The portion of the Report most relevant for the subject of this blog are under a couple of headings:
Under the section on Most Serious Problems Encountered by Taxpayers:
The Right to a Fair and Just Tax System: ComplexityUnder the section on Legislative Recommendations:
7. OFFSHORE VOLUNTARY DISCLOSURE (OVD): The OVD Programs Initially Undermined the Law and Still Violate Taxpayer Rights
The Right to a Fair and Just Tax System: ComplexityIn this blog entry, I will first quote in the entirety the Executive Summary discussion of the above topics. The executive summary may be viewed in its entirety here. I may add comments below the excerpts as I have time and may have subsequent individual blogs related to portions of the detailed Report. (For example, I plan -- subject to time constraints -- to discuss the IRS resource issues which are addressed in the Report.)
6. FOREIGN ACCOUNT REPORTING: Legislative Recommendations to Reduce the Burden of Filing a Report of Foreign Bank and Financial Accounts (FBAR) and Improve the Civil Penalty Structure
PENALTIES: Improve the Proportionality of the Civil FBAR Penalty
PENALTIES: Require the Government to Prove Actual Willfulness Before Imposing the Penalty for Willful FBAR Violations
FBAR FORMS: Reduce the Burden of Foreign Account Reporting
The portions of the Executive Summary relevant to offshore and related matters is (the initialisms MSP and LR are for Most Serious Problems and Legislative Recommendations, respectively):
MSP #7 OFFSHORE VOLUNTARY DISCLOSURE (OVD): The OVD Programs Initially Undermined the Law and Still Violate Taxpayer Rights Problem
Before it updated the “streamlined” program in 2014, the IRS generally required those who failed to report offshore income and file a related information return (e.g., a Report of Foreign Bank and Financial Accounts (FBAR)) to enter into an offshore voluntary disclosure (OVD) settlement program and pay an “offshore penalty” designed for bad actors. “Benign actors” with inadvertent violations generally had to “opt out” and be audited to obtain a lesser penalty. Uncertainty about what penalty might apply in the audit, the IRS’s one-sided interpretation of the program terms, processing delays, and the cost of representation in an audit prompted some to pay a disproportionate offshore penalty. Inside the 2011 OVD programs, taxpayers with small accounts paid over eight times the unreported tax—over ten times the 75 percent penalty for civil tax fraud—and those who were unrepresented generally paid even more.
Because violations by taxpayers who have small accounts or are unrepresented are more likely to have been inadvertent, the OVD programs undermined the statutory scheme, which applies a higher penalty to “willful” than non-willful violations or those due to “reasonable cause.” The IRS’s one-sided interpretations of its OVD FAQs, which were not explained, appealable, or published, eroded confidence that the IRS would be reasonable in a post-opt-out examination. The IRS now allows benign actors to pay a smaller penalty under the 2014 streamlined program. However, unlike the last time it made taxpayer-favorable changes to an OVD program, the IRS will not allow those with signed closing agreements to benefit from the most recent changes, thereby punishing taxpayers who came in early. Thus, the IRS’s OVD programs eroded taxpayer rights, such as the rights to pay no more than the correct amount of tax, challenge the IRS’s position and be heard, appeal an IRS decision in an independent forum, to be informed, and to a fair and just tax system.
The IRS should improve the transparency of OVD program guidance (e.g., FAQ interpretations); allow taxpayers to discuss OVD and streamlined program guidance interpretations with the IRS employee interpreting the guidance and to appeal the interpretations; and allow taxpayers to amend closing agreements to benefit from recent program changes.[The detailed section of the report, titled: MSP #7 OFFSHORE VOLUNTARY DISCLOSURE (OVD): The OVD Programs Initially Undermined the Law and Still Violates Taxpayer Rights, is here,]
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LR #6 FOREIGN ACCOUNT REPORTING: Legislative Recommendations to Reduce the Burden of Filing a Report of Foreign Bank and Financial Accounts (FBAR) and Improve the Civil Penalty Structure
A U.S. citizen or resident with foreign accounts exceeding $10,000 can be subject to disproportionate civil penalties for failure to report the accounts on a Report of Foreign Bank and Financial Accounts (or FBAR) by June 30 of the following year. Another penalty may apply if the accounts exceed $50,000 and the person does not report them on Form 8938, Statement of Specified Foreign Financial Assets, which is part of the tax return.
Although the FBAR penalty was aimed at bad actors, benign actors (i.e., those who inadvertently failed to file an FBAR) are afraid they could be penalized for willful FBAR violations because the government may rely on circumstantial evidence of willfulness. These fears have prompted some to enter the IRS’s offshore voluntary disclosure (OVD) settlement programs and pay severe penalties. The median penalty applied to taxpayers with the smallest accounts (i.e., those in the 10th percentile with accounts of $17,368 or less) under the 2011 OVD program, is more than eight times the unreported tax.
The IRS reduced the amount benign actors had to pay under a 2014 streamlined program (and allowed those with open OVD cases to receive the same terms), but did not allow those who had already signed closing agreements to receive the same terms. As a result, some people feel penalized for correcting the problem earlier.
