Overview
On January 26, 2022, the IRS issued an internal guide paper for its recently updated Voluntary Disclosure Practice (VDP).1The VDP provides taxpayers with criminal exposure for tax crimes as a means to come into compliance with the law and potentially avoid criminal prosecution.2The IRS released the guide paper in response to a Freedom of Information Act request.3It reveals new information on the IRS's approach to the program, and clarifies information already available in the Internal Revenue Manual and Form 14457, Voluntary Disclosure Practice Preclearance Request and Application. This article summarizes the important takeaways from the guide paper.
Background
The voluntary disclosure regime is a long-standing practice of the IRS.4 Currently, the Internal Revenue Manual provides general voluntary disclosure provisions under the section titled Criminal Investigations—Other Investigations.5 The IRM provides that "a voluntary disclosure will be considered along with all other factors in the investigation in determining whether criminal prosecution will be recommended."6
In addition to this general voluntary disclosure regime, the IRS also periodically offers targeted initiatives. The longest-running of these was the Offshore Voluntary Disclosure Program (OVDP), which was established for taxpayers with exposure to potential criminal liability and/or substantial civil penalties due to a failure to report and pay tax on foreign financial assets. In September 2018, the IRS closed the OVDP following a decline in popularity, with only 600 submissions in 2017 and fewer than 1,000 in 2018.7
Following the closure of the OVDP, the IRS announced the updated VDP in November 2018.8This triggered a number of questions among practitioners, many of which remained unanswered until April 2020, when the IRS released a "revised and retitled" Form 14457.9This was followed by updates to the Internal Revenue Manual in September 2020.10 Prior to the release of the guide paper, the only additional guidance that taxpayers had received was the newest version of Form 14457, released in February 2022.11 The VDP generally calls for a disclosure period of six years,12with one civil fraud penalty and willful FBAR13penalty.14
Guidance Regarding Interviews
The VDP requires taxpayers to make truthful, timely, and complete voluntary disclosures, in which they cooperate with the IRS, submit required returns for the relevant disclosure period, and make good faith arrangements to pay the tax, penalties, and interest determined to be due.15The instructions to Form 14457 state that full cooperation includes "submitting to interviews and providing access to related party witnesses."16 Many practitioners have been concerned with taxpayer interviews, but the guide paper indicates that interviews should only be expected if deemed necessary by the examiner.
The guide paper instructs examiners to "rely first on information document requests and cooperative discussions with the representative for needed documents and information."17While emphasizing that cooperation is the "bedrock" of the VDP, the guide paper notes that "taxpayer interviews, information document requests, and summonses may be used at the examiner’s discretion."18 If practitioners provide organized records and a good narrative, interviews may be unnecessary.19
Guidance Regarding Revocation of Acceptance
The primary appeal of the VDP is the ability for taxpayers to obtain certainty that they will not be criminally prosecuted if they voluntarily come forward to reveal tax crimes. The instructions to Form 14457 note that "in the event a taxpayer fails to fully cooperate with the civil examination, the examiner may request IRS Criminal Investigation revoke a taxpayer’s preliminary acceptance."20 Many practitioners have been concerned with disclosing their client's tax crimes without assurances from the IRS that their client’s preliminary acceptance in the program will not be revoked.21 The guide paper outlines the steps required for revoking preliminary acceptance and emphasizes that revocation should be rare.22
