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Can an OVDP Participant Set Aside a Closing Agreement on the Theory of Duress?

by Stephen M. Moskowitz, Esq. and Anthony V. Diosdi, Esq. 14. July 2014 14:23

I. Introduction and History of the Targeted Offshore Voluntary Disclosure Programs Offered by The IRS

It has been just over five years since the Internal Revenue Service (“IRS”) offered the first of three offshore voluntary disclosure programs for individuals with undisclosed foreign financial accounts. Since the announcement of the first offshore voluntary disclosure program, the IRS has threatened severe criminal and civil penalties against U.S. taxpayers with undisclosed foreign financial accounts.   The IRS threats have not been limited to individuals who utilized offshore accounts to evade the payment of U.S. taxes. Instead, threats have been targeted to just about anyone with a foreign financial account that has not been properly disclosed. These threats have resulted in near hysteria for U.S. taxpayers with foreign financial accounts that have not been timely disclosed formerly on a Foreign Bank Account Report, Form TD F 90-22.1 (“FBAR”) (now FinCEN Form 114)  resulting in a rush to enter into one of the IRS targeted offshore disclosure programs. 

In March 2009, the IRS announced the 2009 Offshore Voluntary Disclosure Program (“OVDP”). Under the initiative, participating taxpayers were required to pay taxes on interest earned from undisclosed foreign financial accounts for the previous six years. Participating taxpayers were also required to pay an accuracy-related penalty on tax liabilities on each of those six years. Finally, participants of the 2009 OVDP were assessed a 20 percent penalty on the aggregate highest balance in their offshore accounts during the 2003 through 2008 time period. This 20-percent penalty was referred to as a miscellaneous penalty under Title 26 of the United States Code.   The 2009 OVDP program was timed to profit from the publicity about IRS’ crackdown of Swiss bank accounts, particularly those held at Union Bank of Switzerland (“UBS”). 

On February 8, 2011, the IRS announced the 2011 Offshore Voluntary Disclosure Initiative (“OVDI”). Under the 2011 OVDI, individuals were assessed a 25 percent penalty on the highest aggregate account balance or asset value for the tax years 2003 through 2010.   For those participants that had offshore accounts totaling less than $75,000, the penalty was reduced to 12.5 percent. Participants could qualify for a 5 percent penalty if: a) the taxpayer did not open or cause the account to be opened unless the bank required that a new account be opened rather than making an ownership change in the existing account upon the death of the owner of the account; b) the taxpayer exercises “minimal, infrequent contact with the account,” e.g., to request an account balance or update account holder information such as a change in address; c) the taxpayer has not withdrawn more than $1,000 from the account in any year covered by the voluntary disclosure, with the exception of a withdrawal closing the account and transferring the funds to an account in the U.S.; and d) the taxpayer can establish that all applicable U.S. taxes have been paid on funds deposited in the account. In 2012, the IRS announced the 2012 OVDP.  The 2012 OVDP program is identical to the 2011 OVDI, except that the highest penalty rate was increased from 25 percent to 27.5 percent and the years covered under the program changed. 

Since the 2009 OVDI was announced over 33,000 taxpayers have participated in one the of three voluntary disclosure programs. At last count, the IRS has collected over $5 billion dollars in tax, interest, and penalties.   From the IRS’ point of view, the targeted offshore voluntary disclosure programs have been a huge success. With that said, many have been critical of the offshore disclosure programs as being overly harsh and inflexible to participants who did not understand that they had a legal duty to disclose foreign financial accounts on an FBAR and other little known reporting requirements of still other forms. 

Over the last several years taxpayers have become far more knowledgeable in the area of international tax disclosures. Now, the term FBAR has become a household name. Not only have taxpayers become more sophisticated in understanding that a foreign financial account needs to be disclosed on an FBAR, taxpayers with previously foreign undisclosed financial assets realize that participation in a targeted offshore voluntary disclosure program is not for everyone. Furthermore, anecdotal evidence suggests that at least some taxpayers are considering other ways short of participation in the 2012 OVDP as the solution to the prior foreign income reporting problem.   In most cases, this means making a so-called “quiet disclosure” to the IRS.

In certain cases, such a strategy may permit a taxpayer to avoid any penalties associated with not timely disclosing a foreign financial account on an FBAR.

However, the questions is where does that leave the taxpayer that innocently omitted foreign financial accounts from an FBAR and paid the associated offshore penalty through a voluntary disclosure program? Many of these individuals entered into an offshore voluntary disclosure program without a full understanding of the law or as a result of poor advice. Do these individuals have recourse to obtain a refund of the offshore penalty paid to the IRS?      

This article explores if there are any circumstances in which an individual who paid an offshore penalty may file an administrative claim for refund of that penalty. This article also discusses if a claim for refund may be ultimately civilly litigated in a federal court. 

II. The IRS’ Position Regarding Disclosures Made Outside A Targeted Voluntary Disclosure Program

Since 2009 calendar year, the IRS’ position has been that all taxpayers who are not compliant with FBAR filing requirements and failed to disclose foreign source income, no matter how small, must participate in an offshore voluntary disclosure program.   This has been reflected in the IRS’ frequently asked questions section for each of the targeted offshore voluntary disclosure program.   For example, in the IRS 2011 Frequently Asked Questions promulgated by the IRS, the IRS states that “quiet” filings do not constitute valid disclosures and could subject the taxpayer to not only a civil challenge, but also criminal treatment.   The IRS’ position was echoed at the American Bar Association Section of Taxation meeting in Washington, D.C. on May 8, 2010 where IRS officials Ronald Schultz and Rick Raven explained that taxpayers were either “in or out” of the offshore targeted voluntary disclosure program and that “quiet disclosures” are not in the program. Ronald Schultz further explained that the IRS will not allow taxpayers to become compliant through the “back door” via an amended return. Ronald Schultz and Rick Raven went on to explain that taxpayers will find that quiet disclosures may result in the worst possible outcome, because noncompliant taxpayers will have flagged their unreported foreign income for the IRS to review without any protection from criminal charges.

Given the threats discussed above, the IRS’ position regarding individuals who are not compliant with a FBAR filing requirement should not surprise anyone; If you are a taxpayer with a previously undisclosed foreign financial account, enroll in a targeted offshore voluntary disclosure program or face severe consequences such as a lengthy prison sentence. However, is making a disclosure outside an offshore voluntary disclosure program a grave mistake for a taxpayer who innocently or mistakenly failed to disclose a foreign bank account?  Obviously an individual who sent untaxed U.S. business receipts to an offshore account in Switzerland held in the name of a Panamanian corporation would not be well served by making a “quiet disclosure.” But can an individual who innocently or mistakenly failed to disclose a foreign financial account on an FBAR safely make a disclosure to the IRS outside of a targeted voluntary disclosure program? Whether or not an individual can safely make a disclosure outside a targeted offshore voluntary disclosure program is heavily dependent on the facts of each individual case.

 

For example, suppose a foreign-born elderly man accidently failed to disclose a foreign account valued at $100,000 on his U.S. tax returns that was established in his home country. Assume that this same elderly taxpayer relied on a certified public accountant to prepare his tax returns. Let us also assume that despite the fact that the elderly taxpayer advised his tax return preparer of his interest in the foreign financial account, the tax return preparer failed to advise this individual of his legal obligation to disclose the foreign account on his U.S. tax returns and on an FBAR. If this taxpayer entered into the 2012 OVDP, he would be liable for a 27.5 percent miscellaneous or offshore penalty. In this example, the penalty would be $27,500 (27.5 % x $100,000 = $27,500). If this taxpayer were to make a so-called “quiet disclosure” to the IRS by amending his tax returns and late filing his FBARs, is this particular individual really exposed to any criminal or civil penalties? By making a “quiet disclosure” the elderly man in our example would amend all returns open for assessments as the result of the statute of limitations, pay all applicable taxes on foreign source income, and pay all applicable interest on previously undisclosed foreign source income. However, since this individual is not participating in the 2012 OVDP, he will not agree to the unforgiving penalty structure of the program.

Since the elderly man in our example has elected not to participate in the 2012 OVDP, once the IRS receives his amended returns and late filed FBARs, the IRS will likely audit this taxpayer’s amended returns and late filed FBAR informational returns. During such an audit, the most important risk that any taxpayer faces outside an OVDP is the risk of criminal prosecution for a willful failure to file an FBAR. Under 31 USC Section 5322(a), a person who is convicted of willfully failing to file an FBAR potentially faces up to five years in prison. Willfulness in the criminal context has been defined by federal courts as the “voluntary, intentional violation of a known legal duty.”   Given that the taxpayer in our example knew nothing about a legal duty to disclose foreign financial accounts on an FBAR and retained the services of a certified public accountant to prepare his tax returns, it is extremely unlikely that the IRS can make good on its threat to prosecute this individual. 

The IRS has threatened to civilly challenge any disclosure outside of an offshore voluntary disclosure program. The most severe penalty the IRS may assess against our hypothetical taxpayer is a willful failure to file an FBAR under 31 United State Code Section 5314. In the case of willful penalty, the IRS can impose a $100,000 or 50 percent of the amount of the financial “transaction,” whichever is greater.    To impose a willful penalty under 31 United States Code Section 5314, the IRS must demonstrate the taxpayer knew that he had a duty to disclose his foreign account on an FBAR, yet intentionally ignored the duty. This standard was defined in Cheek v. United States, 498 U.S. 192, 201 (1991). In Cheek, the U.S. Supreme Court stated that the government must overcome a significant legal hurdle to prove willfulness:

Willfulness … requires the Government to prove that the law imposed a duty on the defendant, that the defendant knew this duty, and that he voluntarily and intentionally violated that duty… “[c]arrying this burden requires negating a defendant’s claim of ignorance of the law or a claim that because of the misunderstanding of the law, he had a good-faith belief that he was not violating any provisions of the tax laws.”  

In our example, the taxpayer’s failure to disclose his foreign financial account was not an act undertaken intentionally or in deliberate disregard for the law. Instead the failure to disclose the account constituted an understandable omission. Thus, the IRS cannot successfully assert the willful civil penalty under Section 5314 against the taxpayer in our example.

Finally, the IRS could attempt to assess against the elderly taxpayer a non-willful penalty under 31 United States Code Section 5321. In cases of non-willful FBAR violations, the IRS may assess a penalty up to $10,000 per violation. Under Section 5321, a penalty of up to $10,000 per violation may be assessed against the elderly taxpayer in our example even if he did not act willfully. With that said, under Section 5321, no non-willful penalty shall be imposed if the violation was due to “reasonable cause.”   At initial glance, the defense to the non-willful penalty seems relatively straightforward; all a taxpayer has to demonstrate is that there was a “reasonable cause” for not filing an FBAR informational return to satisfy the test promulgated under Section 5321. Although the term “reasonable cause” is not addressed in Section 5321, or any regulations, the concept of “reasonable cause” is referred to in the Internal Revenue Manual. 

The Internal Revenue Manual contains the following statements to this effect, including the following:

1)The [non-willful] penalty should not be imposed if the violation was due to reasonable cause.  

2)If the failure to file the FBAR is due to reasonable cause, and not due to the negligence of the person who had the obligation to file, [a penalty should not be assessed].  

3)Reasonable Cause and Good Faith Exception to Internal Revenue Code Section 6662 may serve as useful guidance in determining the factors to consider [in assessing FBAR penalties].  

4)Although tax regulation[s] for Section 6662 does not apply to FBARs, the information it contains may still be helpful in determining whether the FBAR violation was due to reasonable cause.  

The Internal Revenue Manual indicates that an examiner could consider defenses to the Section 6662 penalty in determining whether a taxpayer should be liable for the non-willful penalty. Internal Revenue Code Section 6662 imposes a 20 percent accuracy related penalty to an underpayment of tax due to negligence. Internal Revenue Code Section 6664(c) states that no penalty shall be imposed if it is shown that there was a reasonable cause for such understatement. Therefore, if a taxpayer can show reasonable cause, the Section 6662 penalty will not be imposed. The reasonable cause exception in a Section 6662 penalty has been generally interpreted to mean the exercise of ordinary business care and prudence.   Where an individual exercises ordinary business care and prudence, the individual will not be liable for the Section 6662 penalty where the understatement results from a mistake of law or fact in good faith and on reasonable grounds.  In our example, the taxpayer exercised ordinary business care and prudence by retaining the services of a certified public accountant to prepare his tax returns. As a result of the tax return preparer’s neglect, the taxpayer omitted his foreign financial account from an FBAR.

Since the taxpayer in our example exercised ordinary business care and prudence by retaining the services of a certified public accountant and by disclosing his foreign financial account to his tax return preparer, under the facts of our example, this taxpayer should survive an IRS audit without the assessment of the non-willful penalty or for that matter the assessment of any offshore penalties. Despite the IRS’ dire warnings, the taxpayer in our example is far better off making a disclosure outside the 2012 OVDP instead of agreeing to a penalty structure under that program. 

There are many other examples in which it may be advantageous for noncompliant taxpayers to make a disclosure to the IRS outside a targeted offshore voluntary disclosure program. Take for example a taxpayer that failed to disclose a foreign financial account on an FBAR because of poor English skills or a taxpayer who was too ill to timely file FBAR information returns disclosing an interest in a foreign financial account. In these cases, instead of entering into an offshore voluntary disclosure program, these taxpayers may (by filing amended tax returns and late filing FBARs) potentially make a qualifying voluntary disclosure with the IRS outside the targeted offshore voluntary disclosure program. Certainly, taxpayers that innocently or mistakenly failed to timely disclose a foreign financial account could enter into a targeted offshore voluntary disclosure program to buy “peace” and avoid the hassle of a tax audit. But, taxpayers who innocently or mistakenly failed to disclose a foreign financial account should not feel compelled to enter into an offshore voluntary disclosure program out of an irrational fear of criminal prosecution or the assessment of massive civil penalties.

But where does this leave the taxpayer that innocently or mistakenly failed to disclose a foreign financial account and paid a penalty associated with an offshore voluntary disclosure program? Unfortunately, currently, the IRS does not offer any administrative remedies to seek a return of all or part of the offshore penalty paid through an offshore voluntary disclosure program if a taxpayer mistakenly entered into the program. The only potential relief is to file a civil action to recover the offshore penalty through an appropriate federal court. However, as will be discussed later in this article, the possibility of tax litigation is severely limited by the closing agreement executed by each participant of an offshore voluntary disclosure program.

