IRS Initiatives Make "Hidden Income" Harder to Keep Secret

George Orwell and Motown performer, Rockwell, have at least one thing in common, they both foresaw a future in which privacy would be hard to obtain. In 1949 when Orwell published 1984, he wrote about a totalitarian world in which Big Brother and the Thought Police were ever present. More recently, Rockwell, who was born Kennedy William Gordy to Motown founder and CEO Berry Gordy, released "Somebody's Watching Me" in 1984. The chorus included the verse: "I always feel that somebody's watchin' me, And I have no privacy, I always feel that somebody's watchin' me, Is it just a dream?" Later on in the song, Rockwell continues "Are the neighbors watching me, Well is the mailman watching me, And I don't feel safe anymore, oh what a mess, I wonder who's watching me now?, Who?, The IRS?" Unfortunately, Rockwell's paranoia appears to have come to fruition as not only the IRS is watching. While things may not be as drastic as Orwell predicted, the role of Big Brother continues to expand.

Today, the IRS has various tools available to help revenue agents with examinations. This article explores some of the most common tools used by the IRS to catch taxpayers who are paying less than their share of tax, whether as a result of an error or intent to cheat.

Technology

Technology is just one of the tools being used in ever-increasing ways to help close the tax gap and reduce the extent of noncompliance. IRS Commissioner Douglas Shulman has publicly stated the importance of investing in technology for this very purpose. In a 5/27/2010 speech to the American Payroll Association and the American Accounts Payable Association, he stated "[t]he better use of technology translates into better use of data--extracting knowledge and intelligence. So, we must invest in technology to keep up with new legislation, regulations and strategies in a more complex and interrelated global tax system." FN1.

• In an April 2010 interview with Paul Bonner, editor of the Journal of Accountancy, he stated: "I've been very public that the future of tax administration is all about more and  better third-party information and continuing to develop our programs to analyze that data and act on it. The way we're going to get better at handling the volume and complexity of both the Tax Code and the business world and individual finances isn't by throwing more auditors at the problem; it's by doing better data management and analysis." FN2.

• It would appear that the Senate Appropriations Committee was listening to Commissioner Shulman, as it approved the IRS' request for $387 million to modernize its business systems on 7/29/2010. FN3. Senator Richard Durbin (D-Ill.) indicated that this would allow the IRS to migrate from its obsolete Legacy system to state-of-the-art data systems in the 2012 filing season. FN4.

YK1 software

Even after the IRS updates its computer systems, it will continue to rely on YK1, which is just one of the software programs examiners are using to assist them in their investigations. The software was initially created to assist the IRS in identifying tax shelters. Today, it is used to help an examiner identify all parties connected to an entity, as well as any other entities to which the parties may have a connection. The IRM advises examiners on the use of YK1, and provides as follows: "[f]or cases in which entities related through a flow-through relationship are suspected, but cannot be otherwise identified, examiners should request research using the yK1 Link Analysis Tool. This Tool provides a graphic representation of flow-through relationships created by  partnerships, trusts, and S corporations. The Tool uses Schedule K-1 data to depict ownership relationships and income/loss flows between payers and payees. More information is available at http://sbse.web.irs.gov/Exam/Apps/yK1/yK1.htm. FN5.

On 12/15/2009, the United States Government Accountability office released a report to the United States Senate Finance Committee titled "Tax Gap: Actions Needed to Address Noncompliance with S Corporation Tax Rules." The report detailed the use of YK1 for audits involving S corporations. Specifically, it stated:

One way that examiners detect S corporation noncompliance is IRS's yK1 software program, which uses Schedule K-1 information to graphically depict relationships among taxpaying entities. It displays the shareholders of S corporations as well as any other businesses that are linked to the S corporation, including parent companies and subsidiaries that have common shareholders with the S corporation. Starting with a business entity or individual shareholder, yK1 can show its connections in sending or receiving Schedule K-1s. It shows common use of paid preparers, some family relationships (e.g., husband/wife), and common addresses, among other linkages. For example, if IRS discovers noncompliance that is related to a scheme marketed by a preparer, IRS can use yK1 to identify other entities that used the same preparer. In addition to K-1 data, IRS pulls data from various IRS databases, such as those showing data from filed returns or from information returns filed by third parties. Although there have been no formal analyses of yK1's effectiveness, IRS officials say that its examiners report that using yK1 has helped to identify millions of dollars in unpaid taxes from entities, including S corporations. For S corporations, yK1 data can help examiners determine if the shareholder has stock or debt basis, as well as establish trends in officer's compensation. FN6.

Federal contractors

The Internal Revenue Manual (IRM) provides even greater detail into the use of YK1 when the taxpayer is a federal contractor or vendor. Interestingly, information obtained through the software cannot be revealed to the taxpayer or the taxpayer's examiner. It appears, however that this prohibition may be limited to information obtained on behalf of a federal contractor or vendor. The IRM advises examiners in such investigations, that YK1:

• Is a collection of analytic tools specifically designed to help explore relationships between taxpayers. Currently, it focuses on flow-through relationships (K-1 data) created by partnerships, trusts, S corporations, and corporations.
  

• Is most beneficial when the taxpayer is known to have flow-through income, e.g., parent/subsidiary relationships, abusive transaction, other related-entity relationships.
  

