As we work to close many voluntary disclosures to the IRS regarding foreign accounts, we are noticing a recent trend: the IRS is increasingly limiting the application of the lower, five percent penalty, and instead is imposing the higher penalty of 27.5% of the value of the foreign assets.
Back in the first of the three recent offshore voluntary disclosure programs, the 2009 Offshore Voluntary Disclosure Program (OVDP), a lower penalty applied to certain foreign accounts, typically established by an ancestor or deceased relative, and then inherited. If the inheritor of the account (a) had not opened the account (or caused it to be opened), and (b) the inheritor did not actively use the inherited account, and (c) all US taxes were paid on the funds contributed into the account (such that only account income was untaxed), then a lower five percent penalty would apply.
One example of an account qualifying for the lower penalty is a “Holocaust account”, such as the following example: an account established decades ago in Switzerland, by a survivor of the Holocaust, to receive reparation payments for German atrocities during the Holocaust. The account was never declared to the IRS, not because of any intention to hide income, but rather because the survivor was simply not aware that the Holocaust account was reportable to the IRS. The survivor then died, leaving the account to an heir, such as an adult child, who was then in a position of owning a non-compliant foreign account simply because of inheritance. If the heir did not actively utilize the account (e.g., trade stocks or take withdrawals), then the account could qualify for a lower penalty.
We have successfully obtained the lower penalty for a number of clients with such inherited accounts under the 2009 OVDP. Please see our article, A Few Voluntary Disclosure Successes. In such cases, we obtained penalties as low as $5,000 for each relevant tax year, rather than the more onerous penalty of twenty percent (20%) of the highest aggregate account balance.
Beginning with the 2011 Voluntary Disclosure Initiative (OVDI), the IRS allowed a 12.5% penalty for accounts that did not exceed a value of $75,000. In addition, the IRS allowed for a 5% penalty for inherited accounts (including, but not limited to a Holocaust account discussed above), which remained passive accounts after inheritance. The lower 5% penalty was also allowed under the terms of the most recent program, the 2012 Offshore Voluntary Disclosure Program (OVDP) as well.
FAQ 52 of the OVDP states that taxpayers making voluntary disclosures qualify for a 5% offshore penalty if taxpayers meet all four of the following conditions:
(a) did not open or cause the account to be opened (unless the bank required that a new account be opened, rather than allowing a change in ownership of an existing account, upon the death of the owner of the account); (b) have exercised minimal, infrequent contact with the account, for example, to request the account balance, or update account holder information such as a change in address, contact person, or email address; (c) have, except for a withdrawal closing the account and transferring the funds to an account in the United States, not withdrawn more than $1,000 from the account in any year for which the taxpayer was non-compliant; and (d) can establish that all applicable U.S. taxes have been paid on funds deposited to the account (only account earnings have escaped U.S. taxation). For funds deposited before January 1, 1991, if no information is available to establish whether such funds were appropriately taxed, it will be presumed that they were.
In closing many 2011 voluntary disclosure cases, we are now noticing that the IRS is increasingly limiting the applicability of FAQ 52 and the five percent penalty. We are now seeing that even if the account was inherited, IRS agents are now looking for any reason to disallow the five percent penalty. For example:
- In one case where an account was opened in a taxpayer’s native India, and funded with proceeds from the sale of inherited real estate located in India, the IRS refused to apply FAQ 52 because the taxpayer opened the account to receive the proceeds of the inherited real estate. The IRS took this position, even though the Indian bank required the taxpayer to open the account to receive the inheritance proceeds; even though Indian foreign exchange control laws prohibited our client from transferring the funds to the US, where they would have been deposited into a US account and declared, and even though inheritance of the real estate from a foreign family member (an “NRA”, non-resident alien) is not even subject to US tax.
- In another case, our client inherited assets from her aunt in Italy. She deposited these assets into a bank account in Switzerland. Even though, as in the case above, the foreign inheritance is not even subject to US taxation, the IRS took the position that because the taxpayer took the funds and opened an account not in Italy (where the inherited assets were located), but across the border in Switzerland, the lower penalty was inapplicable.
- In a third case, the IRS took the position that the client’s transfers of funds between a cash account and a second cash account would not jeopardize the account qualifying as a passive account and eligible for the five percent penalty, but a transfer from the cash account to a related securities trading account would be deemed a withdrawal greater than $1,000 so as to no longer qualify for a reduced penalty per FAQ 52. The securities trading was not fatal to the lower penalty, because trading was in the sole control of the foreign banker. However, the transfer of funds was attributable to taxpayer and precluded the lower penalty.
Notwithstanding the increasingly stringent IRS interpretations of its own penalty requirements, we continue to advocate on behalf of our clients before the IRS. Our advocacy includes verbal discussions with IRS revenue agents, their managers and IRS technical advisors who are charged with interpreting IRS regulations and applying the regulations to taxpayers’ facts, as well as written submissions to the IRS in support of lower penalties. If the IRS remains intransigent regarding the lower penalty, we advise clients on “opting out” of the OVDI/OVDP and arguing in support of lower penalties outside the formal voluntary disclosure process. We can also assist in the referral of disputed matters to the IRS Taxpayer Advocate, who has often supported taxpayers’ positions based upon interests of equity and has published serious criticism of the IRS voluntary disclosure policy and procedure.