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Washington Tax Alert October 18, 2010 (FBAR and voluntary disclosure)

Washington Tax Alert from Don Barnes, dbarnes@washingtontaxlaw.com
October 18, 2010

Approximately 14,700 taxpayers made voluntary disclosures of foreign bank and financial accounts and unreported income under the Internal Revenue Service's Offshore Voluntary Disclosure Initiative, which was in effect from March 23, 2009 until October 15, 2009. The purposes of the Offshore Initiative were to centralize the processing of voluntary disclosures, and to offer a uniform penalty structure for taxpayers. Under the Initiative, the Service agreed not to recommend criminal prosecution and imposed a civil penalty equal to 20% of the highest balance in the taxpayer's undisclosed foreign accounts during the preceding six years. This 20% penalty was in lieu of all other penalties, including penalties for failure to file the Report of Foreign Bank and Financial Accounts (FBAR), tax fraud penalties, and penalties for failure to file information returns with regard to foreign corporations, trusts and partnerships.

The experience of most taxpayers participating in the Offshore Initiative has not been favorable. The Service has implemented the Initiative in a manner not anticipated by taxpayers and the lawyers and accounting firms advising them. The major problems are described below.

Taxpayers making voluntary disclosure of unreported income are required to file amended tax returns that are complete and accurate as a condition for the Government not pursuing criminal charges. Historically, tax returns filed by taxpayers making a voluntary disclosure have not been subjected to an extensive examination by the Service. Under the Offshore Initiative, however, the Service has examined the amended tax returns filed by participating taxpayers and requested additional information and interviews with the taxpayer, all of which has resulted in taxpayers incurring substantial additional professional fees.

The 20% penalty offered by the Offshore Initiative was attractive only in comparison to potentially onerous FBAR penalties. In evaluating whether to participate in the Offshore Initiative, many taxpayers failed to consider whether the potential FBAR penalties in their situation might be unconstitutional as an excessive fine. The FBAR penalties in the statute (31 U.S.C. § 5321(a)(5)) bear no relationship to the amount of U.S. income taxes owed on amounts in undisclosed foreign accounts. In many cases, the FBAR penalties are clearly excessive.

Taxpayers entered into the Offshore Initiative without obtaining clarification of certain terms and conditions, and incorrectly assumed the Service would reasonably interpret the provisions of the Initiative. For example, many taxpayers were advised that the 20% penalty might be subject to reduction for reasonable cause or special circumstances. In practice, the Service has insisted on the 20% penalty without exceptions. Other terms and conditions of the Initiative have been also strictly applied.