• Provides a graphic representation of the taxpayer and the taxpayer's investment relationship to other entities. It is not limited to direct investment and displays multiple levels of investment tiering, i.e., one entity is invested into another that is invested into a third.
  

• Uses information from filed Forms 1120, 1120S, 1041, and 1065, and the K-1 associated with those returns.

• Uses individual tax return information of high-income individuals.

• Can be searched using an SSN or EIN." FN7.

Whistleblowers

Even if the IRS computers and technology do not uncover a taxpayer's noncompliance, taxpayers still have much to worry about. As Rockwell feared, taxpayers just do not know who has been watching them. In 2006 Congress introduced legislation creating a whistleblower office within the IRS. FN8. The legislation, codified at Section 7623, became effective on 12/20/2006 and provides incentives for ordinary citizens to share information with the IRS about tax cheats. FN9. The program is designed to prevent annoyance claims from being filed by disgruntled neighbors, jilted spouses, and angry employees because the claim must meet minimum standards.

Eligibility requirements

 To be eligible for an award, the tax, penalties, interest, additions to tax, and additional
amounts in dispute must exceed $2 million for any tax year and, if the taxpayer is an individual, the individual's gross income must exceed $200,000 for any tax year in question. FN10. The award is mandatory, but the amount is somewhat discretionary. By statute the award is at least 15%, but no more than 30%, of the collected proceeds in cases in which the IRS determines that the information submitted by the informant substantially contributed to the collection of tax. FN11. The award can be reduced if the whistleblower was involved in the noncompliance. If the whistleblower is convicted of criminal conduct arising from his or her role in planning and initiating the action, the Whistleblower Office will deny the award.

Whistleblowers who are unable to satisfy the income threshold are not left without options. Section 7623(a) provides authority for the informant to receive a discretionary award with the maximum award being 15%, up to $10 million. Because the award is discretionary, the informant cannot dispute the determination of the award in Tax Court. FN12.

To file a claim with the Whistleblower Office, the informant must complete Form 211, and sign it under penalties of perjury. When the Whistleblower Office makes a final  determination regarding a claim, it sends notification to the informant indicating the amount of the reward it intends to pay. If the informant is not satisfied with the reward, and the reward is issued pursuant to Section 7623(b) , he or she has 30 days in which to file an appeal to the Tax Court. FN13. The Tax Court maintains exclusive jurisdiction.

IRM procedures

On 6/18/2010, the IRS added new provisions to the IRM applicable for the whistleblower program. FN14. The IRM provided procedures for IRS personnel to follow when processing whistleblower claims, whether those seeking the mandatory or discretionary awards. Senator Charles Grassley (R-Iowa) wrote a letter to Treasury Secretary Geithner asking that he delay the implementation of the new IRM update, as the Senator was troubled by the fact that the provision was posted without public comment. He was also disturbed by the fact that the definition of "collected proceeds" appears to limit the payment of a Section 7623(b) award to only those cases where the IRS receives cash from a taxpayer. FN15. This definition would deny rewards to whistleblowers who prevent improper refunds, or reduce a credit balance by a taxpayer.

Perhaps in response to Senator Grassley's comments, the IRS issued a proposed regulation on 1/14/2011 to revise Reg. 301.7623-1 . The proposed regulation clarifies the definition of proceeds of amounts collected and collected proceeds, as the terms are used in Section 7623 . The proposed regulation defines the terms for purposes of Section 7623 as including "tax, penalties, interest, additions to tax, and additional amounts  collected by reason of the information provided; amounts collected prior to receipt of the information if the information provided results in the denial of a claim for refund that otherwise would have been paid; and a reduction of an overpayment credit balance used to satisfy a tax liability incurred because of the information provided." FN16. Notwithstanding the proposed regulations, the IRM still excludes criminal penalties from collected proceeds.

Private bankers as whistleblowers

Whistleblowing is becoming a cottage industry for private bankers. On 5/3/2010, Rudolf Elmer spoke at the 8th Annual OffshoreAlert Financial Due Diligence Conference in Miami Beach. FN17. Elmer worked for Bank Julius Baer in Switzerland, where he was a senior auditor from 1987 to 1994, and then in the Cayman Islands, where he was the group's local Chief Operating Officer from 1994 to 2003. He indicated that he gave internal company documents to officials in several countries, including the U.S. and Germany. FN18. He also indicated that the bank helped clients evade tax. Elmer has been busy as more recently on 1/17/2011, he handed over discs to WikiLeaks founder Julian Assange. FN19. The discs contained information on 2,000 Julius Baer clients who at one time had money invested offshore with the bank.

Elmer was not the first such banker, nor will he be the last. On 8/4/2010, Bloomberg.com reported that Herve Falciani, a former HSBC Holdings Plc software technician now in police protection in France took computer files containing data on at least 24,000 current and former account holders from several countries. FN20. Falciani was preceded by Heinrich Kieber, a former employee of the LGT Bank of Liechtenstein, who in 2008 took more than 12,000 pages of bank documents detailing secret, multi-million-dollar accounts held by taxpayers around the world. FN21. Kieber is living in an undisclosed location, reportedly as part of a witness protection program, after providing information to government officials in England, Germany, the U.S. and other countries on their citizens who hid billions in wealth through the bank.

