Hypotheticals Demonstrating When Opting Out is Detrimental To the Taxpayer

Under what circumstances might opting out of the OVDI be detrimental for the taxpayer?  Below are two examples.

Example 3: Large Unreported Gain

Kevin is a U.S. citizen. In 2008, he opened a checking account in Country A with funds upon which U.S. taxes were previously paid. Kevin owned an apartment building in Country A that he sold in 2008. However, Kevin failed to report the gain from the sale of that building on his tax return.

The fair market value of the apartment building was $10 million. And Kevin’s unreported gain from the sale was $6 million. The related tax deficiency was $2,100,000.

Kevin deposited the entire $10 million from the sale into his foreign checking account. $10 million represented the highest balance in the foreign checking account during the year. It was also the balance in the account as of June 30 of the following year, the date when an FBAR was due.

The apartment building was held in a foreign grantor trust, with Kevin as the grantor. Kevin established the trust in 2008, shortly before selling the apartment building. He then transferred the building into the trust. Kevin never filed a Form 3520 to report the creation of the trust or to transfer the building into the trust.

Kevin entered the 2011 OVDI. He is now having second thoughts and is considering opting out. Because there are no criminal overtones, let’s skip right to step two.

Step two compares the amount due under the offshore initiative to the tax, interest, and applicable penalties for all open years that Kevin 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 Kevin’s foreign checking account was in 2008. Here, it was $10 million, which was comprised of the proceeds from the sale of the apartment building. Therefore, the offshore penalty under the 2011 OVDI is $2.5 million (i.e., 25% of $10 million).

What else is Kevin liable for under OVDI? For starters, he must pay tax on $6 million, the unreported gain from the sale of the apartment building. At a rate of 35 percent, the related tax deficiency is $2,100,000. Second, Kevin must pay interest on the deficiency. And finally, he must pay the accuracy-related penalty. Generally, the accuracy-related penalty is 20 percent of the deficiency.[ii] Because the tax deficiency is $2,100,00, the accuracy-related penalty is $420,000 (20 percent of $2,100,000).

If you’re keeping track, Kevin’s total liability under OVDI is $5,020,000, calculated as follows:

• Income Tax Due: $2,100,000
• Offshore Penalty: $2,500,000
• Accuracy-related Penalty: $420,000

Against this backdrop of parade of horribles should again be compared the potential benefits of opting out. How much must Kevin pay in tax, interest, and penalties outside of the OVDI regime? Let’s begin with the tax deficiency. Kevin’s tax deficiency is $2,100,000. Of course, Kevin would owe tax and interest with respect to that $2,100,000 deficiency.

Let’s turn to the penalties. First, the FBAR penalty. If, upon examination, the IRS determines that Kevin’s failure to file an FBAR in 2008 was willful, he could face a maximum FBAR penalty of $5 million. Holy cow! If that penalty strikes you as being severe, recall that for willful FBAR penalties the maximum FBAR penalty is the greater of (1) $100,000, or (2) 50 percent of the closing balance in the account as of June 30, the last day for filing the FBAR.

Here, there is no question that (2) is greater than (1). Ten million dollars was the closing balance in Kevin’s account as of June 30, 2008. And 50 percent of $10 million is $5 million. Because $5 million is greater than $100,000, $5 million is the maximum willful FBAR penalty. Therefore, the maximum willful FBAR penalty is 50 percent of the closing balance in the account, and not $100,000.

Before the government can assert a $5 million FBAR penalty against Kevin, it must prove that Kevin’s failure to file an FBAR was willful. Can the government carry its burden? Before answering this question, we need to know exactly what burden of proof the government carries. Because willfulness, as it is used in this context, applies to a civil penalty and not to a tax crime, the government’s burden of proof is not beyond a reasonable doubt. Instead, it is by clear and convincing evidence. Therefore, the issue should be framed as follows: Can the government prove, by clear and convincing evidence, that Kevin intentionally violated a known legal duty, specifically the duty to file an FBAR?

