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Failure to Conduct Voluntary Disclosure and Potential Penalties: 2013 Update

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Failure to conduct voluntary disclosure may mean heavy penalties for U.S. taxpayers are not in compliance with international tax laws established by U.S. government. In this article, I summarize some of the key penalties that such non-compliant U.S. taxpayers may face once the IRS finds them.

Penalties in General

In general, if the IRS verifies that a taxpayer failed to disclose his offshore financial accounts and foreign entities (and the income from these sources), the taxpayer may be subject to severe civil and criminal penalties. In addition to income-related accuracy related penalties, the IRS may also assess additional fraud-related penalties, FBAR penalties and foreign asset reporting penalties (with interest). Combined, all of these penalties and interest may exceed the actual value of nondisclosed assets and foreign bank accounts. In the worst-case scenario, a criminal prosecution may be initiated against such noncompliant taxpayers.

Finally, the voluntary disclosure process – which would otherwise be a far less painful way to deal with this problem – is automatically unavailable for taxpayers as soon as they are subject to IRS investigation.

Let’s discuss the penalties in more detail.

Accuracy-Related and Failure to File and Pay Penalties

An accuracy-related penalty on underpayments is imposed under IRC § 6662. Depending upon which component of the accuracy-related penalty is applicable, a taxpayer may be liable for a 20 percent or 40 percent penalty.

If a taxpayer fails to file the required income tax return, a failure to file (“FTF”) penalty may be imposed pursuant to IRC § 6651(a)(1). The penalty is generally five percent of the balance due, plus an additional five percent for each month or fraction thereof during which the failure continues may be imposed. The total penalty will not exceed 25 percent of the balance due.

If a taxpayer fails to pay the amount of tax shown on the return, a failure to pay (“FTP”) penalty may be imposed pursuant to IRC § 6651(a)(2). The penalty may be half of a percent of the amount of tax shown on the return, plus an additional half of a percent for each additional month or fraction thereof that the amount remains unpaid, not exceeding the total of 25 percent of the balance due.

Fraud Penalties

Fraud penalties may imposed under IRC §§ 6651(f) or 6663. Where an underpayment of tax, or a failure to file a tax return, is due to fraud, the taxpayer is liable for penalties that may essentially amount to 75 percent of the unpaid tax.

FBAR Penalties

The most severe civil penalties are likely to come from non-compliance with FinCEN Form 114 formerly Form TD F 90-22.1 (Report of Foreign Bank and Financial Accounts, commonly known as an “FBAR”) non-compliance. Generally, the civil penalty for willfully failing to file an FBAR can be as high as the greater of $100,000 or 50 percent of the total balance of the foreign account per violation (see 31 U.S.C. § 5321(a)(5)). Non-willful violations that the IRS determines were not due to reasonable cause are subject to a $10,000 penalty per violation. For more detailed discussion of the FBAR civil penalties, I refer you to this article.

Form 8938 Penalties

Form 8938 is a newcomer to the world of tax penalties. The Form was born out of the HIRE and came into existence only starting the tax year 2011. Generally, failure to file Form 8938 carries a penalty of $10,000; however, other additional penalties may be applicable (for more detailed discussion of Form 8938 penalties, please read this article).

Penalties for Failure to File Other Information Returns

In addition to these common penalties, additional penalties may apply depending on the particular circumstances of the non-compliant taxpayer. I will summarize a few key penalties here.

Form 5471

If the taxpayer belongs to one of the four categories of required filers of Form 5471 (Information Return of U.S. Persons with Respect to Certain Foreign Corporations) and he fails to do so, he generally faces a penalty of $10,000 for each return. For a more detailed discussion of Form 5471 penalties, review this article.

Form 8865

Where the taxpayer is required to file Form 8865 (Return of U.S. Persons With Respect to Certain Foreign Partnerships) and he fails to do so, the non-compliant taxpayer generally faces a $10,000 per each unfiled return with additional penalties possible. If the taxpayer transferred property to a controlled foreign partnership and he fails to file Form 8865, he faces additional penalties of 10 percent of the value of any transferred property; the penalty is limited to $100,000. Please, review this article for a more detailed discussion of Form 8865 penalties.

