The new information-reporting requirements of the Foreign Account Tax Compliance Act (FATCA), P.L. 111-147, took effect on July 1. Among other things, FATCA requires foreign financial institutions (FFIs) to report on their accounts held by U.S. taxpayers.
More than 77,000 FFIs signed on and acquired approved status in the initial round of FFI registration (see tinyurl.com/ku29njb for a list). According to Treasury (tinyurl.com/q6vg7nj), as of early July, 39 countries had entered into intergovernmental agreements with the United States (with more than 60 others having reached agreements in substance) under which they will permit or require financial institutions within their borders to report on U.S. account holders. For practitioners and their clients, this means that, eventually, most hidden foreign financial accounts will come to light. A new expansion and modification of the IRS’s Offshore Voluntary Disclosure Program (OVDP) may make it more attractive for certain owners of such accounts to come forward. The provisions, announced June 18, ease the options available to taxpayers who have not yet come forward, but in some circumstances could make them harsher.
Realizing that the previous OVDP rules’ 27.5% penalty may have been too harsh or restrictive for some taxpayers, the IRS expanded a streamlined reporting program to apply in more situations. If a taxpayer’s conduct relative to a foreign account could be deemed willful, it likely remains best for him or her to go into the OVDP and pay the penalties (and back taxes and interest) and likely avoid the risk of criminal prosecution and much steeper potential penalties. Under the three previous iterations of the OVDP, approximately 45,000 taxpayers have come forward, and the IRS has brought in $6.5 billion in additional taxes, interest, and penalties as a result (see, by this author, “What to Do When a Client Has an Undisclosed Foreign Account,” JofA, Dec. 2013, page 38).
Taxpayers whose behavior was nonwillful, however, had a few choices under the previous OVDP, none of which were particularly good. One option was to go into the OVDP and pay back taxes, interest, a 20% accuracy penalty, failure-to-file and/or failure-to-pay penalties if applicable, and a miscellaneous offshore penalty of 27.5%. Another option was to make a “quiet disclosure,” in which the taxpayer amended back tax returns, likely for three years, and then filed back FinCEN Forms 114, Report of Foreign Bank and Financial Accounts (FBARs). Still other taxpayers ignored the past and started reporting and filing correctly on a prospective basis. The IRS is on the lookout for quiet and first-time disclosures, which poses some risk for either of these paths. Nevertheless, many were willing to take that risk because of the draconian penalties imposed under the OVDP.
New streamlined reporting. Recognizing that the one-size-fits-all OVDP may not be appropriate for all nonwillful taxpayers, and in the interest of promoting fairness so that foreign account holders will in fact come forward, the IRS expanded an existing streamlined reporting program. The program initially applied to nonresident nonfilers who had $1,500 or less in unpaid taxes each year. Taxpayers had to fill out a risk questionnaire that would determine the level of review that the submission received. However, under the program, taxpayers were not subject to the penalties imposed under the OVDP.
The streamlined program has now been opened to U.S. residents. The $1,500 limitation has been eliminated, as has the risk questionnaire. While there is still no penalty for nonresidents, U.S. residents must pay a 5% miscellaneous offshore penalty. In addition, anyone using this program must certify that the failure to report all income, pay all tax, and submit all required information returns, including FBARs, was due to nonwillful conduct. The 27.5% penalty in the OVDP and the 5% penalty in the streamlined program apply to a different base of assets; they are not necessarily interchangeable. Careful analysis may be required.
Under the streamlined program, taxpayers must file amended income tax returns for each of the most recent three years for which the U.S. tax return due date (or properly applied-for extended due date) has passed, together with all required information returns (e.g., Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts), and FBARs must be submitted for the last six years. More specific instructions are available at tinyurl.com/lgmg7ez.
Taxpayers ineligible for streamlined reporting. If the IRS has initiated a civil examination of a taxpayer’s returns for any tax year, regardless of whether the examination relates to undisclosed foreign financial assets, the taxpayer will not be eligible to use the streamlined procedures. In addition, taxpayers under investigation by the IRS Criminal Investigation Division may not avail themselves of the streamlined procedures.
If a taxpayer has already done a quiet disclosure, that taxpayer may still use the streamlined procedure, understanding that the IRS will not retroactively abate any penalties already asserted. Once a taxpayer makes a submission under the streamlined program, that taxpayer may not participate in the OVDP. Once a taxpayer submits a voluntary disclosure letter (see Question 24 of the 2014 OVDP frequently asked questions at tinyurl.com/pfs4yx9) on or after July 1, 2014, that taxpayer is ineligible to participate in the streamlined program. If a taxpayer submitted a voluntary disclosure letter before July 1, 2014, but does not yet have a fully executed OVDP closing agreement, the taxpayer may request treatment under the streamlined program to take advantage of the reduced penalties without having to opt out of the OVDP.
The IRS and Department of Justice (DOJ) are very aggressive in their prosecution of willfully noncompliant taxpayers, for whom the best course of action may still be the OVDP, to avoid the specter of criminal prosecution. There has been a big change in the OVDP for such taxpayers: In certain cases, including where it has been publicly announced that the financial institution with which the taxpayer has an account is being investigated by the IRS or the DOJ or cooperating with the government, or that a facilitator the taxpayer worked with is being investigated by the IRS or the DOJ or cooperating with the government, the taxpayer may still go into the program if the IRS does not yet have the taxpayer’s name. However, in such cases the penalty is 50% of the highest value of the foreign assets, rather than 27.5%. The higher penalty applies to taxpayers who make preclearance letter submissions on or after Aug. 4, 2014.
THE TIME TO COME FORWARD
The new rules for nonwillful taxpayers make reporting a previously hidden foreign account much more palatable than if the IRS or DOJ first learns about it from a reporting foreign institution. Now is the time for practitioners’ clients to come forward and report their foreign accounts if they have not done so already. In addition, to alleviate some risk, advisers should evaluate the situations of clients who have made quiet or first-time disclosures, to see whether it would be advantageous for them to use streamlined reporting.
It is better to be proactive in this arena sooner than later to potentially avoid the high penalties and criminal exposure that can result. Always consider whether a hidden foreign account matter should be referred to an attorney.
—By Scott Novak, Esq. ( firstname.lastname@example.org ), principal of Scott H. Novak, Attorney at Law LLC, in Hackensack, N.J., and adjunct professor at Fairleigh Dickinson University.
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