Does the IRS “Offshore Penalty” always make sense?
Analysis & Commentary by Amy L. Holbrook, Esq.
The current 2012 Offshore Voluntary Disclosure Program,present taxpayers faced with potentially high penalties (up to 50% of foreign account value per year, for unfiled FBARs) the chance to disclose their foreign assets voluntarily and accept an “Offshore Penalty” of 27.5%, intended to be a better option than facing the FBAR penalties themselves, as well as providing a degree of certainty as to the cost of compliance. The penalty is reduced to 12.5% in the cases of total assets under $75,000, and 5% in certain special cases.
One of the trickier parts of the calculation, though, is income-producing foreign property. The OVDI FAQ makes it clear that “if the assets produced income subject to U.S. tax during the voluntary disclosure period which was not reported, the assets will be included in the penalty computation regardless of the source of the funds used to acquire the assets.” That’s a 27.5% penalty on the fair market value of any property that generated income–which is where the OVDP penalty really becomes confusing.
The 27.5% Offshore Penalty is “intended to be a proxy for the FBAR penalty.” The FAQ does acknowledge cases in which this 27.5% penalty exceeds the penalty for which the taxpayer would otherwise be liable. Rental property is a great example. In the hypothetical case of a taxpayer who owns rental property but no other assets, what is their exposure? The substantial FBAR penalty is no longer a concern; the greatest penalty such a taxpayer would face, when reporting the income, would be the underreporting penalty calculated on the underreported income, usually 20%. Compared to 27.5% of the property value, that’s likely to be a small sum indeed.
There is some relief indicated in the FAQ if you look closely: it is stated that “Under no circumstances will taxpayers be required to pay a penalty greater than what they would otherwise be liable for under the maximum penalties imposed under existing statutes.” However, it is an admission that the 27.5% penalty, felt by some to be draconian, may have very little relationship to the penalties that would otherwise be imposed, or the underlying acts precipitating those penalties.
The IRS Offshore Penalty is supposed to be a proxy. Why include the property value of rental property in the penalty calculation if that’s the case? What would it be a proxy for? There is no penalty for failure to report the existence of foreign real estate and indeed no form or other way to report that you hold foreign real estate. It’s an extra punishment on income that’s earned outside the U.S. Once again, a domestic person who, for instance, is being paid rent in cash and not reporting it, would never be subject to the kind of scrutiny and assumption of guilt that would occur if the property was foreign. Even if the penalty is dealt with as described as above to avoid unfairness, the taxpayer still subjects themself to the labor-intensive task of complying with OVDP deadlines and the extremely long timeline of OVDP case resolution.
The acknowledgement of potentially unreasonable treatment is there. But nothing to address the guidelines–after all, the FAQ is the only guide the taxpayer and practitioner has, in the absence of Internal Revenue Manual or other material–that created it in the first place. There is no reason to include the value of rental property in a penalty calculation. For those taxpayers with foreign real estate that has produced income, certain techniques do exist to address the underlying penalty base, including the potential of opting out of the penalty structure that uses it.