Here, arguments can be made both for and against willfulness. How it will turn out is anyone’s guess. Therefore, whether Kevin’s failure to file an FBAR was or was not willful is a story better left for another day.

What impact does the statute of limitations have on Kevin’s FBAR liability? The statute of limitations for assessing FBAR penalties is six years. This means that Kevin willalso be liable for FBAR penalties for all other open years, assuming of course that the balance in his checking account never fell below $10,000.01 at any given point during any one of those years.

As discussed above, the maximum FBAR penalty is not always an accurate indication of what the FBAR penalty would be outside of the OVDI regime. The question that must be answered is whether the FBAR-related mitigation guidelines might benefit Kevin 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 Kevin, the FBAR-related mitigation guidelines offer no relief. In fact, they might even hurt Kevin in the sense that they validate the maximum 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 account’s $10 million high balance qualifies Kevin for the Level IV willful FBAR penalty.[iii] And the Level IV penalty is $5 million, or 50 percent of the closing balance in the account as of June 30, which just so happens to be the maximum statutory penalty for a willful FBAR violation under these facts.

What other penalties might Kevin be subject to outside of the OVDI regime? There are two. First, if the IRS finds that Kevin’s failure to report the gain from the sale of the apartment building was due to fraud, he faces a 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. Because the unreported gain from the sale of the building resulted in a deficiency of $2,100,000, that represents the amount attributable to fraud. As such, the civil fraud penalty is a staggering $1,575,000 (75 percent of $2,100,000).

The second penalty is a penalty for failing to file an information return, here Form 3520.[iv] As if the willful FBAR penalty and the civil fraud penalty were not bad enough, this penalty can unilaterally cause Kevin’s penalty liability to soar into the penalty stratosphere. The penalty is $3.5 million (35 percent of $10 million).

The final issue is whether any defenses exist to any of the aforementioned penalties. A successful defense can either eliminate the penalty completely, or lessen its impact. For example, if the IRS determines that a taxpayer’s failure to file an FBAR was due to reasonable cause, the IRS might not even assert the penalty. Therefore, defenses must never be overlooked. Here, there are no defenses.

If you’re keeping track, the penalties alone are staggering:

• FBAR Penalty: $5,000,000
• Civil Fraud Penalty: $1,575,000
• Code Sec. 6677 Penalty: $3,500,000

Kevin’s total maximum penalties outside of the OVDI regime are $10,075,000. Of course, this does not include the $2.1 million tax liability, which raises the total maximum amount of tax, interest, and penalties due and owing from $10,075,000 to $12,175,000. By comparison, Kevin’s maximum liability within the OVDI regime is $5,020,000.

The choice is clear. While $5,020,000 is by no means “chump change,” it is less than one-half of what Kevin faces outside of the OVDI regime. Even if Kevin is able to avoid the civil fraud penalty, his liability outside of the OVDI regime is still twice that of what it is inside the OVDI. That might make the pain of paying a $5,020,000 tax liability just a little easier to swallow. Under these circumstances, the obvious choice is for Kevin to remain in the 2011 OVDI.

	Civil   Settlement Structure within OVDI	Opt   out and one year willful FBAR penalty	Opt   out and assume the civil fraud penalty applies
Income Tax Due (not including   interest)	$ 2,100,000	$ 2,100,000	$ 2,100,000
20% Accuracy-related penalty	$ 420,000 (20% of $ $ 2.1   million)	$ 420,000 (20% of $ $ 2.1   million)	$ 0
25% Offshore Penalty	$ 2,500,000 (25% of $ 10   million)	$ 0	$ 0
Civil Fraud Penalty	$ 0	$ 0	$ 1,575,000 (75% of $ 2,100,000)
§ 6677 Penalty	$ 0	$ 3,500,000 (35% of $ 10   million)	$ 3,500,000 (35% of $ 10   million)
FBAR Penalty	$ 0	$ 5,000,000 (50% of closing   account balance on June 30, the date that the FBAR was due)	$ 5,000,000 (50% of closing   account balance on June 30, the date that the FBAR was due)
Total	$   5,020,000	$   11,020,000	$   12,175,000