Joseph Insinga, a finance specialist with the Dutch Bank, Rabobank, is another banker turned whistleblower. He told the IRS that the bank was financing tax shelters on behalf of U.S. companies. He provided information that led to investigations against Cardinal Health FN22 and Newell Rubbermaid Inc. FN23. Of course, Insinga was preceded by the
revelations former Swiss UBS private banker, Bradley Birkenfeld, provided the IRS and Department of Justice, which ultimately led to the February 2009 UBS deferred  prosecution.

The Whisleblower Office submitted its annual report to Congress on 12/13/2010 and indicated that it received more than 5,000 cases in fiscal year 2009, 460 of which will likely qualify for an award. FN24.

LMSB/international realignment

Effective 10/1/2010, the Large and Mid-Size Business division (LMSB) was renamed the Large Business and International division (LB&I). FN25. The reorganization is designed to improve the IRS' global tax administration efforts and create a more centralized organization dedicated to improving international tax compliance.

While its name changed, LB&I continues to serve the same taxpayers that were served by LMSB. Specifically, LB&I focuses on taxpayers, whether individuals or entities, who have more than $10 million in assets.

The August 4 release that announced the reorganization also indicated that the realignment would strengthen international tax compliance for individuals and entities in several ways, including:

• "Identifying emerging international compliance issues more quickly.

• Removing geographic barriers, allowing for the dedication of IRS experts to the most pressing international issues.
  

• Increasing international specialization among IRS staff by creating economies of scale and improving IRS international coordination.
  

• Ensuring the right compliance resources are allocated to the right cases.

• Consolidating oversight of international information reporting and implementing new programs, such as FATCA.

• Coordinating the Competent Authority more closely with field staff that originate cases, especially those dealing with transfer pricing.
  

• Otherwise centralizing and enhancing the IRS's focus on transfer pricing." FN26.

Global High Wealth Industry group

On 10/26/2009, Commissioner Shulman spoke at the American Institute of Certified Public Accountants (AICPA) National Conference on Federal Taxation in Washington, D.C. While he touched on various topics during his presentation, the Commissioner announced for the first time that the IRS had recently created the Global High Wealth Industry group ("Global Wealth"). FN27. At the time of his announcement, the group was housed within LMSB. In accordance with the 8/4/2010 reorganization announcement, however, effective 10/1/2010, Global Wealth is housed within LB&I. FN28.

Global Wealth focuses on unraveling the business structures created by wealthy taxpayers to avoid their tax obligations. While it was not stated, this program may use the economic substance doctrine as its main weapon.

Shulman did not provide the minimum dollar threshold for a taxpayer to be included within the Global Wealth group, but he did state that initially "we will be looking at individuals with tens of millions of dollars of assets or income." FN29. He went on to explain that "high wealth individuals are not your typical Form 1040 filers with a W-2, some 1099 income, and maybe a Schedule C enclosed with their return. And you cannot assess compliance among the nation's wealthiest individuals by looking only at their 1040s. Their tax picture is much more complicated than this. ... They may include trusts, real estate investments, royalty and licensing agreements, revenue-based or equity-sharing arrangements, private foundations, privately-held companies, and partnerships and other flow-through entities that require looking at the entire, and often huge, spectrum of transactions and entities. A single high-wealth individual may have actual or beneficial ownership of numerous related entities, sometimes alone and sometimes along with other family members or business associates."

The IRS believed that it was unable to adequately examine taxpayers who would be included within Global Wealth, as a result of their sophisticated business and investment structures, which led to the group's creation. Shulman indicated that the IRS was hiring agents and specialists, such as flow-through specialists and international examiners, to begin the examinations of taxpayers included within Global Wealth. FN30. It would appear that agents within Global Wealth will rely substantially on the YKI software to assist them with their investigations.

Shortly before announcing the creation of the group, Shulman indicated that it was part of "the globalization of taxadministration," which he called a "game changing trend." FN31.

Criminal enforcement

The days of the kinder, gentler IRS have long passed. Taxpayers should be aware that the Service intends to continue its focus on enforcement, a direction continuously reinforced by IRS officials, the Commissioner, and Congress.

On 2/18/2011 during a webcast sponsored by BNA Tax & Accounting, IRS Deputy Chief of Criminal Investigations, Rick Raven, indicated that the IRS has investigations ongoing in countries outside of Switzerland in its efforts to end bank secrecy and tax evasion. "This isn't just a Swiss problem. ... In my years with CI, we've never had as many banks under investigation as we do right now." FN32.

Raven's comments followed those of Victor Song, Chief of IRS Criminal Investigation Division (CID), who told the American Bar Association Section of Taxation Civil and Criminal Tax Penalties Committee at its 1/23/2010 meeting that the IRS' most significant criminal focus would be on the international arena. He stated "our big focus is international. We are not going to go away." FN33. Song also indicated that CID's hiring was "unprecedented." Song was back speaking to the ABA Section of Taxation Civil & Criminal Tax Penalties Committee at its spring meeting on 5/8/2010, where he indicated that CID now had a presence in 11 countries. 34 Additionally, he indicated CID employs 4,200 employees worldwide, of whom 2,700 are special agents. CID now has a presence in the following foreign cities:

• Frankfurt.
• Mexico City.
• Bogota.
• Hong Kong.
• Beijing.
• London.
• Bridgetown (Barbados).
• Ottawa.
• Panama City.
• Sydney. FN35.

