On January 9, 2012 the United States Internal Revenue Service (“IRS”) announced the indefinite extension of the 2011 Offshore Voluntary Disclosure Initiative (“OVDI”).
Because Canada is the great neighbour to the north and home to many U.S. taxpayers, many residents here find themselves with unmet U.S. tax filing obligations. The good news is that the extension of the 2011 OVDI may afford these individuals the opportunity to file delinquent U.S. returns pay reduced penalties.
The OVDI has been touted by the IRS as a beneficial way for delinquent taxpayers to bring their filing obligations current and to save time, money and headaches in the long run. This may be true for certain taxpayers whose circumstances necessitate enrolling in OVDI.
However, many delinquent taxpayers may be better off bringing their tax filings current by submitting 6 years of filings requesting a waiver of penalties based on reasonable cause.
Determining the best course of action is a complex task even for a sophisticated taxpayer and making the wrong decision can have financially devastating results. Therefore, it is highly advisable to discuss your unique situation with a tax professional.
Penalties are the Real Threat
Aside from the tax obligations outstanding, what is often more damaging to one’s wallet is the array, and magnitude, of civil penalties which may apply to delinquent filings. There is a laundry list of penalties which, depending on the facts, can stack up to be financially injurious. Under U.S. tax filing obligations there are a number of forms which must be filed depending on the circumstances of the taxpayer, and failure to do so could lead to penalties ranging from $10,000 to $100,000 or more per violation.
In addition to the civil penalties, a taxpayer who does not enter under the voluntary disclosure program could also be subject to criminal charges of tax evasion, filing a false return, failure to file an income tax return, wilfully failing to file a Foreign Bank Account Report (FBAR), and wilfully filing a false FBAR, depending on the circumstances of the matter. Penalties for these offences include prison time and substantial monetary fines.
OVDI in General
Under the OVDI, a taxpayer is required to submit their income tax returns and information returns for the previous eight years. OVDI enables noncompliant taxpayers to resolve their tax liabilities and minimize their chance of criminal prosecution. When a taxpayer truthfully, timely, and completely complies with all provisions of the voluntary disclosure practice, the IRS will not recommend criminal prosecution. Furthermore, in lieu of the numerous penalties attributable to the failure to timely file certain information returns such as the FBAR, 3520/3520-A, etc., OVDI offers a penalty based on the value of the taxpayer’s undisclosed assets.
The OVDI requires taxpayers to pay a penalty of 27.5% of the highest aggregate balance in foreign bank accounts/entities or value of foreign assets during the eight tax years prior to disclosure. However, this amount can be reduced to 12.5% or 5% depending on the facts surrounding the taxpayer. Thus, a voluntary disclosure also provides the opportunity to calculate, with a reasonable degree of certainty, the total cost of resolving all offshore tax issues. Fluctuations in many taxpayers’ financial position during the eight year period may cause a taxpayer under the OVDI to pay a penalty upon foreign bank accounts/entities or value of foreign assets which is grossly overstated compared to the current value of the assets.
“Reasonable Cause” – The Grounds for elimination of Penalties
A major consideration in determining whether or not it is advisable for a taxpayer to enter into the OVDI is the potential for the taxpayer to raise a credible “reasonable cause” defence for their failure to timely file. Frequently, people with little or no perceived connection to the U.S. learn that they do in fact have U.S. tax filing obligations. The IRS allows for the removal of penalties where evidence demonstrates there was reasonable cause for failing to file the required forms. The acceptance of a reasonable cause argument is determined through an evaluation of the facts and circumstances surrounding the taxpayer and must be supported by evidence.
In the IRS News Release FS-2011-13, released in December 2011, (“December News Release”) guidance was provided as to what factors would support a reasonable cause argument. The IRS outlined certain factors, noting other factors not listed may also be considered, which would weigh in support of a reasonable cause argument for the reduction or elimination of penalties based on the taxpayer being unaware of their filing obligations. These factors include:
- The education level attained by the taxpayer;
- Whether the taxpayer has previously been subject to the tax;
- Whether the taxpayer has been penalized before;
- Whether there were recent changes in the tax forms or law that the taxpayer could not reasonably be expected to know; and
- The level of complexity of a tax or compliance issue.
The Key Lessons:
It is advisable for taxpayers who have U.S. tax filing obligations to consult with a tax professional promptly to determine whether or not it is prudent to make a voluntary disclosure to the IRS under the OVDI or via a reasonable cause statement. Each case is unique and in certain circumstances it may in fact turn out that filing under the OVDI is detrimental in comparison to filing returns for the previous 6 years and requesting an exemption based on reasonable cause. It should be noted that if it is desirable to participate in the OVDI, the taxpayer must act before an investigation is initiated against them; it will be too late to take the benefits of the OVDI once the taxpayer is under civil or criminal investigation.
The IRS has undertaken significant efforts to educate the public about their disclosure obligations and remains steadfast in seeking out those who fail to comply. This effort by the IRS will likely stymie an argument put forth by the taxpayer that they were unaware of their filing obligations and therefore, based on the reasonable grounds defence, they should be exempted from the potential penalties. Based on the increase in avenues by which the IRS obtains financial information about foreign financial matter, including the Foreign Account Tax Compliance Act (FACTA) (see previous blog for more information), it appears that it may only be a matter of time before offshore finances are located and taxpayers are subject to increased penalties.
Invitation for Discussion:
If you have any questions or concerns regarding your U.S. tax filing obligations, or if would like to discuss your best course of action in resolving any outstanding tax obligations, please contact one of our lawyers in the Tax & Estate Planning group at Nerland Lindsey LLP.
Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encouraged to seek proper legal advice.
IRS Circular 230 Disclosure
To ensure compliance with requirements imposed by the U.S. Internal Revenue Service, we inform you that any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (1) avoiding tax-related penalties under the U.S. Internal Revenue Code or (2) promoting, marketing or recommending to another party any tax-related matters addressed herein.