III. Proceeding with a Claim for Refund of a Penalty Paid Through an Offshore Voluntary Disclosure program 

A. Introduction 

So exactly how does an individual who mistakenly paid an offshore penalty proceed with filing a civil action in federal court to obtain a refund of the penalty? With a few important distinctions, an individual seeking a refund of an offshore penalty would proceed much the same as if that taxpayer was seeking a refund of an overpayment of a federal tax liability. Like a taxpayer seeking a claim for refund of an income tax liability, a taxpayer seeking a refund of an offshore penalty must first file an administrative claim for refund with the IRS. The Internal Revenue Code discusses the procedure regarding filing an administrative claim for refund. Internal Revenue Code Section 7422(a) explains that such a claim must be filed before bringing a lawsuit:

No suit or proceeding shall be maintained in any court for the recovery of any internal revenue tax alleged to have been erroneously or illegally assessed or collected, or of any penalty claimed to have been collected without authority, or of any sum alleged to have been excessive or in any manner wrongfully collected, until a claim for refund or credit has been duly filed with the Secretary, according to the provisions of law in that regard, and the regulations of the Secretary established in pursuance thereof.

A claim for refund is governed by Internal Revenue Code Section 6401. Internal Revenue Code Section 6401(a) provides that the IRS may issue a refund for any overpayment of a tax.   Internal Revenue Code Section 6401(a) defines an overpayment of tax as a payment of any internal revenue tax that is assessed or collected. At first glance, Section 6401 seems to foreclose a refund of the offshore penalty. This is because the offshore penalty is just that- a penalty and not a tax. Even though Section 6401 only authorizes a refund of a tax, the United States Supreme Court has broadened the term “overpayment of tax” for purposes of Section 6401.

The United States Supreme Court has further clarified the term “overpayment of tax” by stating:

[W]e read the word “overpayment” in its usual sense, as meaning any payment in excess of that which is properly due. Such an excess payment may be traced to an error in mathematics or in judgment or in interpretation of facts or law. And the error may be committed by the taxpayer or by the revenue agents. Whatever the reason, the payment of more than is rightfully due is what characterizes an overpayment.  

The broad definition assigned to the term “overpayment of tax” by the United States Supreme Court includes any penalties resulting from an assessment of a tax. In case of the offshore penalty, the penalty is assessed under Title 26 of the United States Code, the body of law that codifies all federal tax laws in the United States.   Since the offshore penalty is an assessment under Title 26 of the United States Code, a penalty derived from Title 26 can easily be classified as income tax penalty. This means that the IRS has the legal authority to process a claim for refund of the offshore penalty.

Procedurally, the administrative claim for refund of an offshore penalty must set forth in detail each ground upon which the refund is claimed and facts sufficient to apprise the Commissioner of the exact basis thereof.   Satisfying this requirement may be somewhat novel in these cases. This is because the offshore penalty is basically a creation of the IRS rather than Congress. Consequently, there are no statutory elements to the offshore penalty. Even though there is no statutory guidance defining an offshore penalty, there is some common sense guidance that may be utilized in filing an administrative claim for refund of an offshore penalty. First a taxpayer seeking a refund of an offshore penalty must advise the IRS as to why he erroneously entered into the offshore voluntary disclosure program. Second, the taxpayer must put the IRS on notice as to why he should not be subject to the offshore penalty. The Offshore Voluntary Disclosure Frequently Asked Questions and Answers promulgated by the IRS sheds some light on how to proceed with a refund claim. In particular, Frequently Asked Questions and Answers Numbers 5 through 7 states that the miscellaneous offshore penalty is designed in lieu of any other penalties for failing to timely file Form TD F 90-22.1, Form 8938, Form 3520, Form 3520-A, Form 5471, Form 5472, Form 926, and Form 8865. In addition, Frequently Asked Question and Answer 7 provides that the miscellaneous penalty is designed to be in lieu of the civil fraud penalty. 

Since the offshore penalty was designed to replace penalties that may be assessed in lieu of failing to file a number of informational returns, civil fraud penalties, and late filing penalties, an administrative refund must address the penalties the offshore penalty was designed to replace in each particular case. For example, assume that the foreign-born elderly man discussed early in this article participated in the 2012 OVDP and paid the $27,500 offshore penalty. Let us assume that this taxpayer would like to proceed with filing an administrative claim for the refund of the offshore penalty. For purposes of this example, the only offshore informational filing omitted by the elderly man was FBAR returns. This means that in this case, the offshore penalty was designed to be in lieu of FBAR penalties and potentially civil fraud penalties.

In order to “set forth in detail each ground upon which [the] refund is claimed to apprise the Commissioner,” an administrative claim filed for our hypothetical taxpayer must set forth in detail the reasons as to why he is not subject to willful and non-willful FBAR penalties. The administrative claim should also address any potential civil fraud penalty. Finally, the administrative claim for refund must state in detail the reasons why the taxpayer believes he erroneously entered into the 2012 OVDP.

In order to meet these required elements, an administrative claim could be drafted as follows:

Title 31 of United States Code Section 5314(a) provides in relevant part that:

Each person subject to the jurisdiction of the United States (except a foreign subsidiary of a U.S. person) having a financial interest in, or signature or other authority over, a bank, securities or other financial account in a foreign country shall report such relationship to the [IRS] for each year in which such relationship exists, and shall provide such information as shall be specified in a reporting form prescription by the Secretary to be filed by such persons.

The Jobs Act of 2004 provides that the Secretary (and by extension the IRS pursuant to delegation of authority) “may” impose penalties on any person who violates United States Code Section 5314. 

During the 2003 through 2011 tax years the taxpayer had an interest in a financial account located in a foreign country. This financial account should have been disclosed on FBAR information returns for the 2003 through 2011 tax years. However, the taxpayer’s FBAR non-filing for the 2003 through 2011 tax year was inadvertent and caused by the unfamiliarity of both the taxpayer and his accountant with the existence of the FBAR form. Since the taxpayer and his accountant were unfamiliar with the FBAR forms, the taxpayer’s failure to file the FBAR forms for the 2003 through 2011 tax years was due to error rather than willfulness. Therefore, the taxpayer should not be assessed any willful FBAR penalties for the 2003 through 2011 tax years. 

Not only should the taxpayer not be assessed willful FBAR penalties for the 2003 through 2011 tax years, the taxpayer should not be assessed non-willful penalties for any of the tax years such a penalty could be assessed. 31 United States Code Section 5321(a)(5)(B)(ii) states in relevant part that the non-willful penalty should not be imposed if the violation was due to “reasonable cause.” The IRS’ own Internal Revenue Manual states that where an individual exercises ordinary business care and prudence, an individual will not be liable for the non-willful penalty. In the present case, the taxpayer exercised ordinary business care and prudence by retaining the services of a certified public accountant. The taxpayer also provided to his certified public accountant all of his documentation regarding the foreign account for the 2003 through 2011 tax years. The taxpayer believed that his interest in the foreign account was property disclosed for U.S. tax purposes. The only reason the taxpayer failed to timely disclose his interest in his foreign financial account was the result of an error of his accountant. Given the facts and circumstances of the present case, the taxpayer should not be liable for the non-willful penalty for any of the applicable tax years.

Any omitted tax liability from the foreign financial account was inadvertent and not the result of willful attempt to avoid paying taxes. Therefore, the taxpayer should not be liable for the civil fraud penalty for any of the years that he had an interest in the foreign financial account. 

According to Question Two of the Frequently Asked Questions & Answers promulgated by the IRS, “the objective of the OVDP is to bring taxpayers into [compliance] that have used undisclosed foreign accounts and undisclosed foreign entities to avoid or evade compliance with United States tax laws.” In the present case, the taxpayer did not purposely utilize undisclosed foreign accounts and undisclosed foreign entities to avoid or evade compliance with United States Tax laws. The taxpayer erroneously believed that the 2012 OVDP was his only option to become compliant with his filing requirements with the IRS. The taxpayer now realizes that he was not legally required to enter into the 2012 OVDP and that he mistakenly paid an Offshore Penalty through the voluntary disclosure program. The taxpayer respectfully requests a refund of the Offshore Penalty that he paid. 

The sample claim for refund discussed above should meet all the requirements stated in the Income Tax Regulations. The administrative claim for refund apprises the Commissioner of the Internal Revenue that the taxpayer in our example erroneously entered into the 2012 OVDP. Furthermore, the administrative claim for refund puts the Commissioner of the Internal Revenue on notice that the taxpayer is not liable for any penalties that the offshore penalty was designed to replace.  The example above provides guidance on how a claim for refund may be drafted for a taxpayer with a relatively simple set of facts. Obviously, the complexity of a claim for refund for an offshore penalty will increase as the facts of each case warrant.

B. Statutory Limitation on a Claim for Refund and Jurisdiction of a Federal Court to Hear the Controversy

Not only must a taxpayer correctly file a claim for refund. Any participant of a voluntary disclosure must keep in mind that there are strict statutory limitations regarding filing a claim for refund. In particular, Internal Revenue Code Section 6511 explains the period of limitation for filing a claim for refund:

(a) Claim for credit or refund of an overpayment of any tax imposed by this title in respect of which tax the taxpayer is required to file a return shall be filed by the taxpayer within 3 years from the time the return was filed or 2 years from the time the tax was paid, whichever of such periods expires the later, or if no return was filed by the taxpayer, within 2 years from the time the tax was paid…..

(b) (1) No credit or refund shall be allowed or made after the expiration of the period of limitation prescribed in section (a) for the filing of a credit or refund, unless a claim for credit or refund is filed by the taxpayer within such period.

Section 6511 imposes a strict two year limitation on a claim of the offshore penalty. This means that a claim for refund must be filed within two years of the date the penalty was satisfied.  Any individual seeking a refund of the offshore penalty must carefully keep the date the penalty was paid in mind. An administrative claim for refund must be filed with the service center serving the Internal Revenue district in which the penalty was paid.   Once the IRS receives the claim for refund, the IRS will likely review the claim and act on the claim. Should the IRS reject the administrative claim or fail to act on the administrative claim more than six months from the date of submission, the taxpayer may proceed with litigating the claim before either the Court of Federal Claims or a United States district court. We will discuss the importance of selecting the proper forum in more detail below.

VI. The Limitation a Closing Agreement Will Place on Tax Litigation

A. A Review of the Closing Agreement Utilized in an Offshore Voluntary Disclosure Program

Once a civil action is filed in a federal court, the first challenge a taxpayer will face is the daunting task of setting aside the closing agreement that he or she executed through an offshore voluntary disclosure program. All participants of an offshore voluntary disclosure initiative must execute a Form 906 entitled “Closing Agreement on Final Determination Covering Specific Matters.” 

Form 906 states in relevant part:

Under Section 7121 of the Internal Revenue Code, [the taxpayer] and the Commissioner of Internal Revenue make the following closing agreement.

The Taxpayer agrees to pay, and the Internal Revenue Service may assess under Title 26 of the United States Code a miscellaneous [offshore] penalty.

By signing this closing agreement, [the participant] consents to the assessment and collection of the liabilities for tax, interest, additions to tax, and penalties determined by or resulting from the determinations of this agreement, including any defense based on the expiration of the period of limitations on assessment or collection. 

By executing the Form 906, the taxpayer has entered in a closing agreement with the IRS. A closing agreement is a written agreement between an individual and the Commissioner of the IRS which settles or “closes” the liability of that individual with respect to any internal revenue tax for a taxable period.   The Internal Revenue Code provides that if a closing agreement is signed and accepted by the Commissioner or his delegate, the agreement is final and conclusive as to both the taxpayer and the IRS.   A closing agreement will not be final and conclusive if there is a showing of “fraud or malfeasance, or misrepresentation of a material fact.”   In order for a closing agreement to be set aside by reason of misrepresentation, there must be misrepresentation of a material fact that goes to the essence of agreement.   

Some participants may argue that IRS’ threats of criminal and civil penalties forced them to execute a closing agreement as a result of fraud, malfeasance, or misrepresentation. Such a position will not likely persuade a federal court. This is because federal courts uniformly have held that closing agreements are binding and conclusive upon parties even if the tax or penalties are later declared to be unconstitutional or in conflict with other internal revenue sections.   Furthermore, the Ninth Circuit Court of Appeals has even held that the IRS is “not under any sort of duty” to provide taxpayers with legal advice regarding the signing of a closing agreement.   Given the reluctance of federal courts to find fraud, malfeasance, or misrepresentation, even if the IRS may have potentially overstated the true risk of criminal or civil penalties to certain individuals that participated in an offshore voluntary disclosure programs, a closing agreement will not likely be set aside on these grounds.

B. Can A Closing Agreement Be Set Aside Under Ordinary Contractual Principles?

Even though it does not appear that a closing agreement can be set aside on its face under a theory of fraud, malfeasance, or misrepresentation, other contractual theories may be utilized to set aside an IRS closing agreement. For example, closing agreements are analyzed in a manner similar to other contracts.   Although closing agreements are governed by federal contract principles rather than state contract law, closing agreements under Internal Revenue Code Section 7121(a) “are contracts and generally are interpreted under ordinary contract principles.”   Under ordinary contract principles, a contract will be unenforceable if the contract was arrived at through duress.

Having found that an offshore voluntary disclosure program’s closing agreement will not likely be set aside on the grounds of fraud, malfeasance, or misrepresentation we arrive at the next question. Does the IRS’ threats of criminal prosecution and severe civil penalties against any individual with undisclosed foreign financial accounts amount to duress? If so, will a federal court set aside a closing agreement if it is determined that a participant of an offshore voluntary disclosure program executed a closing agreement under duress? Federal courts recognize the doctrine of duress. However, the Federal Court of Claims and the district courts have applied the doctrine of duress to contracts with the government differently. Therefore, the importance of selecting a proper court is extremely important in refund litigation of an offshore penalty. 

C. The Contractual Concept of Duress and the Court of Claims 

We will begin our analysis of the doctrine of duress in the context of the enforceability of a closing agreement in cases argued before the Federal Court of Claims. The United States Federal Court of Claims has stated that duress exists where 1) one side involuntarily accepted the terms of another; 2) that circumstances permitted no other alternative; and 3) that said circumstances were the result of coercive acts of the opposite party.   The court also determined an agreement is voidable on grounds of duress if a party’s manifestation of assent was induced by an improper threat which left the recipient with no reasonable alternative but to agree.   It is important to note that the Court of Claims tests duress by an objective, not subjective, standard.   

