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
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.
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.
 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.
 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.
 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.
 SeeIRS News Release IR-2012-5 (Jan. 9, 2012), available at http.//www.irs.gov/pub/irs-mews/ir-12-005.5pdf.
 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.
 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.
 See Id. at note 4, 5, and 6.
 See id. at note 16.
 United States v. Pomponio, 429 U.S. 10 (1976).
 31 U.S.C. Section 5321(a)(5)(C)(i).
 Cheek v. United States, 498 U.S. 192, 201 (1991).
 31 U.S.C. Section 5321(B)(i).
 IRM 184.108.40.206.3.1 (07-01-2008).
 United States v. Boyle, 269 U.S. 241, 246 (1985).
 Scott v. Commissioner, 1 T.C. 654 (1974).
 See IRC Section 6401.
 Jones v. Liberty Glass Co., 332 US 524, 531 (1947).
 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.
 Treas. Reg. Section 301.6402-2(b).
 Treas. Reg. Section 301.6402-2(a)(2).
 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.
 IRC Section 7121.
 IRC Section 7121(b).
 Ingram v. Comm’r, 32 B.T.A. 1063, 1064, 1935 WL 287 (1935).
 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).
 In re Guy Miller v. Internal Revenue Service, 174 B.R. 791 (1994).
 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).
 Roach v. United States, 106 F.3d 720, 723 (6th Cir. 1997).
 Fruhauf Southwest Garment Co. v. United States, 111 F.Supp. 945, 951 (Ct.Cl.1953).
 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”).
 Christie v. United States, 518 F.2d 584, 587 (Ct.Cl.1975).
 See Systems Technology, 699 F.2d at 1387.
 Beatty v. U.S., 168 F.Supp. 204 (Ct.Cl.1958).
 Morrill v. Amoskeag Sav. Bank, 90 N.H. 358, 9 A.2d 519, 524.
 David Robinson v. U.S., 95 Fed.Cl. 480 (2011).
 Johnson, Drake & Piper, Inc. v. U.S., 531 F.2d 1037, 1042 (Ct.Cl.1976).
 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).
 111 F.Supp. 945, 951 (Ct.Cl.1953).
 See Fed. Deposit Ins. Corp., supra note 40 (citing Sims v. Jones, 611 S.W.2d 461, 462 (1980))
 1995 WL 556621 (M.D.Fla).
 76 F.Supp.2d 736 (1999).
 32 T.C.M. (CCH) 955 (1973).