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Taxpayers who uncover a retroactive need to file and amend returns in relation to offshore assets (based on failures to file forms such as FBARs and Form 8938, and failures to include income from foreign assets on Form 1040) are inundated with options regarding remedying their prior omissions.  Individuals who discover their errors are faced with options which can often be overwhelming, and they require guidance on the proper route to take.

As a primer on reporting obligations for offshore accounts and assets, penalties can be imposed for failures to file Form 8938 (required if foreign assets subject to reporting exceed threshold amounts for reporting) or other assorted reporting forms, or for failures to report income from international sources.  However, the primary reporting requirement for offshore assets (and the focus of consternation for both taxpayers and tax professionals) is the FBAR (FinCEN Report 114).  Taxpayers with funds in offshore accounts aggregating $10,000 or more in any given year are required to make a FBAR filing.  A six-year statute of limitations exists for FBARs; thus, failures to file as far back as 2008 remain open for assessment until June 30, 2015 (the FBAR’s due date is June 30 of the year immediately following the calendar year being reported).  For clear overt attempts to evade reporting requirements, criminal ramifications can exist; however, these typically are reserved for the most egregious of actors.

However, civil penalty assessments are not reserved for such circumstances, and are assessed regularly by the Service.  Where a failure to file the FBAR occurs, penalty amounts hinge on the level of willfulness determined by the Internal Revenue Service.  For failures determined to be nonwillful, penalties of $10,000 per account per year can be assessed.  Even more damaging are failures determined to be willful; where this determination is made, penalties of the greater of $100,000 or 50% of aggregated account balance can be assessed for each year the statute of limitations is open.  Importantly (and as noted above), the statute of limitations period for FBAR penalties is six years; this means that penalties can be assessed for each year in which a failure to file the FBAR occurred.  Common practice by the Service is to assess FBAR penalties (whether willful or nonwillful) for either one or two years; however, the Service is authorized to go beyond the one to two year period if they so choose.

Numerous options exist for retroactive disclosures of prior reporting obligations.  The first option which immediately comes to mind for many taxpayers is to simply remove all funds from the foreign account in order to remove the reporting requirements themselves (at least prospectively).  For an assortment or reasons, this route is inadvisable.  Funds withdrawn from foreign banks would then need to be deposited in domestic banks; domestic banks receiving more than $10,000 are required to report those deposits to the federal government (and include identifying information on the depositor).  The government would then be given all information necessary on the depositor to conduct a full investigation as to the source of funds.  If multiple deposits, each under $10,000, but in all totaling $10,000 or above, are made and the deposits are deemed “suspicious”, the government can seek to seize funds deposited.  Where any type of attempt to evade tax or reporting requirements occurs, the Service will undoubtedly be much more inclined to assess willful FBAR penalties (and could also potentially seek criminal charges under these circumstances).  Closing the offshore account without taking other action to come into compliance thus is extremely inadvisable, and could risk dire consequences both in the civil and criminal context.

Another option which initially appears appealing to some taxpayers is to make a so-called “quiet disclosure” to remedy past omissions.  Under a quiet disclosure, taxpayers submit amended returns to include income which previously went unreported and file original FBARs for prior years (typically, tax returns and FBARs are filed for all years for which the statute of limitations remains open).  Under this approach, no penalty amount is paid with the amended returns and FBARs; the hope is that the Service will simply accept the documents and make no assessment.

Unfortunately, this hope is becoming increasingly unrealistic.  Service representatives have stated that the government has representatives assigned to evaluating FBARs submitted after the form’s due date; when submitted, Service representatives will check to see if amended tax returns were submitted concurrently with the FBARs (or within a short timeframe of the submission of the FBARs).  Where amended returns are submitted with FBARs (evidencing income associated with the foreign accounts reported), an audit is likely to be triggered.  The Service has sought to dissuade taxpayers from making “quiet disclosures” by assessing aggressive FBAR penalties when these types of disclosures are discovered.

As with the withdrawal of funds discussed above, the Service increasingly views “quiet disclosures” as attempts to “game” the system; they seek to disincentivize these approaches given the options which they have made available.  Two primary disclosure options have been offered by the Service: the Offshore Voluntary Disclosure Program (“OVDP”) and the Offshore Disclosure Procedures (the “Streamlined Program”).

The OVDP was the first program offered in a widespread fashion to taxpayers by the Service; short-term versions of the OVDP (lasting for a few months) were made available in 2009 and 2011.  An open-ended version was made available in 2012; this version of the OVDP has remained in existence, with some modifications made in 2014.  The Service states that the OVDP can be withdrawn as an option by the Service at any time; however, no indications have been given that the Service will withdraw the OVDP at any point in the near future.