In applying the three part test, a number of taxpayers that participated in an offshore voluntary disclosure program can conceivably argue that IRS’ threatened severe criminal and civil penalties forced them to accept the terms of an offshore voluntary disclosure program. Given the IRS’ position regarding quiet disclosures, some participants may have believed that they had no viable alternatives outside the program and these taxpayers were forced into a choice between forfeiting to the IRS an OVDP miscellaneous civil penalty or risk paying enormous civil penalties along with possible criminal prosecution with lengthy periods of incarceration. 

In deciding whether the IRS’ threats of criminal prosecution and severe civil penalties amount to duress, the Court of Claims will not inquire whether these threats are indeed actions that the IRS could pursue. Instead, the court must measure, from an objective standpoint, whether the IRS’ overt or subtle threats would be enough to “defeat…the will of the party coerced.”   It is important to note that threats made against individuals who willfully or recklessly failed to disclose foreign financial accounts are justified. In these cases, “[i]t is not duress for a party to do or threaten to do what it has a legal right to do.”   However, IRS threats of criminal prosecution and severe civil penalties were likely exaggerated to individuals who mistakenly or innocently failed to disclose a foreign financial account on an FBAR. 

In these cases, can the IRS’ threats be considered so overpowering as to have inhibited taxpayers who mistakenly or innocently failed to disclose a foreign financial account from the unfettered exercise of reasoned judgment?  Whether or not such IRS threats may be considered so overpowering as to inhibit a taxpayer’s unfettered exercise of reasoned judgment will depend upon the facts and circumstances of each individual case.   As a preliminary observation, incompetent, unsophisticated, or elderly individuals will have a stronger case to set aside a closing agreement for duress than other taxpayers. This may be good news for taxpayers with facts similar to the hypothetical foreign-born elderly man discussed earlier in this article. However, the threshold to find a closing agreement contract unenforceable on theory of duress will be greater for educated individuals that have access to counsel. In these cases, the court is likely to take the position that the government’s threats of legal action are not usually sufficient to overcome the free will of the person.

Even though it appears that the Court of Claims is more likely to grant relief to taxpayers that executed a Form 906 and who are easily swayed by IRS pressures such as incompetent, unsophisticated, or elderly taxpayers rather than sophisticated taxpayers who have access to legal representation; A comprehensive definition of the circumstances constituting duress is impossible; cases decided by the Court of Claims have pointed out that each case must be decided on its own facts.   The fact that the court will review each case on its own facts should offer some hope to taxpayers that erroneously entered into an offshore voluntary disclosure program out of a fear of prosecution or enormous civil penalties. With that said, any individual bringing a case before the Court of Claims to set aside a closing agreement under a theory of duress, must be prepared to demonstrate that IRS’ threats were enough to “defeat…the will” of that particular individual. On a positive note, case law indicates that the Court of Claims will at least review the facts of each case carefully. This may provide some hope to taxpayers who believe that they were mistakenly compelled to enter into an offshore voluntary disclosure program and paid the hefty offshore penalty.

D. The Contractual Concept of Duress in District Courts

Similar to the Federal Court of Claims, district courts in jurisdictions throughout the United States recognize that the threat of criminal prosecution may constitute duress whether or not the threatened party is actually guilty of a crime.   With that said, district courts do not employ the three part test for duress enunciated by the Court of Claims in Fruhauf Southwest Garment.  Rather, district courts seem to review the facts and circumstances of each case to determine if duress exists. With that said, in exercising discretion in applying the concept of duress to contracts with government agencies such as the IRS, some district courts weigh public interest in the enforcement of these contracts heavily in favor of the government.   This means that a district court will likely find a closing agreement unenforceable on the grounds of duress only in cases of extraordinary circumstances. The fear of criminal prosecution or severe civil penalties will not likely convince a district court that a closing agreement was entered into under duress.

For example, in Thomas L.  Largen and Patricia K. Largen; Franklin D. Clontz and Jean T. Clontz, et al., v. United States   Dr. Largen and Dr. Clontz attended a seminar at which International Capital Management (“ICM”), promoted investment packages. Dr. Largen and Dr. Clontz were convinced by ICM to invest in various investments packages. The taxpayers took personal income tax deductions for business losses related to the investments for tax years 1982 and 1983. In March of 1984, an IRS criminal investigator visited the taxpayers. The criminal investigator told the taxpayers that they were suspects in a criminal tax evasion scheme. The criminal investigator told the taxpayers that his intentions were to put the taxpayers in jail. Although the taxpayers were apparent targets of a criminal investigation, they were never indicted by a grand jury. The taxpayers ultimately executed a settlement agreement with the IRS. The taxpayers ultimately filed suit before a United States district court and sought to have the settlement agreement set aside.

The taxpayers alleged that they were forced into signing a settlement agreement by emotional and economic coercion. The taxpayer contended that they were forced into a choice between criminal penalties and potentially enormous civil fraud penalties or foregoing their right to have their tax claims heard before a court. The taxpayers argued that they were forced to choose between a certain sum forfeited to the IRS and their reputations and, potentially millions of dollars. The district court stated that: 

“while [the taxpayers’] choice was difficult and painful, it is far from unique. All parties to potential litigation, when offered a settlement, must weigh the odds of prevailing upon a claim and potential gains against possible liabilities. The choice is never easy, but it is not unfair or inequitable.” 

Similarly, in Federal Deposit Insurance Corporation v. John A. White,   the defendants John White and Donna White attempted to repudiate a settlement agreement with the Federal Deposit Insurance Corporation (“FDIC”). The defendants allege that they were threatened with criminal prosecution throughout the settlement process. The defendants felt coerced into signing the settlement agreement just to keep from going to jail. Even though the district court acknowledged that the defendants concern about their potential criminal exposure was “for good reason,” the court refused to find that the settlement agreement between the FDIC and the Whites was the result of duress. The Largen and White cases demonstrate the reluctance of a district court to set aside a written agreement on the grounds of duress with the government despite threats of criminal or civil penalties. 

The only conceivable fact pattern in which a district court may find a contract with the government unenforceable as the result of duress was in Robertson v. Commissioner.   Although Robertson was decided by the United States Tax Court, it is conceivable that a district court could align itself with the Tax Court if the issues were similar to the the facts and circumstances of Robertson. In Robertson, an IRS revenue agent offered an uncounseled taxpayer a choice between signing a consent form or subjecting his property to seizure. The Tax Court found duress under those circumstances. It is difficult to imagine any participants of an offshore voluntary disclosure program being subjected to the same overreaching from the IRS as the taxpayer in Robertson suffered. Given the weight that district courts place in the public interest to contracts with the government, it is difficult to imagine a case where a district court would find that a closing agreement was executed under duress.

The discussion above demonstrates that a United States district court may only find duress in extreme cases. Therefore, an individual seeking court intervention to set aside a closing agreement executed in an offshore voluntary disclosure program under a theory of duress should not litigate before a United States district court. 

E. The Closing Agreement is set Aside, Now What?

If a court determines that a closing agreement is valid, the case will likely be disposed of through a dispositive motion such as a motion to dismiss. On the other hand, if a court were to determine that a closing agreement was executed under duress, there are two potential outcomes. First, a court could rescind the closing agreement compelling the IRS to refund the offshore penalty paid through an offshore voluntary disclosure program. At that point, litigation would come to an end.

In the second and most likely scenario, the government would file a counterclaim for all penalties that could have been assessed in lieu of the offshore penalty paid in a voluntary disclosure program. In this case, the individual bringing suit to recover the offshore penalty would be forced to defend against the offshore and domestic penalties that could have been assessed against the participant outside a voluntary disclosure program.

V. Conclusion

In recent years, the government has marshaled its forces in its battle against offshore tax evasion. Its well-publicized crackdown on the use of secret offshore bank accounts appears to have encouraged a number of taxpayers to participate in the voluntary disclosure initiatives it has offered. Even though the IRS boosts a huge success rate with the various offshore voluntary disclosure programs, the IRS fails to take into consideration individuals that may have enrolled in the program erroneously as the result of their threats. There is currently no administrative relief available to individuals who enrolled in a voluntary disclosure program by error. The only conceivable theory to obtain relief from the miscellaneous penalty is through tax litigation. The major hurdle to taxpayers litigating a claim for refund is the closing agreement that they executed to participate in the offshore voluntary disclosure program. In order to proceed with litigating a refund claim, taxpayers must convince a court to determine a closing agreement is unenforceable. The only viable theory at this time to set aside a closing agreement would be to argue that an individual entered into a closing agreement as the result of duress. In any case, convincing a federal court to find a closing agreement unenforceable on the grounds of duress is a daunting task. The only court to offer a glimmer of hope to set aside a closing agreement is the Federal Court of Claims. In cases brought before the Court of Claims, the participant must be prepared to demonstrate that the IRS’ threats of criminal and civil penalties overpowered the taxpayer’s unfettered exercise of reasoned judgment and resulted in the taxpayer erroneously executing a closing agreement. 


[1] The 2009 targeted offshore program was specifically targeted to individuals who utilized foreign financial accounts to avoid paying U.S. taxes. The first true offshore voluntary disclosure initiative was in 2003. That initiative was related to an offshore credit card project the IRS pursued starting in 2000. The program was designed to allow taxpayers to step forward and ‘clear up their tax liabilities.’ The program provided that the IRS would “in appropriate circumstances, impose the delinquency penalty under Section 6651, the accuracy-related penalty under Section 6662, or both penalties against taxpayers that participate in the Offshore Voluntary Compliance Initiative. The program waived the fraud penalty, the fraudulent failure-to-file penalty, and certain information return penalties otherwise applicable to participating taxpayers. In addition, participating taxpayers would not be criminally prosecuted.

[2] The participants of the 2009 OVDI were required to execute a Form 906 entitled “Closing Agreement on Final Determination Covering Specific Matters.” Under the terms of the closing agreement, the participant must agree to pay a miscellaneous penalty under Title 26 of the United States Code.

[3] SeeIRS 2011 Offshore Voluntary Disclosure Initiative Frequently Asked Questions and Answers, Note 35 (Feb 4, 2013), available at http://ww.irs.gov/businesses/international-businesses/2011-offshore-voluntary-disclosure-intiative-frequently-asked-questions-and-answers, which states in relevant part: The offshore penalty is intended to apply to all of the taxpayer’s offshore holdings that are related in any way to tax non-compliance. The penalty applies to all assets directly owned by the taxpayer, including financial accounts holding cash, securities or other custodial assets; tangible assets such as real estate or art; and intangible assets as patents or stock or other interests in a U.S. or foreign business. If such assets are indirectly held or controlled by the taxpayer through an entity, the penalty may be applied to the taxpayer’s interest in the entity or, if the Service determines that the entity is an alter ego or nominee of the taxpayer, to the taxpayer’s interest in the underlying assets. Tax noncompliance includes failure to report income from the assets, as well as failure to pay U.S. tax that was due with respect to the funds used to acquire the asset.

[4] SeeIRS News Release IR-2012-5 (Jan. 9, 2012), available at http.//www.irs.gov/pub/irs-mews/ir-12-005.5pdf.

[5] The IRS 2012 Offshore Voluntary Disclosure Initiative (OVDI): Is It Really Such A Good Deal For You? Is It Really For Everyone? By Richard J. Sapinsky, Esq. & Lawrence S. Horn, Esq.

[6] The IRS provides an exception to taxpayers that paid tax on all taxable income for prior years but did not file FBARs. In these situations, the taxpayer will not be assessed a penalty as long as the delinquent FBAR is filed and a statement is attached explaining why the FBAR was filed late. See IRS 2011 FAQ, note 17.

[7] See Id. at note 4, 5, and 6.

[8] See id. at note 16.

[9] United States v. Pomponio, 429 U.S. 10 (1976).

[10] 31 U.S.C. Section 5321(a)(5)(C)(i).

[11] Cheek v. United States, 498 U.S. 192, 201 (1991).

[12] 31 U.S.C. Section 5321(B)(i).

[13] IRM 4.26.16.4.3.1 (07-01-2008).

[14] Id.

[15] Id.

[16] Id.

[17] United States v. Boyle, 269 U.S. 241, 246 (1985).

[18] Scott v. Commissioner, 1 T.C. 654 (1974).

[19] See IRC Section 6401.

[20] Jones v. Liberty Glass Co., 332 US 524, 531 (1947).

[21] See Subparagraph 4 of Form 906 entitled Closing Agreement on Final Determination Covering Specific Matters which states the “Taxpayer agrees to pay, and the Internal Revenue Service may assess under Title 26 of the United States Code a miscellaneous [offshore] penalty.

[22] Treas. Reg. Section 301.6402-2(b).

[23] Treas. Reg. Section 301.6402-2(a)(2).

[24] A closing agreement is a final agreement between the IRS and a taxpayer on a specific issue or liability. Under Internal Revenue Code 7121, the IRS can negotiate a written closing agreement with any taxpayer to make a final resolution of any of the taxpayer’s tax liabilities for any period.

[25] IRC Section 7121.

[26] IRC Section 7121(b).

[27] Ingram v. Comm’r, 32 B.T.A. 1063, 1064, 1935 WL 287 (1935).

[28] Aetna Life Ins. Co. v. Eaton, 43 F.2d 711, 714 (2d Cir.), cert. denied, 282 U.S. 887, 51 S.Ct. 90, 75 L.Ed. 782 (1930) (holding tax levied and collected illegally under a statute declared unconstitutional cannot be avoided when included in closing agreement); Wolverine Petroleum Corp. v. Comm’r, 75 F.2d 593, 596 (8th Cir) (holding closing agreement takes priority over conflicting statute).

[29] In re Guy Miller v. Internal Revenue Service, 174 B.R. 791 (1994).

[30] See U.S. v. Nat’l Steel Corp., 75 F.3d 1146 (CA7 1996); Rink v. Comm’r., 47 F.3d 168 (CA6 1995); Alexander v. U.S., 44 F3d 328 (CA5 1995).

[31] Roach v. United States, 106 F.3d 720, 723 (6th Cir. 1997).

[32] Fruhauf Southwest Garment Co. v. United States, 111 F.Supp. 945, 951 (Ct.Cl.1953).

