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Don’t sign that closing agreement yet! IRS taxpayer advocate says some offshore account FBAR penalties are too high

A recently-disclosed exchange of correspondence between the top management of IRS and the head of the Taxpayer Advocate Service (TAS) has raised the hopes of many taxpayers that there may be some relief for the high cost of participating in the offshore account voluntary compliance initiatives.

Behind-the-scenes IRS battle over excessive FBAR penalties

On August 16, 2011, the National Taxpayer Advocate, Nina E. Olson, issued Taxpayer Advocate Directive 2011-1 (TAD), attempting to force the IRS to change its procedures for closing agreements under the 2009 and 2011 offshore account voluntary disclosure programs. The TAD accuses the IRS of a bait-and-switch.

The bait:

The IRS promised taxpayers (in FAQ #35) that the 20% or 25% compliance penalty under the voluntary disclosure program will not be applied if the taxpayer would have been entitled to pay lower penalties under existing law.

The switch:

IRS agents don’t fully apply existing law. They are required to assume that all program participants would have been subject to the WILLFUL failure-to-file-FBAR penalty under existing law. By refusing to consider the NON-WILLFUL penalty structure, or to consider whether a taxpayer might have mitigating circumstances which deserve leniency under existing law, it would be impossible to qualify for less than the 20% or 25% penalty rate.

The TAD is quite an unusual action, but it’s just the start of the story. The TAD required the IRS to take action within 15 days. The IRS avoided this deadline by filing an appeal to the TAD on August 30. The IRS claimed taxpayers can still qualify for the lower penalties by “opting-out” of the voluntary disclosure programs and going through full audits.

On September 22, the TAS replied with its disagreement, noting that taxpayers who opt-out are risking “massive civil and criminal penalties, even in the most sympathetic cases.” The

TAS rebuttal accuses the IRS of assuming “all participants are tax evaders hiding money overseas, when in fact, the IRS steered many people into the program who made honest mistakes.”

This unusually heated exchange prompted the IRS Deputy Commissioner for Enforcement to use his authority on October 14 to rescind those portions of the TAD that would have required IRS agents to change their procedures. The National Taxpayer Advocate responded on October 26, demanding that the Commissioner issue a “formal response” to the TAD by January 26, 2012. Tax practitioners and affected taxpayers are now awaiting that formal response. If the Commissioner continues to pursue the agency’s present course, the National Taxpayer Advocate can escalate the dispute to the Congressional IRS Oversight Committee.

This is more than merely an extraordinary glimpse into an intramural dispute between the IRS Commissioner and the National Taxpayer Advocate. It may actually require the IRS to refund some of the $4.0 billion it has collected to date from the 33,000 taxpayers who participated in the 2009 and 2011 voluntary disclosure programs. It may also slow down the processing of applications under the just-announced 2012 voluntary disclosure program, since those specially-trained revenue agents will get back many of their closed cases for reconsideration of the lower penalties.

Who might pay less?

Existing law provides two distinct FBAR civil penalty regimes—one for willful failure to file and another for non-willful failures. To complicate matters, failures occurring before October 23, 2004, are subject to one set of rules, and failures occurring later have different rules. Willful violations that occurred before October, 2004, can be subject to a penalty of 100% of the account balance, up to a maximum of $100,000 per violation. The 2004 changes increased the potential civil penalty to the greater of $100,000, or 50% of the account balance per violation.

Under the programs’ directives, IRS agents must use the maximum willful-FBAR penalties in the comparison-test against the 20% or the 25% compliance penalty. No surprise—the 20% or 25% always comes out to a lower amount. That’s what participants have been required to pay to get a closing agreement.

By contrast, the non-willful FBAR penalties may not exceed $10,000 per violation. Further, the Internal Revenue Manual includes detailed guidelines for revenue agents permitting them to reduce the penalties in appropriate cases, and even to issue an “FBAR warning letter” in lieu of any monetary penalties.

What should I do now?

If you have made a voluntary disclosure under either the 2009 or the 2011 program and signed off on your closing agreement, you should review whether you may have been eligible for lower FBAR penalties under existing law. If so, you should consider filing a refund claim. Assuming the IRS either denies the claim or fails to respond, you will be entitled to seek the refund through litigation.

(Note that merely being eligible for the lower FBAR penalty does not assure that you would have qualified for it. Check the penalty rules in Section 4.26.16 of the Internal Revenue Manual, available on this website.)

If you have made a voluntary disclosure under either the 2009 or 2011 program but you have not yet signed off on your closing agreement, don’t sign until you consider the lower FBAR penalties.

If you’ve been thinking about making a voluntary disclosure but have not yet done so, a new 2012 program has just been announced with no deadline for filing. You can start working on the disclosure now, with the assurance that someone ahead of you in line will resolve this FBAR penalty issue before your case is actually reviewed by an IRS agent.