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Offshore Voluntary Disclosure Program: Advantages and Disadvantages

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2012 Offshore Voluntary Disclosure Program (2012 OVDP) now closed may offer tremendous benefits to certain types of taxpayers, but it may not be as beneficial in other circumstances. Whether to enter the 2012 OVDP is a decision that should be made by the taxpayer only after he had an opportunity to discuss this matter in depth with an experienced attorney who specializes in offshore voluntary disclosures. In this article, however, I wish to outline some of the broader considerations with respect to entering into the 2012 OVDP in order to provide some background information to the readers so that they can understand better their attorney’s advice.

Background Information

2012 OVDP was announced by the IRS barely four months after the end of the wildly-successful 2011 OVDI (Offshore Voluntary Disclosure Initiative). However, the actual terms of the program were not announced until much later, June 26, 2012.

2012 OVDP brought in tougher terms than 2011 OVDI (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. 2012 rules also clarified many heretofore obscure procedures and contained new features that may benefit certain classes of taxpayers, especially those who owned Canadian retirement accounts.

The basic structure of 2012 OVDP, however, remains largely similar to 2011 OVDI. It still has three penalty levels (27.5%, 12.5% and 5%), highly demanding information disclosure requirements and general rigidness with respect to its terms.

General Cost-Benefit Considerations

There are actually three general analytical steps with respect to benefits and drawbacks of entering into the 2012 OVDP. First, the extent of current liability exposure of the taxpayer outside of the 2012 OVDP. Second, the estimate of the OVDP liability of the taxpayer and comparison of OVDP versus non-OVDP exposure (here, an attorney would also explore the non-tax aspects of the OVDP disclosure such as the comfort level of the taxpayer with the invasive nature of the OVDP requirements). Finally, whether 2012 OVDP is the best route to proceed vis-a-vis alternative voluntary disclosure options.

Since the first and the third steps are outside of the scope of this article, I will concentrate on the calculation of advantages and disadvantages of entering of the 2012 OVDP versus non-OVDP exposure. It should be remembered, however, that this calculation will depend heavily on the individual circumstances of each case.

Primary Advantages of the 2012 OVDP

2012 OVDP enjoys five primary advantages over non-OVDP options. First, it is an official IRS program with a virtual certainty (though, according to the IRS, not a 100% guarantee) of elimination of criminal prosecution.

Second, 2012 OVDP provides a taxpayer with an opportunity to calculate, with a reasonable degree of certainty, the total cost of resolving all offshore tax issues at the same time. This is the case because OVDP rules assess one single Offshore Penalty with respect to all information returns – Forms 5471, 8865, 926, 3520, FBARs, et cetera. This can highly advantageous for the taxpayer, because, outside of the OVDP, he will have to deal with the penalties associated with each form.

Moreover, paying one single penalty may represent huge savings over paying penalties outside of the OVDP. The IRS provides a hypothetical example where a taxpayer would pay, outside of the 2012 OVDP, $4,543,000 (plus interest) in tax, accuracy-related penalty, and FBAR penalty on a single $1,000,000 account with the undisclosed income of $50,000 per year. This is not even counting the additional penalties and jail time in case the IRS decides to initial a criminal prosecution. On the other hand, in the same example, a taxpayer would pay only $518,000 plus interest under the 2012 OVDP rules (assuming 27.5% offshore penalty category).

Third, 2012 OVDP rules provide for a certain flexibility where the taxpayer’s attorney can look for strategies to lower the Offshore Penalty further if the circumstances of the case allow for such possibility. Therefore, despite its overall rigidness, the OVDP does take some individual circumstances into the account. However, it is important to point out that much of this flexibility is likely to be achieved only securing the agreement of the IRS agent in charge of your case, his manager and the technical analyst – this is a very hard achievement even for an experienced attorney (though, unfortunately, there are a number of cases where the taxpayers’ representatives failed to even try to achieve this goal) and it puts very strict limits on the OVDP flexibility.

Fourth, 2012 OVDP limits the taxpayer’s liability to eight years and the IRS will not look further absent extraordinary circumstances. Outside of the OVDP, the IRS does have an argument that failure to file certain information returns may keep the statute of limitations open to IRS examination with respect to affected tax returns.

Finally, 2012 OVDP provides a definite closure to the case. At the end of the OVDP process, Form 906 (the Closing Agreement) is signed by the taxpayer and the IRS by which both sides agree to the terms of the Agreement and the case is over (absent extraordinary circumstances, such as fraudulent claims by the taxpayer during the voluntary disclosure process).

