The obligation to report affects not just the very wealthy. For example, if a taxpayer has a Canadian bank account with $10,000 in it, that taxpayer has a reporting obligation. Even more concerning is there are situations where a taxpayer may not even realize they have an interest in a foreign account. A great example of this is foreign-issued life insurance policies with a cash surrender value. Per IRS regulations, such a policy is a “financial account” that must be reported.
The concern these taxpayers have is in large part driven by the increased attention of the Internal Revenue Service (IRS) to the subject. Up until recent years, however, the IRS was limited in its ability to identify these taxpayers. Except for some relatively higher-profile circumstances where employees of certain banks leaked the information to the federal government, the IRS has more or less had to rely on the taxpayers themselves to come forward and pay penalties voluntarily. To incentivize people to do so, the IRS launched a “once in a lifetime” means to become compliant, i.e., the “Offshore Voluntary Disclosure Initiative” in 2009. In exchange for coming forward, the potentially crippling civil penalties would be reduced to a fixed percentage of the account’s value and criminal prosecution would not be recommended.
This is a once in a lifetime opportunity proved so successful at raising money for the Treasury Department, that second, third, and fourth in a lifetime programs were subsequently introduced. A significant perceived failure of these programs was they were essentially one size fits all. In other words, the taxpayer who kept millions of dollars in the Cayman Islands for the sole purpose of producing unreported income was subject to the same penalty amount as the taxpayer who maintained an $80,000 account in Spain for their elderly parents to access should the need arise.
To the IRS’s credit, the IRS responded to this criticism and now offers a “choose your own adventure” means to become compliant. Penalties can range from as low as zero on up to 50% of the account or asset’s value. What determines this range of penalties is the so-called state of mind of the taxpayer. Taxpayers with no knowledge of their reporting requirements can choose the 5% adventure whereas taxpayers who were more purposeful in their non-compliance may choose the 50% adventure.
Why would someone choose the adventure with the highest penalty? Simply put, it is because in exchange for paying the higher penalty, the IRS will not recommend criminal prosecution and, at the end of the process, the taxpayer will receive a closing document resolving the matter. These incentives are not available to someone who pays the lower penalty. Rather, the IRS reserves the right to conduct a full-scale examination of any taxpayer submitting under those procedures. Thus, a taxpayer who submits a request for the lower penalty could find themselves years later being hauled into an audit under which penalties exceeding the account’s value to criminal prosecution could be on the table. Such uncertainty is enough for many taxpayers to simply pay the higher penalty and move on.
The concern for any taxpayer who has not come forward as of yet should be that the IRS may receive information from the foreign bank directly. A federal law passed a few years back (FACTA) requires banks that want to take profits out of the U.S. to turn over to the federal government the identity of any account holders who may be “U.S. persons.” Having addressed the criticisms of its initial programs being unfair and indiscriminate, it is widely perceived that by introducing these methods of compliance, the IRS will take a harsh look at any taxpayer that makes the IRS chase them. FACTA’s requirements will likely give the IRS a head start on that chase.
The bottom line is the decision about what to do with unreported assets and income is a difficult one to make. After all, the line between purposeful non-compliance and negligent non-compliance is not easily distinguished. It is only after looking at all the facts and circumstances surrounding a taxpayers’ situation that guidance can be offered. In the vast majority of others, it is not.