I assume a simple fact pattern (set forth below) to illustrate the process. My discussion does not deal with complex fact patterns. With more complex fact patterns, a similar analytic process can be used but the process must then deal with the complexities which make conclusions harder to draw. Whether complex or not, the analytic process is not for the faint-hearted or risk-averse or for clients who do not have experienced counsel to make the judgment calls required by the procss. Hence I write this blog principally to generate discussion among tax professionals who are readers of this blog. I caution readers who are not tax professionals to seek individualized help from tax professionals before implementing any strategy they think they may perceive in this blog.
The facts are these: U.S. taxpayer, T, has one foreign financial account of $500,000 (in US $, no PFIC investments) and foreign real estate of $1,000,000 which have had values that have stayed constant from 2003 to 2009. Both assets were U.S. tax noncompliant for that period. T is fully compliant for 2010 (having filed the required FBAR and properly reported the income, deductions and resulting tax liabilities. During the period 2003 to 2009, (i) on the financial account, the taxpayer earned $70,000 (1% net per year), the earnings on which was withdrawn (so the amount remains static) and (ii) on the real estate the taxpayer's net after all deductions for the period was $35,000 (also 1% net per year). I assume further that the taxpayer did not pay any foreign tax with respect to income. I assume further an effective U.S. tax rate of 25% for each year, so that the income tax liability over the period was just over $25,000; and in each tax year, the additional unreported income (however calculated) does not exceed 25% of the reported income on the U.S. tax return. I also assume a key fact -- that the facts, when fully developed, would not permit the Government to prove either by clear and convincing evidence or beyond a reasaonable doubt that T intentionally violated a known legal duty either with respect to U.S. income tax or with respect the FBAR obligation. (This is a key assumption; that type of proof is a pretty high bar as I will note later.)
On these facts, the costs within OVDI are: (i) income tax (assume the 25% rate) of just over $25,000 plus 20% penalty plus interest on both the tax and penalty from the due date of the respective returns; and (ii) "in lieu of" penalty of $375,000 (no interest).
The steps I go through with the client are:
1. I ask the question whether, on the client's unique facts considered in the context of the Government's criminal tax enforcement system, the client is at material risk of criminal prosecution? Those who watch the criminal tax enforcement system know that DOJ Tax prosecutes only cases of material misconduct. I cannot develop the basis for this observation in the confines of this blog, but experienced criminal tax practitioners understand the concept and deal with it regularly in their practices, in all areas including the foreign financial account area. The fuzz word here is the word "material;" a client not at material risk is not the same as a client at no risk, so clients for whom this question is even relevant must be willing to assume some risk; the only guaranteed result is to get in OVDI and stay in it. And, it is important to understand that, even with foreign financial accounts which are subject to the FBAR regime outside the Internal Revenue Code, the criminal tax enforcement system will substantially govern prosecution unless there is some other priority such as drug dealing, FCPA, embezzling public resources, etc. For the use of foreign financial accounts where the only material (that word again) footfault relates to taxes, the criminal tax enforcement system and its priorities will govern whether the taxpayer is subject to material risk of criminal prosecution. So, if the client is at material risk of prosecution in the Government's criminal tax enforcement system, OVDI is the easy choice and probably the only rational choice other than the ostrich approach of hoping the Government (DOJ Tax or IRS) will not discover the past problems. But if the client is not at material risk of criminal prosecution, OVDI is not the obvious choice or, if OVDI is chosen to eliminate even the immaterial risk of criminal prosecution, staying in OVDI for the civil penalties is not the obvious choice. In my facts, based on the key final assumption, the taxpayer is not at material risk of criminal prosecution.I again cautioned readers who are not tax professionals that the foregoing assumes competent advice at each step of the process by a tax professional. The downside risks are too great not to have competent advice -- i.e., the risks are criminal prosecution and even more onerous FBAR penalties than available inside OVDI.
2. I then ask whether, on the client's unique facts, the Government can prove by clear and convincing evidence that the client intentionally violated a known legal duty (either a tax reporting and paying duty and/or the FBAR duty)? Even this is subtle, because if the taxpayer only violated the FBAR duty, the taxpayer can get a pass on the FBARFBAR. For my previous blogs: Government Fails to Prove Willfulness in FBAR Civil Case (9/2/10); see also for the Government's view of the willfulness requirement, Government Pursues FBAR Penalty in Civil Case (10/31/10). This is not an exercise for the fainthearted or uncounseled. And, as noted this is not an exercise for anyone without some tolerance for risk. The risk averse should get into the OVDI and be done with it, perhaps with the thought of later opting out if further developments so indicate. Again, on the facts I posit, there is no material risk that the Government can prove intentional violation of a known legal duty) under any standard.
3. For a client who has passed both of these tests (no material risk of criminal prosecution and no material risk of a finding by clear and convincing evidence of a violation of a known legal duty), I then attempt to develop the costs and risks if the taxpayer either does nothing or gets into OVDI and opts out. On the facts assumed, the income taxes (and resulting interest) are substantially less than in the program, because the IRS will only be able to get 3 years from the date of the notice of deficiency or, if earlier, a consent to extend the statute of limitations. The accuracy related penalty will be no more on those limited years and might be less. (The taxpayer might file amended returns for the back years and claim the qualified amended return waiver of penalties altogether, but that is another blog.) So, a client might be comfortable that there is no material risk that the income tax, penalties and interest will exceed the amount offered under the OVDI and, indeed, comfortable that it is likely that they will be materially less (keep in mind no interest on the earlier years that drop off). And, there is no "in lieu" of penalty that will apply, but instead, the FBAR penalty might apply. But the draconian willfulness FBAR penalty will not apply under the facts posited, so the maximum penalty will be $10,000 for each open year when the FBAR penalty is asserted. At a maximum that will be 6 years assuming the IRS acts immediately or gets a consent (as demanded in OVDI). So the maximum penalty outside the OVDI penalty regime is substantially less than inside the OVDI penalty regime. And, depending on the facts and the IRS's fair administration of the FBAR penalty regime during any audit (either opting out of OVDI or being audited without ever joining OVDI), then the penalty may be less than $10,000 per year.
4. And, to close the loop on all this, given the IRS's design of the OVDI, the IRS has incentivized a taxpayer in the profile of my example to not join OVDI. He or she can stay out of OVDI and take the risk of audit. The taxpayer may never be discovered or, if discovered, audited. In that case, the taxpayer wins a form of the audit lottery, a lottery that is a built in feature of the IRS's design of OVDI. But, if the taxpayer is discovered and audited, his or her costs are still less than demanded in OVDI and the same if he or she had joined OVDI and opted out. If the OVDI penalty is the bar, staying out of OVDI is win-win for the taxpayer.