Commissioner Shulman, however, sets the tone for the IRS, and in prepared remarks given at the 23rd Annual Institute on Current Issues in International Taxation on 12/9/2010, he indicated that the IRS had received significant information from the participants in the IRS Offshore Income Reporting Initiative, which is helping to develop new cases and investigations. FN36. Approximately 15,000 taxpayers participated in the program, which was announced on 3/23/2009 and continued through 10/15/2009 ("2009 VDP"). He  stated, "[w]e have been scouring the vast quantity of data we received from the VDP applicants and from other sources. Although more data mining is still to be done, this information has already proved invaluable in supplementing and corroborating prior leads, as well as developing new leads, involving numerous banks, advisors and promoters from around the world, including Asia and the Middle East."

While speaking at the California Tax Bar and California Tax Policy Conference in San Diego, California, on 11/5/2010, Julio La Rosa, the deputy director of LB&I stated, "CI is very much focused on international compliance in finding the taxpayers that think that they're going to stay off the radar and the promoters that are helping them to do that." FN37.

Treasury Secretary Geithner has expressed the view that increasing funding for IRS enforcement is a necessary part of closing the tax gap. FN38. Perhaps consistent with Geithner's view, the Senate Appropriations Committee on 7/29/2010 allocated $5.68 billion for fiscal year 2011 towards IRS enforcement efforts. FN39.

Treaties and information exchange agreements

The U.S. currently has 68 income tax treaties and 22 tax information exchange  agreements (TIEA) in effect.

Income tax treaties

The key provision within an income tax treaty is the exchange of information clause. Generally, this gives the IRS broad powers to obtain information from another country. A number of treaties are based on the OECD Model Treaty, which contains a broad exchange of information provision in Article 26. Essentially, Article 26 provides for the exchange of information "without regard to whether the conduct being investigated would
constitute a crime under the laws of the requested Party if such conduct occurred in the requested Party." The Model Treaty also permits tax examiners from the requesting country to travel to the requested party to conduct a tax examination, interview witnesses, and review documents.

Article 26 of the OECD Model Treaty states that the information must be "foreseeable relevant" to the administration or enforcement of the domestic tax law of the country concerned. The commentary indicates that "the standard for foreseeable relevance is intended to provide for exchange of information in tax matters to the widest possible extent and, at the same time, to clarify that Contracting States are not at liberty to engage in fishing expeditions or to request information that is unlikely to be relevant to the tax affairs of a given taxpayer." FN40.

Some of the treaties the U.S. previously entered into did not have such a broad exchange of information provision. For example, in September 2009, Switzerland signed a new treaty with the U.S. incorporating Article 26 from the Model Treaty. The new treaty expanded the circumstances in which the Swiss would disclose information to the U.S.
Previously, disclosure required that the conduct classify as tax fraud under Swiss law. Now disclosure is permitted for conduct that involves the failure to report income (i.e., tax evasion).

Tax information exchange agreements

TIEAs are executive agreements under United States law based on either he U.S. Treasury Discussion Draft TIEA created in 1984 or the OECD Model TIEA created in 2002. TIEAs are designed to provide assistance in civil and criminal tax matters. Information must be provided even if the information relates to a person who is not a resident or national of the U.S. or the TIEA partner. Finally, the TIEA must provide for the disclosure of information regardless of local "confidentiality" laws that may prohibit such disclosure, including laws relating to bank secrecy or bearer shares. FN41.

The exchange of information provisions are quite similar to those within treaties. For example, on 12/8/2008, the U.S. signed a new TIEA with Liechtenstein, which will permit the U.S. to obtain information from Liechtenstein on all types of federal taxes, and in both civil and criminal matters. FN42. Under the TIEA, the requested information must be obtained and exchanged without regard to whether the country receiving the request needs the information for its own tax purposes or whether the conduct being investigated would be a crime under its law. If the country receiving the request for information does not have the requested information in its possession, it must take relevant information gathering measures to provide the requested information. Moreover, requests from one country to the other must be honored, even if the information relates to, or is held by, nonresidents.

The U.S. can and does access information received pursuant to a TIEA to prosecute U.S. taxpayers. On 4/23/2010, Bill Melot, a New Mexico businessman was convicted with the assistance of information provided by a Bahamian bank in accordance with the TIEA, which should indicate the effectiveness of TIEAs. FN43.

Under a treaty or TIEA, information can be exchanged automatically or following a specific request or simultaneous examination. "Exchange of information on request occurs when the competent authority of one country asks for particular information regarding specific taxpayers from the competent authority of another country. ... Information that is exchanged automatically is typically information comprised of many individual cases of the same type. Usually, this type of information exchange consists of details of income arising in the source country (e.g., interest, dividends, royalties, or pensions). This information is obtained on a routine basis (generally through reporting of the payments by the payer) by the sending country and is thus available for transmission to its treaty partners. ... Information is exchanged spontaneously when a country, having obtained information in the course of administering its own tax laws, which it believes will be of interest to one of its treaty partners for tax purposes, passes on the information without the latter having asked for it." FN44.

Additional international agreements

The U.S. has additional formal means for acquiring information from other jurisdictions. These include the Convention on Mutual Administrative Assistance in Tax Matters FN45 and exchanges made pursuant to the Joint International Tax Shelter Information Centre. FN46.