Primary Disadvantages of the 2012 OVDP

2012 OVDP also has numerous disadvantages. First, this is a very rigid program with numerous requirements. The side-effect is that the OVDP process can be an expensive one for the taxpayer when it comes to legal and accounting fees.

Second, despite having some flexibility with respect to the calculation of penalties, OVDP rules are not likely to be sensitive to major circumstances of a taxpayer’s case, such as non-willfulness of his conduct. While it is never officially stated, the OVDP unofficially incorporate the assumption that the OVDP applicants acted willfully in its Offshore Penalty structure and there is no reasonable cause that can explain their failure to comply with U.S. tax laws. This often leads to a result where innocent taxpayers with smaller cases or taxpayers who live overseas (and for one reason or another do not satisfy the requirements of the 5% penalty category) can be highly penalized under the OVDP structure.

Third, related to the preceding paragraph, the OVDP penalty structure may actually impose a higher penalty on a taxpayer where IRS is not able to establish the willfulness of the taxpayer’s conduct. This is a highly complex calculation that should be made by an attorney, but, generally, the higher the chances of the taxpayer to establish non-willfulness, the less appealing the OVDP penalty structure is likely to be. This is especially true where OVDP Offshore Penalty includes the assets that would not otherwise either be subject to penalty outside of the OVDP or be subject to a much lower penalty.

Fourth, 2012 OVDP has no real appeal structure in place – in most cases, the IRS agent’s decision is final. If you do not like it, the only real recourse is to opt-out with its murky consequences (it may still be an option depending on the individual circumstances of the case, especially when the taxpayer should not have been in the OVDP program in the first place). The only exception is having a full examination of the tax return and an appeal maybe filed with respect to any tax and penalties imposed by the IRS on examination, but the IRS decisions on the terms of the OVDP closing agreement is almost never subject to an appeal. Such dependance on the good will of an IRS agent in charge of the case naturally produces certain anxiety among the OVDP applicants and constitutes a major drawback of entering into the program.

Finally, 2012 OVDP may take a fairly long time to complete (there are still some 2009 OVDP cases open in 2013). The IRS does try to process the cases as soon as possible, but it has few resources and its agents are overwhelmed with the number of cases pending on their desks. On the average, a taxpayer should expect about a fifteen to eighteen-month process between the acceptance into the OVDP and the final resolution of the case.

Contact Sherayzen Law Office for Help with Your Offshore Voluntary Disclosure

This article merely outlines some of the main consideration with respect to the 2012 OVDP. The actual cost-benefit calculation is much more complex and will vary wildly depending on the individual circumstances of each case.

This calculations and the probabilities with respect to each disclosure option should be done by an international tax attorney experienced in the offshore voluntary disclosures.

This is why you should contact Sherayzen Law Office for help with your voluntary disclosure. Our international tax firm is highly experienced in the voluntary disclosure process. We will thoroughly examine the circumstances of your case, assess your penalties under the various disclosure scenarios, prepare all of the required legal documents and tax forms, and rigorously represent your interests during negotiations with the IRS.

Partnership Property Contribution and Taxable Exchange

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Partnerships offer many tax advantages for their partners. One such benefit is that when property is contributed to a partnership in return for a partnership interest, typically no gain or loss will be recognized. This general rule applies both to partnerships already in existence as well as newly-formed partnerships.

However, this is not always the case. This article will cover several common examples of instances in which a taxable exchange may result at some point.

Disguised Sales

Under Internal Revenue Code Section 707(a), in certain circumstances, the IRS will deem a supposed contribution of property to a partnership in exchange for a partnership interest to be a “disguised sale”. A disguised sale occurs when property that has appreciated in value is contributed, and soon after, the partner receives a distribution from the partnership. The IRS will view the distribution received as a payment for the property contributed.

Recently the IRS issued final regulations regarding disguised sales. In general, contributions and distributions made within a two-year period will be deemed to be sales. A disguised sale may also occur when a partner contributes property to a partnership, and the same property is then transferred to another partner either as a distribution, or as a liquidation of the second partner’s interest in the partnership. Additionally, a contribution may be treated as a disguised sale when, either before or after the contribution, different property is distributed to the contributing property within two years.

Under the regulations, however, if a distribution is made to a partner over two years after property is contributed and the distribution is reasonable in light of a variety of factors, the distribution will generally not be deemed to be a disguised sale.

Pre-Contribution Gain (Built-in Gain)

In general, taxable gains may also occur when contributed property that originally had a fair market value different from its basis (“pre-contribution” or “built-in” gain), and within seven years of the contribution date, the property is distributed to a different partner. In such instances, the distribution will be treated as a sale, and the contributing partner will recognize any net pre-contribution gain on the property. Any gain recognized by a contributing partner will increase his or her basis in the partnership interest.