 

Example 4: Possible Referral to Criminal Investigation for investigation or to DOJ for Prosecution

 

Sam is a U.S. citizen. He owns a building located in Country X. In 2002, he sold the building for $400,000 short term capital gain. Sam intentionally failed to report the gain on his 2002 Form 1040. Assume that Sam’s basis in the building was zero.

Sam deposited the proceeds from the sale of the building in an offshore bank account located in Country Y. The account in Country Y is in the name of a trust. Sam established the trust in Country Z in 2000. The account earned $12,000 in interest each year from 2003 through 2010.

Sam closed the account in Country Y and repatriated the funds back to the United States, disguising them as a loan from an allegedly unrelated entity. The highest balance in the foreign account was $496,000.

Sam entered the 2011 OVDI. He is now having second thoughts and is considering opting out.

Step one is to determine whether Sam is at material risk of criminal prosecution. Indeed, this fact pattern gives rise to at least two potential tax crimes. However, this problem focuses on just one: tax evasion. Tax evasion is the capstone of traditional tax crimes. As it applies to these facts, it is the attempt by a taxpayer to prevent the IRS from knowing that additional tax is due and owing (i.e., otherwise known as evasion of assessment).

The government must prove three elements beyond a reasonable doubt. First, that the taxpayer owed substantially more tax than what was reported on the income tax return. Second, that the taxpayer knew that he owed substantially more tax than what he reported on the return. And third, that the taxpayer’s purpose was to evade or defeat the payment of taxes. An affirmative attempt to evade or defeat the tax due and owing is sufficient.

One small word is all that distinguishes civil tax liability from criminal tax liability. What is that pestilent word? It is willfulness. That very word strikes fear in the hearts of taxpayers. Why? Because it means the difference between whether the taxpayer will be subject to nothing more than a penalty or whether the taxpayer will become a guest of “Club Fed.” And despite the jokes about Club Fed, spending several years—if not longer—confined to a cold, dank cell is no laughing matter. To add insult to injury, as harsh a sentence as prison can be, it does not absolve a taxpayer of paying hefty fines and penalties upon release.

While only a small percentage of cases are referred to the DOJ for prosecution, those that are have a devastating impact on the taxpayer. For example, while easy to overlook, the collateral consequences of having a felony conviction can be even more serious than incarceration itself. By far, one of the most serious collateral consequences is stigmatization. Indeed, that alone can bring personal, social, and financial ruin. For those with families to support, the loss of a professional license may mean the loss of their livelihood, and thus the ability to provide for their family. This is why those who find themselves ensnared in the criminal justice system view the collateral consequences of having a felony conviction to be far more severe than serving a lengthy prison sentence.

Willfulness is the cornerstone to any criminal tax matter. It is defined by courts as an intentional violation of a known legal duty. In the criminal setting, the government carries the heavy burden of proving—beyond a reasonable doubt—that a taxpayer acted willfully. The definition of willfulness can be bifurcated into two parts. As explained in the IRM: “Willfulness is demonstrated by the [taxpayer’s] knowledge of the reporting requirements and the [taxpayer’s] conscious choice not to comply with the requirements.”[i]

Willfulness is a state of mind. Seldomly are there any witnesses and only in a rare case would a defendant admit the required state of mind. The question thus becomes, how does the government prove willfulness? State of mind is proved through circumstantial evidence—i.e., by conduct or acts from which a person’s state of mind can be inferred. The landmark case is Spies v. United States.[ii] In Spies, the Supreme Court of the United States held that an affirmative willful attempt may be inferred from the following conduct:

(1) keeping a double set of books, (2) making false entries or alterations, or false invoices or documents, (3) destruction of books or records, (4) concealment of assets or covering up sources of income, (5) handling of one’s affairs to avoid making the records usual in transactions of the kind, and (6) any conduct, the likely effect of which would be to mislead or to conceal.[iii]

These are known as the “badges of fraud.”

