NOTE: This article was written on February 2, 2014. The IRS OVDP process rules have changed substantially as announced by the IRS on June 18, 2014, and are still in place as of this current edit (February 2017) . This information presented below should be viewed with care as some of the rules have changed. For more current information, please click on the box below.
* * *
So let's say that you are thinking about reporting your foreign income and assets under the IRS 2012 OVDP/OVDI rules. Shouldn't you know what the OVDP process entails before engaging in what will be a rather intimate relationship with the IRS? In this article, we will discuss the entire OVDP process from start to finish so that you will know what to expect.
OVDP Process: The OVDP Pre-Clearance
In order to submit a proper voluntary disclosure, huge reams of documents must be created and supplied to the IRS. These include amended returns, penalty computations, bank statements, and asset valuations along with FBAR forms. The problem is that it can take time for these documents to be received and to be prepared. And because you are at risk of criminal charges or civil detection, even though you made the decision to declare your unreported income and assets, the IRS recognized that a "Pre-clearance" would benefit many taxpayers who wish to use the offshore voluntary disclosure program as part of the OVDP process.
So by submitting a rather straightforward form to the IRS criminal investigation division, you can be pre-cleared to enter into the voluntary disclosure program, with all of its attendant protections, well before your entire voluntary disclosure package is completed.
A Pre-clearance used to take about two days to receive back from the IRS. Now they take 7 to 10 days. And we have seen delays as long as a month.
OVDP Process: The OVDP submission
Months after your Pre-clearance has been accepted, there will be a due date for the entire submission. An extension can be granted if more time is needed. During the submission, the typical documents provided are amended tax returns, original returns, FBAR forms which have been recently electronically filed, penalty computations and supporting documentation, bank statements, foreign life insurance policies and foreign rental property valuations and a list of encumbrances.
At this point, you would file any other missing informational returns such as Form 3250, Form 3250-A, Form 5471, and Form 5472. Next, we have our client pay any taxes due. The reason why is two-fold. First, interest is running on those tax assessments. Second, and this may come in handy down the line, is that it shows good faith by the taxpayer.
We may suggest to our client that they pay the calculated offshore penalty, but that is only in cases where we are positive that the taxpayer will not opt-out and argue for the lower penalty amount.
OVDP Process: The OVDP review
Once submitted, an OVDP Examiner will review the entire submission. If documents are missing, they will send out something called an "Information Document Request", or what the IRS refers to as an IDR.
Proposed changes to the tax returns will be discussed, and there is a meaningful opportunity to object to additions.
Also, the OVDP Examiner will review the penalty computations that you have supplied. Here, there will also be a meeting to discuss any proposed changes. Common areas of disputes involve transfers of money, the tax consequences of a foreign life insurance policy, and the valuation of foreign real estate that was rented.
If you or your legal representative do not respond to the OVDP Examiner's IDRs, you can expect that the examiner may send out a Form 906, which will be discussed immediately below, in order to elicit a response.
OVDP Process: OVDP Form 906
Form 906 is the OVDP closing agreement. Three copies must be signed and returned if you agree. The thing is, Form 906 is a little bit difficult to understand. Also, if there are any proposed tax increases, it is difficult from the closing agreement alone to determine how the examiner reached his or her conclusion.
Many taxpayers and legal professionals make the mistake of believing that a Form 906 is a take it or leave it proposition. In fact, it can be used as a beginning point for negotiations. That, if you don't agree with a Form 906 you can contest it with an examiner, who may then issue a subsequent substitute Form 906, if they agree with your proposals. We have had cases where it took three Form 906s to get the result we wanted.
Many taxpayers are alarmed at the language of Form 906. To them it looks like they are admitting to some criminal acts. The vast majority of our clients never did anything that approached criminality; they just made innocent or negligent mistakes. Form 906 does not require an admission of criminal wrongdoing. All it requires is the taxpayer to admit that they did not report all of their income. Form 906 can't be used for any other purposes except to close out the OVDP process, provided the standard offshore penalty amount is agreed to.
What if you don't agree with the standard offshore penalty and want to negotiate a smaller penalty?
If you do not agree with the penalty amount and conclusions of the OVDP Examiner, you may opt-out of the standard penalty rate. And this is the point at which we inform the IRS that our client wishes to "opt-out".
Now, when you "opt-out", the criminal protection will still apply, you are just presenting an argument why the standard penalty amount would be unfair considering your circumstances. For most of our clients, an opt-out is seriously considered.
The OVDP "Audit"
Once your opt-out is processed, an OVDP Examiner will then select at least one year's tax return to audit completely. The difference between what happens in the opt-out, and in what occurred during the submission process, is that your entire return – not just your unreported income – is open to examination. This is an important consideration for those whose domestic income and expenses may be difficult to substantiate.
The OVDP audit actually has two components. The first, Title 26, is a standard tax examination. If you disagree with any of the examiner's conclusions you have the administrative remedies and tax court remedies available to you.
OVDP Process: The FBAR Audit
The other part of the OVDP Audit, should you opt-out, is the Title 31 portion. Here the examiner will question why you didn't report your foreign income and why you didn't file an FBAR or if you filed partial FBARs. For many of our clients, these audits are all done remotely with our clients not having to meet with the IRS. If the auditor wishes to interview his/her client, we prepare our clients extensively so that they know exactly what to expect and that if there are any loose ends, they are properly secured.
The best result is a warning letter. A warning letter means a penalty of 0% will be imposed. Sometimes, non-willful penalties will be assessed. It depends on the facts of your case and how those facts are presented to your OVDP Examiner. If you agree with the FBAR assessment or non-assessment in the tax charges you would sign a consent form and your case would be closed.
If you disagree with the proposed FBAR assessment, you have the right to administrative appeal. One important consideration on wondering if an opt-out would benefit you is this: If the IRS wishes to collect on an FBAR penalty, because it is a Title 31 assessment, it is actually quite difficult for the IRS to get that money. They just can't send you a bill and love you if you don't pay, like they can do with a Title 26 tax assessment.
Rather, the government must file suit in federal district court to convert their assessment into a civil judgment. This is a very expensive and time-consuming procedure for the IRS to do. And, because they must convince a jury that it is fair to assess the FBAR penalty — all when typical jury members will have no idea what an FBAR form is!
This is a practical limitation that reduces the chances for a disproportionate FBAR penalty. Remember, the IRS has no criminal charges to leverage against you — they can't compel you to agree to an FBAR penalty in order to reduce a jail sentence as you have no threat of jail time. Rather, in litigation, the government has to go up against the taxpayer who is well supported, and can't afford a proper litigation defeat. They have better things to do with their time (like go after the 10,000 taxpayers they know made a "soft-disclosure").
Is the OVDP process worth it?
As you can see, the OVDP process is quite extensive and can be even more involved if an opt-out is executed. After the conclusion of this OVDP process, we've asked our clients whether or not it was worth it. And they all say that despite the expense and the attention that was required, it was worth it. Their offshore problems are well behind them, and now they have the rest of their life to focus on.