Other Common Information Returns

Depending on a taxpayer’s situation, he may face additional penalties for failure to file Forms 926, 3520, 3520-A, 5472 and other forms.

Criminal Prosecution

In the worst-case scenario, a criminal prosecution may be conducted by the IRS. Huge penalties and potential jail time are the possible in case of tax evasion.

Possible criminal charges related to tax returns include tax evasion (26 U.S.C. § 7201), filing a false return (26 U.S.C. § 7206(1)) and failure to file an income tax return (26 U.S.C. § 7203). Willfully failing to file an FBAR and willfully filing a false FBAR are both violations that are subject to criminal penalties under 31 U.S.C. § 5322 (see this article for discussion of the FBAR criminal penalties)

A person convicted of tax evasion is subject to a prison term of up to five years and a fine of up to $250,000. Filing a false return subjects a person to a prison term of up to three years and a fine of up to $250,000. A person who fails to file a tax return is subject to a prison term of up to one year and a fine of up to $100,000. Failing to file an FBAR subjects a person to a prison term of up to ten years and criminal penalties of up to $500,000.

Contact Sherayzen Law Office for Help With Offshore Voluntary Disclosure

If you have undisclosed offshore accounts or foreign entities, contact Sherayzen Law Office for help as soon as possible. We are an international tax law firm that specializes in helping U.S. taxpayers in the United States and throughout the world to avoid the nightmare scenario and properly conduct disclosure of offshore assets, foreign bank accounts, foreign entities and unreported foreign income to the IRS.

If you believe that you may not be in full compliance with U.S. tax laws, the worst course of action is to do nothing and wait for the IRS to discover your noncompliance. Once this happens, your options are likely to be severely limited and the penalties a lot higher. Therefore, contact us so that we can help you with your international tax problems. Remember, all calls and e-mails are confidential.

2012 OVDP: Principal Purpose of the Program

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As 2012 OVDP (Offshore Voluntary Disclosure Program) now closed enters its second tax season, it is important to review once again the reasons behind the existence of the program, what it offers to the IRS and how it may benefit currently non-compliant U.S. taxpayers.

Focus on International Tax Compliance

Since 2003, the IRS has conducted a number of voluntary disclosure programs for U.S. taxpayers with undisclosed foreign accounts or entities and undisclosed income. It is important to emphasize that these programs were not part of the traditional IRS voluntary disclosure program with respect to domestic income. The focus of each offshore voluntary disclosure program is on international tax compliance, particularly Report on Foreign Bank and Financial Accounts (the “FBAR”) and other informational returns such as Forms 5471, 8865, 8868 and so on.

It is important to note that with each new program the rules are becoming more and more stringent as well as complex. The idea behind the tougher terms of each succeeding program is to reward early disclosure and induce taxpayers to enter a voluntary disclosure program as soon as possible.

2012 OVDP

The 2012 OVDP came into existence less than half a year after the tremendous success of the 2011 OVDI (which also came two years after a very profitable 2009 OVDP). It is obvious that the IRS considered the existence of such voluntary disclosure programs a vital part of its international tax compliance efforts.

As expected, 2012 OVDP came in with tougher terms (for example, the highest penalty category is 27.5% instead of 25% as it was under 2011 OVDI rules), closed some 2011 OVDI loopholes and created a more complex and detailed set of rules. However, 2012 OVDP also has some unique features.

The most prominent of these features is that there is no official end to the program – this is the very first time in the history of the voluntary disclosure programs. At the time, the IRS warned that it can end the program at any time, creating a great sense of uncertainty and urgency for the taxpayers who wish to enter the program.

Why the IRS Created the 2012 OVDP

The most obvious reason (and the most repeated one in various articles by commentators) for why the IRS wants a voluntary disclosure program like 2012 OVDP in place is money – these programs brought in billions of dollars to the U.S. treasury. While this is an important reason, I believe that the reasoning behind the 2012 OVDP is much more complex.

