While reading can aid in learning, there is no substitute for doing.  Reading about what steps to take to solve a tax problem is no different than reading about how to ride a bicycle.  In the same way that the only way to learn how to ride a bicycle is by experiencing it firsthand – i.e., by physically getting on it (and perhaps falling off it more than once) – the only way to become proficient at solving tax problems is by trudging through a multitude of hypotheticals.  Therefore, my motto is, “Learning by doing.”

So why not test your problem solving skills out on a few true-to-life hypotheticals? Below are some hypotheticals designed to assist the reader in recognizing when it would be advantageous for a taxpayer to opt out as well as when it would be detrimental for a taxpayer to opt out.  As previously mentioned, opting out is not for the faint of heart, the risk-averse, or for anyone without some tolerance for risk.

Nor is this an activity that should be undertaken by anyone without a background in tax.  Because OVDI is relatively new, there is still much uncertainty surrounding opt outs.  If OVDI is compared to a long and winding desert road with countless forks, decisions have to be made at every fork. And while Yogi Berra’s sayings have an uncanny way of being prophetic, the quote, “When you come to a fork in the road, take it,” will not solve your opt out problems.  For better or for worse, these decisions often come down to judgment calls.

And these judgment calls are not trivial.  Instead, they have the potential to impact not only a person’s financial security but their very freedom.  To that end, I recommend consulting with an experienced tax professional who has the knowledge and expertise to assist in navigating the minefields of an OVDI opt out. Therefore, if you remember nothing else from this article, remember this: “Don’t go it alone.”

            Opting Out: The Solution for the Non-Willful OVDI Taxpayer

Hypotheticals Demonstrating When Opting Out is in the Best Interests of the Taxpayer

Under what circumstances might opting out of the OVDI be advantageous for the taxpayer?  The following examples illustrate the effect of a taxpayer opting out of the OVDI.  The facts of each example were chosen to illustrate particular issues and do not represent a full analysis of a taxpayer’s particular situation.  Consequently, they should not be relied upon in dealing with an actual case.  For all of the following examples, assume a 35% rate on unreported income.

Example 1: Unreported Income but no Tax Deficiency

Trevor is a U.S. citizen who works and lives in Country A. He has a brokerage account in Country A that he opened in 1999. The account had a high balance of $2 million and generated income of $150,000 each year. Trevor did not report any of the income on his U.S. tax return because he mistakenly assumed that he only had to report it on a Country A tax return.

Trevor’s amended Form 1040 returns show that, after applying the foreign tax credit for taxes paid to Country A, there was no tax deficiency with respect to the unreported income. Trevor entered the 2011 OVDI. He is now having second thoughts and is considering opting out.

The analysis is as follows. For ease in following, the analytical framework has been broken down into steps. As you go through these steps, you will see a pattern emerge. For those who like to see the “big picture,” this framework is nothing more than an aid in analyzing the facts to determine whether Trevor should remain in the OVDI or opt out. To that end, the framework compares the potential risks of opting out against the potential rewards.

Step one is to determine whether Trevor is at material risk of criminal prosecution. As discussed above, this issue should be decided with an eye toward the government’s criminal tax enforcement objectives. Assuming that Trevor is at material risk of criminal prosecution, remaining in OVDI is a “no brainer.” Based on these facts, he is not at material risk of prosecution. Therefore, he can breathe a sigh of relief.

Step two compares the amount due under the offshore initiative to the tax, interest, and applicable penalties for all open years that Trevor would owe outside of the OVDI regime. If the former is greater than the latter, then opting out would appear to be the obvious choice. But if the former is less than the latter, then remaining in the program would appear to be the obvious choice.

What is the amount due under the offshore initiative? Let’s start with the offshore penalty. The offshore penalty is equivalent to 25 percent of the highest aggregate value of each undisclosed financial account at any time during the OVDI look-back period (remember this is the 2011 OVDI).[i] In order to calculate the offshore penalty, it’s necessary to determine what the highest value of Trevor’s foreign brokerage account was during the eight-year look-back period. Here, it was $2 million.

Therefore, the offshore penalty under 2011 OVDI is a whopping $500,000 (i.e., 25 percent of $2 million)! If this penalty strikes you as being severe enough to shock the conscience, you would be justified in feeling that way. After all, Trevor owed no tax to the U.S. government and there was no indication of any wrongdoing.

