The IRS had a wildly successful offshore voluntary disclosure initiative in 2009, bringing almost 15,000 taxpayers into the fold of tax compliance. Now the IRS is offering a second chance to those who failed to take advantage of that initiative.

On February 8, the IRS announced a second initiative that will expire on August 31. It is aimed at enticing those with foreign accounts and foreign assets to finally come clean. Here's what foreign account holders will have to do in exchange for escaping criminal prosecution: file amended tax returns for the tax years spanning 2003 to 2010, pay the tax, the interest and a 20% tax penalty on the taxable earnings in the foreign accounts, and pay a so-called "miscellaneous penalty" equal to 25% of the highest aggregate value in these accounts and on certain foreign assets during the eight-year period.

The 2011 Offshore Voluntary Disclosure Initiative (OVDI) is modeled on the 2009 program but is more costly in two fundamental ways. First, the asset period for computing highest account and asset values covers eight years rather than six (2003 through 2008). Second, the miscellaneous penalty applied now is 25% rather than the 20% penalty under the 2009 initiative. The time frame for completing the disclosure is also compressed and is one of the most onerous changes. A "complete package" must be submitted by the August 31 deadline.

This package consists of the offshore voluntary disclosure letter describing the facts, followed by all original and amended income tax returns for the OVDI years, all the backup documentation supporting the amended returns, certain new worksheets relating to financial accounts, financial advisors (for accounts over $1,000,000), a schedule showing computation of the 25% miscellaneous penalty, statute of limitation extensions, a sworn statement that a foreign entity has been dissolved, if applicable, and payment of the taxes, interest and penalties.

The first challenge in most instances will be in obtaining complete asset and income statements from the foreign financial institutions. Hidden accounts typically have a "hold mail" placed on them to safeguard policy, which may make it hard to get foreign institutions to supply information in a timely manner. Providing historical account information often takes considerable time and sometimes financial institutions will charge a high fee for the service.

Obtaining cost basis information for assets sold during the OVDI years, but purchased prior to 2003, also is a challenge, making computation of gains and losses problematic. Should the account contain assets that the IRS considers to be PFICs (passive foreign investment companies)-generally foreign mutual funds-the calculation of income, gains and losses for amended return purposes can be nightmarish, especially for accountants with little or no experience in foreign tax issues. The IRS has offered no guidance on what happens if the taxpayer cannot complete the full submission on time.

On the plus side, there is penalty relief for two categories of filers. In lieu of the 25% miscellaneous penalty on foreign account and asset values, the IRS program offers a 5% penalty in some cases, and a 12.5% penalty in others. To qualify for the 5% penalty, the taxpayer either must demonstrate a low level of involvement with the account and satisfy a four-part test, or be a foreign resident who was wholly unaware of his or her U.S. citizenship.

The four-part test requires that the taxpayer: (i) did not open the account in question; (ii) exercised minimal, infrequent contact with the account; (iii) did not withdraw more than $1,000 from the account in any year covered by the disclosure (other than to close the account and transfer the funds to the U.S.); and (iv) establish that all required U.S. taxes were paid on the funds deposited to the account. There are nuances that may apply to each of these requirements. Examples are also provided which demonstrate that each prong of the four-part analysis will be strictly construed. Therefore, application of the 5% penalty based on either minimal contacts with the account or lack of knowledge of U.S. citizenship is likely to be infrequent. The burden of establishing entitlement to the 5% penalty is on the taxpayer and that burden can be a heavy one, especially if it involves proving a negative, such as a lack of knowledge of citizenship, or producing financial records that date back beyond ten years. The 12.5% penalty applies to small accounts, defined as those with a highest aggregate annual value of less than $75,000 for each of the eight years covered by the 2011 OVDI. Again, these requirements are strictly construed to ensure uniformity and consistency in the application of the OVDI program.

If there is one thing that was learned from the 2009 OVDI initiative, it is that there were many unique factual situations that called for more flexibility by the IRS. The "take it or leave it," "one size fits all" approach did not make sense in many of the cases. Yet this IRS approach largely continues in the 2011 OVDI, notwithstanding the opportunity for reduced penalties.

An increase in the severity of the second initiative was to be expected, so as not to be unfair to those who came in early. The intended message is that the longer you wait to make a disclosure, the more severe the consequences.
And, if you make no disclosure and the IRS finds you, the financial cost will soar and a criminal investigation and possible criminal prosecution can ensue. Indeed, it is the risk of criminal prosecution that drives the voluntary disclosure program. For those with no real criminal tax exposure, the OVDI initiatives are not always a good fit. They offer transparency on monetary penalties but no flexibility where there is a reasonable cause defense to the penalties or where a non-willful penalty should apply. In situations where the fact pattern varies from year to year, where offshore assets outside of bank or brokerage accounts are involved, where long-standing foreign residents or recent immigrants are involved, or where bank accounts are nominally larger than $75,000 but are still relatively small, among others, the OVDI program may not be the best option. A close and analytical study of the situation by an experienced tax controversy or criminal tax attorney is essential, particularly since protecting client confidence is important during the early planning phase.