Unexpected and disproportionate FBAR penalties may violate a taxpayer’s rights to be informed and to a fair and just tax system. Because they prompted benign actors to pay excessive OVD settlements, they may also erode the rights to pay no more than the correct amount of tax, challenge the IRS’s position and be heard, and appeal an IRS decision in an independent forum.
In the legislative recommendations that follow, the National Taxpayer Advocate offers specific proposals to:
■ Improve the proportionality of the civil FBAR penalty;
■ Require the government to prove actual willfulness before imposing the penalty for willful violations;
■ Treat taxpayers who correct violations early the same as (or better than) those who correct them later; and
■ Reduce the burden of foreign account reporting.
These proposals should help address concerns about the existing offshore penalty programs, and also establish principles of procedural fairness that could help the government design future penalty initiatives.
PENALTIES: Improve the Proportionality of the Civil FBAR Penalty Problem
The maximum civil FBAR penalty for nonwillful violations is disproportionate—$10,000 per account per year for up to six years. It rises to 50 percent of the maximum account balance (or, if greater, to $100,000) for willful violations. For example, someone with a total of $10,000 in five different foreign accounts ($2,000 in each) could be subject to a non-willful FBAR penalty of $300,000 (six years times five accounts times $10,000) or 30 times the account balance. If the IRS deems the violation willful, the penalty could rise to $3 million (six years times five accounts times $100,000) or 300 times the account balance. The IRS has mitigation guidelines for applying smaller penalties in limited situations because the statutory maximums may “greatly exceed an amount that would be appropriate in view of the violation,” according to the Internal Revenue Manual. However, these guidelines do not apply to everyone.
Legislative history suggests that even the nonwillful civil FBAR penalty was aimed at bad actors engaged in criminal activity. Yet it can hit benign actors who inadvertently failed to file an FBAR even if they have little or no underpayment and the unreported account(s) were not used for criminal activity. It may even apply to the failure to report a checking or savings account in the jurisdiction where the taxpayer resides. FBAR penalties can also overlap with penalties for failure to report the same account(s) on Form 8938, Statement of Specified Foreign Financial Assets, and with the 40 percent penalty for understatements attributable to undisclosed foreign financial assets. By contrast, there is no penalty for failing to file a U.S. income tax return if there is no unpaid tax, and the penalty for failure to file most other information returns is generally $100 per return, rising to ten percent of the unreported amount for intentional violations.
The National Taxpayer Advocate recommends capping the civil FBAR penalty at the lesser of: (1) ten percent of the unreported account balance or five percent for non-willful violations (similar to the IRS’s mitigation guidelines), and (2) 40 percent of the portion of any underpayment attributable to the improperly undisclosed accounts (similar to the penalty for undisclosed foreign financial assets). She also recommends waiving the penalty when the account information was already provided to the IRS by a third party or on another form; when the unreported income from the account does not create a substantial understatement; and when the taxpayer resides in the same jurisdiction as the account, provided the there is no evidence the account was used in a crime.
PENALTIES: Require the Government to Prove Actual Willfulness Before Imposing the Penalty for Willful FBAR Violations
Benign actors cannot be sure the IRS will not view their FBAR violations as “willful,” and attempt to impose severe penalties. This is because the government has eroded the distinction between willful and non-willful violations. As a result, some benign actors agree to pay more under the IRS’s OVD settlement programs than they would after an examination.
The IRS may meet its burden of proving willfulness if it shows a violation is a “voluntary, intentional violation of a known legal duty.” Because Schedule B of Form 1040, U.S. Individual Income Tax Return, asks if the taxpayer has a foreign account and references the FBAR filing requirement, however, the government has been successful in arguing—in cases involving bad actors—that filing a Schedule B can turn a subsequent failure to file an FBAR into a willful violation (called “willful blindness”), at least if combined with other factors such as efforts to conceal the account. It is unclear what other factors the IRS will consider. It is also unclear if the IRS will distinguish between efforts to conceal the accounts with the intent to evade U.S. taxes or conceal crimes, as opposed to inadvertent concealment, or concealment based on concerns about financial privacy or fears of unwarranted persecution, seizure, or extortion by a government or others (e.g., terrorists or organized criminals). Given this uncertainty, as well as the time and cost of representation in an examination and any potential administrative and appeals, some benign actors have agreed to pay more under the IRS’s OVD settlement program than they would after an examination. Legislation to clarify that the IRS may only assert a willful FBAR penalty if it can prove the violation was actually willful would reduce the IRS’s excessive discretion in determining what penalty may
apply. It would also support the taxpayer right to be informed, which includes the right to a clear explanation of the law.
The National Taxpayer Advocate recommends legislation to clarify that the government has the burden to establish actual willfulness (i.e., specific intent to violate a known legal duty) before asserting a willful FBAR penalty, and cannot meet this burden by relying solely on circumstantial evidence.
