Key Excerpts (footnotes omitted):
Definition of the Problem:
* * * Designed for “bad actors,” these programs burdened “benign actors” who inadvertently violated the rules by requiring them to “opt in and opt out” to get a fair result. The programs were punitive, charging average penalties of more than double the unpaid tax and interest associated with the unreported accounts. Because those opting out faced prolonged uncertainty and a risk of even more severe penalties, some agreed to pay more than they should, as described in prior reports.
Unlike those who remain in the programs, those who opt out are audited, which essentially penalizes them for coming forward. On average, the IRS assessed penalties of nearly 70 percent of the unpaid tax and interest in the audits of those who opted out. Thus, while those who opt out generally face smaller penalties than those inside the OVD programs, they still face very significant ones.
For those who remained in the 2009 program, the median offshore penalty applied to those with the smallest accounts (i.e., those in the 10th percentile with accounts of $87,145 or less) was disproportionate — nearly six times the median unpaid tax. Among unrepresented taxpayers with small accounts it was even more disproportionate — nearly eight times the unpaid tax. It was also disproportionately greater than the median penalty paid by those with the largest accounts (i.e., those in the 90th percentile with accounts of more than $4.2 million) who paid about three times the unpaid tax. Given the harsh treatment applied to those with small accounts, some have made “quiet” disclosures by correcting old returns and others have begun to comply prospectively — in each case without subjecting themselves to the lengthy and seemingly-unfair OVD process.
While 7.6 million U.S. citizens reside abroad and many more U.S. residents have FBAR filing requirements,8 the IRS received only 807,040 FBAR submissions in 2012.9 Yet the FBAR audit rate is less than one quarter of one percent. Thus, the IRS has likely failed to address significant information reporting noncompliance.
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ANALYSIS OF PROBLEM
The IRS’s OVD settlement programs are a good deal for “bad actors” but not for “benign actors.”
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Far from allaying taxpayer concerns about the draconian impact of this statute, the IRS OVD programs magnify them. In general, the programs offer to settle potential FBAR and other penalties for failure to file information returns for a fixed amount called the “offshore penalty.” The offshore penalty is 27.5 percent (or 20 or 25 percent for the 2009 and 2011 programs, respectively) of the highest account value during an eight-year period. For taxpayers who believe the IRS can prove they willfully violated the disclosure statute and who might otherwise be subject to criminal prosecution, this is probably a good deal. For others, the maximum civil penalty under the statute is $10,000 for each non-willful failure or zero if the reasonable cause exception applies.16 Thus, the IRS settlement programs were generally not a good deal for those whose failure was not willful.
Unrepresented taxpayers with small accounts paid more than those with representation or large accounts.
Under a “fair” settlement program, one might expect that those with larger undisclosed accounts — that produced greater amounts of unreported income – would be asked to pay a proportionately greater penalty. By this measure, the IRS’s 2009 program was unfair. The median offshore penalty under the 2009 OVDP for those with the smallest accounts was nearly six times the median unpaid tax, whereas it was only about three times the unpaid tax for those with the largest accounts, as shown in the following table.
TABLE 1.22.1, Comparison of median 2009 OVD penalties to median unpaid tax by account size
Bottom 10% Middle 80% Top 10%Offshore account(s) balance $44,855 $607,875 $7,259,580 2009 OVDP penalty $8,540 $117,803 $1,410,517 Additional tax, years 2003-2008 $1,472 $30,894 $452,966 Offshore penalty as a % of tax assessed 580% 381% 311%
Moreover, among those with the smallest accounts (i.e., the bottom 10 percent), those who were unrepresented paid an even greater median 2009 OVD penalty — 794 percent of the additional tax assessment for tax years 2003-2008.20 By comparison, represented taxpayers in this group paid a median of 514 percent. Perhaps unrepresented taxpayers with small accounts felt more pressure to accept a disproportionate offshore penalty than those who were represented or had larger accounts.
A new “streamlined” program is less burdensome, but is overly narrow and does not provide certainty.
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The IRS expects other benign actors to opt in and then opt out of an OVD program, subjecting themselves to more burden and risk than bad actors.
The only option for benign actors who feel the offshore penalty is “too severe given the facts of the case” is to opt out and be audited. This is unappealing for many. Because IRS settlement programs are a good deal for bad actors concerned about criminal prosecution, bad actors do not need to opt out or risk draconian penalties. Moreover, the IRS initially processed applications from benign actors who are expected to opt out much more slowly than others, though it has recently begun to process them more quickly, as shown by the following table.
The IRS’s one-size-fits-all approach disproportionately penalizes those who apply.JAT Comments:
As of September, 2013, nearly ten IRS examiners (9.5 FTEs) had examined 2,828 returns as a result of opt-out and removal cases, and assessed penalties equivalent to nearly 70 percent (on average) of the tax and interest due.29 While these results are not as draconian as many fear, the IRS is still assessing substantial penalties against taxpayers who have voluntarily come forward to correct a mistake. By contrast, those who make quiet disclosures or ignore the problem are unlikely to be detected or penalized. As the IRS closed only 1,626 civil FBAR examinations in 2012, its FBAR audit rate is less than one quarter of one percent. Moreover, many of these examinations involved taxpayers who opted in and out of an OVD program in an effort to correct a mistake, rather than more egregious cases that the IRS could identify on its own. Although it may try to do more in this area, the IRS is unlikely to have the resources to do significantly more. Its resources are tied up auditing (or certifying) those who came forward voluntarily. Thus, the IRS’s programs effectively penalize taxpayers for coming forward even if they opt out.
1. It is, of course, the Taxpayer Advocate's job to critique IRS programs. (It is Darrell Issa's job to do that as well. It is real easy to critique after the fact -- the Monday morning quarterback syndrome.) It is another to conceptualize a workable program based on limited and competing budge priorities.
2. I too would have designed the program differently. But what I have difficulty saying is that the program as designed by the IRS is fundamentally flawed or fundamentally unfair. The opt out, as clumsy as it is, is the fail safe for the benign actor.
3. At least given the structure, the key nuance I would have added to the program would be to provide 1/2 the FBAR penalty and no accuracy related penalty (like a QAR) on opt out to give taxpayers the incentive to join the program rather than not correcting the past. It seems to me that the IRS could still belatedly adopt that solution by simply (i) applying it for the future and (ii) returning to the taxpayers involved 1/2 the FBAR penalty and the accuracy related penalty going forward. Of course, this does not fix the problem for relatively benign taxpayers who did not opt out because of fear of the black box nature of what would happen on opt out. That too might be fixed, but I think the overall systemic costs might not justify it.