To OVDI or not OVDI: The “In lieu of other penalties” consideration

Deal with the devil

On January 9, 2012 the IRS reopened the Offshore Voluntary Disclosure Program “OVDI”. People should enter OVDI only after an objective discussion with a lawyer who is experienced in U.S. tax compliance issues. Contrary to what at least one tax preparation firm suggests, OVDI is one of a number of compliance options. Although OVDI is available to anyone who wants to enter, it presumes criminality. Minnows should think long and hard before entering OVDI and should have an objective reason based on your specific facts  for entering it. For many people, entering OVDI is an emotional reaction. You need to make a calm, rational decision. Those entering OVDI  should be able to answer in one short sentence the question:

How did your analysis result in your decision  to enter OVDI?”

In any case, this is for you to decide with the help of your lawyer.

Entering OVDI – Your deal with the devil

If you enter OVDI you are entering into a agreement with the IRS. The “deal” is in relation to both “tax issues” and “information reporting issues”.

Tax Issues: You agree to pay the tax you owe and penalties on that tax.

Information Reporting Issues: You agree to pay “in lieu of other penalties” an amount equal to a percentage (ranging from 5% to 27.5%) on the value of your penalty base. Your penalty base may (depending on the circumstances) be the highest value of your worldwide assets over the 8 year period.

What are these “other penalties“? They are penalties for failing to file the appropriate information returns. Since the summer of 2011 (but not before) Mr. FBAR has become a well known information return. The FBAR is probably required by most U.S. citizens living outside the United States and many “Green Card” holders inside the United States. But, there are many other information returns that are not as well known. You might find the following conversation between an experienced IRS attorney and a  minnow to be of interest.

I came across a superb article by Alvin Brown that identifies “some information returns”.  I highly recommend his article. It is very comprehensive and precise. Once again, this is to educate you prior to your visit with your lawyer.

Here are some of the international information returns that he has identified. If you read his article you can learn about the details: penalties, reasonable cause, willfulness, opportunities for judicial review, etc.  While I was reading his article I was asking myself:

“Why would anybody imagine that any of these requirements even exist?”

Mr. Brown begins by noting that:

U.S. persons are required to file certain information returns depending on their interests in, control over, transfers to or distributions from foreign corporations, partnerships, other entities and trusts. Penalties are imposed under various sections of the Internal Revenue Code for failure to file or filing incomplete or inaccurate required returns. Most of these penalties are considered “assessable penalties” that are not subject to the deficiency procedures under Code Sec. 6211. The IRS may assess such penalties without prior notice, although the INTERNAL REVENUE MANUAL provides that examiners should (not must) inform the taxpayer prior to assessing the penalties. To make matters worse, these penalties generally have no statute of limitations for assessment. With that cheery opening, we review some of the information returns frequently required with offshore accounts.

Reasonable cause – it’s about abatement of penalties

Fortunately most of these penalties can be avoided or abated for “reasonable cause”. Please note that what  you might imagine is “reasonable cause” may not be what the IRS considers to be “reasonable cause”. Therefore, you must consider the question of what constitutes reasonable cause.

Here we go – A Tour Through “Form Nation”:

Form 5471—Information Return of U.S. Persons with Respect to Certain Foreign Corporations

The Form 5471 must be filed by U.S. persons that have a certain level of control (i.e., officers, directors or shareholders) of certain foreign corporations to report information required by Code Secs. 6038 and 6046. This information includes foreign corporation entity data, stock ownership data, financial statements and intercompany transactions with related persons.

