Reduced US 5% offshore penalty for foreign residents

On June 6 the IRS announced it was making changes to the 2011 OVDI helping certain individuals living outside the US and giving limited extensions.

In our article that appeared in The Jerusalem Post on February 22, we described the 2011 Offshore Voluntary Disclosure Initiative (2011 OVDI). This is intended by the US Internal Revenue Service (IRS) to allow US citizens, green-card holders and US tax residents to come forward and report previously undisclosed foreign financial accounts and unreported income from said accounts.
On June 6 the IRS announced it was making changes to the 2011 OVDI, which would be more favorable to certain individuals living outside the US and that it is giving a limited 90-day extension to the original August 31 deadline.
What is the OVDI about?First, a recap. The major thrust of the 2011 OVDI is that the taxpayer, in addition to paying any previously unpaid tax plus a 20 percent accuracy-related penalty and interest on the tax, may choose to pay an “offshore penalty” that was, in most cases, equivalent to 25% of the highest aggregate value of the undisclosed offshore accounts in any of the years 2003 through 2009. The 25% “offshore penalty” is in lieu of a range of other possible penalties in the US tax law.
However, the 25% penalty could also be applied to nonfinancial offshore assets acquired with funds on which no US tax was paid, even though the assets themselves do not produce any income. The 2011 OVDI made provisions for two reduced offshore penalties, one for 12.5% and one for 5%, but the conditions to meet these reduced penalties were so restricted, they were limited to a small class.
The major problem was that the IRS lumped together into the same box the US citizen residing in Boston, who was intentionally not disclosing his ill-gotten gains deposited in an offshore account, together with the US citizen, who has been residing in a foreign country (such as Israel) for many years, or was even born in a foreign country and had foreign bank accounts and other foreign financial assets just because he was resident of a foreign country.
New 5% offshore penalty
Under pressure from tax professionals, the IRS is now recognizing that the US citizen or green-card holder living in a foreign country should be classified differently than the US person residing in the United States. There is a new reduced 5% offshore penalty for US persons (citizens, green-card holders) living outside the US. The conditions under which it can be claimed are as follows:
1. Taxpayer is a foreign resident.
2. Meets all three of the following conditions for all of the years of his voluntary disclosure: a) taxpayer resides in a foreign country; b) taxpayer has made a good-faith showing that he or she has timely complied with all tax-reporting and -paying requirements in the country of residency; and c) taxpayer has $10,000 or less of US source income each year.
The IRS also declared that for “these taxpayers only, the offshore penalty will not apply to nonfinancial assets, such as real property, business interests, or artworks, purchased with funds for which the taxpayer can establish that all applicable taxes have been paid, either in the US or in the country of residence.”
Therefore, if you are resident of Israel and have been paying Israeli tax on all your foreign-source income (e.g., Israeli salary, rental income from Israeli real estate, pensions, etc.) and have $10,000 or less of US source income in each year, you should meet the conditions for the 5% penalty.
The fact that many Israeli residents are not required to file income-tax returns should not disqualify you, providing you have been paying the taxes through withholding at source or payment vouchers (e.g., 10% tax on residential rental income).
Taxpayers, who participated in the 2009 OVDI are entitled to have the new reduced 5% offshore penalty applied if they qualify.
A possible scenario
Here is an example of the new 5% penalty from the IRS: A taxpayer is a US citizen who has lived and worked as a corporate executive in Country X (such as Israel, apparently) since 1995. His income has included earnings in excess of $250,000 in each year, as well as bank interest and investment income on financial accounts that had a high aggregate balance of $1.2 million in 2009. He has paid all required taxes on his earnings and investment income in Country X in every year, but he has filed no US income-tax returns since moving out of the United States.
In addition to his financial accounts, the taxpayer has acquired a personal residence in Country X with an equity of $900,000 and an automobile worth $85,000, both financed with previously taxed savings from the US, as well as his salary and investment earnings in Country X.
If the taxpayer was fully tax compliant in Country X, he will be eligible for a reduced offshore penalty of 5% of the value of the financial accounts, or $60,000. The residence and automobile will not be included in the penalty base because the funds used to acquire them were fully taxed in the Country X.
Why should I voluntarily disclose?
While the 5% offshore penalty may still seem to be a bitter pill to swallow for many US persons living in Israel for many decades, or even those born here, it should be seriously considered as a means of getting back into the US tax system in the least restrictive way.
If accepted into the program and you meet the conditions for the lower penalty, you have the certainty to know exactly what it will cost you in the end. If you do not enter the 2011 OVDI with the lower penalty, you will have to be willing to live with the uncertainty of potential civil and criminal penalties.
Additionally, it is going to become increasingly more difficult for anyone who has any previously undisclosed income from overseas assets and/or has not disclosed these financial assets on FBARs (Foreign Bank Account Reports).
For example, starting with the 2011 US income-tax return, in addition to having to file FBARs, one will have to disclose on a new Form 8938, attached to the tax return, the aggregate balance of all “foreign financial assets” of more than $50,000. There will be substantial penalties for failing to make this disclosure.
In addition, starting with 2013, every foreign bank in the world will have to have a signed agreement with the IRS to disclose all of its US account holders, or suffer consequences that these financial institutions may not want to incur. Therefore it will become increasingly difficult to hide foreign financial accounts from the IRS.
Extension to file documents
To qualify for the 2011 OVDI, all documentation must be submitted by August 31, 2011. The package of documentation includes original or amended US income-tax returns for 2003-2010, FBARs for the same years and copies of offshore financial-account statements for all years in which the aggregate highest balance exceeded $500,000. If you have not already started the process with a tax professional, there is not much time left to prepare the documentation.
The IRS announced that it will grant a 90-day extension, providing you can demonstrate a good-faith attempt to fully comply with the IRS requirements.
Opting out
As we reported in our February 22 article, you can always elect to withdraw from the 2011 OVDI if you do not like the offer made to you. In its revised FAQs issued on June 6, the IRS now recognizes that there might actually be circumstances in which it would be better for the taxpayer to opt out of the program. It discusses several examples.
Israeli tax implications
If you reside in Israel, you can only qualify for the new US 5% offshore penalty if your Israeli tax affairs are in order. If they are not, consider applying to the IRS and the Israel Tax Authority; each country has programs for this.
To sum up, we strongly suggest that if you qualify for the reduced 5% penalty, discuss your situation as soon as possible with professional advisers in each country.
Don Shrensky is a qualified US and Israeli CPA. Leon Harris is an Israeli CPA and international tax specialist.