On 5/27/2010, the Treasury Department announced that the U.S. and 16 other countries in the OECD signed a protocol to the Convention on Mutual Administrative Assistance on Tax Matters, in order to bring the existing Convention into conformity with current international standards for the exchange of information for tax purposes between national revenue authorities. FN47. The protocol provides for the full exchange of information on request in tax matters without regard to a domestic tax interest requirement or bank secrecy laws, such as those that have delayed the sharing of information on UBS's bank customers with U.S. authorities. The proposed protocol also provides updated rules regarding the confidentiality and permitted uses of exchanged information as well as the level of detail that countries must provide when making a request for information. In addition, the Protocol permits countries that are not members of the OECD or of the Council of Europe to become parties to the Convention, subject to unanimous consent by the existing parties.

Resolving noncompliance

For taxpayers concerned about their noncompliance, the best solution, short of death, to resolve the noncompliance is a voluntary disclosure. Incidentally, death does not end the noncompliance, the responsibility for resolving it simply passes to someone else.

The IRM defines a voluntary disclosure as having taken place when the taxpayer's communication is truthful, timely, and complete. FN48. These terms require that the taxpayer show a willingness to cooperate (and does in fact cooperate) with the Service in determining the correct tax liability. The taxpayer also has to make good-faith
arrangements with the IRS to pay in full the tax, interest, and any penalties the Service determines are applicable. FN49.

When successful, taxpayers can use the voluntary disclosure program to come into compliance and avoid criminal prosecution. Taxpayers need to be aware that not all voluntary disclosure submissions are accepted, and thus criminal prosecution is a potential outcome from a disclosure that is found not to qualify. FN50. Cases involving illegal source income do not qualify.

Disclosures are timely if they are received before the occurrence of any of the following:

(1) The IRS has initiated a civil examination or criminal investigation of the taxpayer, or has notified the taxpayer that it intends to commence such an examination or investigation.

(2) The IRS has received information from a third party (e.g., informant, other governmental agency, or the media) alerting the IRS to the specific taxpayer's noncompliance.

(3) The IRS has initiated a civil examination or criminal investigation that is directly related to the specific liability of the taxpayer.

(4) The IRS has acquired information directly related to the specific liability of the taxpayer from a criminal enforcement action (e.g., search warrant, grand jury subpoena). FN51.

On 2/8/2011, the IRS announced the creation of a second voluntary disclosure program for taxpayers with unreported foreign assets (2011 VDP). FN52. The 2011 VDP differs significantly from the 2009 VDP. In reality the 2011 VDP is designed for taxpayers with unreported foreign income, as the failure to report the existence of non-incomeproducing
foreign assets can be cured without participating in the newly announced program. The three most significant differences between the 2009 and 2011 VDPs are as follows:

(1) Years applicable. The 2009 VDP required taxpayers to correct their noncompliance during the six-year period of 2003-2008. Of course, if the noncompliance involved fewer than six years, only those years needed to be resolved. In order to participate in the 2011 VDP, taxpayers are required to resolve any noncompliance occurring during the eight-year period of 2003-2010. One again, however, if the noncompliance involves fewer than eight years, only those years with noncompliance must be cured.

(2) Deadline. As indicated above, the 2009 VDP terminated on 10/15/2009. Simply stated, taxpayers had only to identify themselves to the IRS and express their desire to participate in the 2009 VDP by that deadline. On the other hand, the 2011 VDP not only terminates on 8/31/2011, but taxpayers have to submit all of the appropriate returns to the IRS by that date.

(3) Payments. The 2009 VDP required taxpayers to pay all of the following: (a) income tax deficiencies during the six-year period, (b) interest on the deficiencies, (c) accuracy and delinquency penalties, and (d) a 20% penalty on the highest aggregate balance held within the foreign accounts during the six-year period. The highest aggregate balance on which the penalty was based also included the value of any income-producing assets, whether held in or outside of an entity.

Taxpayers participating in the 2011 VDP are responsible for the same payments, but instead of paying a 20% penalty on the value of offshore assets, the penalty is increased to 25%. The 2011 VDP also contains a reduced penalty structure of 5% and 12.5% for eligible taxpayers. The 2011 VDP has procedures for taxpayers who participated in the 2009 VDP to receive the benefits of the reduced penalty structure, provided such  taxpayers can otherwise satisfy the requirements.

Reduced penalties

Shortly after the IRS announced the 2011 VDP to the media, it added a new website for 2011 Offshore Voluntary Disclosure Initiative Documents and Forms (2011 VDP Website). FN53. From this website, there is a link to the 2011 Offshore Voluntary Disclosure Initiative Frequently Asked Questions and Answers (Q&As). FN54. These Q&As flesh out the 2011 VDP, and certainly provide details of the requirements to qualify for the reduced penalty structure. Q&A #52 provides two examples demonstrating that the 5% penalty is available to two classes of taxpayers:

(1) Those who inherited the accounts.

(2) Those who did not know they were U.S. citizens.

Inherited accounts

Taxpayers must satisfy all four of the following requirements in order to qualify for the reduced penalty:

(1) The taxpayers did not open the account or cause the account to be opened. If the bank required a new account to be opened following the death of the initial account owner, this is permitted, and the taxpayer will not be disqualified from qualifying for the reduced penalty.

(2) The taxpayers have had infrequent contact with the account and have exercised minimal control over it. Thus, the taxpayers can contact the bank to provide new contact information or to request the account balance but may not make investment decisions. Similarly, if the taxpayers provided a "hold mail" document to the bank, this will disqualify them from the reduced penalty.

