A Ceasefire in the IRS’ War on US Citizens

Published July 2, 2014

Around 10 years ago, the United States declared war on a select group of Americans—the nearly 8 million U.S. citizens and green card holders living abroad.

The IRS conducted this war quietly and stealthily. Its campaign consisted of extortion and intimidation, in an effort to force expats to comply with their U.S. tax obligations.

You may be scratching your head at this point and thinking, “You mean U.S. persons who don’t actually live in the United States have to pay U.S. taxes?”

Taxed Anywhere in the World

Yes, that’s right. The United States is the only major country with this policy. U.S. persons living abroad also have the same reporting responsibilities as homelanders. For instance, U.S. persons—no matter where they live—who have signature or “other” authority over any non-U.S. bank, securities or other financial accounts must report them if their aggregate value exceeds $10,000.

The penalties for failing to file some of these forms far exceed those for merely failing to file a tax return. For instance, the civil penalty for “willfully” failing to file this “foreign bank accounts report” (FBAR) is the greater of $100,000 or 50 percent of the total balance of the foreign account. Criminal penalties may also apply for willful violations. Non-willful violations are subject to a $10,000 penalty per account per year.

Few Ways to Avoid Penalties

Until June 18, there were only a couple of ways to avoid these penalties. If you had no underreported tax liabilities, you could file delinquent FBARs and other reporting forms with no penalty at all. And about a year ago, the IRS decided nonresident taxpayers it considered to be a “low compliance risk” would also be eligible for more favorable treatment.

Otherwise, the best you could hope for would be to come forward under the IRS’s “Offshore Voluntary Disclosure Program” (OVDP). In exchange for signing up for this program, the IRS promised not to prosecute you for criminal tax evasion or impose its most severe civil penalties. Instead, you had to pay 27.5 percent of the highest aggregate account values for eight years prior to the disclosure.

This calculation method significantly increased the severity of the penalty. For instance, thanks to the global economic downturn in 2008-2009, an unreported international account worth $1 million in 2007 might have been worth only $600,000 at the end of 2012. Yet the 27.5 percent penalty would be assessed against the entire $1 million for 2007, increasing the effective sanction to nearly 50 percent ($275,000 of $600,000). And this is in addition to the penalties for subsequent years.

IRS Offers New Disclosure Program

Early this summer, IRS Commissioner John Koskinen made a speech in which he hinted the IRS might “enhance” the OVDP. Koskinen told his audience the IRS might have been too hard on nonresident U.S. citizens and green card holders. He distinguished between these people—many of whom have lived abroad for decades—and U.S.-resident taxpayers who willfully hide their international investments overseas from IRS scrutiny. In other words, the IRS finally recognized not every expat with an unreported foreign financial account is a criminal.

On June 18 the IRS followed through on Koskinen’s promise. Expats who agree to disclose their foreign accounts and pay U.S. taxes for the previous three years won’t have to pay any penalties. They’ll owe just back taxes and interest, if any. The IRS even extended an olive branch to resident Americans. They’ll be able to come forward and disclose their offshore accounts for the previous three years and pay only a 5 percent penalty, not 27.5 percent.

To take advantage of the “kinder and gentler” IRS approach to international compliance, you’ll need to certify the “the failure to file tax returns, report all income, pay all tax, and submit all required information returns, including FBARs, resulted from non-willful conduct.”

Threat of Big Penalties Remains

If the IRS decides your failure to comply with these obligations was willful, however, you could be socked with a 50 percent penalty, calculated in the same way as the 27.5 percent penalty under the earlier OVDP.

In addition, a recent U.S. court decision made it clear the 50 percent penalty could be imposed for each year you had an undisclosed international account. In other words, you could be liable for a penalty far exceeding the amount of money you ever had in the account.

And as the IRS makes clear in its FAQs for the revised program, that’s just the tip of the iceberg in terms of possible penalties you could face. (See FAQs 5 and 6.) And although it’s far from clear at this point, the act of making a false certification could itself be considered a crime.

In addition, there’s an important—and not well-understood—”stinger” in these rules. U.S. persons who held accounts at a number of Swiss banks and other companies already under investigation by the IRS aren’t eligible. They’ll be socked with a 50 percent penalty.

Mark Nestmann ([email protected]) the president of the Nestmann Group, an investment advisory group based in Phoenix, Arizona. Reprinted with permission of Nestmann’s Notes, http://www.nestmann.com.