Against this backdrop of parade of horribles lurking deep within the bowels of the OVDI regime should be compared the potential benefits of opting out. How much must Trevor pay in tax, interest, and penalties outside of the OVDI regime? As a preliminary matter, there is no tax deficiency.

Let’s turn to the FBAR penalty. If, upon examination, the IRS determines that the FBAR violation was not willful, Trevor would be subject to a non-willful FBAR penalty of up to $10,000 per year, the maximum statutory penalty for non-willful violations.

Can the government prove that Trevor’s failure to file the FBAR was willful? Because Trevor mistakenly assumed that he only had to report the income generated from his foreign account on a Country A tax return, the likelihood that the IRS would find his FBAR violation to be willful is slim to none.

However, if you thought that $10,000 was the total FBAR penalty, you’d have made the very same mistake that many tax preparers make. On the contrary, $10,000 is merely the penalty for one year.

Recall that the statute of limitations for assessing an FBAR civil penalty is six years. Here, this includes FBARs that should have been filed to report the foreign brokerage account during calendar years 2004 through 2009.[ii] Therefore, the maximum total penalty is $60,000 ($10,000/year (x) 6 years).

As discussed above, the maximum FBAR penalty should not always be relied upon as an accurate indication of what the FBAR penalty would be outside of the OVDI regime. The question that must always be answered is whether the FBAR-related mitigation guidelines might benefit Trevor outside of the OVDI framework. The mitigation guidelines may lessen the severity of the FBAR penalty by providing for a penalty that is below the maximum. The amounts proscribed under the mitigation guidelines are based on the account balance.

Unfortunately for Trevor, the FBAR-related mitigation guidelines offer no relief. In fact, they might even hurt Trevor in the sense that they validate the maximum total FBAR penalty in the same way that the “Good Housekeeping” stamp of approval guarantees the quality of everyday household products. The reason why is because the brokerage account’s $2 million high balance qualifies Trevor for the Level III non-willful FBAR penalty.[iii] And the Level III penalty is $10,000, which just so happens to be the maximum statutory penalty for a non-willful FBAR violation under these facts.

But just when things appear bleak for Trevor, a ray of light shines at the end of the tunnel. And that ray of light might help Trevor dodge a $60,000 FBAR bullet. How so? By convincing the IRS that the violation was due to reasonable cause. Reasonable cause is a defense to the assertion of a penalty. It can either eliminate a penalty completely, or lessen its impact.

Here, Trevor might argue that he reasonably relied on the written advice of an accountant after disclosing the facts to him. If successful, he would get out from paying any FBAR penalty.

Even if Trevor is not successful in asserting a reasonable cause defense, opting out is still a win-fall for him. Indeed, as Chart 1 illustrates, opting out saves him almost half a million dollars. Therefore, the obvious choice is for Trevor to opt out.

Example 2: Unreported Income and Failure to File FBAR

Joan is a U.S. citizen who lived abroad for three years from 2007 to 2009. While living abroad, Joan opened an account in 2007 with a bank located in Country X. Assume that the highest balance in that account during the three years (2007, 2008 and 2009) was $200,000.

Joan filed U.S. income tax returns for all three years. However, she only filed an FBAR for 2008 and 2009, not for 2007. Joan was unaware of her FBAR filing obligation until 2008, when she hired an accountant to prepare her return. Joan failed to report approximately $2,000 of interest income from the account. Therefore, she is unable to simply file a delinquent FBAR for 2007. The tax deficiency was $700.

Joan entered the 2011 OVDI. She is now having second thoughts and is considering opting out. Step one is to determine whether Joan is at material risk of criminal prosecution. Based on these facts, she is not.

Step two compares the amount due under the offshore initiative to the tax, interest, and applicable penalties for all open years that Joan would owe outside of the OVDI regime. If the former is greater than the latter, then opting out would appear to be the obvious choice. But if the former is less than the latter, then remaining in the program would appear to be the obvious choice.

What is the amount due under the offshore initiative? Let’s start with the offshore penalty. The offshore penalty is equivalent to 25 percent of the highest aggregate value of each undisclosed financial account at any time during the OVDI look-back period (remember that this is the 2011 OVDI).[i] In order to calculate the offshore penalty, it’s necessary to determine what the highest value of Joan’s foreign account was between 2007 and 2009. Here, it was $200,000. Therefore, the offshore penalty under 2011 OVDI is $50,000 (i.e., 25 percent of $200,000).

