In a recent article, “Offshore Voluntary Disclosure Penalties: The IRS Quietly Drops a Bombshell“, I took issue with the IRS’ rescission of FAQ 35 of the 2009 Voluntary Disclosure Program (OVDP) and the IRS’ retroactive application of that rescission to pre-existing program participants.
Why Is FAQ 35 Important? Because The IRS Promised Lower Penalties
FAQ 35 provided that under no condition would a taxpayer pay OVDP penalties that were greater than the applicable penalties outside the program. Thus, if a taxpayer’s failure to disclose a foreign account was “non-willful”, the maximum applicable penalty would be a maximum of $10,000 per year. While a $10,000 penalty sounds quite high, especially for each of the six years of the OVDP (’03-’08), these non-willful penalties, in many cases, may be less than the penalties that would otherwise apply under the OVDP (typically 20% of the highest aggregate balance of the foreign account).
In rescinding FAQ 35, the IRS changed its position and summarily now presumes that all OVDP participants willfully failed to declare the foreign accounts. “Willful” penalties are the greater of 50% of the account value each year, or $100,000 per year. These penalties are therefore much greater than the maximum $10,000 yearly non-willful penalty. Rather than applying these higher “willful” penalties, the IRS suggests that its 20% OVDP penalty is a more lenient, more charitable penalty. However, the best result for the taxpayer might have been the non-willful $10,000 yearly penalty, which the IRS has now rescinded.
The IRS “Bait and Switch”
Suddenly, two years into the OVDP process, the IRS changed the very terms by which it attracted taxpayers to come forward and disclose their foreign accounts and declared that change to be retroactive. The unilateral change in terms will result in significantly higher penalties. If taxpayers disagree with the OVDP penalties, their only recourse is to exit the OVDP, submit to a full audit and potentially far higher penalties and criminal prosecution.
About the IRS changing the terms and rescinding FAQ 35, I wrote:
We take issue with the IRS changing the terms of the OVDP that have been in place for over two years. Taxpayers who disclosed under the 2009 OVDP did so with an understanding of its terms, including FAQ #35, as well as other guidance issued by the IRS with respect to the 2009 OVDP. We must question whether subsequently, and retroactively, denying such taxpayers the opportunity to benefit from FAQ 35 is a “bait and switch” maneuver that violates basic and fundamental concepts of fairness. Such a policy change is also questionable from a legal standpoint in light of historical precedent which prohibits the IRS from issuing rules and setting policy on a retroactive basis.
To stop the IRS from unfairly mistreating taxpayers, we have appealed rigorously to the IRS, individually on behalf of every applicable client, and demanded that the IRS lower its unjust penalty assessments in accordance with the IRS’ very own guidelines. We are now getting support from official channels.
The Taxpayer Advocate Service Endorses Our Position That The IRS Is Being Unfair
The IRS has come under fire from within its own organization, the Taxpayer Advocate Service (TAS). TAS is an independent organization within the IRS, tasked with “help[ing] taxpayers … who believe an IRS system or procedure is not working as it should.” And this watchdog actually has teeth. Pursuant to Federal law, “the National Taxpayer Advocate (“NTA”) may issue a Taxpayer Assistance Order if the [NTA] determines that the taxpayer is suffering or about to suffer a significant hardship as a result of the manner in which the internal revenue laws are being administered by the Secretary [of the Treasury].” In such an order, the NTA has the authority to “require the Secretary … to cease any action, take any action as permitted by law, or refrain from taking any action, with respect to the taxpayer under … any  provision of law which is specifically described by the NTA in such order.” We have already requested that the IRS stick to its original terms of the OVDP and refrain from taking any action that would result in unfair treatment of our clients. As it turns out, it may soon be TAS who may require the IRS to stick to its terms and refrain from taking any unfair action.
On June 30, 2011, TAS issued its Fiscal Year 2012 Objectives Report to Congress. In this report (“TAS Report”), NTA Nina E. Olson strongly criticized the IRS’ recent conduct towards 2009 OVDP participants in rescinding FAQ 35:
The IRS announced [in its original FAQ 35] … that “[U]nder no circumstances will a taxpayer be required to pay a penalty greater than what he would otherwise be liable for under existing statutes.” Taxpayers who would not be subject to significant penalties because their violations were not willful, or because they qualified for the “reasonable cause” exception, believed this statement applied to them.
On March 1, 2011 . . . the IRS “clarified” its seemingly unambiguous statement. It would no longer consider whether taxpayers in the 2009 OVDP would pay less under existing statutes on the basis of non- willfulness or reasonable cause. Such taxpayers could either agree to pay more than they believed they owed or withdraw from the 2009 OVDP and face the possibility the IRS would assert massive civil penalties and seek criminal prosecution. Both options were problematic. Withdrawal would waste all of the resources already expended on the 2009 OVDP application and would not bring the taxpayer closure or certainty, as advertised. Moreover, in any future examination the IRS might have to request and review the items that were before the examiner processing the 2009 OVDP submission.
Pressuring taxpayers who would pay less under existing statutes to remain in the program and pay more than they believe they owed was even worse. It violated longstanding IRS policy along with most conceptions of fairness and due process. The IRS’s inconsistency and failure to follow its published guidance damaged its credibility with practitioners and could be subject to legal challenge. In 2011, TAS will continue to communicate with taxpayers and practitioners to determine the impact of the IRS’s apparent reversal, advocate for the IRS to abide by the plain language of the original terms of the OVDP (as reasonably interpreted by the public and many of the IRS’s examiners), and document our findings in the National Taxpayer Advocate’s 2011 Annual Report to Congress. (Emphasis added and footnotes omitted).
The TAS has essentially endorsed the arguments raised in my article regarding the IRS’ “apparent reversal” regarding penalties to be imposed on OVDP participants. The result of the TAS Report may be that Congress instructs the IRS to stop its “bait and switch” with respect to the “IRS’s inconsistency and failure to follow its published guidance.”
Taxpayer Options for the IRS “Bait and Switch”
It is important to note that, “TAS will monitor the IRS’s implementation of its voluntary disclosure initiatives to ensure fairness and protection of taxpayers’ rights.” It is possible that if TAS ultimately determines that the IRS continues to “violate … most conceptions of fairness and due process,” TAS might provide taxpayers with the means to achieve retroactive relief from a penalty assessment on the basis of clear IRS misconduct.
The TAS Report gives taxpayers in the 2009 OVDP a third option with respect to penalties. The prior options were: (a) pay the penalty and close the matter, or (b) opt-out of the OVDP and be subjected to full audit, potentially higher penalties and possible criminal prosecution. Now taxpayers might pay the penalty under protest, then file for a taxpayer assistance order (TAO) and if successful pursue a refund of penalties.
We are proud that the TAS has echoed our very concerns. We will continue to argue on behalf of our clients in support of non-willful penalties where the facts allow it. TAS has already issued at least one Taxpayer Assistance Order (TAO) to the IRS regarding offshore accounts. Our advocacy, coupled with TAS support, could compel the IRS to stick to the original terms that it announced.