Over the past few weeks, a giant trove of information regarding individuals holding assets through Panamanian corporations has been leaked to the press. So far, the “Panama Papers” - as they have come to be called - have disclosed that several high-profile individuals around the world were holding foreign bank accounts and other assets through Panamanian offshore entities. Additional information and names are expected to be released as the media sifts through the large volume of now public documents. While holding an offshore entity or bank account may be legal, the implication is that at least some implicated individuals were engaged in illegal activity or failed to properly report the assets.
In the United States, individuals are generally required to report to the IRS their interests in foreign assets such as bank accounts, brokerage accounts, foreign corporations, and foreign trusts. In addition, U.S. taxpayers are required to report their worldwide income each year on their tax returns. Taxpayers who do not properly report their foreign assets may be subject to stiff civil penalties and even criminal prosecution. For the past several years, the IRS and the DOJ have focused on the issue of offshore tax compliance, jointly chalking up many successes - including breaking through Switzerland’s bank secrecy laws, prosecuting dozens of U.S. taxpayers with unreported foreign accounts, and forcing hundreds of banks all over the world to open up their books and reveal their U.S. clients. In addition, the Foreign Account Tax Compliance Act (“FATCA”) now requires banks all over the world to report their U.S. clients to the U.S. government. As a result of these efforts, thousands of taxpayers have come forward and disclosed their unreported foreign assets under the IRS’s various programs and initiatives.
Nonetheless, many U.S. taxpayers still have failed to report their offshore assets. The Panama Papers are a reminder that the risk of continuing noncompliance is only increasing and that the IRS will continue to receive information about noncompliant taxpayers from far-reaching (and sometimes surprising) sources. Taxpayers who have not yet addressed their noncompliance would be well served to consider coming forward under one of the IRS’s initiatives. Taxpayers who do so before the IRS learns of their noncompliance will be able to mitigate the civil penalties they would otherwise face and avoid criminal prosecution.
Paths to Compliance
Taxpayers who wish to come forward have several options. Putting aside some of the narrower compliance routes available only in very limited circumstances, most taxpayers will fit within either the IRS’s Offshore Voluntary Disclosure Program (“OVDP”) or The Streamlined Filing Compliance Procedures (“Streamlined Procedures”). These two programs are very different, with the OVDP requiring a much longer look-back period, the payment of more taxes, and significantly higher penalties. The Streamlined Procedures, on the other hand, are less formal - requiring a shorter look back period and the payment of a much more limited penalty (in some circumstances no penalties).
The Offshore Voluntary Disclosure Program “OVDP”
Under the OVDP, taxpayers are required to submit correct tax returns for the eight most recent tax years, pay the tax due on those returns, and pay a twenty-percent penalty and interest on the additional tax due. In addition, taxpayers are required to file FBARs for the eight-year period and a pay a one-time penalty equal to 27.5% or 50% (depending on whether the taxpayer held assets at certain banks) of the highest aggregate value of the taxpayer's noncompliant foreign assets. The OVDP is available to taxpayers whose actions were willful, fraudulent, and even criminal. Taxpayers who participate in the OVDP will not be required to pay tax or penalties beyond those specified by the program and are protected from criminal prosecution.
The Streamlined Filing Compliance Procedures
The Streamlined Procedures only require the taxpayer to submit tax returns for the three most recent tax years and only requires payment of the tax due and interest. No tax penalty is imposed under the streamlined program. Taxpayers are also required to submit FBARs for the most recent six years. For resident taxpayers, a penalty equal to 5% of the highest year-end balances of the foreign financial assets is required. For nonresidents, no penalty is imposed. The Streamlined Procedures are only available to taxpayers whose actions were not willful. Such taxpayers are protected from the non-willful penalties that could otherwise apply to their noncompliance. The Streamlined Procedures do not provide any protection from criminal prosecution or from the imposition of penalties that can only be imposed upon the showing of fraud or willfulness.
Willfulness is the Key
Determining the appropriate option depends entirely on whether the taxpayer acted “willfully.” A taxpayer whose actions were willful must use the OVDP in order to gain the protections it provides against criminal prosecution and the imposition of stiff penalties, both of which are possible consequences of a willful failure to report foreign assets. However, taxpayers whose actions were not willful - even if they were negligent - can come forward using the Streamlined Procedures because they do not need the protections that the OVDP offers. A taxpayer that has not acted willfully cannot be criminally prosecuted for tax offenses and cannot be made to pay the hefty civil penalties that are reserved for willful or fraudulent conduct.
In many cases, whether or not a taxpayer has acted willfully will be clear. In other cases, however, it can be quite difficult to make that determination. The starting point of the analysis will usually be the taxpayer’s own feelings on the subject. A taxpayer who admits that he or she knew what they were doing was wrong (even without knowing precisely why it was wrong or what law they were violating) does not qualify for the Streamlined Procedures and must use the OVDP program. More difficult situations are ones in which the taxpayer believes that his or her actions were not willful. In such cases, one needs to evaluate the circumstances surrounding the noncompliance to make sure that the IRS will also see it that way.
A big red flag of willfulness is when the unreported assets are held in a known bank secrecy jurisdiction - such as Switzerland, Panama, or the Jersey Islands - unless the taxpayer’s reason for this is unrelated to bank secrecy. Similarly, holding the assets through a nominee corporation, a shell entity, or a trust is another red flag of willfulness because holding assets in these ways tends to obscure the identity of the true beneficial owner of the account. Other factors that tend to indicate willfulness include lying to a return preparer about whether the taxpayer held a foreign account or funding the account with untaxed monies or through surreptitious cash deposits. If any of these factors are present, the taxpayer would be well advised to go straight into the OVDP.
