The voluntary disclosure process is an extremely sensitive and complicated process and should be handled only by an attorney skilled in the substantive and procedural nuances of the processes.
Minimizing Civil Penalties
If the Smiths voluntarily disclose their noncompliance to the IRS after October 15, will they be subject to the full brunt of the civil penalties that the IRS has the ability to impose under the law? The answer to this is far from clear.
Under the partial amnesty program ending October 15, a noncompliant taxpayer who made a voluntary disclosure would be required to pay tax and interest on the unreported income for the last six years, penalties equal to 20% of the tax due for each of the six years, and one 20% FBAR penalty applied to the highest balance in the account during the last six years. This penalty regime covered not only failure to file an FBAR, but also the failure to file certain other informational returns, such as Forms 5471 and 3520. With potential civil fraud penalties equal to 75% of the unpaid taxes, FBAR penalties of up to 50% of the amount in the account for each of their years of noncompliance, and a host of other penalties for failing to file other forms related to foreign entities, this program offered a very significant reduction in penalties. Now that this program is over, however, all bets are off, and the IRS may impose far more serious civil penalties.
There are, however, a few points and considerations that may affect the Smiths' civil penalty exposure. First of all, while no one has a crystal ball, it is possible that the IRS will, at least informally, establish a civil penalty framework for taxpayers that, while not as favorable as the terms of the partial amnesty program, would still allow for some reduction in penalties. A precedent exists for this approach from an IRS initiative in 2003 with respect to taxpayers who had underreported their income tax liability through an offshore financial arrangement. That program ended on April 15, 2003, but the IRS gave noncompliant taxpayers a "last chance" opportunity to comply with penalties that were higher than under the original amnesty program, yet lower than what would have been called for by federal statutes. It is possible, although not certain, that the IRS will take a similar approach in this latest offshore account crackdown. But this shouldn't be taken as a reason to do nothing. Given the potential for criminal prosecution once the IRS has identified a taxpayer's noncompliance, it would be foolish for the Smiths to sit back and assume that they will be given a last chance once their noncompliance is detected by the IRS.
Moreover, it should be noted that under the partial amnesty program, a taxpayer who made a voluntary disclosure was locked into the "one-size-fits-all" penalty structure set forth by the IRS. If the taxpayer tried to persuade the IRS that there were mitigating factors (e.g., the taxpayer was born and lived all of her life outside of the United States and was never aware that she was required to file tax returns and FBARs) that would allow penalties to be reduced or eliminated, the taxpayer would have had to "exit" the partial amnesty program and make those arguments in the course of a regular audit. If the argument was unsuccessful, the taxpayer could not then fall back on the protection of the partial amnesty penalty guidelines. Now that the partial amnesty program is over, a taxpayer may have more flexibility in attempting to assert that there are mitigating factors to reduce or eliminate penalties.
Conclusion
If the Smiths do nothing, they face potential criminal prosecution and significant civil exposure. Under long-standing IRS practices, however, the Smiths should generally be able to avoid criminal prosecution if they voluntarily disclose their noncompliance to the IRS, even though the partial amnesty program has expired, as long as the disclosure is timely under the IRS manual for voluntary disclosures. Whether the IRS will assert the full brunt of civil penalties that exist under the law remains to be seen. If the approach the IRS took under an earlier offshore initiative in 2003 is any precedent, the IRS may assert penalties that are higher than those under the partial amnesty program that ended on October 15 but perhaps not as high as the maximum allowable penalties. In addition, the Smiths should consult with their tax advisor to determine whether there are any favorable mitigating factors that could be brought to the IRS' attention to allow the penalties to be reduced or eliminated.
Seth J. Entin and Barbara T. Kaplan are shareholders of the international law firm of Greenberg Traurig LLP. Entin concentrates in international taxation and Kaplan concentrates in tax controversy, tax litigation and criminal tax matters.