How Can I Prove My Failure to File Was Non-Willful?
You have just discovered that you were required to file disclosures related to foreign financial accounts in your possession. You know that you weren't trying to avoid the IRS, but how do you communicate that your failure to file was non-willful? What can you do to streamline the process and avoid potential penalties?
Earlier in 2016, the IRS changed the qualification requirements for its Streamlined Filing Compliance Procedures using Non-Willfulness Certification Forms. The new forms require taxpayers to provide more background into their failure to file, which could work against their efforts to qualify for "Non-Willful" status.
What Are the Streamlined Offshore Procedures?
To encourage taxpayers with offshore bank accounts and assets to come forward and comply with Foreign Bank Account Reporting (FBAR) requirements, the federal government has created several Offshore Voluntary Disclosure Programs (OVDP). The most recent OVDP, which includes disclosures under the Foreign Account Tax Compliance Act (FATCA), was instituted in 2012. Under the terms of the 2012 OVDP, non-complying individuals and companies can voluntarily report undisclosed foreign income to avoid criminal prosecution and significantly reduce penalties. In exchange, they are required to pay the back taxes, interest, and accuracy-related penalties owed to the government.
Compliance with the 2012 OVDP requires:
- Filing of amended tax returns, together with all required information returns, for each of the most recent eight (8) years for which the U.S. tax return due date has passed. These amended returns include previously-unreported income earned on the foreign accounts and assets and compute the tax on those assets;
- Payment of any tax due with applicable penalties and interest;
- Filing of any delinquent FBARs for each of the most recent eight (8) years for which the FBAR due date has passed; and
- Payment of a penalty equal to 27.5% of the highest aggregate balance/value of the taxpayer's foreign financial assets subject to that penalty during the eight (8) year period covered by the disclosure.
The 2012 OVDP and its predecessors did not make a distinction between "willful" and "non-willful" failure to comply and generally assess the 27.5 penalty on all participants. Non-willfulness could be raised as an extenuating circumstance only by "opting out" of the OVDP prior to the penalty-assessment phase of the process.
In June 2014, the IRS established Expanded Streamlined Offshore Procedures. These modified procedures are available to U.S. taxpayers residing in the United States and abroad who can truthfully certify that their failure to report foreign financial assets and pay all tax due in respect of those assets did not result from willful conduct on their part. The new processes are designed to provide qualifying taxpayers with a streamlined procedure for filing amended or delinquent returns with greatly reduced tax and penalty consequences.
Streamlined applicants fall into two categories: U.S. residents and non-residents. Non-residents have fewer requirements and face fewer penalties than residents, so it preferable to qualify as a non-resident.
Qualifying for Non-Resident Streamlined Offshore Procedures
To qualify for non-resident status, the filer and his or her spouse (if filing jointly) must each have lived outside the United States for 330 days in each of the past 3 tax-filing years. The key question is whether a person was physically outside the U.S., not where the person maintained a legal residence.
Non-Residents' Streamlined Offshore Procedures
If a taxpayer does qualify as a non-resident, he or she may be entitled to Streamlined Offshore Procedures if he or she had failed to report income from foreign financial assets and pay U.S. taxes on that income. This can sometimes include a failure to file mandatory FBARs, and must result from non-willful conduct.
If the taxpayer qualifies, he or she may make a voluntary disclosure of the foreign assets and a Certification by U.S. Person Residing Outside of the U.S. (Form 14653). He or she is then required to file any delinquent FBARs for the last 6 years. The non-resident may also file delinquent or amended tax returns for the last 3 years. These forms are sent to the IRS along with the full amount of taxes and interest owed on the disclosed assets.
A non-resident who makes voluntary disclosures and meets all the Streamlined Offshore Procedures requirements can often avoid paying any penalties resulting from:
- Failure to pay
- Failure to file
- Accuracy errors
- Information return errors
- FBAR penalties, or
- Title 26 Miscellaneous offshore penalty.
U.S. Residents' Streamlined Offshore Procedures
Under the new Streamlined Domestic Offshore Procedures, participating U.S. resident taxpayers must:
- File amended tax returns, together with all required information returns, for each of the most recent 3 years (rather than the 2012 OVDP’s 8 years) for which the U.S. tax return due date has passed;
- File any delinquent FBARs for each of the most recent 6 years (rather than the 2012 OVDP’s 8 years) for which the FBAR due date has passed; and
- Pay a Title 26 miscellaneous offshore penalty equal to 5% (rather than the 20-12 OVDP’s 27.5%) of the highest aggregate balance/value of the taxpayer's foreign financial assets subject to that penalty during the years in the covered tax return and FBAR periods.
The biggest change in the 2016 IRS requirements has to do with the certification forms used to prove non-willfulness. In the past, the IRS told taxpayers to "provide specific reasons for your failure to report all income, pay all tax, and submit all required information returns, including FBARs." This meant that some disclosures didn't provide enough information to satisfy the IRS. In 2016, the instructions changed. The IRS now asks taxpayers to "include the whole story including favorable and unfavorable facts." The instruction requires the taxpayer to disclose:
- Personal background
- Financial background
- Source of funds in each foreign financial account
- Contact with the account including withdrawals, deposits, and decisions regarding investment or management.
In summary, the IRS calls on taxpayers to "[p]rovide a complete story about your foreign financial account/asset."
The added language means Streamlined Offshore Procedures applicants are going to be held to a higher standard to prove non-willfulness. It is going to be up to taxpayers and their tax attorneys to draft a narrative that convinces the IRS examiner that the facts and circumstances lean in favor of non-willfulness. It will be crucial for taxpayers facing the Streamlined process to work with an experienced tax lawyer to ensure that the certification narrative emphasizes the good over the bad.
Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 30 years experience. If you have questions regarding OVDP qualification or requirements, contact Joe Viola to schedule a consultation.