The guide paper states that "examiners should attempt multiple requests (at least 2-3) with a taxpayer before considering revocation."23 The process for revocation begins with the examiner sending an initial letter providing a warning about the lack of cooperation with the taxpayer.24 If the taxpayer continues to be uncooperative, the examiner will send a second letter informing the taxpayer that the examiner may request that IRS Criminal Investigation revoke preliminary acceptance.25 If the lack of cooperation continues, the examiner will send a memorandum to IRS Criminal Investigation providing facts documenting the lack of cooperation. IRS Criminal Investigation will review the request from the examiner.26 When IRS Criminal Investigation revokes preliminary acceptance, IRS Criminal Investigation will do so in writing to the taxpayer with notification to the examiner.27
The guide paper notes that IRS Criminal Investigation can revoke preliminary acceptance at the request of examiners in other "extraordinary circumstances"28But the guide paper illustrates that this caveat is aimed at egregious post-disclosure noncompliance and clear signs of false material statements, not minor missteps in the VDP process.29 It provides an example where a taxpayer admitted underreported skimmed cash receipts of $1 million per year on Form 14457 but failed to report $500,000 per year of unreported income from virtual currency transactions.30 The examiner is instructed in such a scenario to write "a memo to IRS Criminal Investigation to revoke preliminary acceptance based on a materially false VDP submission."31Ensuring that revocation is rare and only brought up in appropriate circumstances was one overarching goal of the guide paper.32The IRS wanted to ensure that examiners did not use revocation as a leverage to scare representatives.33
Guidance Regarding Offshore Tax Issues
The instructions to Form 14457 and the Internal Revenue Manual provide very limited guidance on offshore tax issues. This creates uncertainty for taxpayers and disincentivizes them from participating in the VDP. The guide paper, however, has provided much-needed information on international information return penalties, FBAR penalties, and transition tax.
International Information Return Penalties
The VDP provides examiners with significant discretion regarding the assertion of civil penalties. The instructions for Form 14457 state that "a civil fraud penalty or a fraudulent failure to file penalty . . . will apply to at least one year of all voluntary disclosures" and "willful FBAR penalties will apply to all cases involving FBAR noncompliance where facts and law support the assertion of a willful FBAR penalty."34 But on top of that single-year penalty framework, the instructions state that the examiner has the discretion to consider the application of penalties for information returns.35 Many practitioners have been concerned with the IRS stacking these penalties on top, but the guide paper indicates that these penalties will generally not be assessed if a taxpayer cooperates and agrees to the single-year penalty framework.
According to the guide paper, the IRS only anticipates the application of international information return penalties "in rare situations to provide penalty consistency among similarly situated taxpayers holding foreign assets."36 This might occur "in some unusual cases where taxpayers hold foreign assets not reportable on FBARs."37The example gives some certainty to taxpayers regarding when the IRS might deem it appropriate to assert (and not assert) international information return penalties.
FBAR Penalties
The instructions to Form 14457 state that "willful FBAR penalties will be computed in accordance with existing IRS penalty guidelines under IRM 4.26.16 and 4.26.17."38But given ambiguities with the regular FBAR examinations procedures, many practitioners have been concerned that willful FBAR penalties could apply to more than one year of the disclosure period. The guide paper clarifies that the willful FBAR penalty should generally be asserted for only one year. The guide paper states: "in general, the willful FBAR penalty will be 50% for the year of the disclosure period with the highest aggregate account balance."39 Elaborating, the guide paper notes that "the civil fraud or fraudulent failure to file penalty does not need to be applied to the same year as the willful FBAR penalty."40 This creates a default single-year penalty framework for both the civil fraud penalty and the willful FBAR penalty.