In addition to bringing more money to the cash-starved U.S. government and allowing people to become tax-compliant with the understanding that their penalties will be definite and limited, there are two other primary reasons behind the 2012 OVDP and all other similar voluntary disclosure programs. First, the voluntary disclosure programs have a tremendous collateral impact on the overall international tax compliance. The collateral effect is reflected not only in assuring that the persons who go through the voluntary disclosure are likely to continue to comply with U.S .tax laws in the future, but also in the tremendous publicity of the program and the U.S. tax laws.

However, the most curious collateral product of the 2012 OVDP is the fear that induces wider tax compliance and more entrees into the voluntary disclosure program. It seems paradoxical that a voluntary disclosure would create this apprehensive feeling, but it is very logical once you understand that this is not a fear of the 2012 OVDP itself, but the terror of seeing widespread compliance which singles out the non-compliant taxpayers more and more with each new OVDP participant.

The second reason behind the voluntary disclosure programs is information gathering. Each 2012 OVDP participant brings a treasure trove of information about where they keep their money, the level of complicity by foreign banks, the particular foreign and domestic advisors involved in promoting international tax non-compliance, and other valuable information. This information allows the IRS to establish the overall patterns of non-compliance (both geographic and with respect to particular individuals and organizations), identify the next investigation targets and amass evidence for future prosecutions.

IRS is currently sitting on a mountain of data and it is inevitable that this information will be used in the future against non-compliant U.S. taxpayers and their foreign advisors. Already in 2012, we observed aggressive IRS moves in Liechtenstein and Israel as well as engagement of over 50 jurisdictions around the world regarding FATCA compliance. My prediction is that this trend of expanded enforcement into other countries will continue in 2013 and will result in larger number of prosecutions.

What is the Benefit of 2012 OVDP for U.S. Taxpayers

The 2012 OVDP does not only benefit the IRS, but also certain U.S. taxpayers. The benefit is at least three-fold. First, for certain U.S. taxpayers 2012 OVDP is the only way to avoid tremendous penalties and criminal prosecution by the IRS. Equally important is the fact that a taxpayer enters the OVDP program with an ability to calculate(with reasonable degree of certainty) the total cost of resolving all offshore tax issues. However, the decision to enter the OVDP must be made after all of the facts are analyzed and the taxpayer is aware of the consequences of entering the 2012 OVDP.

Second, while generally very rigid, the 2012 OVDP program has a certain degree of flexibility built into its penalty structure. The number of penalty categories and the various rules of the program allow international tax attorneys to determine the best mode of the voluntary disclosure and develop the strategies to implement this particular voluntary disclosure scenario.

Finally, 2012 OVDP allows international tax attorneys to determine the alternative voluntary disclosure ways. For example, Q&A #17 officially supports the long-standing unofficial policy of the IRS that no FBAR penalties are likely if there is additional U.S. tax liability as a result of voluntary disclosure. Moreover, the very fact that 2012 OVDP delineates certain analytical categories places additional tools for strategy development in the hands of the attorneys who seek alternative ways of bringing U.S. taxpayers into full compliance with U.S. tax laws under the existing legal structure outside of the 2012 OVDP.

Contact Sherayzen Law Office for Help with Voluntary Disclosure

If you have undisclosed foreign account or foreign entities, contact Sherayzen Law Office for help with your voluntary disclosure. Our experienced international tax firm will thoroughly analyze your case, assess your FBAR liability as well as other applicable penalties, identify the options available in your case, and work with you every step of the way until your voluntary disclosure is finished. We have helped taxpayers around the world to do various types of voluntary disclosures, including the official Offshore Voluntary Disclosure Programs and Initiatives.

FBAR Criminal Enforcement: Liechtenstein and Israel

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The voluntary disclosure programs provided the IRS with an enormous amount of information regarding countries, banks and individuals involved in US taxpayers’ non-compliance with U.S. tax laws. With so much information, it was reasonable to expect that the IRS would not be satisfied with solely prosecuting Swiss banks. Year 2012 confirmed these expectations; building up on FATCA and the information provided in voluntary disclosures, the IRS made aggressive moves far beyond Switzerland, initiating negotiations about and, in many cases, concluding bilateral FATCA treaties with over 50 different countries. Among these enforcement efforts, two countries stand out as most likely candidates for future prosecutions – Liechtenstein and Israel.