[33] David Nassif Assocs. v. United States, 644 F.2d 4, 12 (Ct.Cl.1981); See Sys. Tech. Assocs., Inc. v. United States, 699 F.2d 1383, 1387 (Fed.Cir.1983) (Systems Technology). (Citing David Nassif and other cases to explain that “[t]he standard [for duress] now looks more closely at the defeat of the will of the party coerced”).

[34] Christie v. United States, 518 F.2d 584, 587 (Ct.Cl.1975).

[35]  See Systems Technology, 699 F.2d at 1387.

[36] Beatty v. U.S., 168 F.Supp. 204 (Ct.Cl.1958).

[37] Morrill v. Amoskeag Sav. Bank, 90 N.H. 358, 9 A.2d 519, 524.

[38] David Robinson v. U.S., 95 Fed.Cl. 480 (2011).

[39] Johnson, Drake & Piper, Inc. v. U.S., 531 F.2d 1037, 1042 (Ct.Cl.1976).

[40] See Fed. Deposit Ins. Corp. v. John A. White, 76 F.Supp.2d 736 (1999) (citing Sims v. Jones, 611 S.W.2d 461, 462 (1980).

[41] 111 F.Supp. 945, 951 (Ct.Cl.1953).

[42] See Fed. Deposit Ins. Corp., supra note 40 (citing Sims v. Jones, 611 S.W.2d 461, 462 (1980))

[43] 1995 WL 556621 (M.D.Fla).

[44] 76 F.Supp.2d 736 (1999).

[45] 32 T.C.M. (CCH) 955 (1973).

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The Qualified Quiet Disclosure: Operating Outside of the IRS Offshore Voluntary Disclosure Initiative

by Stephen M. Moskowitz, Esq. and Anthony V. Diosdi, Esq. 8. November 2013 23:02

Individuals with previously undisclosed foreign assets and/or income have a variety of options to become compliant with the IRS, with two avenues for resolution being the most common:  Qualified Quiet Disclosure and the Offshore Voluntary Disclosure Program ("OVDP").

Absent facts indicating willful or reckless intent, an individual may be better off ‘explaining’ the undisclosed foreign bank accounts through amended tax returns, rather than opting into the Offshore Voluntary Disclosure Program.  Though the IRS prefers everyone opting into the OVDP because the IRS has collected so much money from it, there is another avenue known as a "Qualified Quiet Disclosure."  The IRS has also blessed the "qualified quiet disclosure" which, if a person qualifies, gives the same forgiveness as the OVDP but without paying the heavy penalties, without giving up rights, and without forced admissions of intent to evade U.S. income tax, that can come back to haunt.    Note, a Qualified Quiet Disclosure is very different from a "quiet disclosure," of which the IRS has promised a detection and punishment campaign.      Moreover, the Qualified Quiet Disclosure approach allows a taxpayer to operate outside the OVDP and to thereby, freely and fully, administratively and/or judicially contest the offshore penalties.   Through, an Administrative Agency Procedure Act before the District Court, for instance, an individual may contest the offshore penalty demand as it is applied by the IRS.

Conversely, if a taxpayer enters into the OVDP, he or she must agree to the penalties outlined in the program. The penalties and taxes imposed within the OVDP, are extremely expensive and punitive. For instance, a participant must pay a penalty of 27.5 percent based on the value of the undisclosed assets - as they are defined by the IRS.  In addition to the OVDP penalties, a participant must also pay the original tax, an additional 20 percent accuracy related penalty, failure to timely pay penalties of up to 25 percent of the income tax, and interest.  The taxpayer must also consent to re-open tax years which are already beyond the statute of limitations, thereby allowing the IRS to assess tax and penalties that the IRS otherwise would not be unable to do.    Thus, in many cases, participants are forfeiting assets, including entire lifetime savings and more to the government so that any income, inheritances, or gifts these people may receive in the future will belong to the IRS. 

To make matters worse, participants entering into the OVDP must waive Constitutional Protections against: self-incrimination (5th amendment), unreasonable search and seizure (4th amendment), and excessive fines (8th amendment).  This "Trifecta" of constitutional protections disappear once an individual enters into the OVDP disclosing: their names, social security numbers, undisclosed income, undisclosed assets, and the names of the advisors/3rd parties who facilitated the alleged "offshore tax evasion." Further, the government is not bound by transactional or use immunity for the participant participating in the Program.   For instance, numerous participants of the OVDP have been removed from the program and have been prosecuted with the government using (and the taxpayer being limited by) the very information provided by the taxpayer as part of the OVDP process.     Therefore, a taxpayer should be fully advised of OVDP advantages and disadvantages before deciding to make a disclosure because an OVDP begins first, with a waiver of constitutional rights, and then requires directly disclosing to the IRS criminal investigation division offshore transactions that could be (mis)construed as money laundering, wire fraud, mail fraud, tax evasion, or failing to disclose foreign financial accounts on an FBAR.  An example of such treatment is the Ty Warner matter.

In the case of Ty Warner (Beanie Bag founder, a former member of the Forbes 400 richest Americans, with a previous net worth of $2.6 billion) entered into the IRS OVDP only to be removed from the program for unknown reasons. The risk of entering into the OVDP for Ty Warner can be best understood in the settlement his attorneys reached with the IRS for the civil part of his case; his criminal case is still pending. Ty Warner failed to pay approximately $885,000 of taxes generated from undisclosed Swiss accounts. Even though Ty Warner failed to pay $885,000 taxes, the settlement agreement requires him to pay the government $53 million in taxes, penalties, and interest. This amounts to 60 times the original tax due. In addition, Ty Warner faces up to five years in a federal prison for tax evasion.  There have been a number of other individuals removed from the OVDP program and prosecuted, including most recently a 79 year old widow residing in Palm Beach because she did not report her inheritance of late husband’s foreign accounts.

On the other hand, even though the government has issued ominous threats to individuals who have not entered the OVDP (or previous, similar programs), since 2009, the government has not carried out this threat in any significant way.   For example: a taxpayer made a partial disclosure (i.e., not a Qualified Quiet Disclosure) to the IRS in which he omitted a secret Bermuda account on his amended tax returns.  Evidence suggests that individuals making Qualified Quiet Disclosures outside of OVDP have mostly fared better than individuals making disclosures through OVDP.  Those outside of OVDP, are assessed far less in taxes and penalties than individuals who have elected to make a disclosure through OVDP. In addition, these individuals have not waived their constitutional rights.

To sum it up, despite the fact that the IRS continues to threaten those who chose not to enter OVDP with prison sentences, monetary penalties, and more, those qualified to make a Qualified Quiet Disclosure have a far greater ability to contest IRS allegations of criminal and civil wrongdoing than the participants of the IRS OVDP. As of this date, individuals making disclosures outside the OVDP as a whole are far better off than their counterparts.

For a related article, "A Closer Look at the Non-Willful FBAR Penalty", California Tax Lawyer, Published by the State Bar of California, (Winter 2012).  

Stephen M. Moskowitz is the founding partner of Moskowitz LLP.   He is a member of the California State Bar, and holds an LLM in tax along with admission to practice in the United States Supreme Court, all Federal Courts, and all courts within the State of California.   Before Steve began practicing as a tax attorney, he practiced as a CPA.     He has been a professor of law, tax, and accounting at Golden Gate University, University of San Francisco, and San Francisco State University.   He routinely addresses the public, professionals, students and governments on tax matters impacting individuals and businesses.    

Anthony V. Diosdi is a tax attorney with Moskowitz LLP.   He is a member of the Florida State Bar and holds an LLM in tax.    Anthony concentrates his practice on federal tax controversies, planning, and international taxation. 

Moskowitz LLP is a tax law firm.   We save financial lives by relentlessly pursuing all avenues to successfully resolve client tax matters.  From audits, appeals, trials and tax planning to tax opinions and civil and criminal defense, we help individuals and businesses understand their entire tax picture and act accordingly.  We defend personal liberty and dignity through our skill, experience and an aggressive approach.  Whether it’s spending time in court or negotiating with the government, we passionately treat your case as if it were our own.  We do whatever it takes, within the bounds of the law, to deliver top quality, non-judgmental legal representation to help you save your life’s work, resolve tax matters pending, and to enjoy your life and thrive.  

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Moskowitz LLP, A Tax Law Firm, Disclaimer: Because of the generality of this blog post, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations. Prior results do not guarantee a similar outcome. Furthermore, in accordance with Treasury Regulation Circular 230, we inform you that any tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purposes of (i) avoiding tax related penalties under the Internal Revenue Code, or (ii.) promoting, marketing, or recommending to another party any tax related matter addressed herein.

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Anthony Diosdi | Offshore & Foreign Compliance | Offshore Tax Initiative | Penalties | Stephen Moskowitz | voluntary disclosure

What a Tax Attorney Can Do for You: Understand How Apple, Inc. Legally Does Not Pay Income Tax

by Stephen M. Moskowitz, Esq. and Anthony V. Diosdi, Esq. 21. May 2013 12:09

When Apple Inc., disclosed that it has not paid any corporate income tax over the past 4 years, it got the government’s attention.    Hailed before the Senate, Apple is confident in their tax position because, it is legal.

Essentially, Apple games the system by aggressively manipulating the Internal Revenue Code and tax treaties to save billions of dollars in taxes. 9 Billion and counting to date.  The Apple plan may work for any company whose assets can be sold anywhere in the world because the nature of the business allows for forming the necessary subsidiaries in tax havens (countries that have no income tax) while still maintaining the ability to conduct computer-generated sales. For example: if Apple sells an ITune or IPad app in the United States, the sale produces federally taxable gross revenue. However, if the same ITune or app is sold through an offshore haven, no federal revenue is generated for US tax purposes. Therefore, Apple is not taxed on the income generated from the sale of the ITune or app until it is repatriated to the US, if ever.

Apple takes advantage of the laws of Ireland. Ireland has recently enacted numerous laws to attract foreign investors. Apple uses a technique known as the “Irish-Dutch Sandwich.”  For tax planning reasons it is known as a sandwich because it involves more than one different countries, much like Hungary, Lichtenstein, and Switzerland are used to practically eliminate capital gains taxes that foreign investors would normally be paid on capital gains to the US for gains in real property or securities (See our article, U.S. Tax Effects of Treaties in the Context of Foreign Investment in the U.S.).

Here, Apple successfully utilizes the “Irish-Dutch Sandwich”:  

Intellectual property is transferred from the U.S. corporation to a subsidiary established in Ireland. The subsidiary is managed by individuals residing in a Caribbean tax haven country such as the Cayman Islands, Nevis, Bermuda, or the British Virgin Islands. A sale is generated in Ireland. However, the gross proceeds of the sale are quickly transferred to an offshore tax haven in order to avoid taxation in Ireland. Under Irish law, the company established in that jurisdiction is not taxed due to the fact that the manager resides outside of that jurisdiction. (Typically, a corporation is a tax resident of the country where it is incorporated. This is not the case under Irish law. Under Irish law, a corporation is a tax resident where its manager resides.) Therefore, an entity can incorporate and conduct business in Ireland. However, if its management is located in a tax haven jurisdiction such as the ones discussed above, the corporation is considered incorporated in the tax haven jurisdiction, not Ireland.

However, by virtue of the corporation maintaining its domicile in Ireland, it can utilize tax friendly agreements amongst European Union members.   For instance, Apple next takes the sales revenues which were generated in Ireland, transferred to a non-Irish country, and finally diverted to the Netherlands. The Netherlands charges only a small tax on royalty income from the sale of ITunes or apps and since it is within the European Union, there is no tax withholding or tax between Ireland and it.    It should be noted that rock groups such as the Rolling Stones and U2 have transferred sales from worldwide record sales to the Netherlands to avoid paying taxes in their home countries.

In conclusion, by establishing a multinational chain of subsidiaries, Apple has successfully avoided paying US taxes for years, even though it is headquartered in the US.

As the result of favorable world-wide income tax treaties, foreign investors in the U.S. may be able to arrange their business transactions in the U.S. without realizing any U.S. tax liability.    Further, corporations of really any size can potentially utilize this system because it is relatively inexpensive.   Particular attention must be paid to both the tax treaties of different countries and also the additional tax savings in planning the use of multiple tax treaties and multiple entities to legally avoid the taxes that would otherwise be paid.
To better understand this intricate area of tax law, consult with a tax attorney at Moskowitz, LLP by calling (415) 394-7200 or via our Tax Law Firm’s website.

Moskowitz LLP, A Tax Law Firm, Disclaimer: Because of the generality of this blog post, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations. Prior results do not guarantee a similar outcome. Furthermore, in accordance with Treasury Regulation Circular 230, we inform you that any tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purposes of (i) avoiding tax related penalties under the Internal Revenue Code, or (ii.) promoting, marketing, or recommending to another party any tax related matter addressed herein.

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Collection Due Process Hearings: Is it A Second Chance for Taxpayers to Litigate a Matter Previously Missed?

by Stephen M. Moskowitz, Esq. and Anthony V. Diosdi, Esq. 28. March 2013 23:44

Introduction

It happens all the time. Taxpayers are assessed tax liabilities by the Internal Revenue Service (IRS). To make matters worse for many taxpayers, they fail to timely petition the United States Court to contest the assessment. In many cases, had such a taxpayer timely petitioned the United States Tax Court, the federal liability at issue could have been significantly reduced or even eliminated. Unfortunately, in such a situation, short of paying the liability in full and filing a claim for refund, the IRS offers few post assessment remedies. This article discusses how a Collection Due Process may be utilized to contest an IRS assessment.

The Law Governing Collection Due Process Hearings

On July 22, 1998, Congress enacted Internal Revenue Code Sections 6320 and 6330. These Internal Revenue Code Sections provides taxpayers with an opportunity to contest or debate with a disinterested IRS Appeals Officer, the validity and amount of an underlying tax liability and the appropriateness of collection techniques being utilized by the IRS. In most cases, a taxpayer will have the opportunity to petition the United States Tax Court if the taxpayer disagrees with the Appeals Officer’s post hearing decision.