(3) During the years covered by the VDP, the taxpayers did not withdraw more than $1,000 in any calendar year, unless closing the account and transferring the funds to the U.S.

(4) Prove to the IRS that all applicable U.S. taxes have been paid on the funds deposited in the account. If the funds were deposited into the account prior to 1991, the IRS will presume that all applicable taxes were paid. However, if any deposits were made subsequent to that date, taxpayers must identify the source of the deposit and, if that source was taxable in the U.S., prove that tax was paid on it.

Foreign resident U.S. citizens

If a taxpayer was born to foreign parents--but within the U.S., such that the taxpayer is a U.S. citizen--and the taxpayer grew up in the foreign jurisdiction, the taxpayer is entitled to the 5% penalty provided he or she did not know he or she was a U.S. citizen. However, if the taxpayer satisfies the same facts, but did know he or she was a U.S. citizen, then the reduced penalty does not apply. Apparently, the IRS believes that all such persons should have proactively sought out tax guidance to determine their U.S. tax obligations.

Q&A #53 indicates that taxpayers can qualify for the 12.5% penalty provided that during the years covered by the 2011 VDP: (1) the highest aggregate account balance, (2) the fair market value of assets generating income, which were not reported in the U.S., and (3) the fair market value of assets in undisclosed foreign entities, if procured with
untaxed funds, at no point exceeded $75,000.

2011 VDP: not the only option

The 2011 VDP is not required to correct all forms of noncompliance. Q&A #17 indicates that taxpayers may file delinquent Report of Foreign Bank and Financial Accounts (FBARs) and avoid penalties, provided no unreported taxable income is associated with the account. However, the delinquent FBARs must be filed by 8/31/2011. Q&A #18 provides similar benefits to taxpayers who failed to file Forms 5471 or 3520 reporting their connection to a controlled foreign corporation or foreign trust. Such taxpayers must file the delinquent informational returns with the appropriate service center by 8/31/2011.

Q&A #38 indicates taxpayers may file delinquent FBARs and avoid penalties if the purpose of that FBAR is to report signature authority over an account in which the taxpayer has no beneficial interest. These delinquent FBARs must also be filed by 8/31/2011. Taxpayers filing the delinquent informational returns in accordance with Q&A #17, #18, or #38 must also submit a letter along with the delinquent return explaining the reason behind the noncompliance; such taxpayers would be wise to reference the particular Q&A under which the delinquent return is being filed.

Whether taxpayer noncompliance involves unreported foreign assets, the Q&As make clear that the 2011 VDP is not the only option. The 2011 VDP website indicates that taxpayers may still make a voluntary disclosure in accordance with the IRM. FN55.

Taxpayers should be aware that Q&A #11 indicates that civil penalties may apply for tax years prior to 2003 for any taxpayers who make a voluntary disclosure subsequent to 8/31/2011, in accordance with the IRM. It is not clear if the IRS intends to pursue civil penalties prior to 2003 for taxpayers who submit a voluntary disclosure in accordance
with the IRM prior to 8/31/2011. While the statute of limitations is forever tolled until the required informational  return is filed, the IRS is somewhat limited by the statute of limitations when it comes to assessing income tax. Section 6501(a) provides that the IRS generally has three years from the filing of a return in which to audit a taxpayer and assess additional tax.

This statute of limitations also applies to information required to be reported on certain foreign transfers. As a result of the Foreign Tax Compliance Act (FATCA), the period is increased to six years if a taxpayer omits 25% or more of gross income ( Section 6501(e) ). FATCA section 513 amended Section 6501(e) to extend the statute of limitations to six years also where a taxpayer omits more than $5,000 of income attributable to one or more assets required to be reported under Section 6038D . Thus, even if the taxpayer does not have a substantial understatement, the IRS has six years in which to investigate and audit the taxpayer. In addition, however, the three-year and six-year statutes of limitations are suspended until the information required to be reported under Section 1295(b) , 1298(f), 6038, 6038A, 6038B, 6038D, 6046, 6046A, or 6048 is provided to the IRS.

Problems with the 2011 VDP

Among the problems with the 2011 VDP, these three are of greatest concern:

(1) Punishing dual citizens.
(2) Penalty computation.
(3) Retroactive application.

Punishing dual citizens

One of the main problems with the 2011 VDP is that it subjects accidental Americans to
penalty. These can be persons born in the U.S. to foreign parents, but who otherwise grew up in the foreign country. Under certain circumstances it can also include persons born outside of the U.S. if one of the parents is a U.S. citizen and files the necessary paperwork with the U.S. Embassy in the foreign country.

If a taxpayer is otherwise off the U.S. radar, imposing unjustified penalties for coming forward will likely serve to further keep these individuals underground. If these dual-citizen taxpayers do not consider themselves U.S. citizens, or in certain instances even realize they have such status, there is simply no justification for punishing them, much less drawing a distinction in the penalty amount. The 2011 VDP appears to be designed to punish these taxpayers who receive none of the benefits of U.S. citizenship, and the penalty is disproportionate.