Banks in Liechtenstein and Israel Are Targets in U.S. Probes

In May of 2012, the IRS issued a request to Liechtensteinische Landesbank AG (LLB) to disclose information regarding accounts of at least $500,000 owned by U.S. taxpayers. The request covers all years 2004 through present time. The bank already sent out the letters to its U.S. clients describing their intention to comply with the request. It should be noted that Liechtenstein has been under tremendous pressure not only from the United States, but also France and Germany to wind down its secrecy laws.

At the same time, the IRS became very concerned about the money flow between Switzerland and Israel. It appeared that some taxpayers decided to exit Switzerland in light of the USB and Wegelin case and moved all of their accounts to Israel. The IRS caught up with this trend and decided to pursue these taxpayers in Israel.

The focus is on three Israeli banks – Bank Leumi Le-Israel, Bank Hapoalim and Mizrahi-Tefahot Bank. It appears that these banks are cooperating even ahead of the 2013 deadline and U.S. taxpayers with undisclosed accounts in these banks are well-advised to assume that their accounts will be disclosed to the IRS sooner rather than later (especially given the close relationship between Israel and the United States).

Voluntary Disclosure for Non-Compliant U.S. Taxpayers in Liechtenstein and Israel

It appears that U.S. taxpayers with undisclosed accounts in Liechtenstein and Israel are in a race against time and they are losing to the IRS. Therefore, at this point, it is absolutely essential for these taxpayers to consider their voluntary disclosure options as soon as possible. Otherwise, they run a tremendous risk of being discovered by the IRS and subject to severe criminal and civil penalties.

2012 OVDP voluntary disclosure, Reasonable Cause (Modified) voluntary disclosure and FAQ #17 and #18 (absence of additional U.S. tax liability) disclosure are options that may be open to such taxpayers. All of these options must be thoroughly analyzed by an international tax attorney who is familiar with these issues.

Contact Sherayzen Law Office for Help With Voluntary Disclosure of Foreign Accounts and Foreign Income

If you have any undisclosed foreign accounts and/or foreign income, contact Sherayzen Law Office. Our experienced international tax firm will thoroughly review your case, advise you on the available voluntary disclosure options, prepare your voluntary disclosure documentation (including tax returns and offshore information returns such as Forms 5471, 8865, 926, 3520, FBARs and others), guide you throughout the voluntary disclosure process and vigorously represent your interests during your negotiations with the IRS.

FBAR Criminal Prosecution and Smaller Banks: The Case of Wegelin

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On January 3, 2013, Wegelin & Co., the oldest Swiss private bank announced that it will close down following its guilty plea to criminal charges of conspiracy to help wealthy U.S. taxpayers evade taxes through secret financial accounts. The guilty plea and the closure of one of the most prestigious European banks that served its clients since the year 1741 constitute big victories for the U.S. authorities. It surely will inspire additional movement of non-compliant U.S. taxpayers into the 2012 OVDP (Offshore Voluntary Disclosure Program) as well as ensure more widespread compliance with the FBAR, Form 8938 and other numerous international tax forms required by the IRS.

However, in addition to its significance to U.S. tax compliance, the Wegelin case also has other interesting features that may point to future trends in the IRS international tax enforcement. In this article, I will outline these trends and explore their potential implications for U.S. tax enforcement.

Jurisdiction to Prosecute Foreign Banks: Minimal Contact Will Suffice

In order to criminally charge a foreign bank, U.S. tax authorities need to establish some connection between the United States and the foreign bank. It appears that after the Wegelin case, proving U.S. exposure will not a be a significant problem for the IRS.

The main reason for Wegelin’s bold defiant behavior (Wegelin specifically advertised itself as a safe, tax-free alternative to U.S. taxpayers who were fleeing UBS after criminal prosecution charges were filed against UBS in 2008) was its deep belief that it cannot be criminally prosecuted in the United States because U.S. tax authorities have no jurisdiction over it. Unlike UBS, Wegelin had virtually no physical presence in the United States, no operating divisions and no branch offices in the United States.

However, Wegelin miscalculated. The IRS discovered that Wegelin did have presence in the United States because it “directly accessed” the U.S. banking system through a correspondent account that it held at UBS AG (“UBS”) in Stamford, Connecticut. The Justice Department successfully argued that this one correspondent account was sufficient to give the United States government the jurisdiction to criminally charge Wegelin.