Additionally, when a partnership distributes any property (besides cash) within seven years to a partner who has contributed built-in gain property, gain will be recognized on the lesser of: (1) the remaining net built-in gain of the contributing partner, or (2) any excess of the fair market value of property distributed over the partner’s adjusted basis in the partnership interest before the distribution. Any gain recognized by the partner will increase his or her basis in the partnership interest.
An exception to these general rules may apply where property is distributed back to the partner who originally contributed it. In such instances, the partner will not need to recognize built-in gain. Instead, the general partnership distribution rules will be applicable.

Contact Sherayzen Law Office for Help with Partnership Tax Issues

Partnership formation and operation can involve many complex issues, and it is often a wise idea to seek legal advice. Our experienced tax firm will thoroughly review your case, advise you on the available options and implement the customized tax strategy to your business. Contact Sherayzen Law Office to schedule a consultation to discuss your case.

IRS Kicks Off 2013 Filing Season for the 2012 Tax Year

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On January 30, 2013, the Internal Revenue Service opened the 2013 filing season by announcing a variety of enhanced products and services to help taxpayers prepare and file their tax returns by the April 15 deadline.

The IRS began accepting and processing most individual tax returns on January 30, 2013, after updating forms and completing programming and testing of its processing systems to reflect the American Taxpayer Relief Act (ATRA) that Congress enacted on January 2, 2013. The vast majority of taxpayers can file now, but the IRS is continuing to update its systems for some tax filers. The IRS will begin accepting tax returns from people claiming education credits in mid-February while taxpayers claiming depreciation deductions, energy credits and many business credits will be able to file in late February or early March. A full list of the affected forms is available on IRS.gov.

This year, taxpayers have until Monday, April 15, 2013, to file their 2012 tax returns and pay any tax due. The IRS expects to receive more than 147 million individual tax returns this year, with about 75 percent projected to receive a refund.

Last year for the first time, 80 percent of all individual returns were filed electronically. E-file, when combined with direct deposit, is the fastest way to get a refund. Last year, about three out of four refund filers selected direct deposit.

Family Partnerships and Income-Splitting

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Family partnerships can offer an advantageous method for splitting business income between family members who may be taxed at lower income rate brackets. This can result in substantial tax savings. However, because of the potential for widespread abuse of this device by shifting income to close relatives who may perform little or no actual work for a partnership, the Internal Revenue Code Section 704(e) (with related regulations and case law) place certain limitations upon family partnerships.

Under these limitations, the IRS can determine that the family partnership arrangement is invalid for tax purposes and disallow income-splitting. This article introduces the reader to the concept of a “family partnership” and outlines some of the general rules for determining whether family members will be recognized as valid partners.

Who is a Family Member for Purposes of IRC Section 704(e)?

Under IRC Section 704(e), “family members” include spouses, ancestors, lineal descendants, and any trusts for the primary benefit of such persons. It is important to note that brothers and sisters are not listed in this classification.

How Will a Family Member be Recognized as a Valid Partner?

In general, a family member may only be recognized as a partner of a family partnership if either of two conditions is met.

Under the first condition, if capital is a “material income-producing factor” and the partnership interest (allowing for full ownership and control) was acquired in a bona fide transaction, regardless of whether it was obtained by purchase or gift from another family member, a family member may be treated as a valid partner. Typically, capital will be considered a material income-producing factor if the partnership receives a significant portion of its gross income from utilizing capital resources (such as from investments in plant and equipment, or inventories). However, capital will usually not be treated as material income-producing factor if the partnership receives much of its gross income from service-oriented elements (such as commissions or fees). Additionally, the family member/partner must have a legitimate capital interest in the assets of the firm – a profits interest alone will not be sufficient.

Alternatively, pursuant to various cases interpreting IRC Section 704(e), if capital is not a material income-producing factor, but a family member contributes vital services to the partnership, the family member may be recognized as a legitimate partner of a family partnershp.

Transfer of a Partnership Interest to Children

One of the most common traps associated with income-splitting in family partnerships is the transfer of a partnership interest to the partner’s children. In such cases, the general rule is: where the capital is a material income-producing factor and a partnership interest is transferred, whether by gift or purchase, to children under the age of eighteen, a large portion of a dependent child’s income distribution received from the partnership may be subject to the “Kiddie tax” rules. Thus, unless the child’s income constituted earned income, it may be taxed at his parents’ tax rate. If a child performs legitimate services for the partnership, however, the Kiddie tax rules may be inapplicable.

