly, in Fed. Deposit Ins. Corp. v. John A. White, 76 F.Supp.2d 736 (1999) the defendants John White and Donna White attempted to repudiate a settlement agreement with the Federal Insurance Corporation (“FDIC”). The defendants alleged that they were threatened with criminal prosecution throughout the settlement process. The defendants felt coerced into signing the settlement agreement just to keep from going to jail. Even though the district court acknowledged that the defendants concern about their potential criminal exposure was “for good reason,” the court refused to find that the settlement agreement between the FDIC and the Whites was the result of duress. These cases demonstrate the reluctance of a district court to set aside a written agreement with the government on the grounds of duress despite threats of criminal or civil penalties.
The only conceivable fact pattern in which a district court may find a contract with the government unenforceable as the result of duress was in Robertson v. Commissioner T.C. 1973-205. Although Robertson was decided by the United States Tax Court, it is conceivable that a district court could align itself with the Tax Court if the issues were similar to the facts and circumstances of Robertson. In Robertson, an IRS Revenue Agent offered an uncounseled taxpayer a choice between signing a consent form or subjecting his property to seizure. The Tax Court found duress under these circumstances. Given the weight district courts place in the public interest to contracts with the government, it is difficult to imagine a case where a district court would set aside a closing agreement under a theory of duress.
Be Careful What You Wish For
This article only discusses setting aside a Form 906 under a contract theory of duress. There are other possible contract theories available to attempt to invalidate a closing agreement. With that said, I could not find any reported decisions were an individual successful sued the government in either the Court of Federal Claims or a United States district court. Consequently, it is difficult to determine how such a refund of a miscellaneous offshore penalty case would proceed if litigated. With that said, anyone considering litigating the refund of a miscellaneous Offshore Penalty must be prepared for government counterclaim attempting to assess all the penalties that could have been assessed in lieu of the offshore penalty. These are hazards that must be taken seriously by anyone considering taking on the extremely difficult if not impossible task of suing the government for the refund of the miscellaneous offshore penalty.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP. He 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.