Hence, one of the biggest consequences of the Wegelin case is that it will not be difficult for the U.S. tax authorities to establish jurisdiction to criminally charge foreign banks even with very insignificant presence in the United States.

Size Matters: Increased Risk for Smaller Banks

The other important lesson of the Wegelin case is that it appears that the IRS is more likely to aggressively pursue smaller banks than the bigger banks the demise of which can cause systemic instability in the world economy.

The collapse of Wegelin stands in stark contrast to the survival of its bigger Swiss rival, UBS. UBS offered pretty much the same services to U.S. taxpayers as Wegelin involving vastly larger number of U.S. persons and amounts of money (at the very least, 20 billion dollars versus Wegelin’s 1.2 billion dollars). The IRS did file criminal charges against UBS, but UBS entered into a deferred prosecution agreement and charges were dropped eighteen months later.

It could be that some of the aggressiveness of the U.S. government came precisely from Wegelin’s defiant stance. In order to reinforce its recent victory in the UBS case, the IRS had to adopt a more assertive stand. However, it did not necessarily have to end in Wegelin’s demise.

Some commentators argued that Wegelin was already a shadow of its former self at the time of its closure, because it aggressively sold-off all of its non-US related assets. Therefore, it may be argued that it is premature to draw general conclusions from the Wegelin’s case about the risks facing small foreign banks who find themselves indicted by the U.S. government. On the other hand, the very fact that Wegelin decided that it would be better for the bank to sell off its assets rather than fight the IRS and the fact that the U.S. government was not concerned about this decision do point to a conclusion that the Wegelin case may be demonstrative of the general vulnerability of smaller banks in such situations.

Unresolved Issues: Client Information and Sold-Off Practice

One of the most important issues, however, is still unresolved in the Wegelin case and makes it worthwhile to observe to its end. The issue is: will the bank disclose the names of its U.S. clients to the IRS?

Typically, disclosure of the names of U.S. taxpayers constitutes a key request by the IRS in such major investigations. Therefore, it does not seem likely that the IRS will simply leave this issue without at least attempting to obtain the names of non-compliant U.S. taxpayers as part of the final deal.

The other unresolved issue is whether a strategy similar to Wegelin’s sale of its non-US accounts to the Austrian Bank Raiffeisen just before the indictment is going to challenged by the IRS if the sale does involve U.S. clients and maybe even if it does not (especially where the bank is left without any assets). It is not known if we are going to get an answer at this time, but it is likely that this issue will show up again in a future case.

Contact Sherayzen Law Office for Help With Voluntary Disclosure of Foreign Financial Accounts

If you have undisclosed offshore accounts (whether in the hard-hit Switzerland or any other country) ,contact Sherayzen Law Office to explore the voluntary disclosure options available in your case. Our experienced voluntary disclosure firm will thoroughly review your case, explore available options, propose a definite plan for moving forward, prepare all of the necessary legal documents and tax forms, and guide you though the entire case while rigorously representing your interests in your negotiations with the IRS.

Indirect Ownership of Foreign Entities for Form 5471 Purposes

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Every now and then, I encounter foreign business structures built on the incorrect belief that only direct ownership matters for U.S. tax reporting purposes in general and Form 5471 purposes in particular. In this essay, I broadly address the question of Form 5471 reporting with respect to indirect ownership of a foreign company (I am not discussing the major issue of “constructive ownership” in this essay).

Form 5471 Reporting Requirements

In an earlier article I already discussed the purpose of Form 5471 and the general reporting requirements this form entails, but I will briefly address these issues here.

Form 5471 is used by certain categories of U.S. taxpayers to report their ownership of foreign corporations. Generally, the form is designed to address the reporting requirements of IRC (Internal Revenue Code) Sections 6038 and 6046.

