Offshore Income I.R.S. Voluntary Disclosure - The Cost To Disclose

By Ron Cohen, CPA, MST
Partner
Greenstein, Rogoff, Olsen & Co., LLP

Please see the following link for an update on this issue as of 5/26/09: Very Important if this issue effects you! http://community.groco.com/cs/blogs/international_tax_blog/archive/2009/04/28/32406.aspx

On March 26, 2009, Internal Revenue Service Commissioner, Doug Shulman wrote at http://www.irs.treas.gov/newsroom/article/0,,id=206014,00.html the following:

"In the guidance to our people, we draw a clear line between those individual taxpayers with offshore accounts who voluntarily come forward to get right with the government and those who continue to fail to meet their tax obligations. People who come in voluntarily will get a fair settlement. We set up a penalty framework that makes sense for them — they need to pay back-taxes and interest for six years, and pay either an accuracy or delinquency penalty on all six years. They will also pay a penalty of 20 percent of the amount in the foreign bank accounts in the year with the highest aggregate account or asset value. Just to be clear, this is 20 percent of the highest asset value of an account anytime in the past six years. This gives taxpayers — and tax practitioners — certainty and consistency in how their case will be handled.

Please see the calculations here.

I have roughly computed the tax, interest and penalty cost of making such a voluntary disclosure to the I.R.S. to determine what the I.R.S. feels is a "fair settlement."

It appears the tax, interest and penalties come to 129% of the income earned or 33% of the total offshore account balance. If a California resident is the taxpayer, the total cost will exceed 142% of the income earned and almost 36% of the total offshore account balance (depending on how much federal tax deduction is allowed for state taxes, which is often zero for high-income taxpayers in the Alternative Minimum Tax.). The I.R.S. is obliged to communicate the disclosed information to the Franchise Tax Board if the taxpayer does not fulfill his duty to file with the F.T.B.

I used a $10M bank account earning 5% annual interest income. The 129% and 33% seem to be consistent at different levels of offshore income as the tax, interest and penalties are a percentage, therefore the resulting percentages are always consistent. I assumed the taxpayer would be in the top 35% tax federal tax bracket and top 9.3% California tax bracket (there is higher California bracket in some cases for a surcharge related to a Mental Health fund).

As the Commissioner says: "They will also pay a penalty of 20 percent of the amount in the foreign bank accounts in the year with the highest aggregate account or asset value. Just to be clear, this is 20 percent of the highest asset value of an account anytime in the past six years."

The additional 20% foreign bank account penalty, when added, results in total amounts of tax, interest and penalty that exceeds the amount of income earned because the base amount for computing the additional 20% penalty is the "highest aggregate account balance", without any regard to the amount of income earned on the account. The percentages I arrive at may be far too low -- meaning the taxpayer will pay-in a higher percentage of his current account balance -- if the taxpayer has suffered losses in the investment account this (2009) year, as the 20% penalty will be applied to the highest prior year amount looking back 6 years. For purposes of my rough estimate, I assumed the account is all invested in safe, interest-bearing investments with no loss of principal. This CLEARLY may not be the case in the real world.

My observation is that taxpayers trying to decide whether to follow the Commissioner's request are calculating the trade-off between paying the tax, interest and penalty to make a voluntary disclosure, versus staying underground in hopes their tax evasion will never be disclosed. The Commissioner has clearly stated a taxpayer should take his deal or face criminal prosecution. Tax evaders will be evaluating this trade-off, and I leave to the reader (and, hopefully their tax attorney) to decide whether a tax, interest and penalty that results in over 142% of income earned in some cases, provides and incentive to "come forward" as the Commissioner hopes.

I will add that the advice of myself and my firm is to always accurately and timely file and pay all taxes. A taxpayer in the dilemma above should immediately contact a tax attorney as criminal prosecution issues are involved.

I can always be reached for questions or comments at (510) 797 8661 x237.