Contact Sherayzen Law Office for Tax Planning with respect to Family Partnerships

The information contained in this article is general in nature, and does not constitute legal advice. In order to avoid making costly tax mistakes, you may wish to seek the advice of legal counsel.

If you currently have an interest in a family partnership or you would like to create one, contact Sherayzen Law Office, Ltd. Our experienced business tax firm will thoroughly analyze your case, create a customized ethical tax plan that fits your needs and implement this plan (including preparation of any legal and tax documents).

Offshore Voluntary Disclosure Program: Key Requirements

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2012 OVDP (Offshore Voluntary Disclosure Program) (now closed) may present a great opportunity for certain U.S. taxpayers to deal with their current as well prior non-compliance with U.S. tax laws. However, 2012 OVDP is not for everyone; while for certain categories of taxpayers it is the best option, other taxpayers may have additional choices that may make alternative disclosure options more appealing than the entrance into the official voluntary disclosure program – this is the determination that should be made by the taxpayer after a comprehensive overview of his case with an experienced international tax attorney.

In order to make this determination, however, one must understand what are the key requirements of the 2012 OVDP once a taxpayer is accepted into the program (the acceptance requirements are described in another article). In this article, I will strive to provide a broad overview of such requirements, though you will need to consult Sherayzen Law Office for a more detailed explanation of the program and the exact requirements that may apply to your case.

General Understanding of the 2012 OVDP Requirements

The 2012 Offshore Voluntary Disclosure Program is a fairly rigid and invasive program designed to allow certain types of U.S. taxpayers to voluntarily bring themselves back into compliance with U.S. laws in exchange for lower penalties and general avoidance of criminal prosecution. It is important to emphasize the 2012 OVDP is NOT a full-amnesty program; rather, it offers an alternative penalty system in exchange for voluntary compliance with a number of requirements.

The 2012 OVDP requirements can be broadly divided into five categories: statute of limitations, disclosure filings, cooperation, payment and closing agreement.

Statute of Limitations Extensions

As part of the 2012 OVDP requirements, the taxpayer must agree to extension of statute of limitations for the purposes of assessing additional taxes (including tax penalties) and the FBAR penalties. For this purposes, the taxpayer must supply the properly completed and signed Form 872 (Consent to Extend the Time to Assess Tax) and a Consent to Extend the Time to Assess Civil Penalties Provided By 31 U.S.C. § 5321 for FBAR Violations.

The key reason for the Statute of Limitations extensions is the ability of the IRS to extend its power to assess taxes and penalties to eight years instead of usual three years for the tax returns and six years for the FBARs. This is a key requirement of the 2012 OVDP and it must be communicated to the taxpayer before he submits his application to participate in the 2012 OVDP.

Disclosure Filings

This is the biggest part of the OVDP requirements. The taxpayer must provide:

1. Copies of previously filed original (and, if applicable, previously filed amended) federal income tax returns for tax years covered by the voluntary disclosure;

2. Complete and accurate amended federal income tax returns (for individuals, Form 1040X, or original Form 1040 if delinquent) for all tax years covered by the voluntary disclosure, with applicable schedules detailing the amount and type of previously unreported income from the account or entity (e.g., Schedule B for interest and dividends, Schedule D for capital gains and losses, Schedule E for income from partnerships, S corporations, estates or trusts and, for years after 2010). Starting year 2011, this requirement includes Form 8938, Statement of Specified Foreign Financial Assets. Note that, for the taxpayers who began filing timely, original, compliant returns that fully reported previously undisclosed offshore accounts or assets before making the voluntary disclosure for certain years of the offshore disclosure period, these taxpayers must provide copies of the such previously filed returns for all corresponding years;

3. Complete and accurate original or amended offshore-related information returns and Form TD F 90-22.1 (Report of Foreign Bank and Financial Accounts, commonly known as an “FBAR”) for tax years covered by the voluntary disclosure. This requirement includes any forms 5471, 8865, 8858, 3520, 926 and so on;

4. Completed Foreign Account or Asset Statement for each previously undisclosed foreign account or asset during the voluntary disclosure period if the information requested in that statement was not already provided in the initial Offshore Voluntary Disclosures Letter. Also, a copy of the completed and signed Offshore Voluntary Disclosures letter and attachments should be included in the disclosure (I am not discussing this part of the OVDP process here because it is outside of the scope of this article);

