I’ve written extensively in this column during the last four years on the details and relative costs/benefits of the various iterations of the IRS’ voluntary disclosure programs for undeclared foreign assets and income. For taxpayers with this problem, most have already entered one of the defined programs, completed a silent disclosure outside of the various defined programs, or have made the decision to do nothing and wait to see if the IRS audits them. Almost all of the participants in the 2009 OVDI, and a large proportion of participants in the 2011 OVDI have been processed and their cases have been closed. The earliest participants in the 2012 OVDP are now seeing their cases move towards resolution, and in some cases already resolved. This article is not for anyone who has already signed their Form 906 and closed their case. This article is solely for those taxpayers who are now nearing resolution of their case and need to make the difficult decision of whether to accept the 25% (or 27.5% for the 2012 OVDP) offshore penalty on highest year aggregate balance or challenge same by opting-out and having the FBAR issues handled under standard audit procedures governed by the Internal Revenue Manual.
If you’ve reached this point of your case, I assume you’ve been represented by a tax attorney experienced with these matters. You should be having this discussion with your tax attorney. If you’ve been handling your case yourself, now would be a good time to invest some money in a consultation with an experienced attorney; the decision to opt-out or not is not a DIY project. My comments herein are not tax advice and I am not your tax lawyer. The discussion below assumes you’ve agreed to all adjustments related to omitted income and have agreed to pay all outstanding tax on the (up to) eight years of omitted income (including PFIC income from foreign mutual funds) and the 20% accuracy penalty, and you are only challenging the 25% or 27.5% offshore penalty on the highest aggregate balance of the previously undeclared foreign accounts and assets.
Who shouldn’t Opt-Out
First, let’s clearly identify who shouldn’t be considering opting-out. Taxpayers who are even slightly at risk of being found subject to the substantially higher willfulness penalties (higher of $100,000 or 50% of the account balance per violation) should probably take the program deal and move on. For many taxpayers, the proposed offshore penalty is less than $100,000. Accordingly, the risk of the IRS determining even one willfulness penalty charge could be significantly worse than the offshore penalty number and only gets progressively worse with each violation charged. As a general matter, if your facts indicate the IRS could assert the willfulness penalty, opting-out is a poor strategy no matter how high your proposed offshore penalty is. If willfulness could be at issue under a standard audit after opting-out, you should probably not consider opting-out.
On the other side, there are some discrete categories of taxpayers who may be good candidates for succeeding with the opt-out procedure and achieving a substantially lower penalty (or even zero penalty) than their proposed offshore penalty. But even here, one must exercise caution because even the most likely candidate for a successful opt-out never can be 100% certain they will succeed. There is always an element of uncertainty, no matter how small, in this divining process so that even taxpayers falling under the categories described below should be well informed and well advised before making their final decision.
High Balances, Few Accounts
Since the maximum negligence penalty is $10,000 per account per year, anyone with a single foreign account significantly over $240,000 (or about $220,000 if in the 2012 OVDP) should at least do the math and consider opting-out. If the maximum negligence penalty outside one of the defined programs for one account is capped at $60,000 ($10,000 per year times 6 years of open FBAR statute of limitations) without consideration of the FBAR violation mitigation provisions in the Internal Revenue Manual, paying more than that under one of the defined programs (on a per account basis) would only be for taxpayers who fear application of the significantly higher willfulness penalty and need to stay in the defined program. For those with the opposite problem of having multiple bank accounts each with small to moderate balances (this happens quite a lot), the opposite is true: here, the standard FBAR per account per year penalties could be much higher than the proposed offshore penalty and the decision to opt-out becomes much harder to evaluate because the theoretical numbers look so skewed.
High Real Property Value and Low Bank Accounts
For taxpayers with undeclared income from foreign rental real estate, the value of such real estate must be included in the offshore penalty highest aggregate balance calculation. This is not true outside the defined programs where any FBAR audit can address undeclared financial accounts only, not foreign real estate. Accordingly, someone whose penalty calculation worksheet is comprised primarily of foreign real estate, and has few bank accounts having moderate balances, may find opting-out to be beneficial simply because their largest asset contributing to the offshore penalty is no longer in play for potential FBAR penalties. Beware, however, if you’ve had foreign property sales during the program disclosure period where the proceeds flowed through the foreign bank account. That spike in the bank account will contribute to the highest aggregate balance for offshore penalty purposes, and in effect, the value of the property will then be subject to the offshore penalty or considered during the FBAR audit and application of the mitigation provisions.
Immigrants with Solely Foreign Source Earnings and Savings
This is the category of taxpayers where we’ve seen the best chances of success with opting-out and avoiding all FBAR penalties. The typical taxpayer in this category is someone who had moderate to significant earnings and savings achieved before immigrating to the U.S., and never closed such accounts upon moving to the United States. Generally, this taxpayer also will not have sent any post-immigration U.S. source earnings overseas, nor brought any of the foreign source savings to the United States. Ideally, use of the foreign source funds will be limited to personal expenses incurred during occasional visits to their country of origin. In this situation, where offshore money remained offshore and onshore money (fully taxed in the U.S.) never went offshore, the taxpayer should have strong arguments to avoid all FBAR penalties during the post-opt-out audit.
The decision to opt-out or not is a very difficult one highly dependent on the specific and unique facts of each individual taxpayer. Since there are no reported cases of prior opt-out decisions to rely upon, guidance on this topic comes primarily from the judgment and experience of qualified tax practitioners who have handled many such cases. If you are considering opting-out and haven’t been advised by an experienced tax lawyer, now would be the time to do so.