By Anthony Diosdi
On November 20, 2018, the Internal Revenue Service (“IRS”) issued a Memorandum discussing the rules for all voluntary disclosures (foreign and domestic) after the expiration of the final Offshore Voluntary Disclosure Program (“OVDP”). The Memorandum is broken down into multiple parts: background and overview, IRS Criminal Investigation (“CI”) procedures; civil processing, case development, and civil resolution framework, each of which are discussed in detail below. This article will also discuss the significant hazards of making a voluntary disclosure to the IRS.
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 income that was used to pay for such assets. After the expiration of the 2009 OVDP, the IRS created the 2011 OVDP Initiative. After the expiration of the 2011 OVDP, the IRS opened another version of the program, the 2012 OVDP, which was significantly modified in July of 2014. The OVDP programs ended on September 28, 2018; however, the IRS voluntary disclosure program continues. On November 20, 2018, the IRS issued Memorandum discussing new procedures for voluntary disclosures. According to the IRS Memorandum issued on November 20, 2018, contrary to the previous “one size fits all” application of OVDP programs of the past, “examiner discretion” based on all relevant facts and circumstances will be utilized for purposes of penalty mitigation. Finally, unlike previous OVDPs, offshore and domestic voluntary disclosures will be handled in the same manner.
Making a Voluntary Disclosure- Buyer Beware
The Memorandum states that the intent of the new voluntary disclosure program is to address either potential criminal liability or substantial civil penalty exposure due to a willful failure to report foreign financial assets and pay appropriate income tax thereon. Under current practice, a participant who failed to file a tax return or declare his full income and pay tax due can potentially escape criminal prosecution through voluntary disclosure of the deficiency, so long as the voluntary disclosure is made before an investigation has started. A disclosure must also be truthful, complete, and the participant must cooperate with IRS personnel in determining the correct tax liability. (Cooperation includes making good faith arrangements to pay unpaid taxes and penalties to the extent of the participant’s actual ability to pay). Unfortunately, even if a participant makes a timely disclosure and cooperates with the IRS, for reasons discussed below, a voluntary disclosure is far from a “sure thing.”
A voluntary disclosure will not in and of itself guarantee immunity from prosecution. Examples of this are illustrated in United States v. Tenzer, 127 F.3d 222,226 (2d. Cir. 1997) and Crystal Pools v. United States, 172 F.3d 1141, 1146 (9th Cir. 1999). In Tenzer, a taxpayer attempted to negotiate an installment payment plan with the IRS and filed amended tax returns pursuant of a voluntary disclosure. The IRS unilaterally determined the taxpayer did not qualify for the voluntary disclosure program because his offer to settle his back tax liabilities was inadequate. The IRS unilaterally determined the taxpayer did not qualify for the voluntary disclosure program because his offer to settle his back liabilities was inadequate. The taxpayer was charged with four counts of failing to file tax returns.
The taxpayer moved to dismiss the charge on the ground that the IRS had violated his due process rights by prosecuting him in violation of the voluntary disclosure program. The district court found that the taxpayer had complied with the voluntary disclosure policy and that the IRS was constitutionally required to comply with its own published policies; therefore, the charges against the taxpayer had to be dismissed. The Second Circuit Court of appeals reversed the district court’s decision, stating that the taxpayer’s due process rights had not been violated because the taxpayer had not paid his taxes or made arrangements to pay his taxes. The Second Circuit Court of Appeals also held that the IRS is not constitutionally required to comply with its own published policies.
In Crystal, the taxpayers, through their attorney, initiated contact with the IRS of Los Angeles for a voluntary disclosure. The attorney was told that voluntary disclosures were generally handled by the taxpayers’ local IRS district office. The attorney contacted the CID office for southern California, who confirmed that the IRS still had a voluntary disclosure program permitting taxpayers to amend past tax returns without the threat of criminal prosecution. Upon further discussion, the IRS told the attorney that the taxpayers’ profiles fit the program’s requirements and that there was no prior IRS investigation underway that would disqualify them. In the meantime, the taxpayers’ attorney faxed the IRS a confirmation letter of voluntary disclosure concerning the taxpayers’ unreported income. The Los Angeles office thereafter initiated a full investigation of the taxpayers. When the taxpayer argued that they had been misled in making disclosures to the IRS, and that the IRS acted in bad faith, the district court found their voluntary disclosure did not foreclose investigations. In addition, the misrepresentation upon which the taxpayers relief could not be imputed to the IRS. The Ninth Circuit Court of Appeals affirmed the case.
