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Foreign Bank Accounts and Undisclosed Income: IRS's 2011 Offshore Voluntary Disclosure Initiative (OVDI)

Introduction

IRS announced a second Offshore Voluntary Disclosure Initiative (OVDI) for taxpayers with unreported foreign income or financial accounts. OVDI eliminates potential criminal prosecution for tax violators, but comes with steep penalties. Since the first initiative, which netted 15,000 disclosures, another 3,000 taxpayers have come forward.

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Because of the harsh set of penalties, OVDI will appeal primarily to tax cheats: those who willfully and repeatedly have violated the tax law.

Unfortunately, many taxpayers with inactive foreign accounts or minor amounts of foreign income could mistakenly enroll in OVDI out of an unrealistic fear of criminal prosecution.

Foreign Accounts

Taxpayers with foreign bank or financial accounts (totaling more than $10,000 at any time during the year) are required to file a Report of Foreign Bank and Financial Accounts, Form TD F 90-22.1 (FBAR) on or before June, 30 of the following year; there are no extensions. The deadline to report foreign accounts held in 2010 is just days away, June 30, 2011.

Note: When calculating the highest balance during the year for FBAR purposes, use the exchange rate at the end of the year.

Almost every type of financial account in which the taxpayer has signature authority, including joint accounts and accounts over which the taxpayer has a power of attorney, are considered foreign bank or financial accounts for FBAR purposes and must be reported.

Note: IRS considers annuities, IRA-type retirement accounts and cash value life insurance products to be foreign accounts.

Foreign Income

U.S. residents and citizens are taxed on, and must report, all foreign income. There are foreign tax credits and certain exclusions for foreign earned income that may be claimed, but all foreign source income must be reported.

OVDI addresses the failure to file FBARS or report foreign income from all sources. For instance, in addition to bank and financial account earnings, unreported business or investment income or profits, as well as real estate rents, are encompassed within the OVDI process.

Key ODVI Provisions

1. The penalty amount is raised to 25% (up from 20%) of the highest aggregate amount in all foreign accounts from 2003 to 2010. Some taxpayers will be eligible for 5% or 12.5% penalties.

2. In general, the 5% penalty involves accounts which were not opened by the taxpayer; the taxpayer had minimal contact with the account; no more than $1,000 per year has been withdrawn; and there is no untaxed principal in the account. Also, non-residents who filed and paid taxes in the foreign country of residence and who earned less than $10,000 a year in U.S. source income may be eligible for the 5% penalty.

3. For those who do not qualify for the 5% penalty, the 12.5% penalty applies when the aggregate balance of all foreign accounts from 2003 through 2010 never exceeded $75,000.

4. Participants must file returns (or amend returns), pay back-taxes and interest for up to eight years as well as pay accuracy-related and/or delinquency penalties, by August 31, 2011. Under the first initiative, the period was six years.

5. A major exception: lf all foreign income has been reported but FBARs were not filed, there is no penalty for filing delinquent FBARs. This exception applies Form 3520 reporting failures of required foreign trust distributions, gifts and inheritances.

Eligibility

Disclosures under OVDI must be filed before IRS starts an inquiry, whether or not the scrutiny involves unreported foreign income or financial accounts. Thus, taxpayers under a current examination or investigation are ineligible for OVDI.