United States: How To Reduce Criminal Tax Risks Through An IRS Voluntary Disclosure

The government has long recognized that taxpayers make bad decisions, even criminal ones. In an effort to nudge taxpayers back into compliance with their tax obligations, the IRS offers the Voluntary Disclosure Practice (VDP). Under the VDP, a taxpayer may mitigate criminal tax exposure for prior year filings or even non-filings if the taxpayer voluntarily comes forward to report the non-compliance. Currently, the VDP permits disclosures for a litany of different non-compliance matters, including income tax, employment tax, estate and gift tax, and foreign income and reporting.

Eligibility for VDP

Not all taxpayers qualify for the VDP. Indeed, in exchange for reduced risks of criminal prosecution, the IRS imposes numerous requirements on those who seek the benefits of the program.

First, the submission must be timely. Generally, a submission is timely if the IRS does not already have information related to the non-compliance and is not very close to determining the non-compliance through its own examination efforts. Under this requirement, taxpayers are barred from the VDP if the IRS obtains information through informants, other government agencies, John Doe summonses, or criminal search warrants. Moreover, the submission is not timely if the IRS has initiated a civil or criminal examination of the taxpayer, even if the agency is unaware of the non-compliance at the start of the examination.

Second, the taxpayer must agree to cooperate with the IRS during the course of the VDP process. For these purposes, cooperation includes: (1) providing statute extensions or waivers for income tax and FBAR matters; (2) promptly providing accurate and complete records when responding to IRS requests; (3) agreeing to interviews and making other witnesses available; (4) providing delinquent or amended returns, information returns, and supporting documentation; and (5) providing bank secrecy waivers, if it is an offshore case.

Third, the disclosure must be complete and truthful. The failure to properly answer IRS questions and the omission of relevant facts results in disqualification from the program.

Fourth, the taxpayer must be prepared to make full payment of the additional taxes, interest, and penalties that are determined under the VDP. In limited circumstances, however, the IRS may agree to accept a proposed collection alternative instead of full payment, although this is not the norm.

Fifth, the taxpayer's source of income must not derive from illegal sources. For these purposes, state law is irrelevant—the IRS is looking at whether the source of income is illegal under federal law.

Steps In the VDP

There are effectively three steps in the VDP, and IRS Form 14457, Voluntary Disclosure Practice Preclearance Request and Application, plays a large role in the first two steps.

Initially, the taxpayer must come forward and submit Part I of Form 14457 to IRS-Criminal Investigation (IRS-CI). This portion of the form requires identifying information (e.g., name, social security number, date of birth, etc.) and also the identification of entities and bank accounts that were involved in the non-compliance. IRS-CI reviews this information with the information it has on file to determine whether the disclosure is timely. If it is timely, the taxpayer is notified of "preclearance" and requested to prepare and submit Part II of Form 14457.

The second part of Form 14457 is more invasive. For unreported income disclosures, the taxpayer must make a good-faith estimate of the total annual unreported income earned during the disclosure period, which is generally six years. For foreign asset disclosures—i.e., undisclosed foreign accounts and FBAR-related items—the taxpayer must disclose the highest aggregate account or asset value during the disclosure period. And with respect to all disclosures, the taxpayer must provide personal and professional background information, the names of any professional advisors who assisted in the noncompliance, and a "non-compliance narrative." The non-compliance narrative requires a full disclosure of all relevant facts associated with the non-compliant conduct. IRS-CI reviews Part II of Form 14457 primarily for completeness, and taxpayers who pass this review are notified that they have been granted "preliminary acceptance" into the VDP.

The final step of the VDP process requires more IRS contact. Specifically, an IRS examiner is assigned to the case and conducts an examination of the delinquent or amended returns and any information returns. Similar to any other audit, the examiner may ask questions and issue Information Document Requests (IDRs). After completion of the examination, the IRS will propose assessments of additional tax and penalties. For most disclosures, the taxpayer will be required to pay a 75% fraud penalty on the highest tax liability year. If the taxpayer and the IRS agree with the proposed assessments and penalties, the taxpayer executes a binding closing agreement with the agency.

Benefits Of A VDP Submission

There are numerous benefits associated with a VDP submission. First and foremost, taxpayers who submit disclosures under the program are generally not referred to DOJ-Tax for criminal prosecution. In addition, because the 75% fraud penalty is in lieu of other potentially applicable civil penalties, the taxpayer may in some instances be better off entering the VDP, at least compared to the alternative of having an examination outside the program. Finally, in circumstances where the non-compliance extended outside the VDP disclosure period (again, generally six years), the taxpayer may benefit in that payment of taxes must be made only for the disclosure period. Examples of these benefits follow.

Example One: John is the sole owner of ABC Corporation. ABC Corporation has not filed employment tax returns for six years, nor has ABC Corporation remitted withheld employment taxes to the IRS. John and ABC Corporation enter the VDP and satisfy all of the requirements of the program, resulting in a closing agreement from the IRS for the employment tax matters. As a result of his successful participation in the VDP, the IRS agrees not to refer John's employment tax non-compliance to DOJ-Tax for criminal prosecution.

Example Two: Although Mary had income tax filing obligations for 2018 through 2022, no returns were filed. If returns had been filed, Mary would have owed income taxes of $100,000 for 2018, $100,000 for 2019, $150,000 for 2020, $150,000 for 2021, and $200,000 for 2022.

Mary enters the VDP and meets all of the requirements of the program, resulting in a closing agreement from the IRS for the non-filed income tax returns. If Mary had not entered the VDP and had been examined, Mary would have had to pay the income taxes, plus an additional 25% late-filing penalty for 2018 through 2022 which would equal roughly $175,000 (not taking into account adjustments to the penalty for the late-payment penalty). Under the VDP, however, Mary must pay a 75% fraud penalty on the highest tax liability year of 2022 which would equal $150,000 (75% x $200,000). The fraud penalty is in lieu of other civil penalties, including the late-filing penalty. Mary actually pays less civil penalties under the VDP.

Example Three: Alex is a sole proprietor who has not filed tax returns for 10 years. Alex has never been subject to IRS examination regarding his non-filings. Alex enters the VDP and meets all of the requirements of the program, resulting in a closing agreement from the IRS for the non-filed income tax returns. Under the general guidance of the VDP, Alex would only have to file and pay tax with respect to the last six years of non-filed tax returns. The IRS would not seek payment of tax for the four years outside the disclosure period, even though Alex did not file tax returns for those years.

As seen by the above examples, the VDP can be a smart move for certain taxpayers with criminal tax risks. Therefore, taxpayers with criminal tax exposure should carefully consider the VDP as a viable compliance option.

Originally published by Forbes.

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