Form 5472 – Business

The Form 5472 reports transactions between a 25-percent foreign-owned domestic corporation or a foreign corporation engaged in a trade or business in the United States and a related party as required by Code Secs. 6038A and 6038C.142

Form 926—Return by a U.S. Transferor of Property to a Foreign Corporation

U.S. persons, U.S. domestic corporations and domestic estates and trusts must report any exchanges of property to a foreign corporation as set forth in Code Sec. 6038B(a)(1)(A) and Reg. §§1.6038B-1 and 1.6038B-1T. The information is reported on a Form 926 and filed with the taxpayer’s income tax return for the tax year that includes the date of the transfer. There are certain exceptions to these filing requirements, as well as additional rules that must be considered for transfers by U.S. partnerships, transfers by a husband and wife, and transfers of cash to a foreign corporation.

Form 3520—Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts

The Form 3520 reports various transactions involving foreign trusts, including creation of a foreign trust by a U.S. person, transfers of property from a U.S. person to a foreign trust and receipt of distributions from foreign trusts under Code Sec. 6048. This return also reports the receipt of gifts that, in the aggregate, exceed $10,000 from foreign entities under Code Sec. 6039F.157 Subject to certain exceptions set forth in the Instructions, you are required to file the Form 3520 in any of the following circumstances:
• You are the responsible party for reporting a reportable event that occurred during the current tax year, or you held an outstanding obligation of a related foreign trust (or a person related to the trust) that you treated as a qualified obligation during the current tax year.
• You are a U.S. person who, during the current tax year, is treated as the owner of any part of the assets of a foreign trust under the grantor trust rules.
• You are a U.S. person who received (directly or indirectly) a distribution from a foreign trust during the current tax year or a related foreign trust held an outstanding obligation issued by you (or a person related to you) that you treated as a qualified obligation during the current tax year.
• You are a U.S. person who, during the current tax year, received either:
• more than $100,000 from a nonresident alien individual or a foreign estate (including foreign persons related to that nonresident alien individual or foreign estate) that you treated as gifts or bequests; or
• more than $13,561 (adjusted each year) from foreign corporations or foreign partnerships (including foreign persons related to such foreign corporations or foreign partnerships) that you treated as gifts.
The Form 3520 is due on the same date as the related income or estate tax return (including extensions), but must be filed separately with the Internal Revenue Service Center, P.O. Box 409101, Ogden, UT 84409.

Note the following in relation to an abatement of penalties due to reasonable cause in relation to form 3520:

The fact that a foreign country would impose penalties for disclosing the required information, or reluctance of a foreign fiduciary to provide such information, does not constitute reasonable cause.

Form 8865—Return of U.S. Persons with Respect to Certain Foreign Partnerships

U.S. persons with certain interests in foreign partnerships must file Form 8865 to report interests in and transactions of the foreign partnerships.

Note that I referred to the above as “some information returns”. Mr. Brown has identified some of the returns identified under the Internal Revenue Code. He has not discussed information returns that may be required under tax treaties. For example, the Canada U.S. tax treaty requires the filing of form 8891 which is the required election for your RRSP. A failure to file form 8891 will not subject you  to a direct penalty for failure to file. But, it can cost you a great deal down the road if you fail to file it. On this (to use the word of Alvin Brown) “cheery” note, if you have RRSPs, you might want to read:

When bygones aren’t bygones by FBAR Scholar Hale Sheppard.

A consideration for Canadians …

The U.S. Canada tax treaty does not require the Canada Revenue Agency to collect FBAR penalties. Finance Minister Flaherty has confirmed that Canada will NOT collect FBAR penalties for the IRS. If you enter OVDI, you are paying a penalty “in lieu of other penalties”. In other words, you are neither paying nor being assessed an FBAR penalty.


The preceding has been a description of some of the “other penalties” that are referred to.  They may be abated because of “reasonable cause”. You and your lawyer must compare these “other penalties” to the “in lieu of other penalties” calculation under OVDI. Remember that “reasonable cause” is available in OVDI only under the “opt out”.

As a U.S. citizen living abroad you are subject to a large number of reporting requirements that you can’t even imagine exist. U.S. tax compliance is too expensive for most people. But, the penalties are so severe that the cost of compliance is always less than the cost of non-compliance.

U.S. citizenship has been priced out of the market!

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