Now that the voluntary disclosure programs (OVDI / VDP) have ended, tax professionals are wondering what’s going to happen next. With OVDI participants facing stiff penalties, the IRS must either increase penalties for voluntary disclosers going forward or risk angering participants who will rightfully feel that they were deliberately entrapped by unfulfilled promises of leniency.
Scott Michel and Mark Matthews, two tax professionals, have written a report detailing some of the issues, from a tax professional’s standpoint, of the two OVDI programs and the difficulty the IRS will have in moving forward.
Previous to the OVDI programs, tax professionals simply recommended a “quiet filing” (filing and paying back taxes without drawing attention). “From our perspective, the system worked beautifully – knowing that draconian consequences were unlikely, taxpayers were encouraged back into compliance, and Treasury was provided with pools of assets to be taxed each year with little or no IRS resources being expended.”
Tax professionals are now unsure if this is still a realistic option, or if OVDI has irrevocably changed the options available to those who wish to come into compliance.
By the time we reached OVDI #2, we had all suffered through the series of policy changes and reversals during 2009 and 2010. We had endured unanticipated and unadvertised aggressive audits of our clients’ amended returns, spent hours explaining to clients why they had to sign new powers of attorney and Form 872 statute extensions, and helplessly watched while a cadre of IRS technical advisers interpreted discounted penalties and safe harbors so narrowly that they became meaningless, in some cases producing absurdly unfair and disproportionate results. The Service’s reversal on FAQ 35 and its refusal to consider individual cases of non-willfulness were nearly the last straws. We and our colleagues came to doubt the fairness of the IRS process and communicated that (intentionally or not) to new clients.
The effects of the IRS’s draconian and inconsistent policies were quickly seen:
A far larger percentage of our clients elected not to enter OVDI #2 than entered OVDI #1. Many just walked away. That was not what the IRS wanted, but it happened because we had no choice but to answer our clients’ questions about our experiences in OVDI #1.
It only added insult to injury that the level of scrutiny in auditing every submission under the OVDI programs was so high. Not only is it stressful to the taxpayer, it is “unnecessary in a rough-justice VDP when the taxpayer, under the guidance of a tax practitioner, has voluntarily acknowledged the non-compliance. The odds of a taxpayer deliberately committing new acts of evasion during a voluntary disclosure are remote. Spot-checks alone would be more than enough to keep the applicants honest.”
And there are legitimate questions to be raised over whether the OVDI programs even attracted the intended people:
In the relatively narrow categories of behavior associated with unreported bank accounts, private practitioners encountered a broad range of culpability. There were a few of the stereotypical offshore tax cheats — native-born U.S. citizens who, on their own accord, decided to evade taxes and developed plans to use offshore entities and accounts to shield from taxation funds earned in the United States. That is the media image of offshore tax evaders and an image promoted by IRS public statements. For that group, the penalty levels in the OVDI programs were, in our judgment, appropriate, perhaps even generous when combined with a criminal amnesty. It may surprise most observers, but we saw few cases like that. It is anyone’s guess why. It may be that this aggressive and risk-prone group was prepared to let it ride. Or perhaps there simply are not as many of them as anticipated.
One large group of taxpayers in OVDI #1 comprised persons whose foreign accounts were established by their parents or other family members, with the assets passing by gift or inheritance. Those taxpayers often had knowingly failed to disclose their accounts to their return preparers, and thus they did not report the accounts on FBARs or report the income on their returns. Many of them had family stories involving the Holocaust or political or economic oppression outside the United States. The persons who had opened the accounts originally were often foreign-born and had since died. The funds were rarely earned in the United States, and our clients often relied entirely on non-U.S. financial advisers. Many clients were afraid to come forward or to discuss the issue with friends and family, and they believed that if they approached a professional they would send family members to jail or even risk their own exposure by an unethical lawyer seeking a whistleblower reward. To us (not to mention to our clients), that group was categorically different than the core tax evader who skimmed funds from a business and deposited them in an overseas account.
Yet OVDI #1 made no real distinction between that group and the volitional tax evader. While IRS guidance would have reduced the penalty to 5 percent for some inherited or similar accounts, officials interpreted that guidance so narrowly that we joked about the mythical unicorn. We suspect that out of the thousands of participants in OVDI #1, very few received that 5 percent safe harbor penalty, even though a large component of the program involved inherited or gifted accounts.
Starting mostly with OVDI #2, another group of taxpayers began streaming in. They had lived abroad for many years. Some had been born to foreign parents and left this country as infants; many were dual citizens at birth. All had routine “foreign” bank accounts in their country of residence and were fully compliant with the tax laws of that country. Few had grown up in countries that taxed worldwide income. Others had been assured by foreign accountants that they did not owe U.S. taxes (which was often true because of the foreign tax credits available to them). A few did not even know they were U.S. citizens. Yet, in part because of frightening publicity in their home country, for the first time, the taxpayers in that group — which comprised probably only a small percentage of noncompliant Americans living abroad — were anxious and concerned.