The typical U.S. citizen who fails to report foreign assets under the 2011 VDP will pay a 25% penalty on the value of these foreign holdings. This contrasts with dual-citizen taxpayers who never hid money or assets, but rather who hold such assets in their home country. Further compounding the problem is this penalty imposed on the assets held
by dual-citizen taxpayers on their entire net worth, provided such taxpayers have no U.S. holdings. The net result is that a dual-citizen taxpayer is punished more severely under the 2011 VDP than a domestic-based U.S.-citizen taxpayer.

The IRS and Congress have recognized in related circumstances the tenuous relationship that certain citizens may have with the U.S. For this reason, the exit tax imposed under the expatriation law enacted by the Heroes Earnings Assistance and Relief Tax Act of 2008 (P.L. 110-245, 6/17/08; the "HEART legislation") has two exceptions. The first
exception applies to individuals who became dual citizens at birth. In order to qualify for exemption from the exit tax, three requirements must be satisfied:

(1) The individual must have obtained U.S. citizenship solely by reason of birth, as well as citizenship of another country.

(2) At the time of the expatriation, the individual must remain both a citizen and income tax resident of the other country.

(3) The individual was not a U.S. resident under the substantial-presence test for more than ten years out of the 15-year period ending with expatriation. FN56.

The 2011 VDP is not a statutory creation; it is simply a program announced by the IRS. The IRS should follow the logic of the HEART legislation and permit such dual-citizen taxpayers to come into compliance without imposing any penalties.

Penalty computation

Q&A #50 states "under no circumstances will taxpayers be required to pay a penalty greater than what they would otherwise be liable for under the maximum penalties imposed under existing statutes." Revenue Agents are charged with making the determination as to whether penalties would be lower outside of the program. However, Revenue Agents are required when making this determination to assume in all open years that the maximum penalties could be assessed by the IRS. Unless the taxpayer was actively involved in evading tax, it is doubtful that reasonable cause or other mitigating factors would not help reduce the size of any assessed penalty. The Q&A goes on to indicate that the penalties are determined "without regard to issues relating to reasonable
cause, willfulness, mitigation factors, or other circumstances that may reduce liability." Consequently, it is not clear as to when a 50% FBAR penalty, which is the maximum that could be imposed, would ever be less than the penalties provided under the 2011 VDP.

Retroactive application

In the 2009 VDP, Q&A #35 provided "under no circumstances will taxpayers be required to pay a penalty greater than what they would otherwise be liable for under the maximum penalties imposed under existing statutes." In substance, this is identical to Q&A #50 under the 2011 VDP. However, in the 2009 VDP, the answer makes no reference to the penalty under the VDP being compared to the maximum civil penalties that would
otherwise be applicable. In practice, Revenue Agents often requested representatives to provide them with their analysis as to why the 20% penalty should not apply. However, subsequent to the 2011 VDP, this is no longer possible. Some Revenue Agents have advised that subsequent to the 2011 VDP, practitioners are no longer able to provide Revenue Agents with analysis as to why the 20% penalty applicable under the 2009 VDP should not apply. The propriety of changing rules retroactively is questionable, but unless a taxpayer is willing to challenge the IRS on this issue, it appears that the IRS is able to do as it pleases.

Importance of compliance

During the announcement introducing the 2011 VDP, IRS Commissioner Doug Shulman stated, "As we continue to amass more information and pursue more people internationally, the risk to individuals hiding assets offshore is increasing. This new effort gives those hiding money in foreign accounts a tough, fair way to resolve their tax problems once and for all. And it gives people a chance to come in before we find them."

He continued to urge those taxpayers with noncompliance to use the 2011 VDP when he stated, "[c]ombating international tax evasion is a top priority for the IRS. We have additional cases and banks under review. The situation will just get worse in the months ahead for those hiding assets and income offshore. This new disclosure initiative is the last, best chance for people to get back into the system."

Previously Commissioner Shulman in prepared remarks given at the 23rd Annual Institute on Current Issues in International Taxation on 12/9/2010 FN57 stated, "[w]e have been scouring the vast quantity of data we received from the VDP [referring to the 2009 VDP] applicants and from other sources. Although more data mining is still to be done, this information has already proved invaluable in supplementing and corroborating prior leads, as well as developing new leads, involving numerous banks, advisors and promoters from around the world, including Asia and the Middle  East."

In a further warning to taxpayers, CI Deputy Chief Raven indicated the quantity of information the IRS has received from the prior VDP participants, whistleblowers, and foreign governments has been overwhelming. FN58. Considering the warning provided in Q&A #11 that the IRS will consider civil penalties in years prior to 2003 for taxpayers who come forward subsequent to 8/31/2011 and statements from Commissioner Shulman and Deputy Chief Raven, taxpayers are well advised to come into compliance.

Conclusion

IRS officials have quite clearly indicated that the IRS is focused on international compliance. There is nothing secretive about the IRS' desire to end tax evasion, reduce the tax gap, and bring taxpayers back into the fold. With the IRS' unprecedented hiring, not to mention its opening three new international criminal offices last year, it is primed for greater enforcement.

As for a taxpayer who is not in substantial compliance, experience strongly suggests that once the IRS has such an individual in its sights, whether through its software technology, an examination, an investigation (LB&I, Global Wealth, or CI), a whistleblower filing, or exchange of information, the individual may well consider himself or herself
fortunate if the resolution is only tax, interest, and substantial penalties, as opposed to incarceration.