Notification Required to be Given to Taxpayer by the IRS

These mandates for due process in IRS collection matters significantly changed the way in which the IRS may collect an assessed tax liability. The Internal Revenue Code Section 6320 provides that within five days after the filing of a Notice of Federal Tax Lien, the IRS must provide the affected taxpayer with written notice of the filing of a federal tax lien and the amount owed to the government. Internal Revenue Code Section 6320 also requires the IRS to inform the taxpayer regarding the procedures available to release the lien. Finally, and most important, Internal Revenue Code Section 6320 requires that the IRS provide the taxpayer with the available administrative appeal rights, including the right to request a Collection Due Process Hearing. Internal Revenue Code Section 6330 requires that the IRS provides written notice to a taxpayer no less than 30 days before any intended levy of property. The procedural requirements of Section 6330 are identical to Section 6320. The notice required by Internal Revenue Code Sections 6320 and 6330 state that the notice may be served on the taxpayer, in person, or left at the taxpayer’s residence or usual place of business, or sent by certified or registered mail to the taxpayer’s last known address.

If a taxpayer disagrees with the proposed lien or levy action, the taxpayer has 30 days from the date of the correspondence to contest the IRS’ proposed lien or levy action in a Collection Due Process Hearing.


Hearing Requirement for A Collection Due Process

If a timely Request for a Collection Due Process Hearing is filed, the Internal Revenue Code provides that the hearing will be held before an Appeals Officer who had no prior involvement in the case. In conducting the hearing, a disinterested Appeals Officer is required to determine that all procedural requirements for collections have been met and that any proposed collection action balances the need for the efficient collection of taxes with the legitimate concern of the taxpayer.1  The Appeals Officer will not consider an issue that was raised and considered at an earlier Collection Due Process Hearing or in a judicial proceeding where the taxpayer “participated meaningfully.”2

However, a taxpayer may raise “any relevant issue relating to the unpaid tax or a proposed levy.” 3  Issues that could be raised in a Collection Due Process include, but are not limited to,  1) challenges to the amount or existence of a tax liability; 4 2) offers to utilize alternative collection mechanisms, such as an offer in compromise or an installment agreement; and appropriateness of the collection actions being taken or proposed to be taken. 5
A timely requested Collection Due Process Hearing will suspend all enforced IRS collection actions such as levy actions.  However, the statute of limitations on collections will be extended during this time.

Tax Court Jurisdiction

At the conclusion of a Collection Due Process Hearing, the Appeals Officer will issue a letter of determination. A party may appeal an adverse determination issued by the Appeals Officer within 30 days of the date of the letter. 6 In order to appeal an adverse determination by an Appeals Officer, a taxpayer must file a petition with the United States Tax Court. The United States Tax Court has promulgated Tax Court Rules 330 through 334 to provide procedural guidance to parties seeking to appeal a Collection Due Process Hearing.

Can A Taxpayer Utilize a Collection Due Process Hearing Procedure to Contest a Liability After He or She Already Had the Opportunity to Contest the Liability in Tax Court?

As discussed above, a party may dispute the amount or validity of an underlying tax liability only if the taxpayer did not receive a statutory notice of deficiency or otherwise have an opportunity to dispute the assessment. In addition, a party may raise any issue unless that same issue has been addressed in a previous administrative or judicial proceeding in which the person raising the issue had an opportunity to meaningfully participate.
Therefore, parties who are assessed a liability by the IRS prior to receiving a statutory notice of deficiency are free to contest an IRS liability in a Collection Due Process Hearing and ultimately litigate the issue before the United States Tax Court. With that said, it is inevitable that some taxpayers will attempt to use the Collection Due Process Hearing procedures to attempt to contest a tax liability assessed by the IRS after previously being afforded an opportunity to contest the liability through traditional means (i.e., the taxpayer was issued a statutory notice of deficiency, but failed to timely petition the Tax Court). Are these taxpayers precluded from contesting an IRS liability through a Collection Due Process Hearing procedure and are these taxpayers barred from petitioning the United States Tax Court? Maybe not. Below we will discuss when a taxpayer who missed responding to a statutory notice of deficiency may utilize a Collection Due Process Hearing to contest a tax.

Suppose the IRS assessed a tax liability against a taxpayer for the 2010 tax year in the amount of $100,000. For the purposes of this example, we will assume that the IRS properly issued to this taxpayer a statutory notice of deficiency and the taxpayer failed to timely petition the Tax Court. Now, let’s assume that this taxpayer files an amended tax return for the 2010 tax year and the amended return claims deductions that were not claimed on the original 2010 tax return. Finally, let’s assume that the 2010 amended tax return reflects a tax liability of only $10,000 or a $90,000 difference from that of the IRS’ assessment. Can the taxpayer from our example dispute the amount or validity of the $90,000 difference between the IRS assessment and the amended tax return through a Collection Due Process Hearing?

A broad reading of Section 6320 and 6330 indicates that the taxpayer in our example can dispute the difference between the amended tax return and IRS assessment. The statutory language of Sections 6320 and 6330 provides that a party may raise any issue unless that same issue has been addressed in a previous administrative or judicial proceeding in which the person raising the issue had an opportunity to meaningfully participate. The relevant statutory language does not foreclose a taxpayer from contesting an IRS assessment for an entire tax year after a statutory notice of deficiency is issued. Sections 6320 and 6330 only prohibits taxpayers from contesting underlying tax liabilities in which he or she had the opportunity to dispute. In above example, the taxpayer filed an amended return claiming deductions that were not claimed on his or hers original 2010 tax return. Arguably, this taxpayer did not have a meaningful opportunity to dispute or contest the deductions claimed on the amended tax returns in a previous administrative or judicial hearing. Since the taxpayer in our example may not have had the opportunity to contest or dispute the deductions claimed on the amended tax returns in an administrative or judicial hearing, our taxpayer may potentially raise the underlying liability reflected on the amended tax returns in a Collection Due Process Hearing and upon appeal to the United States Tax Court.

As of the date of the writing of this article, the author is unaware of any decisions issued by the United States Tax Court specifically addressing this issue on point. Thus, there currently are more questions than answers regarding whether a taxpayer may utilize an amended return to contest a federal income tax liability. However, the author of this article will state that he has effectively utilized this strategy to contest federal liabilities through Collection Due Process Hearings and in cases brought before the United States Tax Court and settled with opposing counsel before the United States Tax Court. Therefore, the IRS is well aware of the litigation hazards for the government in denying taxpayers the opportunity to contest an IRS liability through an amended tax return in the context of a Collection Due Process Hearing.

Obviously, the theory discussed above will now apply to all taxpayer who failed to timely respond to the IRS. However, a significant number of taxpayers may benefit through the strategies discussed in this article. Therefore, in any case which a taxpayer has the opportunity to file a Request for a Collection Due Process Hearing, it is extremely important to carefully review the tax returns for the tax years at issue to determine if amended tax returns may be filed.

About Moskowitz LLP

Moskowitz LLP is San Francisco-based tax law firm that caters to clients on a local, national and global scale. The tax attorneys, CPA’s, and EA’s at Moskowitz LLP, some of whom have practiced in tax for over 30 years, have helped professionals, small businesses and private citizens with tax conflicts including, but not limited to, tax audits, liability disputes, and criminal defense against evasion and fraud charges - and also as it applies to international tax compliance.  We have an established reputation for producing results, even in cases deemed "un-winnable" by larger firms, and can also assist with effective tax planning and tax collection matters.

  1. IRC Section 6330(c)(3)(C).
  2. IRC Section 6330(c)(4)(B).
  3. IRC Section 6330(c)(2)(A).
  4. IRC Section 6330(c)(2)(B) provides that a taxpayer may contest a tax liability as long as the taxpayer has not previously received a statutory notice of deficiency, or otherwise had an opportunity to dispute the tax liability raised in the hearing. It should be noted that IRC Section 6330(c)(2)(B) is silent if a taxpayer may file an amended tax returns after a notice of deficiency is issued for a particular year and if a taxpayer may take the position that the amended tax return supersedes a notice of deficiency.
  5. IRC Section 6330(c)(2)(A).
  6. IRC Section 6330(d)(1).

 

Disclaimer:  Because of the generality of this blog post, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations. Prior results do not guarantee a similar outcome. Furthermore, in accordance with Treasury Regulation Circular 230, we inform you that any tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purposes of (i) avoiding tax related penalties under the Internal Revenue Code, or (ii.) promoting, marketing, or recommending to another party any tax related matter addressed herein.

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Second Chance

The State of California Seeks Back Taxes from Small-Business Shareholder- Not So Fast

by Stephen M. Moskowitz, Esq. and Anthony V. Diosdi, Esq. 13. February 2013 16:55

A closer look at federal constitutional case law would seem to indicate that the State of California may not find it so easy to seek refunds plus interest after all.

In Cutler v. Franchise Tax Board, the second District Court of Appeal held that because the purpose and effect of California’s qualified small business stock statues is to favor California corporations over foreign corporations, the statues are discriminatory and cannot stand under the commerce clause of the U.S. Constitution.   As such, the Franchise Tax Board has issued a statement that for tax years after January 1, 2008, it will issue Notices of Proposed Assessments to thousands of small businesses who received tax breaks based on small business stock exclusion and deferral statutes.

Is this legal under Federal Constitutional law? Probably not. According to the United States Supreme Court, retroactive legislation is constitutional unless its application is so “harsh and oppressive as to transgress the constitutional limitation.”  Welch v. Henry, 305 U.S. 134, 1475 (1938). The United States Supreme Court also formulated a test to determine if retroactive legislation is constitutional. According to the Supreme Court, 1) the retroactive application of the statute must be supported by a legitimate legislative purpose furthered by rational means such that the [Government’s] purpose in enacting the amendment was neither illegitimate nor arbitrary; and 2) the [government] acted promptly and established only a modest period of retroactivity. United States v. Carlton, 512 U.S. 26, 30-31, 32 (1994).
 
The Ninth Circuit Court of Appeals has stated that a retroactive tax increase to reduce a budget deficit by ensuring higher revenue is permissible and rational. Licari v. Commissioner, 946 F.2d 690, 692 (9th Cir. 1991). Consequently, the retroactive application sought by the FTB plus interest will likely survive constitutional scrutiny as being a rational basis to raise revenue.  Where the retroactive claim for a tax refund and interest becomes questionable is the period of time that the state seeks to demand a refund. In this case, the disallowance of a tax incentive amounts to a retroactive tax increase.  The retroactive effect of a tax increase has “generally been confined to short and limited periods required by the practicalities of producing … legislation.” Carlton, 512 U.S. at 32-33 quoting United States v. Darusmont, 449 U.S. 292, 296-297 (1981). Though Licari predated Carlton by three years, the Ninth Circuit Court of Appeals in Licari applied the same standard formula in Carlton and found that a four-year period of retroactivity in question was “far longer than required simply by the practicalities of producing … legislation.” Licari, 946 F.2d at 694.
 
In the present case, the period of retroactivity extends four years. Applying the test enunciated by the Ninth Circuit Court of Appeals in Licari, the four year look-back period would not pass constitutional scrutiny. Arguably, even retroactively seeking refunds from taxpayers for less than four years could run into question under some constitutional authorities. For example, Justice O’Conner stated in her concurring opinion that “a period of retroactivity longer than the year preceding the legislative session in which the law was enacted would raise, in my view, serious constitutional questions.” Carlton, 512 U.S. at 38 (O’Conner, J. concurring).

 

See more articles from Stephen M. Moskowitz, Esq. and Anthony V. Diosdi, Esq.

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California Tax Law

Just how is the Expatriation Tax Calculated?

by Stephen M. Moskowitz, Esq. and Anthony V. Diosdi, Esq. 11. September 2012 18:34

Introduction

It has been all over the news lately, wealthy U.S. taxpayers, such as, Eduardo Saverin (a Facebook founder), Denise Rich (songwriter), and another eighteen hundred, or so, have forfeited their U.S. citizenship for U.S. tax reasons.    Federal law provides that some U.S. taxpayers who elect to renounce their U.S. citizenship must pay a so-called federal exit tax or expatriation tax. The computation of this tax is incredibly complex. Only by reviewing the originally enacted expatriation tax in 1966 and the intervening modifications to the expatriation tax law over a four decade period can one begin to understand how to properly compute the so-called “exit tax” regime.

In our International Tax Practice, we have found individuals seeking to learn how the Exit Tax came to be and some of the considerations commonly sought.   This article provides an overview of the federal law governing expatriation tax and the modifications to the law over the past four decades.

The Original Expatriation Tax Provision as Defined by the Foreign Investors Tax Act of 1966

The expatriation tax was introduced to U.S. tax law by the Foreign Investors Tax Act of 1966 (“FITA”). FITA introduced Sections 877, 2107, and 2501 to the Internal Revenue Code.

Section 877 imposed a tax, calculated at higher rates applicable to nonresidents who were not former U.S. citizens or at the rates applicable to U.S. citizens, on the U.S. source income of former citizens who expatriated for a principal purpose of tax avoidance for 10 years following expatriation. In order to correctly determine an individual’s expatriation tax rate, it was necessary to make two calculations known as the “alternative tax” regime.

U.S. source income for purposes of FITA was defined to include gains from the sale of exchange of property (other than stock or debt obligations) located in the U.S. as well as gains from the sale or exchange of stock or debt obligations issued by a domestic corporation or U.S. person. In addition, gains from the sale or exchange of property having a basis determined by reference to such property, in whole or in part was treated as U.S. source income for a 10 year period in order to capture gains from non-U.S. property.

Under Section 2107, added by FITA, if an expatriate subject to the alternative tax regime of Section 877 died within 10 years following expatriation, his or her U.S. estate was assessed the expatriation tax. The expatriation tax was also assessed shares held at the death of the individual comprising a 10 percent or greater direct or indirect interest in a foreign corporation considered to be owned by more than 50 percent by the decedent, directly, indirectly, or constructively, in portion to the foreign corporation’s underlying U.S. situated property. In addition, Section 2501(a)(3) was enacted by FITA. Section 2501(a)(3) provided that the normal gift tax exclusion did not apply for gifts made within 10 year period of expatriation.

For purposes of the expatriation tax, if the IRS was able to establish that it was reasonable to believe that a U.S. citizen expatriated with a principal purpose of tax avoidance, the burden of proof on this matter was placed on the expatriate or his estate to prove otherwise.

Amendments Made to the Expatriation Tax through Health Insurance Portability and Accountability Act of 1996

In 1996, Congress enacted changes to the rules governing expatriation tax through the Health Insurance Portability and Accountability Act (“HIPAA”). Under this act, the category of “covered expatriates” was expanded to include “long-term resident aliens,” defined as “lawful permanent residents” (green card holders) residents for expatriation tax purposes if the individual was a resident in the U.S. in eight of the prior 15 tax years. For purposes of HIPAA, expatriation was considered to have occurred at date stated for citizens under U.S. immigration law (the date of an expatriation act) and for long-term residents under tax residency rules.

