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Tax Advocate: problems remain with the IRS offshore voluntary disclosure program

National Taxpayer Advocate (NTA) Nina Olson has released her annual report to Congress, and it highlights flaws with the IRS offshore voluntary disclosure program (OVDP). According to the NTA, the flaws do not bode well for fairness and justice in IRS’s implementation of future settlement programs and undermine voluntary taxpayer compliance. The NTA has recommended a number of changes, including allowing taxpayers to amend their IRS closing agreement in order to benefit from a number of recent OVDP changes.

Background on OVDP. In 2009, IRS announced an OVDP for those who voluntarily and timely disclosed unreported offshore income for 2003 through 2008. A second OVDP in 2011 allowed taxpayers with undisclosed income from hidden offshore accounts for 2003 through 2010 the chance to get current with their taxes. In 2012, IRS announced a new OVDP that was similar to the 2011 OVDP, but had no set deadline for using the program (see Weekly Alert ¶  32  01/12/2012). IRS also provided streamlined filing compliance procedures for certain “low risk” nonresident U.S. taxpayers who were subject to different degrees of review based on the amount of the tax due and the taxpayer’s response to a “risk” questionnaire. In June of 2014, IRS made key expansions in the streamlined procedures to accommodate a wider group of U.S. taxpayers who have unreported foreign financial accounts (see Weekly Alert ¶  1  06/26/2014).

Background on NTA report. The NTA’s annual report to Congress creates a dialogue within IRS and the highest levels of government to address taxpayers’ problems, protect taxpayers’ rights, and ease taxpayers’ burden. The NTA delivers its report directly to the tax-writing committees in Congress (the House Committee on Ways and Means and the Senate Committee on Finance), with no prior review by the IRS Commissioner, the Secretary of the Treasury, or the Office of Management and Budget.

2014 NTA report. The NTA’s 2014 annual report cites the IRS OVDP as one of the agency’s most serious problems for taxpayer rights, despite recent changes to the program.

According to the NTA annual report, between 2009 and 2014, IRS generally required persons who inadvertently failed to report offshore income and file one or more related information returns (e.g., a “Report of Foreign Bank and Financial Accounts” (FBAR)) to enter into a punitive OVDP and either pay a penalty designed for “bad actors” or “opt out” and be examined.

In general, persons with inadvertent violations had to “opt out” and be audited in order to seek a lesser penalty. Unfortunately, under the “opt out” process, there was uncertainty about the penalty that would result from the audit, process delays, and the cost of representation.

According to the NTA’s annual report, “[i]nside the 2011 OVD programs, taxpayers with small accounts paid over eight times the unreported tax—over ten times the 75 percent penalty for civil tax fraud—and those who were unrepresented generally paid even more.”

NTA’s analysis of the problems. According to NTA, the penalty for failure to file a Form 114, Report of Foreign Bank and Financial Accounts (FBAR), was aimed at criminals and other “bad actors.” In fact, Congress dramatically increased the maximum penalty for willful violations, as a result of reports of people intentionally “attempting to conceal income from the IRS.”

The IRS’s efforts to apply willful penalties to “bad actors” has eroded the distinction between willful and non-willful violations. Because Schedule B of Form 1040 (U.S. Individual Income Tax Return) asks if the taxpayer has a foreign account and references the FBAR filing requirement, the government has been somewhat successful in arguing— in court cases involving “bad actors” — that, in some cases, the filing of a Schedule B can turn a subsequent failure to file an FBAR into a willful violation (called “willful blindness”). The IRS acknowledges that the existence of the checkbox on Schedule B does not turn every FBAR violation into a willful one. However, it suggests that it may do so when the taxpayer has also tried to conceal the account and/or has a large account. The IRS does not identify other relevant factors or provide assurance that it will only pursue a willful penalty against those also engaged in tax shelters, tax evasion, or criminal conduct. As a result, most taxpayers do not know how the IRS will apply this guidance to them.

Until recently, IRS generally required “benign actors,” who inadvertently fail to comply, to enter its OVDP settlement and pay the same offshore penalty as “bad actors” or risk “opting out,” according to the NTA. However, NTA stated that it is inconsistent with the statutory scheme for “benign actors” to pay the same penalty as “bad actors.” Nonetheless, IRS data indicate that “benign actors” paid a proportionately greater offshore penalty than “bad actors.” The NTA attributed the problems to IRS delays, which may have prompted some “benign actors” to accept disproportionate offshore penalties. Furthermore, the NTA stated that IRS’s one-sided interpretations of OVDP FAQs likely prompted other “benign actors” to accept disproportionate offshore penalties.

Even though recent OVDP changes treat certain benign actors more reasonably, the OVDP guidance-making and disclosure process remains flawed, according to the NTA. For example, IRS will not allow those who already agreed to pay disproportionate offshore penalties to benefit from the most recent changes.

According to the NTA, IRS still does not formally ask for internal or external comments before issuing OVDP guidance or publicly explain its rationale for adopting certain comments and not others. Finally, IRS does not disclose its interpretations of FAQs or other internal guidance to the public.

NTA’s recommendations. The NTA stated that IRS’ correction of the flaws would further the taxpayer right to be informed. In this regard, the NTA has recommended that IRS undertake the following actions:

1. Improve the transparency of OVDP guidance and streamline programs;
2. Allow taxpayers to elevate or appeal a revenue agent’s OVDP determination and streamlined program determination; and
3. Allow taxpayers to amend their IRS closing agreements to benefit from recent changes to OVDP.

References: For the IRS offshore voluntary disclosure initiative, see FTC 2d/FIN ¶  V-3829  et seq.; United States Tax Reporter ¶  72,014.15; TaxDesk ¶  871,019; TG ¶  71869.