By George G. Jones and Mark A. Luscombe

The Internal Revenue Service’s current focus on tax shelters has, in general, had a corporate emphasis, trying to shut down various types of transactions that are often structured to generate losses to offset income and to fit, arguably, within the letter of the law - even if it’s not within the spirit of the law.

The IRS feels that it can best address the corporate tax shelter problems if it can quickly identify the particular transactions that are being promoted, since there are relatively few taxpayers involved and large dollar amounts are at stake in each case.

Perhaps even more troubling to the IRS, however, is the individual use of offshore trusts and bank cards and accounts. These offshore schemes are generally focused on individual taxpayers, each with smaller dollar amounts at stake, but with many more taxpayers involved, creating the potential to mushroom into a major compliance problem if not checked at this point.

Unlike corporate tax shelters, promoters of these individual offshore trusts and other foreign-jurisdiction-based schemes rarely have any color of authority for the tax savings that they are promoting, except possibly in their own distorted view of the world. The Internet has permitted these offshore scheme promoters to greatly expand the reach of their marketing efforts.

Likewise, credit and debit cards issued by banks in foreign jurisdictions with purported secrecy laws are marketed to appeal to U.S. residents who wish to hide taxable income, even though it is the taxpayer’s failure to report the income that is illegal, rather than having a foreign account. The IRS’s main job with foreign-based tax avoidance arrangements, therefore, is not to challenge the law that is claimed to be underlying the transaction.

Rather, it is to identify the promoters and then shut them down or, in the case of foreign accounts, to gain access to bank and credit card company information to track down the holders for examination.

The Offshore Voluntary Compliance Initiative

In January of this year, the IRS inaugurated the Offshore Voluntary Compliance Initiative in Revenue Procedure 2003-11. Taxpayers not already brought to the attention of the service were given until April 15, 2003, to come forward and identify the use of offshore credit cards or other offshore financial arrangements, including foreign bank accounts, corporations, partnerships and trusts, used to underreport their U.S. income tax liability.

The IRS had, for the last couple of years, been using “John Doe” summonses to financial institutions and retail establishments to develop a database of offshore cardholders. Over 100 such summonses have been issued to date, with a focus on MasterCard, Visa and American Express. The voluntary compliance initiative was the next step taken by the IRS to get better information on the promoters and users of these offshore schemes.

In exchange for providing personal identifying information, identifying the tax shelter promoter, and submitting all promotional and transactional materials and correspondence, the taxpayer could avoid certain fraud and information return civil penalties. Taxpayers could also avoid potential criminal prosecution. Taxpayers accepted into the initiative would still be subject to the unreported taxes, interest, and delinquency and accuracy-related penalties.

The focus of the compliance initiative was on tax years ending after Dec. 31, 1998. Final acceptance into the initiative was to be signified by the execution of a closing agreement with the government. While one purpose of the compliance initiative was to bring those taxpayers back into compliance, the principal purpose was to collect additional information with respect to the promoters of these schemes.

Results of the initiative

Even before the introduction of the Offshore Voluntary Compliance Initiative, the IRS had approximately 50 promoters under examination. The IRS has announced, in Information Release 2003-58, that the Offshore Voluntary Compliance Initiative has resulted in 1,253 individuals coming forward to apply for the initiative. These individuals have identified an additional 80 promoters beyond the 50 already under IRS examination. The initiative identified more than $50 million in uncollected taxes.

The IRS release also included a list of additional information gleaned from the applications. Taxpayers submitting applications included not only individuals but also domestic and foreign corporations and trusts and estates. Nearly 20 percent of the applicants claimed to have been cheated by the promoters. Taxpayers submitting applications represented a wide variety of occupations, including lawyers, dentists and business executives.

The IRS also noted that tax practitioners played a key role in bringing the initiative to the attention of their clients. It is likely that the April 15 deadline was selected by the IRS in order to encourage the initiative to become an item of discussion in the return preparation process.

What happens next?

The IRS now has a great deal of data. With 80 revenue agents and 40 attorneys assigned to promoter audits, the service clearly hopes to move quickly to follow up on the information that it has assembled.

First, the IRS will review the applications to determine the eligibility of those who have applied for the program. Once notified of eligibility, taxpayers will have 150 days to file amended returns and pay the correct tax and interest, plus any assessed penalties.

With respect to the promoters identified in the initiative, the IRS will initiate procedures to pursue civil and/or criminal penalties. The agency has also been seeking injunctive relief by requesting cease-and-desist orders.

The IRS also noted an increase in the number of amended returns during this period that, although filed outside of the voluntary compliance initiative, appeared to relate to offshore activity. These amended returns may have been filed in an attempt to come forward voluntarily, yet “under the radar,” and therefore, perhaps, avoid criminal prosecution or the fraud penalties - but without providing the promoter information required as part of the voluntary compliance initiative.

The IRS intends to investigate these returns to attempt to ascertain additional information about schemes involved there. These amended returns may have been an attempt to follow the voluntary disclosure procedures to avoid the criminal prosecution discussed below.

The identification of the promoters and further use of “John Doe” summonses against these promoters and foreign credit/debit card issuers is expected to lead to a pursuit of other clients of the promoters or foreign banking customers who did not come forward in the voluntary compliance initiative.

The IRS has already reviewed millions of offshore transactions and has more than 1,000 offshore cardholders under audit. It estimates that in excess of $100 million eventually may be collected as a result of its efforts.

Voluntary disclosure

A taxpayer who missed the deadline for the Offshore Voluntary Compliance Initiative may still follow the voluntary disclosure program outlined in IR-2002-135 to reduce the risk of criminal prosecution in the future. The voluntary disclosure program does not guarantee that criminal prosecution will not be sought, but it does appear to greatly reduce the chances.

It is possible that a taxpayer, such as discussed above, who has followed the voluntary disclosure program rather than the Offshore Voluntary Compliance Initiative in order to protect the identity of the promoter, may still have the threat of criminal prosecution held out by the IRS in order to extract information about the promoter.

As more and more information is made available to the public about the nature of these offshore schemes, it will become more difficult for taxpayers to contend that they were duped by the promoters and continued to believe, until the IRS knocked on their door, that these offshore schemes were legitimate.

The voluntary disclosure initiative requires a taxpayer to demonstrably cooperate with the IRS and make good faith arrangements to pay in full any tax, interest and penalties determined by the IRS to be applicable. The taxpayer must not already be under examination.

However, it is still considered voluntary disclosure if the IRS has identified the taxpayer’s promoter but has not yet commenced an examination of the taxpayer or notified the taxpayer of its intent to do so. It is not voluntary disclosure if the taxpayer was a partner in a partnership already under examination by the IRS or a shareholder in a corporation already under examination by the IRS.

The voluntary disclosure program offers only the hope, not the guarantee, of avoiding criminal prosecution. Further, it does not include any waiver of penalties. However, voluntary disclosure could also be a relevant factor in determining the propriety of assessment of fraud penalties.

Clearly, a significant problem still exists for many taxpayers, based upon initial IRS estimates that the number of taxpayers hiding income in offshore accounts reaches into the millions. Its Offshore Voluntary Compliance Initiative netted only 1,253 taxpayers coming forward.

Based on these numbers, the agency will be continuing its aggressive campaign to smoke out many more taxpayers, either with or without their cooperation.

As the IRS continues these endeavors, tax practitioners will want to be proactive in making sure that their clients are aware of both the growing risks of involvement in these schemes, and the programs that are available to reduce their potential exposure.

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