HIPPA also introduced the notion of “presumptive tax avoidance purpose” based on a number of economic factors that pertained to the taxpayer seeking to expatriate. A tax avoidance motive was presumed if an individual’s net average U.S. income tax liability in the 5 years preceding expatriation was $100,000 or more (“income tax liability test”) or if his net worth at expatriation exceeded $500,000 (“net worth test”).

In addition, HIPAA significantly enlarged the categories of income considered to be U.S. source income. For example, income and gains derived from former controlled foreign corporations (“CFC”) were considered controlled by an expatriate if held within two years prior to expatriation and were considered to be U.S. source income for tax purposes.

Finally, HIPAA expanded federal tax law to require an expatriating U.S. citizen to provide an information statement, including a statement of net worth, to the Department of State when applying for expatriation.

The Impact of the American Jobs Creation Act of 2004 on the Expatriation Regime

The American Jobs Creation Act of 2004 (AJCA) adopted a number of changes to the tax laws governing expatriation. The AJCA removed the requirement that an individual have a principal tax avoidance purpose and changed the income tax liability test. The income tax liability test threshold was changed to “greater than” $124,000 (indexed annually), the net worth test standard was increased significantly to $2,000,000 (not indexed). In addition, the AJCA added a third test which provided that an expatriate certify that he has fully complied with all U.S. tax requirements for the five years preceding expatriation.

The AJCA also amended the expatriation gift tax rules to add a provision which imposes tax on gifts of a foreign corporation owned by the expatriating taxpayer ten years subsequent to the expatriation period.

In addition, AJCA added Section 7701(n) to the Internal Revenue Code which provides that an individual will continue to be treated as a U.S. citizen or long-term resident until he both gives notice of his expatriation to the Department of Secretary or Department of Homeland Security, and furnishes an information statement. Furthermore, the AJCA increased the information reporting rules requiring that an expatriate file an annual information statement for each of the ten post-expatriation years regardless of whether the expatriate had any U.S. source income for each year at issue. Expatriating taxpayers were now required to Form 8854 advising the Government of his or assets.

Finally, the AJCA added a new residency classification to the expatriation taxing regime. Under this new rule, an individual who has expatriated will suffer U.S. worldwide income tax if he or she is physically present in the U.S. for more than 30 days during any of the ten years preceding expatriation. Typically, a non-resident alien is permitted an average of 121 U.S. days per year without becoming a U.S. tax resident.

The Heroes Earning Assistance and Relief Tax Act of 2008 and the Impact of this act on Expatriation Taxation

Prior to Section 301 of the Heroes Earning Assistance and Relief Tax Act of 2008 (“HEART Act”), expatriates generally were subject to a ten year “alternative tax” regime on U.S. source income as discussed in FITA.

Section 877A replaces the former alternative tax regime on U.S. source income of “covered expatriates” with a mark-to-market tax on gains in excess of $600,000 (indexed for 2012 to $651,000) from a deemed sale of an individual’s worldwide assets on the day prior to the individual’s expatriation date. The term “covered expatriate” includes individuals who renounce or relinquish U.S. nationality or terminate their status as long-term permanent residents (i.e. green card holders for at least eight of the 15 taxable preceding expatriation) and whose average net income tax liability for the five years preceding exceeds $124,000 indexed for inflation (for persons expatriating in 2012, $151,000) 1 or whose net worth at the date of expatriation equals or exceeds $2 million (not indexed).

Under the provision, a covered expatriate can irrevocably elect, on an asset by asset basis, to deter the payment of the mark-to-mark tax attributable to an asset until the due date of the return in which such property is sold or exchanged. In order to make the election, a taxpayer must provide “adequate security” (including a bond conditioned on the payment of tax and interest) and irrevocably waive the benefit of any U.S. tax treaty that would preclude assessment of tax. The election will terminate as to any property not sold or exchanged when a taxpayer dies or when the IRS determines that security is no longer adequate. In addition, certain property, including deferred compensation items, “specified tax deferred accounts,” such as individual retirement accounts and health savings accounts are exempted from the mark-to-market tax.

Expatriation date is defined to mean the date that a citizen relinquishes U.S. nationality or a long-term resident alien ceases to be a lawful permanent resident. A citizen is considered to have relinquished U.S. citizenship at the earliest of the dates: 1) he renounces his nationality before a U.S. diplomatic or consular officer; 2) he provides a statement of voluntary relinquishment to the Department of State; 3) the Department of State issues the individual a Certificate of Loss of Nationality; or 4) a U.S. court cancels a naturalized citizen’s certificate of naturalization.

Finally, for purposes of the mark-to-market taxing regime, all nonrecognition deferrals and extensions of time for the payment of tax are considered terminated the day before expatriation.

The HEART Act added Section 2801 to the Internal Revenue Code. Section 2801 imposes a tax, at the highest applicable gift or estate tax rates on the receipt by a U.S. person of a “covered gift or bequest,” which is defined as a direct or indirect gift or bequest from a “covered expatriate” within the meaning of Internal Revenue Code Section 877A. The tax is assessed on, and intended to be paid by, the recipient of a covered gift or bequest. The succession tax will be reduced by any foreign gift or estate tax paid. The new succession tax does not apply to gifts covered by the annual exclusion of Section 2503(b), currently at $13,000 per done per annum. It also does not apply to gift or bequests entitled to a marital or charitable deduction.

Conclusion

Over the past four decades, the expatriation tax has evolved into an extremely complex taxing regime. In 2009, the Treasury and the Internal Revenue Service (IRS) promulgated Notice 2009-85 to provide limited guidance to determine an expatriating individual’s tax liability. Unfortunately, the Notice fails to provide any meaningful guidance regarding Section 877 and 2801. The failure to provide meaningful guidance in regards to the expatriation tax. This failure only makes determining the proper the expatriate tax more difficult than is necessary which can result in disastrous consequences. This is because the failure to properly compute an expatriation tax may result in a bar of re-entry of former citizens who to the U.S.

In 1996, the so-called “Reed amendment” was enacted as part of the Illegal Immigration Reform and Immigration Responsibility Act. Because of a number of statutory defects, the Reed Act has never been enforced. 2 Even though the statutory language of the Reed amendment may be flawed, The Department of Homeland Security has been working to develop regulations to implement the Reed amendment. If this project is to move forward, former citizens or long-term residents could discover that their re-entry to the U.S. is bared if they fail to fully comply with their expatriation tax obligations. Given the current climate Washington regarding individuals seeking to expatriate from the U.S. for tax purposes, it is not to difficult to imagine regulations being promulgated by the Department of Homeland Security barring ex-citizens from re-entering the U.S. for failing to comply with their expatriation tax obligations. This could disastrous for former citizens with families and economic interests in the U.S.

Given the foreseeable consequences of failing to properly compute an expatriation tax, individuals considering repatriation should consult with a tax attorney to determine how the exit tax will impact them.    We welcome your feedback and questions regarding this article and your tax questions.    You can learn more about our firm at www.moskowitzllp.com or by calling our firm (415) 394-7200. 

  1. Rev. Proc. 2011-52, 2011-45.
  2. The Reed amendment has the following statutory flaws: 1) it is unclear from the language of the statute if it encompasses all acts of expatriation; 2) it is uncertain if the Reed amendment violates the Constitutional Due Process rights of certain former citizens by barring them from reentering into the U.S.


Moskowitz LLP, A Tax Law Firm, Disclaimer:   Because of the generality of this blog post, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.   Prior results do not guarantee a similar outcome.   Furthermore, in accordance with Treasury Regulation Circular 230, we inform you that any tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purposes of (i) avoiding tax related penalties under the Internal Revenue Code, or (ii.) promoting, marketing, or recommending to another party any tax related matter addressed herein.

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International Tax Matters

U.S. Tax Effects of Treaties in the Context of Foreign Investment in the U.S.

by Stephen M. Moskowitz, Esq. and Anthony V. Diosdi, Esq. 6. September 2012 15:53

Introduction

Foreign investors in the U.S. tend to have the same goals as their U.S. counterparts. Like U.S. taxpayers, foreign investors seek to minimize their income tax liabilities associated with their U.S. real estate and business investments. However, foreign investor’s objectives are clouded by the fact that they are not U.S. persons for tax purposes. In addition, foreign investor’s objectives may be complicated by income taxes of their home countries. Furthermore, the U.S. has a special income tax regime that is applicable to foreign persons. Specifically, if a non-U.S. person derives certain types of passive income, it is typically taxed at a flat 30 percent rate (without an allowance for deductions), unless an applicable tax treaty reduces this rate. On the other hand, if the U.S. activities of the foreign person rise to the level of constituting a “U.S. trade or business,” the foreign person will be taxed much like a U.S. person. This article addresses how tax treaties may be utilized to reduce a foreign person’s global tax liability. This article also addresses the recent developments in tax treaties. As an example of whether U.S. income taxation of a foreign investor would be impacted by a U.S. Income Tax Treaty, we shall address whether a foreign investor could utilize the U.S.-Hungarian Income Tax Treaty or the U.S.-Polish Tax Treaty.

U.S. Taxation of Foreign Persons

Two different U.S. tax regimes apply to non-U.S. taxpayers. First, non-residents engaged in a trade or business in the U.S. are taxed on income that is effectively connected with a trade or business. Such income is taxed at applicable graduated U.S. individual rates. A different tax regime applies to income that is not effectively connected with a trade or business in the U.S. Under this regime, a flat 30 percent tax is imposed on U.S. source fixed or determinable annual or periodic income such as (interest, dividend, rents, annuities, and other types of “fixed or determinable annual or periodical income,” collectively known as FDAP income). This tax is imposed on gross income, with no deductions allowed. In general, this tax is collected by withholding. The 30 percent tax may be reduced or eliminated by bilateral income tax treaties to which the U.S. is a party.

Impact of Tax Treaties

Even though the statutory rate of withholding on U.S. source payments of FDAP income to a foreign person is 30 percent, for the most part, income tax treaties will reduce and in some cases eliminate the U.S. withholding on FDAP income. For a non-U.S. taxpayer to be eligible for treaty benefits, the individual generally must be considered a “resident” of a particular treaty jurisdiction and must satisfy a so-called “limitation on benefits” (LOB) provision in the treaty. Under most U.S. income tax treaties, a foreign person will be considered a resident for treaty purposes if such person is “liable to tax therein by reason of its domicile, residence, citizenship, place of management, place of incorporation, or any other criterion of similar nature.” 1

Under most “modern” income tax treaties, a resident of a treaty country will satisfy the LOB provision if that resident is an individual, or a corporation that is at least 50 percent owned by citizens or residents of the U.S. or by residents of the jurisdiction where the corporation is formed and not more than 50 percent of the gross income of the foreign corporation is paid or accrued, in the form of deductible payments, to persons who are neither citizens nor residents of the U.S. or residents of the jurisdiction where the corporation is formed. However, in many cases, there is no such residency requirements under older income tax treaties in which the U.S. has negotiated with foreign countries.

U.S. Tax Planning Opportunities Utilizing Income Tax Treaties Without LOB Provisions Prior to the 2012 Calendar Year

Currently, it is the policy of the U.S. to include a LOB provision when negotiating a new tax treaty. With that said, certain older income tax treaties do not contain LOB provisions. As of the 2011 calendar year, the income tax treaties with foreign countries in which the U.S. did not contain LOB provisions where: 1) Egypt; 2) Greece; 3) Hungary; 4) Korea; 5) Morocco; 6) Pakistan; 7) the Philippines; 8) Poland; 9) Romania; and the former U.S.S.R. (which now applies to Armenia, Azerbaijan, Belarus, Georgia, Krgyztan, Moldova, Tajikstan, Turkmenistan, and Uzbekistan. The benefits of these treaties were to reduce the rates for U.S. income tax purposes. For example, the U.S. treaties with Egypt, Hungary, and Poland reduce the withholding rate on payments of U.S. source dividends to as low as five percent for federal income tax purposes. In addition, the treaties with Greece, Hungary, and Pakistan completely eliminate the U.S. withholding tax on payments of U.S. source royalties. The combination of these reduced withholding rates, coupled with favorable local tax benefits in some of the foreign jurisdictions, provided significant worldwide tax benefits to a U.S. inbound foreign investors.

Repatriating U.S. Profits to a Foreign Jurisdiction Utilizing Global Treaties to Minimize Worldwide Tax Liabilities

As discussed above, payments of U.S. source dividends to a foreign corporation are generally subject to a 30 percent federal withholding tax. While many treaties reduce or eliminate this withholding rate, not all U.S. foreign investors are residents to qualify for a treaty that provides for these reduced rates. These foreign individuals may utilize a strategy of establishing a company in a jurisdiction with a treaty with the U.S. that has no LOB provision and provides for a reduction in the U.S. withholding tax.

For example, prior to the 2012 calendar year, instead of a Bermuda resident investing directly in a U.S. corporation, the Bermuda resident was able to invest in the U.S. through a Hungarian corporation. Using this approach, a dividend paid from the U.S. would only be subject to a five percent U.S. federal withholding tax and the dividend received in Hungary would be completely exempt from Hungarian corporate income tax as a result of its favorable participation exemption.2 Moreover, a dividend paid out of Hungary could be completely exempt from Hungarian withholding tax.3 Since US-Hungary tax treaty entered into force on September 18, 1979 contained no LOB provisions, just about any non-U.S. person, regardless of residence eligible to take advantage of this structure. Prior to the 2012 calendar year, because of the favorable provisions in the US-Hungary tax treaty, foreign investors often utilized a Hungarian corporation as a vehicle to invest in the U.S.

Not only did foreign investors utilize the Hungarian-U.S. treaty to limit their exposure to taxes on FDAP gains, foreign investors often utilized the Hungarian-U.S. treaty to limit their exposure to gains realized from the disposition of real property. In order to better understand how foreign investors utilized the Hungarian-U.S. treaty to limit their exposure to U.S. tax on gains from real property transactions, we will first discuss the U.S. tax implications of foreign investors in the U.S. real estate market.