FBAR Penalty Relief
In determining whether an FBAR violation was willful or non-willful, examiners have discretion under the regular FBAR examinations procedures to consider mitigation guidelines contained in the Internal Revenue Manual.41This leaves open the possibility that taxpayers could meet the requirements of the mitigation threshold conditions under the VDP and potentially avoid FBAR penalties through the FBAR reasonable cause exception. The guide paper states that under the VDP, "willful FBAR penalties will presumptively apply to all cases involving FBAR noncompliance.”42The reason provided is “that for most cases FBAR penalty 'mitigation threshold conditions' . . . will not be met since the terms of the Voluntary Disclosure Practice require the assessment of a civil fraud penalty."43
It is unclear from the guide paper if and when the IRS would consider a request for FBAR penalty relief. The guide paper states that “if the taxpayer does not want to accept the default terms of the Voluntary Disclosure Practice (fraud penalty for one year and willful FBAR penalty), then examiners must probe any reasonable cause arguments that the taxpayer might raise against the assertion of penalties.”44The purpose of this probe is not to consider the validity of the taxpayer’s reasonable cause defense, but rather to “help solidify and support the assertion of fraud and willful FBAR penalties and international information return penalties if the taxpayer becomes uncooperative.”45 At the very least, the assertion of a reasonable cause defense is likely to result in an expansion of the examination. Examiners are instructed, “to question the taxpayer specifically as to possible reliance on tax experts in deciding whether or not to report the income which may have been diverted to these offshore bank accounts and the income earned on these accounts.”46Interviews of both the taxpayer and "the experts the taxpayer claims to have relied upon” are likely.47
However, the guide paper suggests that a reasonable cause defense may be justified in certain circumstances. If the taxpayer claims to have relied on the advice of professionals, examiners are instructed to "determine who provided the advice and whether the taxpayer provided the advisor with all the information necessary to make a proper judgment."48 Allowing taxpayers to deviate from the default willful FBAR penalty in certain circumstances would be consistent with the approach taken in the VDP with respect to the civil fraud penalty. The guide paper states that taxpayers may request "the imposition of accuracy-related penalties under I.R.C. § 6662 instead of the civil fraud penalty."49To qualify for this relief, the taxpayer must present "clear and convincing evidence to the satisfaction of the Service to overcome the presumptive application of the civil fraud penalty."50 The guide paper emphasizes, however, that any "any deviations to the penalty structure must be elevated to the designated domestic or offshore analyst” for coordination and VDP counsel review, with counsel approval required at closure.51 Additional guidance would be helpful regarding if and when the IRS would consider a request for FBAR penalty relief.
Transition Tax
A major benefit of the VDP is the ability to limit the relevant lookback period to the taxpayer’s applicable disclosure period (normally six years). For taxpayers that own controlled foreign corporations (CFCs) or otherwise have Subpart F income, part of coming into compliance includes reporting applicable Subpart F income. But many practitioners wondered if the VDP constructively provides taxpayers with Previously Taxed Income (PTI) for pre-disclosure years.
The guide paper states that "absent the Subpart F income actually being reported by the taxpayer, VDP does not constructively provide the taxpayer with PTI for pre-disclosure years."52 This is particularly important for purposes of section 965 "transition tax". Section 965(a) defines deferred foreign income as the greater of the accumulated post-1986 deferred foreign income of such corporation determined as of November 2, 2017, or December 31, 2017. Section 965(d) further clarifies that in the case of a CFC, deferred foreign income does not include PTI. In other words, taxpayers are not able to avoid paying transition tax on the pre-disclosure period earnings and profits of CFCs in which they are US shareholders.
Conclusion
Identifying the best option for rectifying a taxpayer's noncompliance can be a difficult task. Taxpayers usually want certainty, e.g., certainty as to non-prosecution with respect to criminal violations of the tax laws, the applicable penalty structure (civil and criminal), and the relevant lookback period. While the IRS has worked diligently to issue guidance to practitioners, the guide paper provides invaluable insights into the IRS's approach to the VDP process. In addition to benefiting taxpayers by giving them greater certainty, the release of the guide paper should benefit the IRS by avoiding some inevitable disputes over the general voluntary disclosure regime.
Endnotes
1 Internal Revenue Service, Voluntary Disclosure Practice Examiner Guide Paper (Jan. 6, 2022).
2Internal Revenue Manual ("I.R.M.") § 9.5.11.9(1) (09-17-2020).
3 Andrew Velarde, IRS Voluntary Disclosure Guide Reveals New Details of Practice, Tax Notes, Jul. 14, 2015.
4 I.R.M. § 9.5.11.9(1) (09-17-2020).
5 I.R.M. § 9.5.11.9 (09-17-2020).
6I.R.M. § 9.5.11.9(3) (09-17-2020).
