08 April 2009

Something to declare: IRS issues guidance for US taxpayers declaring offshore accounts

Jay Krause
Partner | UK

Executive Summary

  • US taxpayers with undeclared offshore bank accounts and entities have until 23 September 2009 to report those assets to the Internal Revenue Service under new voluntary disclosure guidelines.
  • Those who come forward will be subject to back taxes and interest for six years and standardised penalties.
  • Voluntarily disclosing to and co-operating with the IRS will mitigate the risk of criminal prosecution, where potentially applicable.
  • The position for taxpayers failing to come forward during the six month window ‘will only become more dire’ according to the IRS Commissioner.

IRS seeks to bring undeclared accounts into compliance

Taxpayers looking to get right with the US government have a new reason to do so: IRS Commissioner Douglas Shulman has announced guidance for US taxpayers making voluntary disclosures within the next six months. The guidance aims to provide a ‘predictable set of outcomes’ for taxpayers by allowing them to mitigate the risk of criminal prosecution in exchange for paying taxes, interest and standardised penalties.

The guidance comes in the wake of ongoing efforts by the IRS and the Department of Justice to uncover the names of US taxpayers with undeclared offshore accounts. Additional scrutiny from the G20 has focused on numerous International Financial Centres, including Switzerland, Lichtenstein, Luxembourg, Monaco, Singapore and Hong Kong, all of which have agreed in recent weeks to modify their international information sharing agreements to comply with OECD standards and, where applicable, alter their banking secrecy laws such that they will no longer protect any form of tax offence. This radical shift in the contours of private banking has put those with undeclared offshore accounts at a heightened risk of discovery, and the announcement by the IRS is seen as an attempt to bring taxpayers hiding accounts offshore back into the US tax net by providing a clear and consistent outline for how they will be treated.

At the same time as providing that taxpayers coming forward voluntarily could cap their liabilities at six years of back taxes, interest and standardised penalties and could mitigate the risk of criminal prosecution, Commissioner Shulman also stressed that IRS agents were instructed to fully develop cases where taxpayers had not voluntarily disclosed and would be pursuing both civil and criminal avenues, including maximum penalty charges potential significantly in excess of those available under the new guidance.

IRS guidance

Although the ‘voluntary disclosure’ process has been available for some time, the new IRS guidance applicable to taxpayers with unreported offshore bank accounts clearly lays out consistent penalty treatment and confirms that the IRS will not attempt to impose the maximum penalties potentially applicable under current law.

In order to be eligible for a voluntary disclosure, a taxpayer with an unreported offshore account cannot have income from an illegal source and must not already be the subject of an IRS civil examination or criminal investigation. In addition, the IRS must not already have acquired information directly related to the taxpayer’s specific liability from a criminal enforcement action (e.g., search warrant or grand jury subpoena) or from a third party alerting the IRS to the taxpayer’s specific non-compliance. Finally, the taxpayer must fully cooperate with the IRS in all matters during course of their voluntary disclosure and must affirm that (apart from the matters being addressed in the voluntary disclosure) their tax affairs are otherwise compliant in all respects.

Importantly, even taxpayers with UBS accounts who potentially are in the group of ‘John Does’ named in the 1 July 2008 Department of Justice summons will be eligible for the new guidelines as long as the IRS has not yet obtained specific information pertaining to their UBS accounts. In fact, the new guidelines apply to all existing voluntary disclosures with unreported offshore bank accounts currently being processed by the IRS for which a closing agreement has not yet been executed.

The voluntary disclosure procedure allows US taxpayers with unreported offshore accounts to cap their potential exposure by filing six years of amended income tax returns, all associated information returns, and foreign bank account reporting forms (‘FBARs’). Under the new guidance, taxpayers who participate will be liable for the following:

  • Back taxes for the past six years;
  • Accuracy penalties of 20 to 25 percent of the tax amount for each of the six years;
  • Interest on the tax and accuracy penalty amount (from the original due date of the return the income should have been included in until the date of full payment); and
  • A new penalty of 20 percent of the total asset value in all unreported foreign bank accounts and entities (calculated by reference to the year in which the value of such accounts and entities was the highest for the 6 year period).1

The IRS’ decision to limit the assessment period to six years is more significant than most taxpayers may realise, given that the IRS has the ability to revisit any and all prior tax years where (for example) fraud was present or certain returns were not filed. These unfiled returns include Form 5471 (Information Return of US Persons With Respect to Certain Foreign Corporations), Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts) and Form 3520-A (Annual Information Return of Foreign Trust With a US Owner).

These new IRS directives clearly terminate the informal and uneven-handed manner in which voluntary disclosures were conducted up until now: a representative can no longer negotiate terms for an anonymous taxpayer. Under the new guidelines, any taxpayer seeking voluntary disclosure must be identified up front. The IRS will then determine whether that taxpayer qualifies for voluntary disclosure,and all offshore cases will be processed in a centralised unit in Philadelphia.

The guidance will be in effect for six months from 23 March 2009 and will then be re-evaluated to determine whether it should be extended or replaced with a new program under which higher penalties could be assessed.

Foreign Bank Account Reporting

Although this new penalty likely represents a significant amount (given that most offshore accounts now have declined greatly in value from their high points in the past six years), for many clients it is substantially less than the potential penalties they otherwise faced for failing to file FBARs and information returns, as outlined below.