CLOSING AGREEMENTS: Authorize the IRS to Modify Closing Agreements to Treat Taxpayer Who Correct Violations Early the Same As (or Better Than) Those Who Correct Them Later
The IRS announced changes to its Offshore Voluntary Disclosure (OVD) programs in 2014. These changes generally allowed benign actors (i.e., those who certified their violations were not willful) to pay less to correct FBAR reporting violations. In contrast to prior revisions to its OVD programs, however, the IRS did not allow those with signed closing agreements to benefit from the more lenient program terms announced in 2014.
The IRS may not have the legal authority to modify OVD closing agreements. Under common law principles, agreements can be modified with the consent of both parties. Moreover, Treasury Regulation § 301.7121-1(b)(1) contemplates “a series of closing agreements relating to the tax liability for a single period,” which might suggest, in effect, a change to the original agreement. However, IRC § 7121(b) provides that with limited exception, closing agreements “shall be final and …shall not be reopened as to the matters agreed upon or the agreement modified.” Thus, legislation to clarify that the parties can modify closing agreements by consent would empower the IRS to treat those who corrected violations early the same as those who corrected them later.
The National Taxpayer Advocate recommends legislation to authorize the IRS to modify closing agreements with the taxpayer’s consent, particularly when necessary to promote equity or public policy (including consistency). She further recommends directing the IRS to use this authority to amend OVD closing agreements to make them consistent with the terms of agreements publicly offered to similarly-situated taxpayers in subsequent IRS programs.
FBAR FORMS: Reduce the Burden of Foreign Account Reporting Problem
U.S. citizens and residents may be required to report foreign accounts on different forms (FBAR vs. Form 8938), at different times of the year (June 30 for FBAR vs. April 15th or September 15th for Form 8938), when they reach different thresholds ($10,000 for FBAR vs. $50,000 or more for Form 8938), and using different definitions, even though the government may already know about the accounts. Because of the Foreign Account Tax Compliance Act (FATCA), in 2015 many banks will also begin reporting the foreign accounts of U.S. persons to the IRS. All of these requirements combine to make foreign account reporting excessively burdensome.
Requiring taxpayers to report many of the same accounts on two different forms on two different dates may increase preparation expenses and the possibility of error. Taxpayers must remember two filing deadlines and potentially pay to consult two different advisors at two different times. In addition, although the $10,000 FBAR reporting threshold has fluctuated, it is the same as it was in 1970. If indexed for inflation from 1970, it would be more than $61,000 in today’s dollars – significantly more than the $50,000 threshold the IRS established for reporting on Form 8938. Over 30 percent of the FBARs the IRS received in calendar year 2012 reported accounts of less than $49,999. Thus, assuming most taxpayers file only one form, coordinating the FBAR filing threshold with the Form 8938 threshold could reduce taxpayer burden by nearly one third. Moreover, information about larger accounts may be more useful for tax administration. One reason the IRS cannot create a new form that consolidates foreign account reporting is because taxpayer privacy protections prohibit the IRS from sharing information from a tax return (e.g., from Form 8938) with the Financial Crimes Enforcement Network (FinCEN), which needs the information provided on an FBAR.
The National Taxpayer Advocate recommends legislation to align the FBAR filing deadline and threshold(s) with the Form 8938 filing deadline and threshold(s). She further recommends requiring the Treasury Department to consolidate the reporting of foreign accounts (i.e., the FBAR and Form 8939) so taxpayers only have to report them on one form. To facilitate this change, the legislation could authorize the IRS to disclose the information now reported on an FBAR to FinCEN without violating the privacy rules applicable to tax information, as long as the information is prominently identified on the new form as either not being part of the return or not subject to the privacy rules.[The detailed section of the report, titled: LR #6 FOREIGN ACCOUNT REPORTING: Legislative Recommendations to Reduce the Burden of Filing a Report of Foreign Bank and Financial Accounts (FBAR) and Improve the Civil Penalty Structure is here,]
- Lay readers should understand the role of the Taxpayer Advocate. She is supposed to advocate for the taxpayer within the system. She is not tasked with administration of the tax law, but simply trying to point out and act where the administration of the tax law has rough edges and can be improved. She does not set policy for the IRS much less for Congress. Her proposals are proposals that may or may not be administratively adopted (where the law permits administrative change) or legislatively adopted. She serves an important role and the IRS and Congress will listen to her. But they may not act.
- I like the recommendation to require the IRS to prove actual willfulness. As readers of this blog know, willful blindness is not the same as willfulness (as interpreted in Cheek). I will post more when I get into the detailed recommendations.
- On a quick review, I noticed the following: "The maximum civil FBAR penalty for nonwillful violations is disproportionate—$10,000 per account per year for up to six years." This is stated in an executive which often sacrifices nuances for the bigger picture. However, as stated, my understanding is that, as stated, that is the IRS's claim but that claim has not been contested and may not be the law. Perhaps that is clarified in the detailed discussion. In addition, whatever the maximum limits of the nonwillful penalty, they are just maximums. The statute permits lesser amounts down to zero.