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On March 23, 2009, the US Internal Revenue Service (IRS) announced the creation of a new voluntary disclosure program for undeclared foreign accounts. The IRS Offshore Income Reporting Initiative (the "Initiative") is only available for six months, or until September 23, 2009, and provides that those taxpayers who qualify will not be subject to criminal penalties or the civil-fraud penalty.
United States taxpayers (whether citizens temporarily residing in Israel, citizens who have made aliya, or dual US/Israeli citizens) are responsible for filing tax returns and reporting their worldwide income, including income associated with foreign accounts. In addition, there are numerous informational returns that US persons may be required to file, including TDF 90-22.1 Report of Foreign Bank and Financial Accounts (the "FBAR"). There are significant penalties associated with a taxpayer's failure to file these informational returns, and in the case of the FBAR, the penalties are confiscatory.
Pursuant to the Initiative, taxpayers are required to do the following:
â€¢ File six years of amended or delinquent tax returns, including informational returns, and the FBAR;
â€¢ Pay six years of all tax and interest due;
â€¢ Pay a 20 percent accuracy-related penalty for income previously omitted from a tax return, or the 25% delinquency penalty for failure to timely file. These penalties are mandatory and apply for each of the six years in which the omission occurred. No longer is reasonable cause a defense to the imposition of these penalties, as the memorandum specifically excludes reasonable cause; and
â€¢ Pay a one-time 20% penalty in the year with the highest aggregate account balance, including all offshore accounts. This penalty is in lieu of all other available penalties, including the penalty for not filing the FBAR.
There are two limitations on these rules, the first of which is that if the foreign account was opened within the six-year period, then taxes, interest and all penalties will begin from the date the account was opened. The second limitation is a reduction of the 20% penalty to 5% of the highest aggregate balance. The 5% penalty will only apply if the taxpayer: (1) did not open or create the foreign account, (2) has never withdrawn money from the foreign account or added money to the foreign account, and (3) all US taxes have been paid on the funds that were deposited into the account. Thus, the only noncompliance that may exist on the part of the taxpayer is not reporting the income earned on the foreign account.
In a wide-ranging statement announcing the Initiative on March 26, 2009, IRS Commissioner Douglas Shulman stated: "[W]e have instructed our agents to resolve these taxpayers' cases in a uniform, consistent manner. Those who truly come forward will pay back taxes, interest and a significant penalty, but can avoid criminal prosecution.... [M]y goal has always been clear - to get those taxpayers hiding assets offshore back into the system."
Why come forward?
Even though the penalties under the Initiative may cause some financial difficulties, taxpayers should not lose sight of what they avoid by submitting a disclosure consistent with the Initiative. While not a complete summary of potential penalties, those that follow are some of the most common:
â€¢ Criminal prosecution;
â€¢ Civil-fraud penalties, which can amount to penalties of 75% of the unpaid tax;
â€¢ Failure to pay penalties;
â€¢ Failure to file penalties;
â€¢ Penalties for failure to file foreign corporation information returns (Form 5471 and or Form 5472), which begin at $10,000 and can run as high as $50,000 per return;
â€¢ Penalties for failure to report transfers of property to a foreign corporation (Form 926), which begin at 10% of the value of the property transferred to the corporation and which can reach a maximum of $100,000 per return;
â€¢ Penalties for failure to file a Form 3520 reporting the transfer of funds to a foreign trust or receipt of a distribution from a foreign trust, which begins at 35% of the amount transferred to or received from the foreign trust;
â€¢ Penalties for failure to file a Form 3520 to report the receipt of a gift or inheritance from a foreign person or estate, or a gift received from a foreign corporation or partnership, which begins at 5% of the value of the gift and can reach as high as 25% of the value;
â€¢ Penalties for failure to file Form 3520-A reflecting ownership of a foreign trust under the grantor trust rules, which consists of a penalty of 5% of trust assets;
â€¢ Penalties for failure to file foreign-partnership information returns (Form 8865), which start at $10,000 and can reach a maximum of $50,000 per return, plus up to $100,000 of the value of property transferred to the foreign partnership; and
â€¢ Penalties for failure to file FBARs, which can reach as high as 50% of the account balance, and in certain situations jail.
If avoiding the imposition of the above penalties is not a significant enough carrot for taxpayers, they should understand that the situation will not get any better. IRS agents have been instructed by Shulman that if the taxpayer did not self-report through a voluntary disclosure, they are "to fully develop these cases, pursuing both civil and criminal avenues, and consider all available penalties including the maximum penalty for the willful failure to file the FBAR report and the fraud penalty."
The Initiative eliminates the reasonable-cause exception for failure to file the FBAR and assumes that all such failures are attributable to the taxpayers' willfulness. This is a complete reversal from how FBAR submissions were previously handled.
What is even more troubling than the elimination of a reasonable-cause defense is the IRS's determination that all such failures to file the FBAR are now deemed willful in nature.
Taxpayers with offshore noncompliance - regardless of whether it involves unreported foreign accounts, failure to properly account for subpart F income, or failure to file an informational return - should take advantage of the Initiative to come forward now. While the penalties may appear to be severe, as Shulman stated, taxpayers now have consistency and predictability on their side. More importantly, taxpayers will also avoid criminal prosecution and imposition of the civil-fraud penalty.
Taxpayers only have one opportunity to make a submission, and failure to qualify for the Initiative, depending upon the fact, may lead to criminal prosecution. Consequently, taxpayers should seek the assistance of a qualified tax attorney with particular knowledge and experience in submitting voluntary disclosures. This is a standard CPAs should also follow when contacted by a taxpayer who wishes to pursue a voluntary disclosure.
What about Israel?
US taxpayers living in Israel should check whether US taxes paid are eligible for a foreign tax credit under domestic Israeli tax law and the US-Israel Tax Treaty. Penalties are not eligible. But some may be exempt from Israeli tax in their first five to 10 years of residence in Israel.
Israel has its own amnesty for qualifying irrevocable trusts formed before 2006. Taxpayers may elect to pay tax at rates ranging from 4%-10% of the fair-market value of trust assets at the end of 2005. This amnesty can be elected, if desired, by June 30, 2009. This has two potential advantages: (1) cleaning up the past; (2) the cost of trust assets is "stepped up" to the amnesty value for future capital-gains tax purposes. June 30 is also the deadline for reporting trust income derived in 2006-2008. Detailed Israeli tax rules relating to trusts must be checked out, and specialist advice is vital.
As always, consult experienced professional advisers in each country at an early stage in specific cases.
Kevin E. Packman is a partner with Holland & Knight in its Private Wealth Services Department. Leon Harris is an international tax specialist.