Under the OVDP, taxpayers are required to submit eight years’ worth of amended tax returns and FBARs (to enter the OVDP, a taxpayer is required to extend the statute of limitations for both).  Submissions are made in three steps: first, taxpayers initially submit a preclearance request to be admitted into the OVDP.  Once admitted, a preliminary disclosure occurs, wherein taxpayers answer questions regarding their offshore holdings.  After acceptance of this submission, a full disclosure is made, at which time amended returns, FBARs, and a penalty are all submitted.

The biggest drawback to the OVDP is the penalty amount required to be paid under the program: to participate, taxpayers must pay a one-time penalty of 27.5% of the highest yearly aggregated balance of foreign assets (subject to reporting) over an eight-year period.  Assets subject to reporting generally include foreign accounts and offshore assets which generate income (i.e. foreign rental real estate).

Benefits are afforded to participants, however.  The biggest benefit is that, once accepted into the OVDP, taxpayers no longer have to worry about imposition of the higher penalties which could be assessed upon audit.  Taxpayers receive an acceptance letter typically within 30 days of seeking entry into the OVDP; once accepted, they are only required to comply with the Program’s terms to maintain protection.  After all submissions are made under the OVDP, the submissions are analyzed by the Service, who then make any required adjustments (these adjustments are typically minimal).  A closing letter is then sent, evidencing that the Service has accepted the taxpayers’ submission and that the matter is, for all intents and purposes, resolved.

The second Program offered by the Service is the Streamlined Program; this Program was first announced in 2012.  However, prior to 2014, participation in the Program was available only to those residing overseas.  In 2014, revisions were announced opening the Program to United States residents (among other revisions, including the elimination of a tax threshold for participation).

The Streamlined Program offers much friendlier terms than the OVDP in terms of penalty amounts and years covered.  To participate in the Streamlined Program, taxpayers are only required to pay a 5% penalty on the highest yearly aggregated balance of foreign assets (subject to reporting).  The reporting period under the Streamlined Program is only six years, rather than eight (and taxpayers are only required to file three years’ worth of amended tax returns; taxpayers file six years of amended/original FBARs).  Unlike the OVDP, submissions of entire packages are made immediately (rather than making three submissions over time).

Importantly, significant risks exist with a submission into the Streamlined Program.  To participate in the Streamlined Program, a taxpayer’s failures to file prior year FBARs, include income from foreign assets in Forms 1040, and pay tax on said income must be deemed “non-willful.”  For these purposes, the IRS defines “non-willful” as conduct due to negligence, inadvertence, or mistake or conduct that is the result of a good faith misunderstanding of the requirements of the law.  The standards for willfulness (and corresponding standards for non-willfulness) have been partially developed by existing case law. However, given the lack of clear case law on the topic and similar lack of clear guidance from the Service, enormous ambiguities in the term’s definition still exist (and, importantly, determinations for Streamlined Program purposes will be at the discretion of the IRS).

Where a taxpayer makes a submission under the Streamlined Program, the expectation is that the Service will review the submission at some point.  If the Service reviews the submission and determines that the taxpayer does not meet the non-willful standards, the Streamlined Program submission will be rejected.  Once rejected, the Service has made clear that an audit will ensue (of note is that taxpayers who are rejected from the Streamlined Program cannot thereafter make a submission to enter the OVDP Program).  Upon audit, assessment of some combination of the aforementioned FBAR penalties (i.e. the 50%/$100,000 penalty, potentially for multiple years) is entirely possible (and, depending on the facts involved, even likely).

Additionally, unlike with the OVDI Program, the Streamlined Program submission is made without any interaction with the Service (unless additional information is needed and/or adjustments to the submission are made).  No closing letter is issued under the Streamlined Program; therefore, no definitive statement from the Service that a Streamlined Program submission has been accepted occurs.

Juxtaposing the two programs, it is clear that, while taxpayers incur higher costs under the OVDI Program, they also receive far greater assurances regarding their disclosure being a “final determination.”  One helpful method of analysis is that taxpayers pay a premium under the OVDI Program to obtain certainty regarding penalty amounts.  Under the Streamlined Program, penalty amounts are lower; however, rejection from the Program (and subsequent audit/assessment of significant penalties) is absolutely within the realm of possibility.  The Streamlined Program can be a fit for taxpayers who were nonwillful by any interpretation of the term; however, where there is any possibility of a finding of willfulness, the OVDP Program provides a safer alternative.

Ultimately, decisions on the proper method for disclosure depend entirely on the specific facts of the taxpayers involved.  Consultation with an experienced professional can be of assistance in getting a full picture of the risks present and best avenues for proceeding.