Guest Blog: Analysis of the Data in the GAO Report (5/13/13)

Introduction:  I previously posted a blogged on the recent GAO Report on the OVDI/P initiatives.  See GAO Report Targets Strategies Other than OVDP (4/26/13), here, and More on the GAO Report on IRS Offshore Disclosure Initiatives (4/27/13), here.  A reader made some comments to one of those blogs and, thinking that the comments might be refined by the reader and useful to other readers as a stand-alone blog, I invited the anonymous reader to do a guest blog on his comment.  The reader agreed to do so, but has chosen to remain anonymous.  Accordingly, the remainder of this blog is the Anonymous reader's comments as refined for this blog entry.  I have not attempted to verify the statements and conclusions of the reader by tracking them to the GAO Report, so I encourage those interested to do so and post any of their thoughts as comments for the benefit of all readers.

Particular thanks to this anonymous reader.  The balance of this blog entry is the Anonymous reader's offering.  I have not done anything other than cut and paste the offering and provided the full link to the GAO publication.

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Finally, the GAO report on the 2009 OVDP has some data which strongly suggests that a large majority of those who entered the OVDP had tax-compliant principal and only the earnings had not been taxed. It also shows how disproportionate the FBAR penalty has been.

Link: http://www.gao.gov/assets/660/653369.pdf

Table 2 divides participants into categories based on account size. For the 10th percentile group, with median account size of $78,315 the total unpaid taxes over the six-year 2003-2008 lookback period were $103 (or $17 per year.) It would be hard to imagine anyone wilfully setting up and maintaining a foreign account to cheat for such an insignificant amount of money, yet the average FBAR penalty for this group was $13,320 or 129 times the amount of unpaid tax. Had this been unreported domestic income the fraud penalty would have been 75% of $103, or $77.

If unpaid taxes were $107 and assuming a 35% marginal tax rate, this means that there was $306 of unreported income, which would mean that the account principal raised no tax issues and only the account earnings had escaped taxation.

Let's not forget that these people had to spend time and money amending six years of returns, and perhaps even spent money on legal fees.

A $13,320 FBAR penalty in a case with $107 in previously unpaid taxes is grossly disproportionate in such cases.

For larger accounts the penalty is also disproportionate.

The 25th percentile group with a high balance of $190,365 had $1,661 total unpaid taxes over six years, and  paid a penalty of $35,670.For this group,  $1,661 in unpaid taxes results in unreported income of about $4,745 over six years,, or $791 per year, using a 35% marginal tax rate for this group also, the numbers suggest that the entire principal was tax compliant and only earnings had escaped taxation.

The median account had a high balance of $568,735 and unpaid taxes of $12,748. This suggests untaxed total income of $36,422 over the six years, or $6,070 per year. This is about 1.1% of the principal per year, which again suggests that in most cases there was unreported interest or dividend income, but the principal raised no tax issues. The penalty for this group was $107,949, about 8.5 times the previously unpaid taxes.

The 75th percentile group had a high balance of $1,595,805, and owed $60,449 in taxes over the six years, or $10,075 per year, which results in $28,786 untaxed income per year. This is approximately 1.8% of the principal per year, so it would be a reasonable conclusion that in most cases the principal was tax compliant, and only earnings had escaped taxation. . The OVDP penalty of 310,476 for this group is more than five times previously unpaid taxes.

The 90th percentile, those with the largest accounts, had a high balance of $4,054,505. Total additional tax owed for the six years was $190,399 or around $31,733 per year, which suggests unreported income of $90,665 per year, using a 35% marginal tax rate.  This is approximately 2.2% of the principal per year. This is an average, and it is likely that in some cases the unpaid tax pertains to untaxed principal, but it would appear that in most cases it was only account earnings that had previously not been taxed. For this group the OVDP penalty was $793,166 or more than four times previously unpaid taxes.

Just how many of the 90th percentile group, those with the largest accounts, were cases in which the entire balance consisted of unreported income?  The data shows that it can only be a small minority, because if it were one in seven accounts, that account alone would have $1,419,077 in unpaid taxes (35% of the $4,054,505 account balance.)  Dividing $1,419,077 by seven participants would yield average unpaid tax of $202,725.  But since the actual average unpaid tax for this group is $190,399, the number of accounts in which both principal and interest were noncompliant must be less than one in seven, barring some very unusual individual results that would skew the average figures.

If one out of  ten of the largest accounts consisted entirely of tax noncompliant funds, that one case would account for $1,419,077 of the total $1,903,990 in unpaid taxes for ten participants (using the average of $190,399 per participant) leaving $484,913 to be allocated among the other nine.  This would result in average tax liability for the remaining nine participants of $53,799 each, or $8,967 per year, which translates into $25,620 unreported income per year, or annual pretax yield of 0.6% per account.

If one in twenty of the largest accounts consisted solely of unreported income, one person would account for $1,419,077 of the total $3,807,920 unpaid taxes for twenty participants, leaving $2,388,843 to be spread among the remaining 19 OVDP participants.  Each of these nineteen would have $125,729 total unpaid taxes, or $20,953 per year, which results in $59,871 unreported income, or 1.5% of total principal per year.  This result is roughly consistent with the yield implied in the smaller accounts, so it would not be unrealistic to expect that only one in twenty of the largest accounts consisted solely of previously untaxed principal and earnings.  It would also seem, given the low average earnings for the smaller accounts,  that accounts in which there were tax issues with the principal would be a very small percentage of the total.

There may be cases in which untaxed principal was deposited into an account prior to the 2003-2008 period, but not during 2003 or thereafter.  But given that during the 2003-2008 period the data suggests that only a small percentage of the accounts consisted of untaxed principal, it would seem logical to assume that most of the funds that escaped taxation prior to 2003 were untaxed earnings, and that most of the principal was tax compliant.

Even for the largest accounts, the OVDP penalty seems disproportionately large, as it is far greater than the 75% penalty which would ordinarily be assessed in cases of domestic fraud. It also appears that except for a minority of the largest account holders, it was only account earnings that had been unreported. The OVDP penalty is in addition to back taxes, accuracy related penalty on the back taxes, and interest thereon which OVDP participants have also paid.

Anecdotal observation suggests that subsequent programs, with 25% and 27.5% penalties, appear to have attracted smaller accounts with relatively more innocuous facts, so the penalties in such programs are even more disproportionate to past nonfiling of the FBAR.