5. Completed penalty computation worksheet showing the applicant’s determination of the aggregate highest account balance of his/her undisclosed offshore accounts, fair market value of foreign assets, and penalty computation signed by the applicant and the applicant’s representative if the applicant is represented;

6. Copies of offshore financial account statements reflecting all account activity for each of the tax years covered by your voluntary disclosure (only for the taxpayers who are disclosing offshore financial accounts with an aggregate highest account balance in any year of $500,000 or more). An explanation of any differences between the amounts reported on the account statements and the tax returns should be provided as well. For those applicants disclosing offshore financial accounts with an aggregate highest account balance of less than $500,000, copies of offshore financial account statements reflecting all account activity for each of the tax years covered by your voluntary disclosure must be available upon request;

7. PFIC Statement detailing whether the amended returns involve PFIC issues during the tax years covered by the OVDP period, and if so, whether the taxpayer chooses to elect the alternative to the statutory PFIC computation that resolves PFIC issues on a basis that is consistent with the mark to market (MTM) methodology authorized in IRC § 1296 but does not require complete reconstruction of historical data, and

8. If the taxpayer has a Canadian Registered Retirement Savings Plan (RRSP) or Registered Retirement Income Fund (RRIF) and wishes to make a late election pursuant to Article XVIII(7) of the U.S. – Canada income tax treaty to defer U.S. tax on RRSP or RRIF earnings, then: (a) a statement requesting an extension of time to make an election; (b) Forms 8891 for all tax years and type of plan covered under the voluntary disclosure; (c) a dated statement signed by the taxpayer under penalties of perjury describing (i) events that led to the failure to make the election, (ii) events that led to the discovery of the failure, and (iii) if the taxpayer relied on a professional advisor, the nature of the advisor’s engagement and responsibilities;

Cooperation

By entering into the 2012 OVDP program, the taxpayer agrees to cooperate in the voluntary disclosure process, including providing information on offshore financial accounts, institutions and facilitators, and signing agreements to extend the period of time for assessing Title 26 liabilities and FBAR penalties. Cooperation does mean that the taxpayer may provide information against his former business partners, bank advisors and accountants.

This is a very important requirement, because the taxpayer agrees to comply with any IRS requests which may subject his business dealings to a very close examination by the IRS. This is why it is important to examine the taxpayer’s tax affairs and business deadlines as much as possible (and usually the taxpayer’s attorney will have a very limited time to do so at the beginning of the case) prior to applying to the 2012 OVDP.

Payment

By entering the 2012 OVDP, the taxpayer agrees to pay the following penalties (this is added to the additional tax due as a result of the voluntary disclosure):

1. 20% accuracy-related penalties under IRC § 6662(a) on the full amount of the taxpayer’s offshore-related underpayments of tax for all years (this includes any PFIC tax as well);

2. Failure to file penalties under IRC § 6651(a)(1), if applicable;

3. Failure to pay penalties under IRC § 6651(a)(2), if applicable;

4. Interest on the additional tax due and all applicable penalties (note that the abatement of interest and penalty provisions under IRC § 6404 does not apply under the terms of the 2012 OVDP); and

5. Offshore Penalty – in lieu of all other penalties that may apply to the taxpayer’s undisclosed foreign assets and entities, including FBAR and offshore-related information return penalties and tax liabilities for years prior to the voluntary disclosure period, a miscellaneous Title 26 offshore penalty, equal to 27.5% (or in limited cases 12.5% or 5%) of the highest aggregate balance in foreign bank accounts/entities or value of foreign assets during the period covered by the voluntary disclosure.

A full payment of all tax due, interest, penalties and the Offshore Penalty must be submitted to the IRS with the voluntary disclosure package. However, it is possible to make good faith arrangements with the IRS to pay in parts if the IRS approves the taxpayer’s eligibility for a special arrangement.

Closing Agreement

At the end of the 2012 OVDP process, the IRS agent will prepare Form 906 (Final Determination Covering Specific Matters) which will describe all of the final terms of your voluntary disclosure. Upon signing of the Agreement, the taxpayer agrees to these final terms and the voluntary disclosure process is finished.

Contact Sherayzen Law Office for Help With 2012 Offshore Voluntary Disclosure Program

If you have undisclosed offshore accounts and foreign assets, you should contact Sherayzen Law Office to discuss the option of entering into the 2012 OVDP. Our experienced international tax firm will thoroughly analyze your case, identify the available options and help you determine whether entering 2012 OVDP is the best course of action in your specific case. Once the decision is made, our attorneys will prepare all of the necessary documents and tax forms, guide you through your voluntary disclosure and rigorously represent your interests during your negotiations with the IRS.