Tax preparers should review the terms of Q&A #47 closely as it may limit their ability to represent clients who wish to remain in noncompliance. The relevant provision states quite clearly that "[a] practitioner whose client declines to make full disclosure of the existence of, or any taxable income from, a foreign financial account, may not prepare a
current or future income tax return for that taxpayer without being in violation of Circular 230." The financial benefits associated with representing a client on a prospective basis who has noncompliance that is not being resolved, is simply not worth the potential risk of losing the ability to practice before the IRS.



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1. WebCPA, "IRS Sees Need for More Tax Information Reporting."  http://www.webcpa.com/news/IRS-Sees-Need-for-More-Tax-Information-Reporting-54401-1.html.
2. http://www.journalofaccountancy.com/Issues/2010/Apr/20102509.htm.
3. "Senate Appropriations OK $12.5 Billion in Funding for IRS Enforcement, Services," 145 DTR G-8 (8/2/2010).
4. Id.
5. http://www.irs.gov/irm/part4/irm_04-010-004.html
6. http://www.gao.gov/new.items/d10195.pdf.
7. http://www.irs.gov/irm/part5/irm_05-007-009.html.
8. IR-2007-201, 12/19/2007. http://www.irs.gov/newsroom/article/0,,id=176632,00.html.
9. Notice 2008-4 . 2008-2 IRB 253.
10. Section 7623(b)(5) .
11. Section 7623(b) .
12. Section 7623(a) .
13. Section 7623(b)(4) .
14. http://www.irs.gov/irm/part25/irm_25-002-002.html.
15. "Updated Whistleblower Procedures Could Deter Claims, Grassley Says, Seeks Delay," 26 DTR G-4 (7/2/2010).
16. REG-131151-10, 1/14/2011.
17. http://www.offshorealertconference.com/2010/articles/juliusbaer-release.asp.
18. http://www.reuters.com/article/idUSN0322700320100503.
19. http://www.huffingtonpost.com/2011/01/17/rudolf-elmer-wikileaks-tax_n_809873.html.
20. http://www.bloomberg.com/news/2010-08-04/whistleblower-helps-berlusconi-prosecute-tax-fraud-while-hestands-accused.html.
21. http://abcnews.go.com/Blotter/story?id=5396300.
22. http://www.federalcriminaldefenseblog.com/2009/06/articles/tax-crimes/179-million-tax-whistleblower-case/.
23. http://www.batemangibson.com/docs/05_30_2008.pdf.
24. http://www.irs.gov/pub/irs-utl/whistleblowerfy09rtc.pdf.
25. IR 2010-88, 8/4/2010. http://www.irs.gov/newsroom/article/0,,id=226284,00.html.
26. Id.
27. http://www.irs.gov/irs/article/0,,id=215606,00.html.
28. IR 2010-88, supra note 25.
29. Note 27, supra.
30. Id.
31. Id.
32. "IRS Official Recommends Swift Disclosure of Foreign Assets as Investigations Increase," 35 DTR G-2 (2/19/2011).
33. "Biggest Focus of CI Unit to Be International As Global Footprint Increases, Song Says,' 15 DTR G-6 (1/26/2010).
34. "Tax Crime Enforcement Expanding to More Locations, New Financial Crimes, Song Says," 90 DTR G-5 (5/12/2010).
35. http://www.irs.gov/irm/part4/irm_04-030-003.html#d0e29.
36. IR-2010-122, 12/9/2010, http://www.irs.gov/irs/article/0,,id=232223,00.html.
37. Elliott, "IRS Increases Staffing for Next Round of Offshore Enforcement," Tax Notes, 11/15/2010.
38. Statement at House Budget Committee hearing on President Obama's proposed 2010 budget. http://www.ustreas.gov/press/releases/tg51.htm.
39. "Senate Appropriations OK $12.5 Billion in Funding for IRS Enforcement, Services," 145 DTR G-8 (8/2/2010).
40. http://browse.oecdbookshop.org/oecd/pdfs/browseit/2310081E.PDF.
41. http://www.ustreas.gov/press/releases/hp385.htm.
42. HP-1320 (12/8/2008). http://www.treas.gov/press/releases/hp1320.htm.
43. http://www.justice.gov/opa/pr/2009/August/09-tax-813.html.
44. http://www.ustreas.gov/press/releases/hp385.htm.
45. http://www.oecd.org/document/14/0,3343,en_2649_33767_2489998_1_1_1_1,00.html.
46. http://www.irs.gov/pub/irs-utl/jitsic-finalmou.pdf.
47. TG-726, 5/27/2010, www.ustreas.gov/press/releases/tg726.htm.
48. IRM 9.5.11.9.3.
49. IRM 9.5.11.9.3.A and B.
50. IRM 9.5.11.9.2.
51. IRM 9.5.11.9.4.
52. http://www.irs.gov/newsroom/article/0,,id=235695,00.html.
53. http://www.irs.gov/newsroom/article/0,,id=235584,00.html.
54. http://www.irs.gov/businesses/international/article/0,,id=235699,00.html.
55. http://www.irs.gov/newsroom/article/0,,id=104361,00.html.
56. Section 877(c)(2)(A) .
57. IR-2010-122; http://www.irs.gov/irs/article/0,,id=232223,00.html.
58. "IRS Official Recommends Swift Disclosure of Foreign Assets as Investigations Increase," 35 DTR G-2 (2/19/2011).