PLEASE NOTE: THERE HAVE BEEN SEVERAL UPDATES SINCE THIS POST AND SOME LINKS HAVE BEEN DISABLED AS A RESULT. PLEASE READ THE LATEST INFORMATION HERE.

Non-compliant Americans overseas now have five simple choices available.

US citizens, residents and green card holders are required to file annual US tax returns whether or not they live in the United States. US persons are also required to file Foreign Bank Account Reports (FBARs) disclosing non-US bank and financial accounts and new for this year in 2012, a Statement of Specified Foreign Financial Assets Form 8938.  Failure to file any of these accurately or on time can lead to substantial penalties.

According to US government statistics, approximately seven million US citizens live outside of the United States but only about 800,000 of these actually file US income tax returns while only roughly 500,000 comply with FBAR filing requirements.

Fred learns he is delinquent!

One morning Fred came by for a chat. Fred has been a client for several years and mentioned casually that he was born in America.  Anyone born in the United States is considered a citizen. Individuals born overseas to one or both parents may also be citizens. Fred learns for the first time he is supposed to have filed US tax returns. In American tax jargon Fred is now a “delinquent”!  What should he do?

Option 1 – Do nothing

Fred can choose not to file and hope he is never discovered.  This exposes risk because Fred could be found by the Internal Revenue Service (IRS) when he visits America, renews a passport or when information exchange under the FATCA rules increases from 2014.  Many UK and international based tax, legal or investment advisers might also feel uncomfortable acting for someone known to be non-US tax compliant.  Fred’s reluctance could expose an adviser to reputational risk simply by acting for non-compliant clients.  In the UK specifically this might lead to an anti-money laundering report to the UKs Serious Organised Crimes Office if there is believed to be US tax payable.  Other countries have similar requirements.

Option 2 – File going forward (and hope the IRS don’t look for the past)

Fred could choose to file for just the most recent or the current US tax year and ignore all past obligations.  This is high risk simply because it makes it far easier for the IRS to argue that choosing not to file for earlier years was “wilful” (civil penalties for wilful actions are higher than for non-wilful behaviour).  This also provides no relief from possible IRS enquiry or even US criminal prosecution for previous years.  It might provide an equal level of discomfort to a UK or international based adviser.

Option 3 -Quietly File (with or without reasonable cause)?

Current IRS policy (stated in Fact Sheet 2011-13, published on 13 December 2011) is to generally accept six years of returns. http://www.irs.gov/newsroom/article/0,,id=250788,00.html

This would require Fred to work out what his US taxable income and deductions were for the six year period, prepare and file US income tax returns and, most importantly of all, be prepared to argue that he has “reasonable cause” for his past omissions.

Fact Sheet 2011-13 re-states long-established Internal Revenue Manual (IRM) policies that reasonable cause might include for example entire ignorance of IRS filing requirements. However for any penalties to be waived the IRS would need to agree that reasonable cause existed.  Fred or his advisers might think it appropriate to minimize the risk of a later argument with the IRS by seeking professional advice on reasonable cause before approaching the IRS.

Option 4 – Traditional Voluntary Disclosure

The fourth alternative is to use the long-standing voluntary disclosure process described in the IRM (9.5.11.9). This formal option includes completing an “optional format letter” for IRS Criminal Investigations (CI).  Assuming there are no criminal matters, CI sends the returns to the IRS civil team for review, examination and agreement.  Filings under this route can include arguing reasonable cause.

Option 5 – The Offshore Voluntary Disclosure Program (OVDP)

The IRS launched a new voluntary disclosure program on 9 January 2012.  http://www.irs.gov/newsroom/article/0,,id=252162,00.html.  This compliance initiative applies to any taxpayer with non-US income or assets and requires filing of all outstanding tax returns and FBARs for the eight years prior to the disclosure.  Any tax due for those years will need to be paid as well as payment of an accuracy related and/or delinquency penalty plus interest.  In lieu of all additional penalties that could be charged – including possible criminal prosecution – a one-time penalty will also be payable calculated as 27.5 percent of the highest aggregate value of non-US bank accounts, assets or entities in the eight year period prior to the disclosure (penalties calculated at either 5 percent or 12.5 percent may be possible in limited circumstances).  Reasonable cause arguments cannot be used.

Fred makes his mind up!

Fred has five possible approaches.  Which one he chooses will require careful comparison of the financial consequences of each option.  In some circumstances penalties under the statute can be lower than those under the OVDP, while in other cases penalties chargeable under the OVDP might prove lower than could be charged under the law.

Before approaching the IRS a careful analysis needs to be made to determine:

•    Which tax years are open under the statute of limitations (often less than the eight years under the OVDP)
•    The amounts of US tax due overall
•    What penalties might be charged ranging from fraud to accuracy related or possibly none
•    What other penalties might be chargeable for failure to file information returns disclosing non-US accounts, gifts, inheritances, trusts, companies, partnerships and other assets.

For more information, please go to our dedicated compliance and voluntary disclosure page.

Fred is not untypical.  There are several million non-US filers who will want to catch up over the coming years before they appear on IRS computer records.  On 8 February 2012 HM Treasury announced it would be assisting the IRS to find US taxpayers by collecting data on behalf of the United States so facilitating greatly enhanced automatic exchange of information.  In Switzerland and other countries, several banks have already sent letters to their clients advising about the upcoming enactment of the FATCA law and that their information will likely be sent to the IRS in the future.

Fred’s time to correct past oversights is limited.  He has five simple choices.  There is no better time than today for Fred and his advisers to start getting US tax filings up to date.