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Offshore or In-Lieu Penalty AND Opt-Out

March 26, 2020

What Calculation is Used in the Offshore Voluntary Disclosure Program (OVDP) to Levy the Offshore or In-Lieu Penalty?

There is a large mandatory penalty associated with Offshore Voluntary Disclosure Program (OVDP). It is equal to 27.5% of the highest balance in the taxpayer’s foreign bank accounts, and 27.5% of any “non-compliant” assets even if said assets do not need to be reported on a Foreign Bank Account Report (FBAR) FINCEN FORM 114, formerly TD-F 90-22.1. What makes an asset non-compliant is if jt that generated income that was supposed to be detailed on a U.S. tax return but was not. Assets acquired with monies on which U.S. tax went unpaid also qualify as non-compliant. (Refer to IRS FAQ No. 35). This compounded fee structure is hardly fair and can cost a taxpayer enormous penalties under OVDP relative to the actual value of unreported assets.

An holder of a securities account at a Foreign Financial Institution (FFI), for example, like HSBC India, of a total value of $50,000, with undeveloped land values at $2M could run into problems under this hypothetical scenario: The land was financed, but part of the down payment came from the HSBC India account. Their penalty on the total assets of $2,050,000 at 27.5% would equal a whopping $ 563,750!

Mercifully, there is a limited exception under OVDP. Using FAQ 52, Category 3 (if applicable), the U.S. person could avoid paying a penalty ok the value of the undeveloped land and then the penalty on the cash in the bank account would be a mere 5%. Rare is the case where FAQ 52, Category 3 can be applied. A U.S. persons must meet ALL of the following criteria:

Reside outside of the United States for all of the years included in the voluntary disclosure (generally 8 years):

Made a good faith showing that he timely complied with all tax requirements of the country of residence; and

Has less than $10,000 per year of U.S. source income.

Individuals who are currently filing for OVDP are NOT eligible for this exception, nor is anyone who filed for OVDP on or after July 1, 2014.

If you fit these conditions, you might do well to opt-out of the OVDP, or maybe, steer clear of OVDP altogether unless there is serious criminal tax exposure. A consultation with an experienced tax litigation attorney should help you make the right choice.

Hold On, We Are Not Done Yet!

In addition to the 27.5% penalty, a taxpayer going into the OVDP is obligated to file 8 years’ worth of amended tax returns regardless of the fact that the statute of limitations for assessing FBAR penalties is 7 years from the original due date of the FBAR. Taxpayers who go into the OVDP must file a statement waiving the 6-year statute of limitations on assessing the FBAR penalty. They are also forced to waive the statute of limitations on the assessment of additional taxes, which would usually be either three or six years, depending on the circumstances.

Added to the OVDP penalty (also known as the “in lieu penalty” as it is “in lieu” of the FBAR and fraud penalties), taxpayers entering the OVDP are also charged an accuracy-related penalty under Internal Revenue Code Section 6662. The accuracy-related penalty is 20% of the tax due. On top of that, they pay interest on both the outstanding tax and the accuracy-related penalty.  There is no interest on the 27.5 percent in lieu penalty.

That in lieu penalty can leap to 50% if the taxpayer had an account with an FFI (Foreign Financial Institution) that was publicly identified as coopering with a government investigation or being under investigation. If the taxpayer had help from a so-called “facilitator” (a go-between who assisted them in establishing or maintaining an offshore arrangement), if that facilitator was publicly indicated as cooperating with a government investigation, or if the facilitator himself is under government investigation, then the 50% penalty also applies.  As far as the term “publicly identified”, The IRS has a puzzling and not particularly intuitive interpretation of this term. For practical purposes, referring to the list of foreign financial institutions and facilitators published by the IRS is a safe bet. As of November 8, 2016, the IRS listed 97 foreign financial institutions largely located in Switzerland, with a few in other countries. The list also identifies 48 facilitators by name.This list of facilitators is used to generate pre-clearance letters that are submitted to the Internal Revenue Service’s Criminal Investigation division on or after November 15, 2016.

What is an Opt-Out?

The 2012 version (the most current) of the OVDP (Offshore Voluntary Disclosure Program)  is rather inflexible. Before the 2012 program was implemented, the IRS allowed a taxpayer to argue that since his or her conduct was not willful, that a lower penalty than the exhorbitant in-lieu or offshore penalty should be applied under the version of FAQ 35 that existed then. Sadly this option ceases to exist . A person who decides that the 27.5% in-lieu penalty is unreasonable has to leave the OVDP. That is what is referred to as an “opt-out.”

Choosing to opt-out from OVDP comes with risks. According to FAQ No. 51, a taxpayer who opts out of the program may be subject to a “full scope” tax audit. The IRS could audit your non-foreign issues as well as the offshore ones. They can audit back many years, even to years that would otherwise be closed. If they could to prove that there was any tax evasion, the normal statute of limitations ceases to apply.

Some tax lawyers have raised concerns that the IRS could even bring criminal tax charges against persons who opted out of the OVDP. Our tax attorneys don’t believe that is a completely accurate interpretation of the FAQs. FAQ 51 provides that a criminal tax referral could be made IF the IRS discovers that items were left undisclosed as part of the OVDP. This would mean that without such a misrepresentation the taxpayers who entered the OVDP continue to enjoy protection even if they opt out. Actually, FAQ 51 proceeds to “remind taxpayers” that even after they opt out of the civil settlement structure that they remain part of the Criminal Investigation Voluntary Disclosure Practice, and that must continue to cooperate with the IRS. Basically, taxpayers who are concerned about potential criminal exposure should be advised against opting out of the OVDP.

Regardless of the possible pitfalls of opt-out, the silver lining of an opt-out is potentially negotiating a settlement much lower than the 27.5% offshore penalty. Persons who are liable for the non-willful penalty are subject only to a penalty of $10,000 per year, (and possibly per account) FBAR penalty. Under IRS settlement guidelines published in the Internal Revenue Manual smaller accounts can draw  even lower penalties than that. Taxpayers who can prove “reasonable cause” for failure to file their FBAR can avoid penalties altogether. For some cases, the Internal Revenue Manual also allows Revenue Agents to issue warning letters instead of going directly to charging penalties.

An opt-out decision is irrevocable once communicated to the IRS in writing, so this determination should only be made after considering every possible scenario.



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