Guest Blog: IRS FOIA Request Unveils Previously Undisclosed Estate Tax National Policy for Offshore Disclosures (3/28/16)

Pursuant to an IRS Freedom of Information Act (“FOIA”) request, my colleague at Anaford AG, James Gifford, discovered that the IRS for the past several years has had a “national” policy which selectively denies an estate tax deduction for the miscellaneous Title 26 offshore penalty (“MOP”) incurred in Offshore Voluntary Disclosure Program (“OVDP”) cases (see FOIA response from IRS dated March 17, 2016, here).

But first, some background on the issue.

In the OVDP, participants are required to pay in lieu of all other penalties that may apply to the previously undisclosed foreign assets and entities a miscellaneous Title 26 offshore penalty generally equal to 27.5%[1]of the highest aggregate value for those assets during the period covered by the voluntary disclosure.  Inevitably, some OVDP participants include estates.  Ordinarily, administration expenses are deductible from a decedent’s gross estate under I.R.C. § 2053 for purposes of determining the estate tax.  These include administration expenses incurred in the collection of assets, payment of debts, and distribution of property and normally would include the MOP.

However, it appears since at least 2013 and possibly since 2009, the IRS instituted an undisclosed nationwide policy that the MOP is not deductible as an administration expense by an estate except in the limited situation where only the decedent was “cognizant” of the foreign accounts or assets.[2]  According to internal IRS emails obtained under the FOIA request, the IRS national policy states:

If anyone other than the decedent (which would include a surviving spouse, children, siblings, accountant, attorney, or anyone else with a material interest) was cognizant of the existence of the offshore account, and the executor/personal representative failed to disclose the existence of the account (or, did not file a Form 706) by the due date of the return, then we will not allow a reduction to the gross estate for the related OVDI [OVDP] offshore penalty.

Even though the IRS issues voluminous rules and guidance each year, the IRS acknowledged in a Tax Notes article posted on March 28, 2016 (“IRS Inconsistent in Denying Estate Tax Deduction for OVDP Penalty”) that it has not previously published any guidance on this policy.  Thus, it appears the IRS has not followed any public procedures for creating this policy or informed applicants to the OVDP of this policy.  Nor has it issued any notice, bulletin, or any form of rulemaking for communicating and establishing this policy.

The problems with this policy are many, but to summarize, the policy overtaxes and overreaches.

The policy overtaxes by denying a deduction for the MOP, which should be deductible in all circumstances not some limited exception created from whole cloth where only the decedent was cognizant of the foreign assets.  It is unambiguously the prerogative of Congress to decide how we are taxed and on what.  Deductions are “a matter of legislative grace,” not the whims of bureaucrats (New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934)). The IRS cannot deny a valid deduction simply because they would like to do so.

Moreover, the IRS policy for denying a deduction here overreaches.  The IRS is denying a deduction, which Congress says should be allowed, simply because a confidante of the deceased, such as an accountant or attorney, knew of the account.  Yet this policy punishes the heirs of the deceased, not the confidante. The executor who fails to report the account on time may or may not be an heir, and an heir may or may not be a confidante of the deceased.   The policy also treats family members in the OVDP disparately simply based on the timing of death.  It is troubling that the IRS has taken upon itself to punish the family members of the deceased in this illogical fashion. 

So, what is to be done for persons affected?  At the time of this writing, the IRS has been recalcitrant about resolving these cases fairly (hence our FOIA request).  Therefore, litigation may be an unfortunate necessity.  Dennis I. Leonard, here, from Ramsbacher Prokey Leonard LLP in San Jose, California, a boutique estate and tax litigation firm, shared with me that he had a docketed U.S. Tax Court case where the IRS ultimately conceded this issue.[3]   Dennis cleverly argued as an alternative to the deduction argument that the MOP reduces the value of the estate, which ended in the same result.  The theory being that the estate value under I.R.C. § 2033 is reduced by a valuation discount dollar-for-dollar for the penalty amount.  In that case, the IRS seemed reluctant to litigate the valuation discount issue and thus conceded the issue.  Hopefully, the IRS will reconsider its position, but until that time there appear to be some sustainable arguments against this policy.

Guest blogger Milan Patel and his colleague James Gifford are U.S. tax attorneys at Anaford AG, which is a law firm based in Zurich, Switzerland.  Milan and James represent clients from around the world in the various IRS offshore voluntary disclosure compliance programs with a particular emphasis on cross-border and international tax issues.  Comments may be made to this blog and, if desired, specific comments may be made directly to Milan via his email milan.patel@anaford.ch or James via his email james.gifford@anaford.ch.   Further contact information is available at Anaford’s web site http://www.anaford.ch/meet-the-team/.

---

[1] In limited circumstances this penalty may be reduced to 12.5% or 5%, or actually increased to 50%.  See OVDP FAQs for further clarification.

[2] Presumably this policy does not apply to Streamlined cases due to non-willfulness, although this is by no means certain.

[3] I thank Leonard for sharing his idea and note that he is a former student of Jack Townsend.