Article Analyzes Counter-Intuitive Effects of IRS Offshore Penalty Structure (2/12/14)

In a comment, a reader directed me and other readers to a recent article that is quite good, so I decided to elevate the article to a separate blog entry.  The article is Patrick W.Martin & Michelle Ferreira, The 2013 GAO Report of the IRS Offshore Voluntary Disclosure Program (1/10/14).  The web version is here, and the pdf is here.  The authors' bios are here and here.

As the authors note, "the GAO Report indicates [that] taxpayers with little or no criminal or civil fraud exposure were punished proportionately in higher amounts than those who participated and had true criminal tax exposure."  The authors break these categories into Bad Actors and other actors, referred to as Benign Actors.  That Bad Actors would be treated better than Benign Actors is a counter-intuitive result.

The authors also analyse the data to conclude that, relative to aggregate collections from those who don't opt out, the income tax is relatively small -- i.e., 64% of the collections is the in lieu of penalty, called the "Offshore Penalty," and 36% is income tax, penalty and interest.

The authors state:

One key question that the GAO Report raises, is why would so many taxpayers enter into the Offshore Voluntary Disclosure Program if they were not at least as liable for income taxes or penalties under the law? The authors think the answer to this question can be simply answered. Neither taxpayers nor many of their tax advisors understand how tax penalties actually apply under the law, particularly because some penalties are not in the Internal Revenue Code. Instead of understanding what the requirements are under the law, taxpayers simply relied upon the  Internal Revenue Service to inadequately explain how penalties could apply in and outside of the Program. Based upon only the Frequently Asked Questions (which were published subsequent to the Program’s announcement), taxpayers and their advisors had to make swift and uneducated determinations as to whether a taxpayer should participate on the Offshore Program at all and many feared all would be criminally prosecuted, as the IRS continuously led them to believe. 

The authors state that the IRS pronouncements -- particularly the FAQs are not very helpful in given good information to help taxpayers and practitioners assess true exposure under the law, thus causing many of them to accept the OVDP program and the Offshore Penalty from fear rather than understanding.  Thus, the opt out procedure is not the safety valve that the IRS perceives it to be. More from the authors:

If a taxpayer does not understand how the complex law applies to their actual circumstances they can easily be misled into making a poor decision and participating in the OVDP; especially when faced only with the choices that are presented in the IRS materials. Many taxpayers are not getting better advice from various tax professionals, who themselves read the IRS website and pass them along to their clients, sometimes verbatim. These choices, in the author’s view are commonly a false choice of (a) losing a large portion, if not all of, their assets to penalties, or worse, going to prison; compared with (b) paying a certain percentage of their assets to the IRS in order to resolve their case. One can understand how and why almost all taxpayers faced with this choice would choose the one that would lead to a more certain outcome, instead of a choice that would most certainly be filled with anxiety, stress and confusion, especially if the taxpayer continued to go back to and read the IRS FAQs and answers, representing some 28 pages in length with more than 16,000 words of explanation. To be repetitive, in no part of the IRS FAQs, is there any attempt to explain how penalties under the law actually apply to any particular factual circumstances if the taxpayer were to NOT participate in the OVDP. To the ill-informed taxpayer, this necessarily would leave them in a deeply confused state, regarding the application of U.S. tax law. 

A layperson who has no real understanding of the complexities of the tax law (particularly in the international area) can be forgiven for their lack of understanding of legal concepts, which for many created the inadvertent mistake in not reporting their foreign accounts. Many U.S. taxpayers are unaware of their Constitutional rights and protections afforded to all U.S. citizen taxpayers in an audit, i.e. if they do not participate in the Offshore Voluntary Disclosure Program. The authors are of the view that many tax lawyers and CPAs do not themselves understand the complexities of the tax law; when penalties can apply under the law, and when a criminal act has actually been committed when evaluating a taxpayer’s options. The result is that many of these advisors may simply have neglected to truly advise their clients of the law and its application and the options available to each and every Benign and Bad Actor separately. 

I highly recommend that readers interest in this subject review and, as appropriate, drill down on this article.