On the other hand, consider the following hypothetical: Taxpayer Jane was born in Canada and lived and worked there until she accepted a job in New York, where her new employer sponsored her green card. Before leaving Canada, Jane had built up some savings, including a $161,000 interest-earning bank account and a brokerage account holding $38,000 of securities. Starting with her first year as U.S. taxpayer, Jane filed U.S. tax returns and reported all of her U.S. income. Her returns were prepared by a return preparer that she corresponded with by email and were ultimately e-filed after they were prepared. The subject of foreign assets never came up in her limited contact with the return-preparer. Because her returns were e-filed and no payment was required, Jane never printed a copy of the returns nor did she review them; she was just glad to see that she was receiving a refund. This practice continued for several years. Jane’s tax returns, however, never reported her Canadian accounts, which continued to be taxed in Canada. Based on these facts, Jane can likely make a compelling argument that she was not willful in failing to report her Canadian accounts. The accounts were located in her home country, were established with funds that would not have been taxable in the U.S., and Jane does not appear to have taken any actions to hide these accounts. Accordingly, Jane is a good candidate for the less expensive Streamlined Submission Procedures.
What if Jane was born in Switzerland and the accounts at issue were located there, a known tax-haven jurisdiction? That alone would not necessarily change the analysis because having an account in Switzerland would be quite natural for someone who worked and lived there. But what if Jane’s accounts held several hundred thousand dollars, or millions of dollars? Is it plausible that Jane maintained such large foreign accounts and didn’t realize that she should discuss them with her accountant? Does the answer change if Jane is a sophisticated and highly educated individual, perhaps an attorney?
There are no easy answers to these questions. Some alternatives, however, bring things into focus. If the accountant asked Jane if she had a foreign account and she said that she did not, that is likely an indication of willfulness even without some of the additional facts mentioned. The same is likely true if Jane, several years after moving to the United States, decided to place her Canadian accounts in the name of an offshore company. While her noncompliance may not have been willful initially, such an action would be good evidence that at some point she realized that her accounts were reportable, but nonetheless chose a course of action to hide them further. Of course, this may indicate a need to use the OVDP to clean up the problem.
Taxpayers with historical foreign accounts located in their home country sometimes innocently fail to report such accounts at the outset, but then misguidedly take actions that willfully fail to report the accounts when they learn of the reporting requirements. A taxpayer needs to come forward as soon he or she learns of the reporting requirements. Even a single willful action will taint all of the taxpayer’s foreign assets and prevent the taxpayer from utilizing the Streamlined Procedures.
Ultimately, it is the role of the tax practitioner to help guide clients in evaluating their behavior and making the right decision. A taxpayer whose actions were willful can face devastating consequences if he or she inappropriately utilizes the Streamlined Procedures in place of the OVDP. If the IRS were to examine such a taxpayer’s Streamlined Procedure submission and conclude that the taxpayer’s actions were in fact willful, the taxpayer could face criminal prosecution and large civil penalties. That would place the taxpayer in a far worse position than the position the taxpayer would be in had he or she just accepted the higher costs of the OVDP from the outset. A taxpayer that is ultimately deemed not to qualify for the Streamlined Procedures after making a submission cannot then reverse course and take advantage of the OVDP. Rather, such taxpayers will be left out in the cold to face the full gamut of possible consequences. The importance of choosing wisely cannot be overstated.
Bryan C. Skarlatos, Esq., represents clients in tax audits, civil tax litigation, sensitive tax issues, criminal tax investigations, voluntary disclosures and IRS whistle-blower matters. He is also an adjunct professor at NYU School of Law where he teaches a course on tax penalties and he has taught several courses on tax procedure, penalties and ethics to various offices of the IRS. Mr. Skarlatos is co-chair of the annual NYU Tax Controversy Forum and chair of the annual Practicing Law Institute program on "Nuts and Bolts of Tax Penalties." Mr. Skarlatos regularly speaks and publishes articles on the topics of civil tax litigation, tax penalties and criminal tax prosecutions. He has been the chair of several tax committees at the American Bar Association, New York State Bar Association and New York City Bar Association and he is an elected Regent in the American College of Tax Counsel. He can be reached at firstname.lastname@example.org.
Michael Sardar, Esq., Mr. Sardar’s practice focuses on all stages of civil and criminal tax controversies. He represents taxpayers before the IRS, state tax authorities, the Department of Justice, and local prosecutors. Mr. Sardar has vast experience representing clients making voluntary disclosures of unreported income to the IRS and state tax authorities. Mr. Sardar has successfully represented scores of clients with unreported foreign assets who have repatriated over half a billion dollars of offshore assets through the IRS’s Offshore Voluntary Disclosure Program and the Streamlined Compliance Procedures. Mr. Sardar also represents taxpayers in New York State and City residency audits and tax investigations. Mr. Sardar is the Vice-Chair of the New York County Lawyers’ Association (NYCLA) Taxation Committee and is also a member of the Committee on Personal Income Taxation, New York City Bar Association. He lectures frequently on tax controversy issues including foreign asset reporting and non-compliance. Mr. Sardar can be reached at email@example.com or (212) 808-8100.