A review of case law and the Internal Revenue Manual (“IRM”) points out that regardless of whether a participant actually benefits or suffers detriment from voluntarily disclosing and rectifying faulty tax returns, that disclosure itself does not formally insulate the participant from prosecution. Anyone considering making a voluntary disclosure to the IRS must understand making such a disclosure is a calculated risk. In deciding whether or not an individual should avail him or herself of the voluntary disclosure program, the individual must weigh competing probabilities. A factor that would tend to discourage submitting to the voluntary disclosure program could be in cases where an individual is providing evidence that could be used against him or her that may not otherwise be unobtainable by the IRS. The factor that would tend to encourage participation in the voluntary disclosure program is when it may not be in the best interest of the government to criminally prosecute, or even attempt to impose the civil fraud on the taxpayer who availed himself of the voluntary disclosure program.
In any event, anyone considering making a voluntary disclosure to the IRS should carefully weigh their options before proceeding. The rule of caveat emptor definitely applies to anyone considering making a voluntary disclosure to the IRS.
The New Procedures Governing a Voluntary Disclosure
After an individual carefully considers his or her options and elects to make a disclosure to the IRS, an initial disclosure must be made to the IRS. The purpose of this initial disclosure is to determine if the individual can qualify to make a disclosure to the IRS. If the IRS has already begun to investigate an individual, that individual will not qualify to make a voluntary disclosure to the IRS. An initial voluntary disclosure may be done by a fax to the IRS CI Lead Development Center. The following must be included in the disclosure:
1) Applicant identifying information including complete names, dates of birth (if applicable), tax identification numbers, addresses, and telephone numbers;
2) Identifying information of all financial institutions at which undisclosed assets were held. Identification of undisclosed financial accounts.
3) Identification of all foreign and domestic entities through which undisclosed assets were held by the individual seeking to make a voluntary disclosure.
IRS CI will notify the participants via fax whether or not they have been cleared to make a voluntary disclosure. Acceptance will be made by letter and simultaneously IRS CI will forward the voluntary disclosure with all attachments to the Large Business and International (“LB&I”) Austin unit for case preparation before examination.
After an individual receives a pre-clearance notification, he or she will have 45 days from the date of the notification to complete Voluntary Disclosure Letter and Attachment (Forms 14457 and 14454). These forms will require information related to taxpayer noncompliance, a narrative providing the facts and circumstances, assets, entities, related parties and any professional advisors involved in the noncompliance.
Upon receipt of the relevant information from IRS CI, LB&I Austin, Texas will “route” the case as appropriate. Austin in effect will assign the case to an IRS examiner. In order to mitigate interest exposure, Austin will accept payment prior to case assignment for those taxpayers wishing to make prompt payment. All distributed disclosures from Austin handled by IRS exam will follow standard IRS audit procedures. With that said, unlike the earlier “take it or leave it” or “one size fits all” offshore voluntary disclosures, examiners are directed to develop cases by using appropriate information gathering tools to determine proper tax liabilities and applicable penalties. The IRS expects that all disclosures made under the practice will be resolved by a closing agreement with full payment of taxes, interest, and penalties for the relevant disclosure period. Failure to cooperate with civil examination could result in the IRS examiner requesting IRS CI to revoke the preliminary acceptance. The Memorandum relies on the IRM for purpose of providing guidance on the meaning of cooperation, which includes assisting the IRS in determining the correct tax liability for the tax returns being audited.
The New Civil Resolution Framework
The Memorandum introduces a new “Civil Resolution Framework” and grants the IRS discretion to extend this framework to non-offshore (i.e., domestic voluntary disclosures that have not been resolved). The Civil Resolution Framework calls for a six-year disclosure period (down from eight years in the 2014 OVDP) and will apply to all voluntary disclosures. However, while this is a general rule to apply to the most recent six tax years, disclosures and examinations periods may vary for voluntary disclosures not resolved by agreement- discretion is delegated to the examiner to expand the scope of the years at issue (i.e., beyond six years) to include the full duration of the non-compliance and may also assert maximum penalties under the law with approval of IRS management.