Unfortunately for taxpayers, in United States v. Williams, the Fourth Circuit Court of Appeals diluted the definition of willfulness to a reckless disregard of a statutory duty. The practical effect of that ruling was to make it easier for the government to prove willfulness. Fortunately, if the IRM is any indication, it appears that the official position of the IRS is to interpret the meaning of willfulness in accordance with the heightened definition (i.e., an intentional violation of a known legal duty), as opposed to the diluted definition.

Viewing these facts in a light most favorable to Sam, let’s assume that the heightened definition of willfulness applies. Unfortunately for Sam, even under the heightened definition, the government will be able to prove willfulness. Indeed, Sam knew that he had to report the gain from the sale of the building on Form 1040. However, he failed to do so. That failure was not due to an oversight or a mistake. Instead, it was born of a choice—a conscious choice—made by Sam to prevent the IRS from knowing that he owed additional tax. In that way, Sam avoided having to pay any tax on the $400,000. Therefore, Sam’s failure to report the gain from the sale of the building was intentional.

Similarly, the government will be able to prove an affirmative act. To do so, they need do nothing more than show that the $400,000 gain from the sale of the building was never reported on the return. After all, the most common affirmative act is the filing of an inaccurate tax return.

Based on these facts, Sam is at material risk of prosecution. Therefore, the only rational choice is for Sam to remain in OVDI. However, for purposes of a complete analysis, let’s work through the remaining steps.

Step two compares the amount due under the offshore initiative to the tax, interest, and applicable penalties for all open years that Sam 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).[iv] In order to calculate the offshore penalty, it’s necessary to determine what the highest value of Sam’s foreign account was. Here, it was $496,000. Therefore, the offshore penalty under the 2011 OVDI is $124,000 (i.e., 25 percent of $496,000).

What else is Sam liable for under OVDI? For starters, he must pay tax on $96,000, the unreported interest income for the tax years 2003 through 2010 ($12,000 interest/year (x) 8 years). At a rate of 35 percent, the related tax deficiency is $33,600. Second, Sam must pay interest on the deficiency. And finally, he must pay the accuracy-related penalty.[v] Generally, the accuracy-related penalty is 20 percent of the deficiency. Because the tax deficiency is $33,600, the accuracy-related penalty is $6,720 (20 percent of $33,600).

If you’re keeping track, Sam’s total liability under OVDI is $164,320, calculated as follows:

• Income Tax Due: $33,600
• Offshore penalty: $124,000
• Accuracy-related Penalty: $6,720

Against this backdrop of parade of horribles again should be compared the potential benefits of opting out. How much must Sam pay in tax, interest, and penalties outside of the OVDI regime? Let’s begin with the tax deficiency. Sam’s total tax deficiency for the years 2002 through 2010 is $173,600 (see Chart Below). Of course, Sam would also owe interest with respect to that $173,600 deficiency.

Year	Unreported   Gain	Source	Tax   Rate	Tax   Deficiency
2002	$ 400,000	Sale of building	35%	$ 140,000
2003	$ 12,000	Interest	35%	$ 4,200
2004	$ 12,000	Interest	35%	$ 4,200
2005	$ 12,000	Interest	35%	$ 4,200
2006	$ 12,000	Interest	35%	$ 4,200
2007	$ 12,000	Interest	35%	$ 4,200
2008	$ 12,000	Interest	35%	$ 4,200
2009	$ 12,000	Interest	35%	$ 4,200
2010	$ 12,000	Interest	35%	$ 4,200
Total	$ 496,000		35%	$   173,600

 

Let’s turn to penalties. First, the FBAR penalty. If, upon examination, the IRS determines that Sam’s failure to file an FBAR was willful, he could face a maximum FBAR penalty of $1,362,000. Holy cow! If that penalty strikes you as being severe, recall two things. First, for willful FBAR penalties, the maximum FBAR penalty is the greater of (1) $100,000, or (2) 50 percent of the closing balance in the account as of June 30, the last day for filing the FBAR. And second, for purposes of assessing FBAR penalties, the statute of limitations is six years, not one.