Foreign persons are typically not subject to U.S. income tax on U.S. source capital gains unless the gains are effectively connected to a U.S. trade or business.4 However, the Internal Revenue Code treats any gain realized by a foreign person on the disposition of a U.S. real property interest (“USRPI”) as if it were effectively connected to a U.S. trade or business. A USRPI is broadly defined by the Internal Revenue Code as: 1) a direct interest in real property located in the U.S. and 2) an interest (other than an interest solely as a creditor) in any U.S. corporation that constitutes a U.S. real property holding corporation (a corporation whose USRPIs make up at least 50 percent of the total value of the corporation’s real property interests and business assets).5

The regulations promulgated under Internal Revenue Code Section 897 provide an example as follows: “a foreign corporation lends $1 million to a domestic individual, secured by a mortgage on residential real property purchased with the loan proceeds. Under the loan agreement, the foreign corporate lender will receive fixed monthly payments from the domestic borrower, constituting repayment of principal plus interest at a fixed rate, and a percentage of the appreciation in the value of the real property at the time the loan is retired. The example states that, because of the foreign lender’s right to share in the appreciation in the value of the real property, the debt obligation gives the foreign lender an interest in the real property “other than solely as a creditor.” The example concludes that Section 897 will not apply to the foreign lender on the receipt of either the monthly or the final payments because these payments are considered to consist solely of principal and interest for U.S. income tax purposes.6

Therefore, the example stated in the Treasury Regulations concludes that the final appreciation payment that is tied to the gain from the sale of the U.S. real property does not result in a disposition of a USRPI for the purposes of Section 897 of the Internal Revenue Code because the amount is considered to be interest rather than gain under Internal Revenue Code Section 1001.

By characterizing a contingent payment on a debt instrument as interest for U.S. income tax purposes, the Income Tax Regulations promulgated under Internal Revenue Code Section 897 may permit non U.S. taxpayers to avoid U.S. income tax on gain arising from the sale of U.S. real estate. As such, a non U.S. individual could lend money from a company established in a jurisdiction such that has a treaty with the U.S. with no LOB provisions such as Hungary and have that interest on the loan tied to gain on the sale of the property. The interest that was tied to the gain of the sale of the real property was completely exempt from U.S. income tax under an applicable Hungarian-U.S. income tax treaty.

However, Hungary had a 16 percent corporate tax rate. In order to reduce this tax, foreign investors would establish a “financial branch” in a “low-tax” jurisdiction. Hungary has tax treaties with Switzerland and Luxembourg. Both these jurisdictions have a very favorable branch taxing regime. Consequently, investors utilizing the Hungarian-U.S. tax treaty to minimize U.S. taxes would register a branch in either Switzerland or Luxembourg. A finance branch registered in either of these two jurisdictions reduced the effective tax rate on interest income to as low as two percent. Therefore, by having a Hungarian corporation own a finance branch in either Switzerland or Luxembourg and by allocating loans and interest from those loans to such a financial branch, rather than to the Hungarian company directly, the foreign income tax imposed on the receipt of interest income was reduced significantly.

Under the above discussed financial structure, any income received by a foreign financial branch in either Switzerland or Luxembourg was exempt from corporate income tax in the jurisdiction of the corporation’s home country under respective income tax treaties.7

The benefit of the previous treaty with Hungary entered into force on September 18, 1979 was that it the treaty contained no “anti-triangular” provisions in the income tax treaties. Typically, an “anti-triangular” typically prevents a non U.S. taxpayer from utilizing treaty benefits if the income tax benefit received is attributed to a establishment located in a third jurisdiction and the combined tax rate of both jurisdictions is lower than the U.S. tax rate.

Recent Developments Regarding the Tax Treaty with Hungary

Recently, the U.S. entered into a new bilateral tax treaty with Hungary. The new treaty includes the LOB provision that is included in many other treaties entered into by the U.S. The inclusion of limitations on benefit provisions significantly eliminates the use of Hungary as a treaty shopping jurisdiction. It is no longer possible to place a Hungarian corporation between the U.S. and a third low tax country in order to significantly diminish global tax obligations. With the adoption of the new tax treaty with Hungary, foreign investors’ ability to treaty shop for international tax planning is limited further and very few opportunities now exist for planning in this context. Although the newly negotiated bilateral U.S.-Hungarian tax treaty is a blow to foreign investors, other opportunities still exist. The remaining countries with tax treaties with the U.S. that do not include limitations on benefits rules are Poland, Greece, the Philippines, Romania, and certain countries of the former U.S.S.R.

We started this article discussing how foreign investors were taking advantage of the U.S.- Hungarian tax treaty to reduce the U.S. income tax liability on gains from U.S. source dividends. Even though it is no longer possible to take advantage of the bilateral U.S.- Hungarian tax treaty to reduce taxes on U.S. source dividend gains, a similar type of plan can still be achieved through the use of a Polish corporation. The U.S.-Polish treaty currently provides for a five percent withholding rate on U.S. source dividends.8 Dividends can then be repatriated out of Poland tax-free to a branch office located in a legal European tax haven jurisdiction such as the island country of Cyprus. Cyprus may be an excellent jurisdiction to repatriate funds out of Poland to due to the fact that the jurisdiction has no withholding tax on dividends.

We also discussed how foreign investors were utilizing the U.S.-Hungarian bilateral treaty to reduce their exposure to U.S. taxes resulting from the gains in real estate. Although foreign investors can no longer take advantage of the U.S.-Hungarian tax treaty to reduce their exposure to U.S. taxes on gains in real estate holdings, the current bilateral U.S.-Polish treaty provides similar benefits to foreign investors as the now defunct U.S.- Hungarian bilateral tax treaty enacted in 1979. For example, suppose a foreign investor realizes a gain on a debt instrument on real property classified as interest under Section 897 of Internal Revenue Code. Like with the previous bilateral U.S.- Hungarian tax treaty, under current U.S.-Polish tax treaty, the foreign investor can lend money from a Polish company and have the gain of the real property completely exempt from U.S. income tax.

As discussed above, the Income Tax Regulations provide that a foreign person can utilize a foreign corporation to lend money to a U.S. individual without realizing taxable gain of a USRPI for purposes of Section 897. Under the U.S.-Polish bilateral treaty, a foreign investor can establish a Polish corporation to lend money to a U.S. individual holding real property. The Polish corporation could secure a mortgage on the U.S. property. Under the loan agreement, the Polish corporate lender would receive fixed monthly payments from the domestic borrower, constituting repayment of the principal plus interest, and a percentage of any appreciation in the value of the real property at the expiration of the loan. The Income Tax Regulations of Section 897 potentially allow a foreign investor to lend money from a company formed in Poland and completely exclude the gain on the real property from U.S. income tax.

In addition, if the transaction is property arranged, the foreign investor could mitigate or avoid Polish corporate income tax which currently has a corporate tax rate of 19 percent. In order to mitigate Polish corporate tax, a “finance branch” may be established in low-tax third party jurisdiction. Poland has bilateral tax treaties with Switzerland, Luxembourg and the United Arab Emirates. These jurisdictions have a very favorable branch taxing regime. Consequently, a “finance branch” could be registered in either of these countries to reduce the effective tax rate on the gains from U.S. real estate activities to a marginal tax rate of less than two percent.9

Under such planning, any income derived by the “finance branch” is exempt from Polish corporate tax under the respective tax treaty. Unlike many newer bilateral income tax treaties with other jurisdictions (including the recent treaty with Hungary), the bilateral U.S. treaty with Poland has no “anti-triangular” provisions. In general, the purpose of this provision is to prevent non-U.S. taxpayers from claiming treaty benefits if the income received by the non-U.S. treaty party is attributed to a permanent establishment in a third jurisdiction.

Conclusion

As the result of favorable world-wide income tax treaties, foreign investors in the U.S. may be able to arrange their business transactions in the U.S. without realizing any U.S. tax liability. The transaction may also be planned to significantly reduce global income taxes. Particular attention must be paid to both the tax treaties of different countries and also the additional tax savings in planning the use of multiple tax treaties and multiple entities to legally avoid the taxes that would otherwise be paid.

To better understand this intricate area of tax law, consult with a tax attorney at Moskowitz, LLP by calling (415) 394-7200 or via our Tax Law Firm’s website.

  1. Article 4(1) of the U.S.-Netherlands Income Tax Treaty.
  2. In general, all dividends received by a Hungarian corporation will be exempt from corporate income tax unless the paying corporation is a “controlled foreign corporation” (CFC), as that term is defined for Hungarian tax purposes. A CFC is defined in Hungary as a foreign corporation that is subject to an effective tax rate below 10.67 percent (which is 2/3 of the 16 percent Hungarian corporate tax rate), unless that foreign corporation has a real economic presence in the jurisdiction.
  3. The exemption from withholding tax on dividends out of Hungary applies only if the recipient is a corporation. Therefore, the individual can own the shares of the Hungarian corporation through a low-tax jurisdiction, such as the British Virgin Islands or the Cayman Islands.
  4. IRC Section 871(a)(2).
  5. IRC Section 897(c)(2).
  6. Treas. Reg. Section 1.897-1(h).
  7. See Article 23(1)(a) of the Hungary-Switzerland Income Tax Treaty; Article 24(1)(a) of the Hungary-Luxembourg Income tax Treaty.
  8. Poland currently has a 19 percent corporate income tax rate. Poland grants a foreign tax credit for foreign taxes paid as long as the Polish corporation owns at least 75 percent of the U.S. corporation.
  9. See Article 23(1)(a) of the Poland-Switzerland Income Tax Treaty; Article 24(2)(a) of the Poland-Luxembourg Income Tax Treaty; and Article 24(1)(a) of the Poland-UAE Income Tax Treaty.

Moskowitz LLP, A Tax Law Firm, Disclaimer: Because of the generality of this blog post, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations. Prior results do not guarantee a similar outcome. Furthermore, in accordance with Treasury Regulation Circular 230, we inform you that any tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purposes of (i) avoiding tax related penalties under the Internal Revenue Code, or (ii.) promoting, marketing, or recommending to another party any tax related matter addressed herein.

Non-Citizens Risk Immigration Status for Offshore Bank Accounts

by Stephen M. Moskowitz, Esq. and Anthony V. Diosdi, Esq. 22. August 2012 16:26

The increased focus by the IRS on foreign income has generated a lot of news and a slew of criminal prosecutions.  While US citizens need to consider the possibility of monetary penalties or a long prison sentence, resident non-citizens (green card holders) also need to worry about the possibility of being deported after they serve their prison sentence and are stripped of their assets.  What is required of resident non-citizens and what are the consequences for failing to disclose offshore accounts and foreign interest income?

All “United States persons,” including green card holders, are compelled to report all their global income, including interest income earned in foreign bank and financial accounts, to the Internal Revenue Service.  According to the general definition in Internal Revenue Code Section 7701(a)(30), both United States citizens and non-citizen residents qualify as “United States persons”.  The international portion of a “United States person’s” income is required to be reported on the following forms:   See Offshore & Foreign Compliance

Form 1040, Schedule B, Part III

This form contains three yes/no questions you must answer regarding any foreign accounts and trusts that you have an interest in and directs you to two additional forms to complete, Form TD F 90-22.1 for foreign accounts and Form 3520 for foreign trusts.  In the event that you are required to file Form TD F 90-22.1, you must also report on Form 1040, Schedule B, Part III where the financial account(s) are located.

Form TD F 90-22.1

The Report of Foreign Bank and Financial Accounts, also known as the FBAR, is required when the total value of foreign financial accounts held is in excess of $10,000 USD at any time within the calendar year.  This includes accounts in which you had signature authority but not an ownership interest.  The form is filed separately from your tax return and reported to the Department of the Treasury.

Form 3520

A separate Form 3520 is required to be filed with your tax return for each qualifying foreign trust transaction or qualifying foreign gift received.  Examples of qualifying transactions include distributions received from foreign trusts and gifts of more than $100,000 from nonresident alien individuals or foreign estates.  A full list of qualifying transactions and exceptions can be found in the Form 3520 instructions.

Form 8938

In tax years beginning after March 18,2010 (for most this is their 2011 filing), “United States persons” meeting the asset thresholds are also required to file the new Statement of Specified Foreign Financial Assets (Form 8938).  For unmarried and married persons filing separately that reside in the U.S. the threshold is $75,000USD at any point during the year or $50,000USD at the end of the tax year.  Married persons residing in the U.S. filing a joint return are required to file this form when their total foreign financial assets exceeds $150,000USD at any point in the year or $100,000USD on the last day of the tax year.  Full filing requirements including exceptions and qualifying assets can be obtained through the Form 8938 instructions.

Failure to file any forms required to disclose the existence of any offshore financial accounts or any income acquired from said foreign financial accounts opens a “United States person” to the possibility for Criminal Tax Crimes and criminal penalties as well as Civil Tax Assessments and penalties.

Filing a False Tax Return

If an individual is proven by the IRS or Department of Justice to have willfully signed or filed a tax return or other document such as the FBAR that he or she did not believe to be true and correct in a material matter, they could be convicted of filing a false tax return.  An individual may also be prosecuted for filing a false tax return if it is proven that the individual willfully aided or assisted in the preparation of a tax return, affidavit, claim, or other document that is fraudulent or false as to any material matter with knowledge that the document would be submitted to the IRS.

Tax Evasion

Willfully attempting to defeat or evade a federal tax due and owing or evasion of payment of an assessed tax can lead to prosecution for tax evasion.

Willful Failure to File an FBAR

Choosing not to file an FBAR can lead to criminal prosecution.  There are increased penalties if this violation occurs concurrently with the violation of other laws or is part of a pattern of illegal activity involving more than $100,000USD in a 12-month period.

Conspiracy to Defraud

If two or more individuals agree to commit a substantive offense against the United States or to defraud the United States, and if the commission of the overt act is in furtherance of the conspiracy, charges could be brought forward for conspiracy to defraud the United States.

IMMIGRATION ASPECTS OF TAX CRIMES

In addition to the formerly mentioned criminal penalties, various civil penalties can be charged, as well as various penalties under state law, for failing to disclose offshore income.  The implications of conviction go further.  Persons failing to disclose foreign account(s) and/or foreign source income and suffering a criminal conviction could face incarceration, serious fines, loss of child custody or even termination of pension benefits.  Some aliens receiving criminal convictions may even face deportation.

