by Brian Mahany
Clint Eastwood had many memorable lines as Inspector Callahan in Dirty Harry. One of my favorite lines was “I know what you’re thinking. Did he fire six shots or only five? Well, to tell you the truth, in all this excitement I kind of lost track myself. But being as this is a .44 Magnum, the most powerful handgun in the world, and would blow your head clean off, you’ve got to ask yourself one question: Do I feel lucky? Well, do ya?” Offshore tax reporting isn’t as exciting as Dirty Harry but the stakes are still quite high.
We are frequently asked to explain the difference in penalties between going through the IRS’ tax amnesty program (called the 2012 Offshore Voluntary Disclosure Porgram or “OVDI”) and what happens if one does nothing and is later caught. Hopefully this post will illustrate the difference using real numbers.
We will assume maximum penalties and a 35% tax bracket. There are other variables, remote but possible, but we will keep this illustration simple.
Taxpayer deposits $1,000,000 into foreign account in 2004 and fails to file FBARs for each year. The account earns 5% interest meaning the balance is as follows:
2004: Interest $50,000 Total: $1,050,000
2005: Interest $50,000 Total: $1,100,000
2006: Interest $50,000 Total: $1,150,000
2007: Interest $50,000 Total: $1,200,000
2008: Interest $50,000 Total: $1,250,000
2009: Interest $50,000 Total: $1,300,000
2010: Interest $50,000 Total: $1,350,000
2011: Interest $50,000 Total: $1,400,000
Coming into OVDI, the taxpayer would pay approximately $553,000 plus interest.
The tax on the unreported income would be $140,000 (8 years x $17,500 per year) plus an accuracy penalty of 20% which equals $28,000 plus the one time OVDI penalty of 27.5% of the highest year which in this example is 2011 ($385,000).
At first blush, that seems ridiculous to pay $553,000 on an account worth $1.4 million but remember, there was no tax paid on $400,000 of income over the last 8 years.
The penalties for not voluntarily coming forward are even more onerous.
If the IRS finds you first (and they are getting very good at that), the potential tax and penalties are in excess of $5,000,000! That’s right, $5 million and this is not a typo.
The penalties that the IRS can impose are the greater of $100,000 per year or 50% of the highest balance for each year the account is unreported. That means:
This is in addition to the $140,000 tax as noted above. If that isn’t bad enough, the IRS can impose 75% fraud penalty on the tax balance and criminally prosecute you.
To impose the higher penalties, the IRS must show that you acted willfully. The IRS often seeks to do this by looking at your back returns. If you checked the box on Schedule B of your income tax return indicating you had no interest in a foreign account, the IRS argues that you acted willfully.
Foreign accounts must be reported each year on a Report of Foreign Bank and Financial Account or “FBAR.” This year, some taxpayers also to have report foreign financial assets (the definition is broader than financial account) on a FATCA form 8938.
The above illustration is designed to help people visualize and understand the potential consequences of not taking action. There are many fence sitters out there wondering if they should come forward or just wait until the IRS comes knocking. Unfortunately, once the IRS finds you, amnesty is no longer an option. The IRS can criminally charge you and impose the higher penalties if they so choose.
If neither of the two options appear very appealing, there are other options. Taxpayers can approach the IRS and seek a traditional voluntary disclosure. There are no guaranties but for those taxpayers who truly didn’t know or understand the reporting guidelines, it is possible to pay greatly reduced penalties. Non willful violations carry a $10,000 yearly penalty, although the IRS has been known to impose the penalty on just one year or even issue a warning letter in lieu of a monetary penalty.
There are also special rules for those with smaller accounts or middle income folks whose unreported income is much smaller.
So, are you feeling lucky?
Deciding what to do is something you should discuss with your tax adviser or a tax attorney. Make sure that your tax adviser is fluent in offshore reporting requirements – most are not.
The tax lawyers at Mahany & Ertl have helped many taxpayers all over the world with a wide variety of foreign reporting and offshore accounts problems. In most cases, we charge a flat fee for our services and stand behind our work – even if we have to take your case to U.S. Tax Court. OVDI, voluntary disclosures, foreign gift reporting, FATCA and foreign corporations are just a few of the things we handle.
Mahany & Ertl – America’s Tax Lawyers. Offices in Milwaukee, Wisconsin; Detroit, Michigan; Portland, Maine & Minneapolis, Minnesota. IRS legal services available anywhere in the U.S. and the world.