In the guidance for OVDI #2, the IRS, to its credit, attempted to create a penalty safe harbor of 5 percent as long as these sorts of individuals involved had little or no U.S.-source income.4 But even that penalty structure discouraged most persons in this group from entering OVDI. Most of them owed little or no U.S. taxes, and having to forfeit 5 percent of their unreported financial accounts just for peace of mind seemed excessive, especially given the need to expend thousands of dollars in legal and accounting fees to submit eight years of tax returns and FBARs. We can attest that many people in that group are likely, at best, to start filing next year, and that some will simply remain noncompliant and expect, with good reason, that the IRS will never find them.
There were other patterns of conduct that did not fit OVDI: corporate noncompliance, unfiled FBARs from minor children, more complicated and yet legitimate trust structures, and the like.
Overall,the authors rate the OVDI programs as failures:
No doubt the IRS initially designed the program believing more hardcore tax cheats would come forward than did. But it was clear by the end of OVDI #1 than most of those who came forward did not fit that category. Some agents have conceded that although they would have imposed no penalties in a particular case, they were told to take a hard line. The oddity, of course, is that OVDI penalties may well be higher than they would have been in an audit initiated by the IRS. This turns the VDP on its head.
This leaves taxpayers and tax professionals reeling, and unsure about continuing to promote tax compliance.
Practitioners, stung by the overly strict application of the criteria for discounted penalties in other instances, have doubts about what will happen. What criteria will the special committee use? Can a revenue agent operate unchecked to assert maximum penalties simply because there is a multiyear pattern of noncompliance? What will happen at IRS Appeals? (Astonishingly, there is no apparent requirement that the revenue agent consider that even convicted offshore defendants were only required to pay a single 50 percent FBAR penalty; and a 50/50 “hazards” settlement on a willful FBAR penalty might represent 150 percent of the value of the account, not a terribly attractive option.) We have already seen a “luck of the draw” aspect to the process – some agents and their managers are more sympathetic than others to the gradations of willfulness.
It is now unclear whether “quiet disclosures”are a legitimate option post-OVDI:
Otherwise, the issue is whether the IRS would react with anger or hostility to a quiet disclosure if the returns or FBARs get pulled for audit. During both OVDI programs, the IRS expressed disdain for quiet disclosures, threatening to detect and even prosecute persons who attempted quiet disclosures during both initiatives. We have heard of anecdotal instances of IRS agents stating as much, and we are aware of a few cases in which quiet disclosures have been detected and opened for examination. In the criminal information filed in a recent case that resulted in a guilty plea, the IRS made plain that quiet disclosures were not considered true voluntary disclosures, although in that very unusual case the quiet disclosure failed to report all accounts.
While we understand the IRS’s motives to drive people into the OVDI programs, we urge it to carefully consider whether to maintain that stance post-OVDI. Many federal prosecutors over the years have acknowledged that it would be almost impossible to get a jury to convict a taxpayer who came forward with a timely, truthful, and complete quiet disclosure. Further, aggressive enforcement action against taxpayers who file amended tax returns, arising solely from the IRS’s wish that they contact CI first, might overwhelm CI and possibly bring the valid and routine practice of amending tax returns to a halt.
Tax professionals are now navigating in uncharted waters and do not know what advice to give their clients. Even if the IRS were to communicate clearly with them,their behaviour during the OVDI programs has proven them untrustworthy.
Absent clear guidance, in the post-OVDI environment, practitioners will often have to speculate with their client on how the IRS will react. We cannot tell a client what will happen because of the uncertainties about the IRS treatments they will encounter in a noisy as opposed to a detected quiet disclosure. This is bad for all parties in the tax system. Taxpayers may face excessive penalties and higher transaction costs as the price of attempting to become compliant. Practitioners will face awkward moments when a client asks for a recommended course of action and the choice frankly involves not just the facts of the case but also the client’s tolerance for risk. We would much prefer to recommend a predictable and fair path to compliance rather than discuss risk. The Service will have no systematic data about the impact of its enforcement efforts, and it will be unwittingly sanctioning “hide the pea” and audit lottery games. This will have other pernicious effects on the tax system. It is time for the IRS to reevaluate the VDP and issue clear guidance.
To complicate matters further, the IRS must balance the desire to promote future voluntary disclosures with the clear message that those who come in after September 9 are not reaping benefits from their delay compared with those who came forward in the OVDI programs.
This is all counter to the IRS’s best interests. The problem with FATCA and the OVDI programs is that they are extremely labour and resource intensive for the IRS.
It is indisputably far more efficient for noncompliant taxpayers to rectify their own misdeeds than it is for the IRS to try to catch them all, much less to then audit, investigate, prosecute, and collect taxes from them.