One such judgment resulting in deportation is “aggravated felony”.  Aggravated felony includes offenses that, as defined in Title 8 of the United States Code §1101(a)(43)(M),”(i) involves fraud or deceit in which the loss to the victim or victims exceeds $10,000; or (ii) is described in section 7201 of Title 26 (relating to tax evasion) in which the revenue loss to the Government exceeds $10,000.”  Aliens in the United States receiving an aggravated felony conviction are not eligible for review from deportation or asylum.  Therefore, it is important for noncitizens with previously undisclosed foreign bank accounts or foreign source income to obtain competent legal counsel to advise them of any immigration consequences that may result from a tax crime criminal conviction.

Unfortunately, not all criminal attorneys representing noncitizen taxpayers are properly prepared with the necessary knowledge of immigration law to competently represent their clients.  This fact was illustrated in the case of Padilla v. Kentucky, 130 S Ct. 1473 (2010).  Padilla, a long-time lawful permanent resident, was charged with a drug offense.  The Kentucky state court charged the defendant with the transportation of marijuana.  Assured by his attorney that his immigration status was secure due to the length of his residence, he accepted a plea bargain.  However, the mere acceptance of his plea bargain caused him to be deportable without the opportunity for relief.  After realizing the consequences of his plea, the defendant attempted to challenge his guilty plea citing ineffective counsel, but the Kentucky Supreme Court denied his challenge on the grounds that the Court did not view deportation as a direct consequence of his conviction and therefore outside the purview of the Sixth Amendment’s guarantee for “the effective assistance of competent counsel.”  The United States Supreme court disagreed with the ruling and overturned the lower state court’s decision.

The lesson to be learned from the Padilla v. Kentucky case is that attorneys representing noncitizens in felony class cases need to be knowledgeable of immigration law.  This understanding is even more pressing when plea agreements are being negotiated on behalf of the client.

As stated by Judge Stevens, addressing the Court, in the case of Padilla v. Kentucky:

Changes to our immigration law have dramatically raised the stakes of a noncitizen’s criminal conviction.  The importance of accurate legal advice for noncitizens accused of crimes has never been more important.  These changes confirm our view that, as a matter of federal law, deportation is an integral part—indeed, sometimes the most important part—of the penalty that may be imposed on noncitizen defendants who plead guilty to specified crimes.

The Supreme Court went on to rule that it is the duty of criminal defense attorneys to competently advise noncitizen clients when pending criminal charges may carry adverse immigration consequences and equally important, when deportation is certain.  By obtaining a qualified criminal defense attorney, the defense counsel may be able to construct a plea that minimizes the possibility for deportation.  In cases relating to undisclosed foreign source income or offshore accounts, noncitizens should look for an attorney competent in immigration law or associated with counsel competent in immigration law, as well as an attorney prepared to promptly discuss the consequences of a criminal conviction.

As previously discussed, an aggravated felony charge can results in an automatic deportation without the opportunity for a discretionary review by the immigration court.  Until recently, the immigration court determined whether a charge fit the definition of an aggravated felony by looking at the language of the statute under which the defendant was convicted.  Generally a categorical approach to review was taken foregoing examination of the underlying facts and circumstances of a conviction.  In the 2009 case of Nijhawan v. Holder, 129 S. Ct 2294, 2300, the United States Supreme Court seems to have changed this approach to an extent.  As the United States Supreme Court discussed whether a conviction for conspiracy to commit fraud was an aggravated felony as defined in 8 U.S.C. §1101(a)(43)(M)(i), it was determined that in order to come to a conclusion it was applicable to review the circumstances of the defendant’s crime to determine the amount of the victim’s loss.  Further, that while the amount of loss suffered by the victim(s) is a legitimate matter to be gleaned from the record of conviction; an actual figure of loss does not need to be included in the conviction.  As such, the immigration court should continue to conclude from the statutory language of the offense whether it included “fraud or deceit,” and then utilize the criminal proceeding records to calculate if the loss exceeded $10,000USD.

As previously discussed, tax evasion is the only tax crime specifically listed in 8 U.S.C. §1101 as being categorized as an “aggravated felony,” when the loss exceeds $10,000.  Among the various Supreme Court circuits, there has been debate as to whether congress meant to exclude other tax crimes from being categorized as “aggravated felonies” or merely wished to ensure that tax evasion is seen as an “aggravated felony.”  All previously mentioned criminal penalties include an element of fraud or deceit and thus at the discretion of the court could meet the first test as to whether or not the offense qualifies as an “aggravated felony.”  Tax offenses that can potentially be classified as fraudulent or deceitful are not limited to those that have been discussed.  As such, it is extremely important for defense attorney(s) representing noncitizen taxpayers to be mindful of the language of offenses being negotiated in a plea and when appropriate specify a tax loss that is less than $10,000 to ensure it does not later come into contention.

U.S. Taxation of Fideicomisos under the FATCA Rules

by Stephen M. Moskowitz, Esq. and Anthony V. Diosdi, Esq. 7. August 2012 15:03

Overview of Fideicomisos

If you own a home or a vacation home in Mexico, chances are that your property is held in a fideicomiso. A fideicomiso is a contractual arrangement that is arguably something in between a trust and a custodial agreement. Under Mexican law, a fideicomiso is a written contract whereby the trustee receives funds or property for the purpose of carrying out a lawful objective.

Fideicomisos are required by the Mexican Government for many U.S. persons for development and acquisition of real property in areas of Mexico where foreign investment is either restricted or limited. In such instances, a transaction may be planned whereby a foreigner may acquire an interest in the fideicomiso itself rather than taking title to the underlying property.

A trustee must be appointed to oversee the fideicomiso. Under Mexican law, the trustee of a fideicomiso is obligated to act in a fiduciary capacity with respect to both the grantor and the beneficiary and must be an approved bank or credit institution. The trustee holds legal title to the property, while beneficial ownership remains vested in the grantor. The grantor retains the sole power to make decisions regarding the sale or transfer of property. Upon the termination of the fideicomiso agreement, the grantor receives legal title except where the grantor is a foreigner and the property held in trust consists of residential real property located in a zone where foreign ownership is prohibited.

Introduction to the Hiring Incentive Restoration Employment Tax and the New Law’s Implications on U.S. Persons that Have an Interest in a Fideicomiso

The Hiring Incentive Restoration Employment (HIRE) Act was signed into law on March 18, 2010. The HIRE Act contains several provisions that change the rules applicable to foreign trusts and their beneficiaries, causing the use of trust property to be treated as a deemed distribution. The HIRE Act broadens the grantor trust rules which treat U.S. settlors of foreign trusts as owners of trust property for federal income tax purposes. The new law was intended to target individuals who utilized foreign trusts to avoid U.S. taxes. However, the HIRE Act has some serious unintended consequences to U.S. Persons or U.S. investors who have an interest in a Mexican fideicomiso.  This article will discuss the U.S. implications tax and reporting to U.S. persons that hold an interest in a fideicomiso.

The Implication of the Grantor Trust Rule to Foreign Trusts with a U.S. Beneficiary

Sections 671 to 679 of the Internal Revenue Code contain the so-called 'grantor trust rules,' which treat certain trust settlors (and sometimes persons other than the settlor) as the owner of a portion or all of a trust's income, deductions and credits for U.S. tax purposes. A trust where the settlor (or other person) is treated as the owner of the trust assets for U.S. tax purposes is referred to as a 'grantor trust.' The grantor trust rules apply to both foreign and domestic trusts, but in different ways.

Under the grantor trust rules, a U.S. person who transfers property to a foreign trust is generally treated for income tax purposes as the owner of that portion of the trust attributable to the transferred property, even if the trust would not have been a grantor trust had it been domestic.  This is the result for any tax year in which any portion of the foreign trust has a U.S. beneficiary. A foreign trust is treated as having a U.S. beneficiary for a tax year unless (i) under the terms of the trust, no part of the trust's income or corpus may be paid or accumulated during the tax year to or for the benefit of a U.S. person, and (ii) if the trust is terminated at any time during the tax year, no part of the income or corpus could be paid to or for the benefit of a U.S. person. The Treasury Regulations under Section 679 of the Internal Revenue Code generally treat a foreign trust as having a U.S. beneficiary if any current, future or contingent beneficiary of the trust is a U.S. person.

Informational Return Filing Requirements of U.S. Persons Having a Financial Interest in a Fideicomisos

Section 6048 of the Internal Revenue Code imposes reporting obligations on foreign trusts and persons creating, making transfers to or receiving distributions from such trusts. For example, a U.S. person who transfers property to a foreign trust must report the transfer to the Internal Revenue Service (IRS), and a U.S. beneficiary who receives a distribution from a foreign trust must report the distribution. Both reports are made on IRS Form 3520 and the failure to file the form in a timely manner results in a penalty generally equal to 35 percent of the gross value of the transfer or distribution per year. In addition, if a U.S. person is treated as the owner of any portion of a foreign trust under the grantor trust rules, the U.S. person is responsible for ensuring that the trust files an annual information return on Form 3520-A and provides information to each U.S. person who is treated as the owner of any portion of the trust, or receives (directly or indirectly) any distribution from the trust.

The Combination of the Grantor Trust Rules and the New HIRE Combine to Produce a Perfect Storm for U.S. Beneficiaries of Fideicomisos

The HIRE Act broadens Section 643(i) of the Internal Revenue Code to provide that any use of foreign trust property after March 18, 2010 by a US grantor, a U.S. beneficiary or any U.S. person related to a U.S. grantor or U.S. beneficiary will be treated as a distribution for federal income tax purposes to such U.S. grantor or U.S. beneficiary of the fair market value of the potential to use the property where it is actually used or not. As discussed above, the recipient of the deemed distribution will be required to file Form 3520 to report the distribution from the foreign trust. Not only will a beneficiary of a fideicomiso have to report the fair market value of the use of the property held in the fideicomiso on a Form 3520, a U.S. person holding an interest in a fideicomiso may have to report the fair market value of the use of the property held in the fideicomiso on his or her federal income tax return, whether it is used or not. This deemed distribution rule will not apply to the extent that the foreign trust is paid fair market value for the use of the property within a reasonable period of time. There is no indication as to what period of time will be considered 'reasonable' and the IRS is likely to provide guidance on this issue.

Conclusion

On June 24, 2011, dated November 17, 2010 and released on June 24, 2011, the IRS Office of the Chief Counsel took the position that as “general information only,” any U.S. person who transfers property to or who has an interest in a Mexican fideicomiso must treat the entity as a foreign trust for purpose of filing Forms 3520 and 3520-A. The new tax laws promulgated by the HIRE Act took elevated this matter. Under the HIRE Act, the United States has moved beyond collecting information on fideicomisos and now seeks to impose tax on a U.S. taxpayer’s interest on a fideicomiso. Clearly, U.S. taxpayers who hold an interest in a fideicomiso must file applicable Form 3520s reporting the fair market value of the use of the property held by the entity. In addition, the new HIRE Act imposes unforeseen federal income tax on U.S. persons who established a fideicomiso or have a beneficial interest in a fideicomiso. Whether the IRS can impose a federal income tax liability against the grantor or beneficiary is unclear, however, please refer to Section C. of our client update regarding foreign trusts for potential tax filing obligations.

Under Article 27 of the Constitution of Mexico, only Mexicans by birth or naturalization or Mexican companies may “acquire direct ownership of lands or waters within a zone of hundred kilometers along the frontiers and of fifty kilometers along the shores of the country.” A fideicomiso is a property-ownership arrangement to comply with Article 27 of the Mexican Constitution under which a Mexican Bank Trust obtains legal title to a piece of real estate within a prohibited zone, and a foreigner, as the beneficiary of the trust, enjoys the beneficial interest in the property, including all the usual rights of ownership.

Section 643(i)(3) of the Internal Revenue Code, as amended by the HIRE Act, provides that the U.S. grantor, or U.S. beneficiary, must report the fair market value rental value of the use of any property placed in a trust. Article 27 of the Mexican Constitution clearly defines a fideicomiso as a trust. Since a fideicomiso is classified as a trust under Mexican law, the IRS will take the position that a U.S. grantor or U.S. beneficiary of a fideicomiso will take the position that the fair market value of the potential use of the property placed in the trust will be taxable on an annual basis, whether it is actually used or not. Currently, U.S. persons who hold an interest in fideicomisos have the use of property that is located in some very expensive and desirable coastal areas. Given the new HIRE Act imposes a duty to recognize a tax liability on the fair market value of the value of real estate placed in a foreign trust, the beneficiaries of fideicomisos may be subject to a very unwelcome new annual federal income tax, unless the person takes effective steps to avoid it.

Unless the grantors or beneficiaries of fideicomisos can distinguish it from a foreign trust, it seems that the realization of a new federal income tax will simply become an enormous cost of having an interest in a fideicomiso. In other words, an argument must be made that a fideicomiso cannot legally be classified as a trust. Given the current state of Mexican law and the wording of most fideicomiso agreements, arguing that a fideicomiso is not tantamount to a trust does seem realistic. Under Mexican law, most fideicomiso agreements will never permit the Mexican property held in the fideicomiso to revert to the U.S. grantor. Fideicomiso agreements are typically limited to a term of years, typically 50 years. Given the very nature of the fact that the usage of the land held by the fideicomiso is limited to a term of years, and title to the property held by the fideicomiso can never pass to the beneficiary or his or her heirs, a compelling position can be taken that a true trust agreement has not been established. Instead, the U.S. person acquiring a property interest in the fideicomiso holds a long term lease on property where foreign ownership is prohibited.

Since the time period which a U.S. person and his or her heirs can enjoy the property is limited by a term of years and title to the property can never revert to the U.S. beneficiary of the fideicomiso, a strong argument can be made that a fideicomiso should not be characterizes as a foreign trust for U.S. tax purposes. Instead, a fideicomiso should be treated as a custodial, nominee arrangement or even a lease agreement in which a U.S. person leases land in Mexico for term of years. And, a Mexican Bank is appointed to hold title to the property at issue.

At this time the rules governing the U.S. taxation of an interest in a Mexican fideicomiso remains in flux. Given the uncertainty in this area, U.S. taxpayers with an interest in a fideicomiso should consider obtaining a private letter ruling to determine the IRS position on the U.S. tax consequences of that particular entity.

Please do not hesitate to contact us to learn more.  

 

Like any Law Firm, we need to add a disclaimer:    Because of the generality of this blog post, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on your particular situation(s).    Furthermore, in accordance with Treasury Regulation, Circular 230, we inform you that any tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purposes of (i) avoiding tax related penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any tax related matter addressed herein.  

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