To get the complete story right from the I.R.S. and see the arsenal of penalties they can impose on offshore income, please see this link and read through the various Memorandums.  The I.R.S. is internally preparing to seriously attack unreported offshore income.  See: http://www.irs.gov/newsroom/article/0,,id=206012,00.html

Update: 2/8/11

Second Special Voluntary Disclosure Initiative Opens; Those Hiding Assets Offshore Face Aug. 31 deadline

WASHINGTON — The Internal Revenue Service announced today a special voluntary disclosure initiative designed to bring offshore money back into the U.S. tax system and help people with undisclosed income from hidden offshore accounts get current with their taxes. The new voluntary disclosure initiative will be available through Aug. 31, 2011.

“As we continue to amass more information and pursue more people internationally, the risk to individuals hiding assets offshore is increasing,” said IRS Commissioner Doug Shulman. “This new effort gives those hiding money in foreign accounts a tough, fair way to resolve their tax problems once and for all. And it gives people a chance to come in before we find them.”

The IRS decision to open a second special disclosure initiative follows continuing interest from taxpayers with foreign accounts. The first special voluntary disclosure program closed with 15,000 voluntary disclosures on Oct. 15, 2009. Since that time, more than 3,000 taxpayers have come forward to the IRS with bank accounts from around the world. These taxpayers will also be eligible to take advantage of the special provisions of the new initiative.

“As I’ve said all along, the goal is to get people back into the U.S. tax system,” Shulman said. “Combating international tax evasion is a top priority for the IRS. We have additional cases and banks under review. The situation will just get worse in the months ahead for those hiding assets and income offshore. This new disclosure initiative is the last, best chance for people to get back into the system.”

The new initiative announced today – called the 2011 Offshore Voluntary Disclosure Initiative (OVDI) -- includes several changes from the 2009 Offshore Voluntary Disclosure Program (OVDP). The overall penalty structure for 2011 is higher, meaning that people who did not come in through the 2009 voluntary disclosure program will not be rewarded for waiting. However, the 2011 initiative does add new features.

For the 2011 initiative, there is a new penalty framework that requires individuals to pay a penalty of 25 percent of the amount in the foreign bank accounts in the year with the highest aggregate account balance covering the 2003 to 2010 time period. Some taxpayers will be eligible for 5 or 12.5 percent penalties. Participants also must pay back-taxes and interest for up to eight years as well as paying accuracy-related and/or delinquency penalties.

Taxpayers participating in the new initiative must file all original and amended tax returns and include payment for taxes, interest and accuracy-related penalties by the Aug. 31 deadline.

The IRS is also making other modifications to the 2011 disclosure initiative.

Participants face a 25 percent penalty, but taxpayers in limited situations can qualify for a 5 percent penalty.

The IRS also created a new penalty category of 12.5 percent for treating smaller offshore accounts. People whose offshore accounts or assets did not surpass $75,000 in any calendar year covered by the 2011 initiative will qualify for this lower rate.

The 2011 initiative offers clear benefits to encourage taxpayers to come in now rather than risk IRS detection. Taxpayers hiding assets offshore who do not come forward will face far higher penalty scenarios as well as the possibility of criminal prosecution.

“This is a fair offer for people with offshore accounts who want to get right with the nation’s taxpayers,” Shulman said. “This initiative offers them the chance to get certainty about how their case will be handled. Just as importantly, those who truly come in voluntarily can avoid criminal prosecution as well.”

The IRS is handling processing of the voluntary disclosures in centralized units to more efficiently process the applications.

The IRS will also launch a new section on www.IRS.gov that includes the full terms and conditions on the 2011 Offshore Voluntary Disclosure Initiative, including an extensive set of questions and answers to help taxpayers and tax professionals. The web site also includes details on how people can make a voluntary disclosure.

In the first voluntary disclosure program in 2009, taxpayers faced up to a 20 percent penalty covering up to a six-year period. Taxpayers came forward with about 15,000 voluntary disclosures in that effort covering banks in more than 60 countries.

Shulman said IRS efforts in the international arena will only increase as time goes on.

“Tax secrecy continues to erode,” Shulman said. “We are not letting up on international tax issues, and more is in the works. For those hiding cash or assets offshore, the time to come in is now. The risk of being caught will only increase.”