Much has been written about U.S. taxpayers residing in Canada who have, for various reasons, failed to file necessary U.S. income tax and information returns. The principle explanations offered by these taxpayers are (1) “I was unaware of my obligation to file” or (2) “I was unaware I was a U.S. citizen.” Although these persons haven’t knowingly violated the law, they could be subjected to tens of thousands of dollars in penalties for not complying with them. In order to correct their oversight, these taxpayers have basically had to choose between (1) filing returns without notifying the IRS (“quiet disclosure”), (2) enrolling in the Offshore Voluntary Disclosure Program (“OVDP”), or (3) filing 6 years of returns along with a request for reasonable cause relief (“noisy disclosure”). As discussed below, each option has its costs, in terms of time gathering information and money paying professional fees, risks of civil and criminal penalties, as well as benefits. However, recent guidance from the IRS, called by some an “amnesty,” may provide a simplified and streamlined process whereby these taxpayers can become compliant.
Brief Overview of Current Alternatives
Since it involves simply filing returns, quiet disclosure offers the lowest professional services cost. However, the IRS has specifically warned taxpayers considering quiet disclosure of possible examination and criminal prosecution. In addition, this option offers no relief from penalties and is essentially playing the audit lottery. Professional fees associated with enrolment in OVDP can be substantial as a result of the 8 year filing requirement and direct involvement with the IRS Criminal Division. It offers relief from most penalties, but, to participate, the taxpayer must agree to pay a penalty ranging from 5% to 27.5% of the value of a taxpayer’s liquid assets. Professional fees for persons engaged in noisy disclosure would generally fall somewhere in the middle of the other two. Because most penalties can be waived upon a showing of reasonable cause, noisy disclosure is often a good option for taxpayers who are likely to meet the reasonable cause standard.
Recent IRS Guidance
On June 26th, the IRS released IR 2012-65 which promises a new procedure designed to simplify the catch-up filing process and filter low risk from higher risk taxpayers. Notably, the guidance suggests a 3 year return filing requirement and a 6 year Foreign Bank Account Report filing requirement. While specific details will be unveiled in the next few months, the new procedure is scheduled to take effect on September 1, 2012.
Risk Assessment Approach
Importantly, the release indicates that the IRS will determine the intensity of its review of returns submitted using this procedure on a compliance risk assessment. For those taxpayers presenting “low compliance risk,” the review will be expedited and the IRS will not assert penalties or pursue follow-up actions. The IRS will determine the level of compliance risk based on information provided on the returns and other information.
Low risk will be predicated on “simple returns” with little or no U.S. tax due. Absent certain risk factors, if the submitted returns and application show less than $1,500 in tax due in each of the years, they will be treated as low risk. Risk factors to be assessed include the taxpayer’s level of income, assets, and economic activity in the U.S., indications of sophisticated tax planning or avoidance, history of non-compliance, the amount and type of U.S. source income. Taxpayers with higher compliance risk may be subject to additional scrutiny and require additional filings.
Canada Specific Relief
It also specifically addresses a simplified means to obtain relief for late filed 8891's (to defer income accruing in an RRSP). To summarize, the taxpayer seeking relief must submit: (1) a request for extension of time to file the 8891, (2) the 8891 and plan description, and (3) a statement outlining reasonable cause for failure to file. Under normal IRS procedures, a taxpayer seeking relief for a late filed 8891 must seek a Private Letter Ruling outlining the individual’s reasonable cause argument and request for relief.
While the IRS hasn't yet provided the specific procedure, we believe the release indicates its intent to provide taxpayers with a less burdensome and costly means to become compliant. With the 3 year initial filing requirement and approach to late filed 8891’s, the IRS may significantly simplify the process of coming forward. The risk assessment presents a common sense approach to balancing the revenue collection function of the IRS with the desire of taxpayers to comply. The questions of who will fall into the “high compliance risk” category and what is a “simple return” remain to be seen. However, in our opinion, this release is good news for taxpayers. We remain cautiously optimistic that the procedure ultimately implemented will allow many taxpayers to become compliant with their U.S. tax filing obligations without an unnecessarily heavy burden in terms of time and money.
Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encouraged to seek proper legal advice.
IRS Circular 230 Disclosure
To ensure compliance with requirements imposed by the U.S. Internal Revenue Service, we inform you that any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (1) avoiding tax-related penalties under the U.S. Internal Revenue Code or (2) promoting, marketing or recommending to another party any tax-related matters addressed herein.