Before a $1,362,000 FBAR penalty can be asserted, the government must prove that Sam’s failure to file an FBAR was willful. Can the government carry its burden? Before answering this question, we need to know exactly what burden of proof the government carries. Because willfulness, as it is used in this context, applies to a civil penalty and not to a tax crime, the government’s burden of proof is not beyond a reasonable doubt. Instead, it is by clear and convincing evidence. Therefore, the issue should be framed as follows: Can the government prove, by clear and convincing evidence, that Sam intentionally violated a known legal duty, specifically the duty to file an FBAR?

This is as good an example as any of a taxpayer who acted willfully. Indeed, the facts explicitly state that Sam intentionally failed to file an FBAR. Therefore, the assessment of a willful FBAR penalty is warranted.

What impact does the statute of limitations have on Sam’s FBAR liability? Because the statute of limitations for assessing FBAR penalties is six years, Sam will be subject to FBAR penalties for all open years assuming, of course, that the aggregate balance in Sam’s account exceeded $10,000 each year.

Here, the threshold condition is satisfied. The balance in Sam’s account never fell below $10,000.01 at any given point during any one of the open years. Therefore, the statute of limitations for assessing FBAR penalties will be open for the 2004 through 2009 calendar years.

What is the total maximum willful FBAR penalty that can be asserted for all open years? It is $1,362,000, or 50 percent of the closing balance in the account as of June 30 for each calendar year for all open years.[i] As discussed above, the open years span from 2004 to 2009. The calculation consists of two parts. Step one consists of calculating the FBAR penalty for each individual calendar year beginning with 2004 and ending with 2009. And step two consists of tallying up all of the FBAR penalties from all of the open years. That sum is the total maximum FBAR penalty. The FBAR penalties for each year are shown below:

Year	Account Balance	FBAR Penalty
2004	$ 424,000[9]	$ 212,000
2005	$ 436,000	$ 218,000
2006	$ 448,000	$ 224,000
2007	$ 460,000	$ 230,000
2008	$ 472,000	$ 236,000
2009	$ 484,000	$ 242,000
Total	$ 2,724,000	$   1,362,000

 

 

As discussed above, the total maximum FBAR penalty is not always an accurate prediction of what the FBAR penalty would be outside of the OVDI regime. The question that must be answered is whether the FBAR-related mitigation guidelines might benefit Sam 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 Sam, the FBAR-related mitigation guidelines offer no relief. The account’s $496,000 high balance qualifies Sam for the Level III willful FBAR penalty.[i] While at first blush, it might appear as though this classification benefits Sam—since Level III is one level below Level IV, the level that triggers the maximum statutory penalty—looks can be deceiving. Therefore, a word of caution is in order: “When it comes to tax, don’t assume anything.” So read on.

Unlike the expression, “the lesser of two evils,” the Level III penalty is the greater of two evils, those being: (1) 10 percent of the maximum balance during the calendar year for each Level III account, or (2) 50 percent of the closing balance in the account as of June 30, the last day for filing the FBAR.

Based on the closing balances in the account spanning all of the open years, (2) is greater than (1). Indeed, on June 30 of each open year, 50 percent of the closing balance in the account consistently exceeded 10 percent of the maximum balance in the account.

Therefore, the total Level III willful penalty is 50 percent of the closing balance in Sam’s foreign account for all of the open years. If that phrase sounds familiar, that’s because it’s identical to the maximum total willful FBAR penalty that Sam is subject to: $1,362,000.