Accordingly, anyone making a voluntary disclosure to the IRS needs to consider the statute of limitations on assessments. On March 18, 2010, the Hiring Incentives to Restore Employment Act (Pub. L. No. 111-14)(“The HIRE Act”) was signed into effect. The HIRE Act dramatically expanded the statute of limitations to assess tax liability on undisclosed foreign income. Anyone with undisclosed offshore income beyond applicable “open” tax years of the new program could find themselves being assessed significant taxes going back to at least the 2003 tax years. This is a major hazard that must be considered by any taxpayer with undisclosed offshore income.
Under the “Civil Resolution Framework,” individuals making a voluntary disclosure must submit all required returns and documents requested for the disclosure period (However, as discussed above, the standard six year disclosure period may be expanded). At the conclusion of the IRS examination of all relevant information, an IRS examiner will determine the applicable tax, interest, and penalties. In regards to the penalties that may be assessed, the Memorandum provides the following guidance:
The civil fraud penalty set forth in Section 6663 will apply to the one year with the highest tax liability. A civil fraud penalty equal to 75 percent of the underpayment of tax attributed to fraudulent conduct. Alternatively, the civil penalty under Section 6651(f) for the fraudulent failure to file tax returns can apply. (Under Internal Revenue Code Section 6651(f), the failure to timely file penalty can be punished by a civil fraud penalty). In “limited circumstances” IRS examiners may apply the civil fraud penalty (whether based on Section 6663 or Section 6651) to more than one year within the circumstances of the case. In the event a participant fails to cooperate and resolve the examination by agreement, examiners are authorized to potentially apply the civil fraud penalty beyond the six-year disclosure period.
In cases of undisclosed foreign bank accounts, willful FBAR penalties (The willful penalty equals to a penalty of $100,000 or 50 percent of the value of the undisclosed foreign financial account(s)) will be asserted in accordance with existing IRS penalty guidance under IRM 4.26.16 and 4.26.17 (i.e., for one year during the disclosure timeframe). Participants may request the imposition of accuracy-related penalties under Section 6662 (The Internal Revenue Code imposes an additional tax of 20 percent on the portion of an underpayment of tax attributed to “negligence for rules and regulations) in lieu of civil penalties discussed above and/or non willful FBAR penalties (In cases of non willful violations, the IRS may assess a penalty up to $10,000 per violation) instead of willful penalties. However, the Memorandum warns that given the “objectives of the voluntary disclosure practice” granting such requests for lesser penalties “is expected to be exceptional.” No examples are given; however, the taxpayer must provide convincing evidence to justify why the civil fraud and willful FBAR penalties should not be imposed where the facts and law supports such penalties. Anyone considering making a disclosure to the IRS should carefully consider defenses to the civil fraud penalties and FBAR before entering into the program.
Taxpayers with undisclosed international informational returns, such as Forms 5471 and 3521, may under certain circumstances utilize the new voluntary disclosure program to reduce their exposure to international penalties. The penalty for late-filing a Form 3520 is $10,000 and the penalty for not timely filing a Form 3520 can be much greater. These penalties are not subject to administrative waivers. See IRM 18.104.22.168.3.2.1 (11-21-2017). Under the new voluntary disclosure procedures, penalties for failure to file international information returns will not be automatically applied. Instead, IRS examiners are granted discretion to take into account the application of other penalties such as the civil fraud penalty and the willful FBAR penalty and resolve the examination by agreement. The Memorandum specifically indicates these penalties will be addressed by IRS examiners based on the facts and circumstances, and examiners are directed to coordinate with appropriate subject matter experts. In certain cases, the voluntary disclosure program may offer relief to those facing significant offshore penalties.
The new voluntary disclosure program is a major departure from prior “take-it-or-leave it” “one size fits all” voluntary disclosure programs. Although the new program may be an opportunity for some participants. The new programs has significant hazards that must be considered by anyone considering making a voluntary disclosure to the IRS.
Diosdi Ching & Liu, LLP represents clients through IRS Offshore and Domestic Voluntary Disclosure Programs and Streamlined Compliance 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: firstname.lastname@example.org.
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.