What else is Joan liable for under OVDI? For starters, she must pay the tax deficiency for each year (here, $700). Second, she must pay interest on the deficiency. And finally, she must pay the accuracy-related penalty. Generally, the accuracy-related penalty is 20 percent of the deficiency. Because the tax deficiency is $700, the accuracy-related penalty is $140 (20 percent of $700).

If you’re keeping track, Joan’s total liability under OVDI is $50,840:

• Income Tax Due: $700
• Offshore Penalty: $50,000
• Accuracy-Related Penalty: $140

Against this backdrop of parade of horribles lurking deep within the bowels of the OVDI regime should again be compared the potential benefits of opting out. How much must Joan pay in tax, interest, and penalties outside of the OVDI regime? Let’s begin with the tax deficiency. Here, Joan would be liable for a $700 tax deficiency for each year. Of course, she would also owe interest with respect to that deficiency.

Let’s turn to penalties. First, the FBAR penalty. If, upon examination, the IRS determines that Joan’s failure to file an FBAR was not willful, she would be subject to a non-willful FBAR penalty of no more than $10,000. That violation would relate to her failure to file an FBAR in 2007.

Can the government prove that Joan’s failure to file a 2007 FBAR was willful? Because Joan was unaware of the FBAR filing obligation until 2008, the likelihood that the IRS would find her failure to file a 2007 FBAR to be willful is slim to none.

As discussed above, the maximum FBAR penalty should not always be relied upon as an accurate indication of what the FBAR penalty would be outside of the OVDI regime. This is especially true under facts such as these where the highest aggregate value of the foreign account is only $200,000. The question that must be answered is whether the FBAR-related mitigation guidelines might benefit Joan outside of the OVDI framework. Indeed, the mitigation guidelines may lessen the severity of the FBAR penalty by providing for a penalty that is below the maximum. Here, the answer is a resounding, “yes!”

Why? The account’s $200,000 high balance qualifies Joan for the Level II non-willful penalty.[ii] And that penalty is $5,000, not to exceed 10 percent of the maximum balance in the account during the year. Unlike the Level III maximum penalty that Trevor had the misfortune of qualifying for in example one, the Level II penalty here is 50 percent less than the statutory maximum.

What does this mean for Joan? Two things. First and foremost, the maximum non-willful FBAR penalty that Joan could be subjected to outside of the OVDI regime is not $10,000, but instead $5,000. And second, the FBAR-related mitigation guidelines have indeed benefited Joan. Indeed, $5,000 is a far more accurate estimate of Joan’s maximum non-willful FBAR penalty outside of the OVDI regime than $10,000 is. The lesson to be learned here is never to overlook the mitigation guidelines and how they can benefit the taxpayer.

Those who think that Joan has “beaten the house” and that $ 5,000 is as low an FBAR penalty as she will ever see should think twice. There is always the possibility—however remote—that Joan might not have to pay any FBAR penalty. That’s because $5,000 is not the actual FBAR penalty that will be asserted. On the contrary, it’s the maximum penalty.

While the maximum penalty can easily turn into the actual penalty, that is not an excuse for overlooking defenses. Indeed, a successful defense can either eliminate the penalty completely, or lessen its impact. For example, if the IRS determines that Joan’s failure to file an FBAR was due to reasonable cause, it might choose not to impose any penalty.

What other penalties might Joan be subject to outside of the OVDI regime? First, she will very likely have to pay an accuracy-related penalty. Generally, the accuracy-related penalty is 20 percent of the deficiency. Because the tax deficiency is $700, the accuracy-related penalty is $140 (20 percent of $700).

In the worst-case scenario, the IRS might assert the civil fraud penalty. The civil fraud penalty applies when an underpayment of tax, or a failure to file a tax return, is due to fraud. Generally, the taxpayer is liable for 75 percent of the deficiency or the amount attributable to fraud. While this doomsday scenario might turn Joan’s luck upside down, it would certainly not be the Apocalypse that she was dreading. Indeed, the civil fraud penalty would only be $525 (75 percent of $700).

If you’re keeping track, Joan’s total maximum penalties outside of the OVDI regime are $5,525:

• FBAR Penalty: $5,000
• Civil Fraud Penalty: $525

Of course, this does not include the $700 tax liability, which raises the total maximum amount of tax, interest, and penalties due and owing from $5,525 to $6,225. This is still a pittance when compared to $50,840, Joan’s maximum liability within the OVDI regime. Under these circumstances, the obvious choice is for Joan to opt out.