Taxpayer Uncertainty Prompts Citizenship Renunciations

The Internal Revenue Service’s newest version of the Offshore Voluntary Disclosure Program is designed to give some reassurance to taxpayers who have been hesitating to come forward and disclose their foreign bank accounts, but the increasing complexities of U.S. tax law are leading more people to renounce their citizenship.

A newly released report to Congress from National Taxpayer Advocate Nina Olson shows that the IRS’s approach to tax compliance by those with foreign bank accounts is still leading to confusion among taxpayers. More and more taxpayers living abroad are going so far as to renounce their U.S. citizenship to avoid dealing with all the headaches.

“Many U.S. taxpayers abroad are confused by the complex legal and reporting requirements they face and are overwhelmed by the prospect of having to comply with them,” said the report. “Some are even renouncing their U.S. citizenship for that reason; about 4,000 people did so in fiscal years 2005 to 2010. Renunciations increased more than tenfold from 146 in FY 2008 to 1,534 in FY 2010, with 1,024 renunciations in the first two quarters of FY 2011 alone.”

The report also found fault with the “bait and switch” approach taken by the IRS enforcement staff with some taxpayers who had come forward under the older voluntary disclosure programs with the promise of reduced penalties, only to find themselves subjected to steeper penalties.

“While the maximum penalty for a ‘willful’ failure to report foreign accounts on Form TD F 90–22.1, Report of Foreign Bank and Financial Accounts (FBAR) is severe, people who voluntarily correct inadvertent violations are generally not subject to a significant penalty,” said the report. “Nonetheless, the IRS ‘strongly encouraged’ nearly everyone with a violation to participate in the 2009 Offshore Voluntary Disclosure Program (OVDP) or face potentially excessive civil and criminal penalties. More than a year after the 2009 OVDP ended, the IRS changed key terms of the program to the detriment of those with inadvertent violations, damaging the IRS’s credibility. The IRS’s statements also leave the public confused and concerned that excessive FBAR penalties may apply to inadvertent violations.”

She noted that while the IRS’s longstanding policy is to use penalties “to encourage voluntary compliance,” the agency may have used penalties as leverage against taxpayers who have entered into voluntary disclosure programs, often penalizing those who are trying to become compliant. Many taxpayers appear to believe the IRS will always seek to apply the maximum penalties, regardless of the situation, even to “benign actors.”

“Absent clear procedures and transparent guidance about how these benign actors can return into compliance without being subject to maximum penalties, the IRS is squandering an opportunity to substantially improve voluntary compliance by millions of low profile U.S. taxpayers abroad,” said the report.

Bob McKenzie, a tax partner at the Chicago law firm Arnstein & Lehr, has been trying to help his clients cope with the IRS’s voluntary disclosure programs. Despite some improvements, he still sees some problems with the latest version, particularly the lack of a deadline.

“Most of my clients are in the two prior iterations,” he said. “We saw that most of the activity was in the last few weeks before the deadlines. At this point after two prior programs, we’re probably starting to pick up procrastinators now. A deadline tends to stop that.”

In just the weekend right before the September 9 deadline for the previous OVDP program, his firm saw eight out of the 60 disclosures that came in for the entire period that the program was open.

“Since that deadline, we’ve had several people who came in who made disclosures because they were told in some manner that their name was about to be released by their banking institution,” said McKenzie. “This new program gives us a great deal of certainty about what might occur because the IRS has made it clear that those who came in during the gap from September to January now will be treated under the January program, so that part of the program was good. There’s certainty. We know exactly what penalties people potentially face, and we can quantify that for our clients.”

Even though clients may initially balk at the amount of money they will need to pay, he explains to them that if they are at high risk, receiving a letter from the IRS that the agency won’t prosecute them has a great deal of value.

“This may not be about the money,” said McKenzie. “It could be about whether you’re one of the lucky, chosen few who gets indicted.”

For people in a position where the problem seems more like a case of ignorance of U.S. tax laws, that might be less of a motivator. For example, people who are dual citizens in Canada or who simply inherited accounts from their grandparents might be viewed more sympathetically.

“The problem so far has been the one size fits all approach of the IRS,” said McKenzie. “You may recall that during the 2011 program they created this concept of ‘opt out.’ They had this set of penalties that you would incur if you participated in the program, but if you thought you could establish that you did not have an intentional violation and should be subject merely to the negligence penalty, you could say, ‘I’m not going to accept the program. I’m going to opt out.’ You wouldn’t create any danger of prosecution.”

But if the IRS thinks the slip-up was intentional, then the taxpayer could lose the benefit of the penalty under the program and the IRS could enforce a 50 percent penalty of the amount in the account. The penalty was 25 percent for people over $75,000 under the 2011 version, McKenzie noted, which has now gone up to 27.5 percent under the 2012 version. But it’s still a gamble. If the IRS doesn’t agree that the oversight was unintentional, the taxpayer could end up owing a whole lot more money.

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