The FBAR is required of all US citizens and residents, green card holders, and ‘persons’ (a term of art that includes entities) ‘in and doing business in’ the US who have a financial interest in or signature authority over financial accounts in foreign countries exceeding $10,000 in the aggregate. The FBAR form is in addition to any tax returns that must be filed and is due by 30 June of each year (extensions are not available).

The penalty for failing to file an FBAR is $10,000 per account per year if the failure was non-wilful. If the failure to file was wilful, the penalty is the greater of $100,000 or 50 percent of the balance of each account per year. In severe cases, wilful violations can lead to harsh criminal sanctions of up to a $500,000 fine and ten years in prison (in addition to the civil penalties described herein).

Not every failure to file accurate US income tax returns, information returns and FBARs results in criminal exposure. As noted, criminal liability depends upon whether these failures were ‘wilful’. If so, the felonies commonly known as income tax evasion (for failure to file returns when due, or for filing tax returns that do not comply with US law) and fraud (filing false tax documents signed under penalties of perjury) are complete as of the moment the inaccurate returns or documents are filed (or not filed when due). Merely amending these returns or documents does not remove the felony risk.

‘Wilfulness’ is a voluntary, intentional violation of a known legal duty. For income tax crimes, the question is whether the taxpayer knew (or should have known) that they were required to file tax returns by a certain date; and (for filed but inaccurate returns) whether the taxpayer knew or should have known to declare offshore accounts and report the related income on these returns. It has become increasingly difficult for taxpayers to argue that omissions are not wilful, particularly in light of the significant press coverage regarding undeclared foreign accounts over the last few years.

Recent changes to the FBAR form have broadened the scope of accounts that trigger a filing obligation. A ‘financial interest’ in an account exists where one is an agent or nominee, an entity (corporation or partnership) in which a US individual owns directly or indirectly more than 50 percent of the shares or controls more than 50 percent of the voting power, and a trust if a US individual has a present beneficial interest (direct or indirect) in more than 50 percent of the assets or from which such individual receives more than 50 percent of the current income.

Often, taxpayers are not aware of FBAR filing obligations. For example, a person appointed under a power of attorney over a foreign account is required to file even if they have not exercised the right to sign. Any person acting on behalf of a trust formed by a US person that has a protector or its equivalent must file if the trust has foreign accounts. Treasurers and managers of entities formed in or doing business in the US (and certain affiliated subsidiaries) that have foreign accounts must file (except in limited circumstances where a company filing is permitted as a substitute). US entities that are disregarded for US tax purposes are reporting entities for FBAR purposes, provided they have a financial interest in or signatory control over foreign accounts exceeding $10,000.

The far-reaching nature of the FBAR obligation and the harsh penalties that accompany failure to file make the new guidance from the IRS an important and valuable concession for those who currently are not compliant.

Other reporting obligations

In addition to tax returns and FBARs, taxpayers may have other information reporting obligations that have not been fulfilled. These obligatory returns and the penalties for failure to file (even where no tax would otherwise be due) include:

  • Form 5471 (Information Return of US Persons With Respect to Certain Foreign Corporations) generally imposing a $10,000 per entity per year failure to file penalty;
  • Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts) generally imposing a penalty of 35 percent of the amount transferred to an offshore trust by a US taxpayer or received from an offshore trust by a US taxpayer; and
  • Form 3520-A (Annual Information Return of Foreign Trust With a US Owner) imposing a penalty of 5 percent on the gross value of trust assets deemed to be owned by a US person.2

As part of the new guidance, the penalties associated with failing to meet these additional obligations will not be assessed if the taxpayer fully cooperates with the IRS and otherwise satisfies the voluntary disclosure requirements. The waiver of these penalties may represent a significant savings over the amount that can be assessed if the IRS discovers that such reports have not been filed and the full range of applicable penalties is imposed.


As the financial world grows more transparent and jurisdictions share ever more information, taxpayers who continue to hold undeclared taxable accounts are increasingly at risk of being discovered. The penalties for such continued action can be severe. The six-month window to rectify all prior US noncompliance issues may represent the best chance to enter the US tax net at a fixed and certain cost. According to IRS Commissioner Shulman, ‘for taxpayers who continue to hide their head in the sand, the situation will only become more dire.’ By engaging a tax professional and coming forward under the voluntary disclosure process, a taxpayer has an opportunity to pay a predictable set of taxes, interest and civil penalties and mitigate the risk of criminal prosecution.

1 A taxpayer can qualify for a 5 percent penalty, rather than a 20 percent penalty if (i) the taxpayer did not open (or cause to be opened) the accounts or entities for which tax is due, (ii) there has been no activity in the account or entity (such as withdrawals or deposits) during the period of control by the taxpayer, and (iii) all applicable US taxes have been paid on the funds in the account or entity (in other words, the initial assets were not untaxed and only the earnings have escaped US tax). Very few clients qualify for this reduced penalty rate, but there may be developments in the next few months that expand the conditions for qualification for a reduced rate.

2 Other information reporting obligations may include Form 926 (Return by a US Transferor of Property to a Foreign Corporation), Form 5472 (Information Return of a 25 percent Foreign Owned US Corporation or a Foreign Corporation Engaged in a US Trade or Business) and Form 8865 (Return of US Persons with Respect to Certain Foreign Partnerships).

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