7 Andrew Velarde, IRS Highlights Trending Problems With Streamlined Filing, Tax Notes, Nov. 9, 2018.
8Internal Revenue Service, Memorandum on Updated Voluntary Disclosure Practice (Nov. 20, 2018).
9Form 14457 (Rev. 4-2020).
10See I.R.M. § 9.5.11.9 (09-17-2020).
11 Form 14457 (Rev. 2-2022).
12 Id. at 4.
13 A foreign bank account report is colloquially referred to as an FBAR. The formal title of an FBAR is FinCEN Form 114.
14 Instructions for Form 14457 (Rev. 2-2022), at 9-10.
15 I.R.M. § 9.5.11.9(6) (09-17-2020); Instructions for Form 14457 (Rev. 2-2022), at 7.
16 Instructions for Form 14457 (Rev. 2-2022), at 10.
17 Internal Revenue Service, Voluntary Disclosure Practice Examiner Guide Paper (Jan. 6, 2022), at 16.
18 Id.
19Andrew Velarde, IRS Voluntary Disclosure Guide Reveals New Details of Practice, Tax Notes, Jul. 14, 2015 ("if practitioners provide organized records and a good narrative, an interview may be unnecessary".).
20Instructions for Form 14457 (Rev. 2-2022), at 12.
21Obtaining preliminary acceptance is a two-step process. First, taxpayers must complete and send only Part I of Form 14457, which is called the "Preclearance Request." If everything is acceptable, IRS Criminal Investigation will notify the taxpayer of their preclearance. The IRS expects this initial review to take at least 30 days and perhaps more than 60 days. Second, taxpayers must complete and send Part II of Form 14457, which is called the "Voluntary Disclosure," within 45 days of receiving preclearance. If everything is acceptable, IRS Criminal Investigation will grant preliminary acceptance and route the case to the appropriate examination division.
22Internal Revenue Service, Voluntary Disclosure Practice Examiner Guide Paper (Jan. 6, 2022), at 28.
23Id.
24 Id. at 27.
25 Id.
26 Id.
27Id.
28 Id. at 30.
29Id.
30 Id.
31Id.
32Andrew Velarde, IRS Voluntary Disclosure Guide Reveals New Details of Practice, Tax Notes, Jul. 14, 2015 (“‘Ensuring that revocation was rare and only brought up in appropriate circumstances is one overarching goal of this guide,' Price said. 'In the review process, discussing with an analyst and discussing with counsel even when the concept came into an examiner's mind was critical to ensure that revocation wasn’t inappropriately even broached with a representative. Revocation cannot be a leverage or a tool to simply scare a representative.'").
33 Id.
34Instructions for Form 14457 (Rev. 2-2022), at 9-10.
35 Id. at 10.
36Internal Revenue Service, Voluntary Disclosure Practice Examiner Guide Paper (Jan. 6, 2022), at 43.
37Id.
38 Instructions for Form 14457 (Rev. 2-2022), at 10.
39 INTERNAL REVENUE SERVICE, VOLUNTARY DISCLOSURE PRACTICE EXAMINER GUIDE PAPER (Jan. 6, 2022), at 36.
40 Id. at 37.
41See I.R.M. Exhibit 4.26.16-2.
42INTERNAL REVENUE SERVICE, VOLUNTARY DISCLOSURE PRACTICE EXAMINER GUIDE PAPER (Jan. 6, 2022), at 19.
43 Id. at 37
44Id. at 35.
45 Id.
46 Id.
47 Id.
48Id.
49INTERNAL REVENUE SERVICE, VOLUNTARY DISCLOSURE PRACTICE EXAMINER GUIDE PAPER (Jan. 6, 2022), at 19.
50Id.
51Id. at 20.
52 Id. at 36.