Under these IRC provisions, four general categories of U.S. taxpayers must file Form 5471 together with their U.S. tax returns: (1) U.S. taxpayers considered as U.S. shareholders (generally, U.S. taxpayers who own 10% or more of a foreign corporation) (these are category 3 filers), (2) U.S. persons who are directors and/or officers of a foreign corporation in which there are U.S. shareholders which meet the requirements of Form 5471 (these are category 2 filers), (3) U.S. persons who had control of a foreign corporation for an uninterrupted period of 30 days (these are category 4 filers); and (4) U.S. shareholders who owned a stock in a foreign corporation that is considered to be a Controlled Foreign Corporation for an uninterrupted period of 30 days and who owned that stock on the last day of the year (these are category 5 filers). Note, that Category 1 was repealed by Congress in section 413(c)(26) of the American Jobs Creation Act of 2004.

What truly adds to the complexity of the application of these four categories are the specific definitions of virtually every word in the description of these four categories which may differ from category to category. For example, “US taxpayer”, “US person”, “control”, “owned” – these are some of the words that are separately defined in the IRS regulations with respect to each category above.

Therefore, for a non-attorney, it is extremely dangerous to rely on these general definitions. Rather, the determination of whether Form 5471 requirement applies to you should be made by an international tax attorney.

Ownership Has Broad Definition for Form 5471 Purposes

As mentioned above, word “owned” has a number of diverse and special meanings for Form 5471 purposes. Generally, it includes not only the direct ownership of a stock, but also indirect ownership and constructive ownership. The concepts of “indirect ownership” and “constructive ownership” are described in separate complex IRS regulations.

The upshot of this discussion is that “ownership” is defined very broadly under the IRS regulations related to Form 5471, and one should not rely on direct ownership in determining whether Form 5471 needs to be filed.

Indirect Ownership for Form 5471 Purposes: IRC Section 958

We now came to the main purpose of this article – discussion of “indirect ownership” for Form 5471 purposes. Form 5471 Instructions as well as IRS regulations generally refer to IRC Section 958 for the definition of indirect ownership.

This provision sets forth the rules for determining stock ownership, including direct, indirect and constructive ownership of a stock. For the purposes of our discussion, we concentrate on Section 958(a)(2) which describes the rules for stock ownership through foreign entities. It states as follows:

“(2) Stock ownership through foreign entities: For purposes of subparagraph (B) of paragraph (1), stock owned, directly or indirectly, by or for a foreign corporation, foreign partnership, or foreign trust or foreign estate (within the meaning of section 7701(a)(31)) shall be considered as being owned proportionately by its shareholders, partners, or beneficiaries. Stock considered to be owned by a person by reason of the application of the preceding sentence shall, for purposes of applying such sentence, be treated as actually owned by such person.”

Thus, it becomes clear that, generally, a U.S. shareholder of a foreign company is likely to be considered a shareholder of other foreign companies owned by this foreign company. For example, where foreign corporation A owns 25% of foreign corporation B, a 45% shareholder of Company A is likely to be deemed as a 11.25% owner of company B. Obviously, this is a very general example and there are various facts and circumstances that may change this simplified calculation. Again, you should retain an international tax attorney to determine your ownership of foreign companies under IRC Section 958.

Implications for Form 5471 Reporting and Tax Planning Strategies

The most obvious result of IRC Section 958 are additional Forms 5471 that need to be timely filed with the U.S. shareholder’s US tax return. It is now easy to see why I would encounter in my practice a situation where a client would comply with Form 5471 requirements for the purposes of some of his companies and fail to do so with respect to the others because either he or his accountant simply did not understand the implications of Section 958 indirect ownership rules.

Section 958 also has a major influence on a U.S. person’s tax plan. Where such person and his tax advisor ignore the relevant implications of IRC Section 958, they are engaging in a potentially disastrous course of action. Beyond the penalties associated with the failure to file Form 5471 timely (as well as other potential penalties stemming from other U.S. international tax forms that may need to be filed), the effect of the entire tax structure could be nullified and potentially expose U.S. taxpayer to additional US taxes.

Contact Sherayzen Law Office for Help With Form 5471 and Tax Planning

If you or your business own companies overseas, contact Sherayzen Law Office for help with U.S. tax compliance, including Form 5471, as well as creating a comprehensible tax plan that would allow you to avoid over-payment of U.S. taxes while remaining in compliance with the Internal Revenue Code.