The IRS Voluntary Disclosure Program for Holders of Foreign Bank Accounts - A Better Investment Than a Bear Market Rally?

During its first 100 days, the Obama administration, primarily through the Internal Revenue Service (“IRS”) and the Treasury Department, has devoted considerable attention to the issue of tax evasion, including the use of foreign, or “offshore,” bank accounts through which wealthy Americans are purportedly hiding assets and allegedly evading billions of dollars in U.S. taxes every year. Although the IRS has a long-standing practice of typically not criminally prosecuting taxpayers who voluntarily disclose previously unfiled returns or unreported income, on March 26th the IRS published a series of memoranda (the “March Memoranda”) detailing a new reduced penalty program (the “Program”) that clarifies the application of its existing voluntary disclosure practice to taxpayers with undisclosed foreign accounts. The new Program will only be available for six months until September 23, 2009. On May 6, 2009, the IRS published a set of Frequently Asked Questions (“FAQs”) regarding the program, explaining the process for requesting application of the Program, and outlining the penalties that might apply if a taxpayer with undisclosed foreign accounts is discovered without having made a voluntary disclosure.

Under the new Program, taxpayers (both individuals and entities) that voluntarily disclose the existence of untaxed foreign accounts may receive closing agreements that provide for reduced penalties and a promise by the IRS not to recommend criminal prosecution. The FAQ’s and the March Memoranda should be read in conjunction with the applicable sections of the Internal Revenue Manual which set out the criteria for what constitutes a voluntary disclosure.

The Process of Making a Voluntary Disclosure

A taxpayer starts the process by making a voluntary disclosure request. A taxpayer must include a statement in the voluntary disclosure request that: (a) shows a willingness to cooperate with the IRS (and, in fact, cooperate); and (b) offers to make a good faith arrangement to pay in full any tax, interest, and penalties determined to be due by the IRS. The FAQs direct taxpayers to make disclosures or inquiries to the Special Agent in Charge at their local Criminal Investigation (“CI”) office. The CI office will determine if a disclosure is “voluntary” and, therefore, eligible for Program consideration. A disclosure is “voluntary” if it is “truthful, timely, and complete.” A disclosure is “timely” if it is made before the IRS learns specifically of a taxpayer’s noncompliance. If the IRS has already commenced an investigation of a taxpayer or of any related party where the taxpayer’s specific liability would be directly related (even if the taxpayer is unaware of the investigation), or if the IRS alerts the taxpayer that it intends to commence an investigation, disclosure cannot be timely.

Note that a voluntary disclosure and offer of compliance must be complete and unconditional. The Internal Revenue Manual essentially requires a taxpayer to “put all of his cards on the table” before the IRS will find that the taxpayer acted voluntarily. For example, an anonymous offer through counsel to come forward and settle a tax liability is not considered a voluntary disclosure. The FAQs further provide that, while such “hypothetical” inquiries may be permitted, they are not voluntary disclosures, and there is a risk that the IRS may learn of the taxpayer’s situation or commence an investigation while the anonymous inquiry is being handled. The March Memoranda makes clear that the Program is “only applicable to taxpayers that make voluntary disclosure requests, and who fully cooperate with the IRS, both civilly and criminally.”

After it is reviewed by CI, the disclosure request is sent to the Philadelphia Offshore Identification Unit (“POIU”) for civil processing. In order to qualify for the Program, the taxpayer must file amended income tax returns and Treasury Department Forms TD F 90-22.1, Report of Foreign Bank and Financial Accounts (“FBARs”), for each of the prior six years or each year since the account(s) in question were opened, whichever is less. If already prepared, amended returns and FBARs should be filed with the voluntary disclosure request, although this is not required, but will eventually be needed by the POIU.

Applicable Civil Penalties Under the Program

Irrespective of the outcome, the taxpayer will be liable for any unpaid income taxes and interest on the unpaid tax liabilities for the last six years (2003 through 2008 for calendar year filers). If the IRS concludes that the disclosure was voluntary, and that the taxpayer has cooperated fully with the IRS, the taxpayer will be subject to the following penalties: (i) either an accuracy-related (20%) or delinquency (25%) penalty, depending on whether prior income tax returns were filed, on the income tax liability for all six years; and, (ii) in lieu of all other penalties, a penalty equal to 20% of the account’s highest value during the prior six-year period. With respect to this latter 20% penalty on the account’s value, this penalty will be reduced to 5% if: (a) the taxpayer did not open the account; (b) there was no activity in the account during the period in which the account was controlled by the taxpayer; and (c) the funds deposited to the account were subject to U.S. taxation (meaning that only account earnings were not taxed). The FAQs go into some detail in describing what would happen to hypothetical taxpayers that either voluntarily disclose or do not voluntarily disclose their foreign assets. Quizzically, the FAQs do not discuss the availability of the reduced 5% penalty, but it is provided in the March Memoranda.

Other Requirements and the September 23, 2009 Deadline

The Program and the IRS’ voluntary disclosure practice come with some important caveats. First, illegal source income is not eligible for voluntary disclosure. Second, a voluntary disclosure request does not obligate the IRS to enter into a closing agreement based on the Program. Even if a taxpayer makes a fully compliant voluntary disclosure request, that does not guarantee that the taxpayer will not be subject to criminal prosecution, or that the taxpayer will receive a closing agreement consistent with the Program parameters. In addition, should a taxpayer make a voluntary disclosure but fail to enter into a closing agreement, the IRS may disregard the Program parameters and seek all available penalties. Third, taxpayers that have already made “quiet” disclosures by amending their tax returns and filing late-filed FBARs are not, based solely on those facts, deemed to have made voluntary disclosures. Instead, they can still take advantage of the Program by writing to request application of the Program and attaching copies of the already-filed amended returns.

Finally, the Program is limited to six months from the date of the March Memoranda, meaning that taxpayers must submit requests for voluntary disclosure by September 23, 2009. The FAQs leave open the possibility that the Program may be extended, however, there can be no assurance that IRS will do so, or on what terms.

Conclusion

Taxpayers with unreported offshore accounts should consider taking advantage of the Program. First, the tax savings for disclosure can be considerable especially when compared to potential penalties, and a closing agreement would permit a U.S. taxpayer to repatriate funds to the U.S. without fear of tax repercussions or prosecution. Second, unlike prior IRS “amnesty” programs, several of which have failed to produce significant taxpayer compliance, the Program is likely to result in many more voluntary disclosures because of a new enforcement focus by IRS on offshore tax evasion, greater cooperation in the form of information exchange between OECD countries and so-called “tax havens,” and enhanced penalties for failure to disclose foreign accounts and other tax evasion behavior.