Although Sam may have qualified for a lower level under the mitigation guidelines, that did absolutely nothing to reduce his willful FBAR penalty liability. Indeed, Sam is still subject to a total maximum willful FBAR penalty of $1,362,000. Put simply, the penalty mitigation guidelines are utterly useless for Sam.

What other penalties might Sam be subject to outside of the OVDI regime? There are three. First, if the IRS finds that Sam’s failure to report the gain from the sale of the building was due to fraud, he faces a 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. Because the unreported gain from the sale of the building resulted in a deficiency of $173,600, that represents the amount attributable to fraud. As such, the civil fraud penalty is $130,200 (75 percent of $173,600).

The last two penalties are asserted under Code Sec. 6677. As if the maximum willful FBAR penalty and the civil fraud penalty were not bad enough, these penalties can unilaterally cause Sam’s liability to soar into the penalty stratosphere.

The first penalty is for failing to file Form 3520 to report the $400,000 transfer to the account. That penalty is $140,000 (35 percent of $400,000). And the second penalty is for failing to file Forms 3520-A. That penalty amounts to $201,600. It is calculated as follows: five percent of $400,000, the short-term capital gain (+) the interest income added each year, from 2002 to 2010. The penalties for failing to file Forms 3520-A are shown below:

Year	Unreported Gain	Penalty Rate	Penalty for Failing to File   Forms 3520-A
2002	$ 400,000	5%	$ 20,000
2003	$ 412,000	5%	$ 20,600
2004	$ 424,000	5%	$ 21,200
2005	$ 436,000	5%	$ 21,800
2006	$ 448,000	5%	$ 22,400
2007	$ 460,000	5%	$ 23,000
2008	$ 472,000	5%	$ 23,600
2009	$ 484,000	5%	$ 24,200
2010	$ 496,000	5%	$ 24,800
Total			$   201,600

 

 

Therefore, the total Code Sec. 6677 penalty is $341,600 ($140,000 (+) $201,600). The final issue is whether there are any defenses to any of the aforementioned penalties. A successful defense can either eliminate the penalty completely, or lessen its impact. For example, if the IRS determines that a taxpayer’s failure to file an FBAR was due to reasonable cause, the IRS might not even assert the penalty. Therefore, defenses must never be overlooked. Here, there are no defenses.

If you’re keeping track, the penalties alone are staggering:

• FBAR Penalty: $1,362,000
• Civil Fraud Penalty: $130,200
• Code Sec. 6677 Penalty: $341,600

Sam’s total maximum penalties outside of the OVDI regime are $1,833,800. Of course, this does not include the $173,600 tax liability, which raises the total maximum amount of tax, interest, and penalties due and owing from $1,833,800 to $2,007,400. By comparison, Sam’s maximum liability within the OVDI regime is just $164,320.

The choice is clear. In fact, it is a “no brainer.” While $164,320 is by no means “chump change,” it is less than 10 percent of what Sam faces outside of the OVDI regime. Moreover, it is a small price to pay to avoid what is very likely to be a referral to the Department of Justice for prosecution, not to mention the peace of mind of not having to worry about how Sam will provide for his family in his absence (i.e., assuming that he is convicted and sentenced to a lengthy prison term). Therefore, Sam should remain in the 2011 OVDI.

	Civil Settlement Structure   within OVDI	Opt out and 8 years § 6677   penalty and 6 years FBAR Penalty
Income Tax Due (not including   interest)	$ 33,600	$ 173,600
75% Civil Fraud Penalty	$ 0	$ 130,200 (75% of $ 173,600)
20% Accuracy-related Penalty	$ 6,720 (20% of $ 33,600)	$ 0
25% Offshore Penalty	$ 124,000 (25% of $ 496,000)	$ 0
§ 6677 Penalty	$ 0	$ 341,600
FBAR Penalty	$ 0	$ 1,362,000
Total	$   164,320	$   2,007,400