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Three important changes to IRS Streamlined filing procedures for US taxpayers resident in Canada

The IRS recently released answers to frequently asked questions (which you may find by clicking here) regarding its new Streamlined filing compliance procedures (“Streamlined”) for US persons who reside outside of the US and are not current on their tax and filing obligations. The FAQs address six questions, three of which resolve important issues:

First, the FAQs examine the $1,500 tax liability threshold that is used to determine whether a taxpayer is eligible for Streamlined. Eligibility is determined by examining a taxpayer’s compliance risk, which is generally measured by the complexity of the returns. The FAQs state that if the taxpayer owes less than $1,500 in any of the three submitted years he will not necessarily qualify as “low risk” and, conversely, if the taxpayer owes more than $1,500 in any of those years he will not necessarily be considered “high risk.”

Second, if the taxpayer is currently a participant in the 2011 offshore voluntary disclosure initiative (“OVDI”) or 2012 offshore voluntary disclosure procedure (“OVDP”) he may opt out of these programs and seek to enter the Streamlined.

Third, taxpayers who have completed one of the IRS’s offshore voluntary disclosure programs, such as the 2011 OVDI or 2012 OVDP, may have their cases reexamined under Streamlined. Taxpayers who are eligible for Streamlined will receive a refund of the penalty imposed by those programs.

The recently released FAQs indicate that the IRS will administer the program without strict adherence to the previously released instructions, but still leave a lot of discretion in the hands of the revenue agent assigned to the file. This discretion is a double edged sword: on one hand, the agent has the flexibility to arrive at the “right” (or “wrong” as the case may be) result for the taxpayer; however, on the other hand there is little certainty of the ultimate result. Streamlined is not a perfect program, but the recently released FAQs show that IRS is moving in the right direction.

Background of Streamlined

As you may remember, the Streamlined procedure is a more palatable way for US taxpayers who are late with their US tax filing obligations to become compliant. Streamlined provides US taxpayers who are late with their filing obligations with an abridged amnesty program; as compared to the lengthy (and painful) offshore voluntary disclosure programs of the past. On August 31, 2012, the IRS released instructions for taxpayers who wish to file under Streamlined. Generally, late filers are eligible for Streamlined if they have not resided in the US since January 1, 2009; have not filed US tax returns for the same period; present a low level of compliance risk; and have simple returns with little or no tax due (that is, the $1,500 tax liability threshold) for each of the three years submitted under the Streamlined procedures. Compliance risk is determined by examining a host of factors, such as if the taxpayer submits a return for refund or has US source income. Please click here for our complete analysis of Streamlined’s eligibility requirements.

Streamlined was created to encourage compliance for low risk taxpayers who have failed to timely file their income tax and information returns by cushioning (but not absolutely relieving) the gauntlet of penalties, and reducing the costs of compliance for US taxpayers living abroad. Streamlined absolves late filers of civil penalties (such as failure to file), but not criminal penalties. It reduces the costs of compliance by requiring three years of tax returns, as opposed to the six that is required under the most recent offshore voluntary disclosure programs. Taxpayers who fail to qualify for Streamlined, however, forfeit their opportunity to benefit from the current voluntary disclosure program.

This all or nothing approach, plus the lack of amnesty for criminal penalties, should be supplemented with concrete rules and standards to determine eligibility to provide taxpayers with the predictability necessary to encourage compliance. This is not the case. Streamlined’s eligibility requirements do not provide predictability; they embody uncertainty.

While Streamlined’s instructions may appear mechanical at first glance, the IRS has substantial discretion to govern its procedures by making eligibility a facts and circumstances inquiry. Moreover, the instructions make it clear that Streamlined is not the solution for everyone. Many questions have gone unanswered; and the instructions generated new interpretative questions for taxpayers who were not clearly eligible. Streamlined can be invaluable for those who obviously qualify, but creates a potential disaster for those who straddle the line of eligibility. These FAQs are meant to delineate eligibility. The question is, to what extent do the new FAQs resolve any of the uncertainty created by Streamlined to encourage compliance and provide a pinch of fairness to the harsh reporting requirements imposed on US persons living abroad?

The $1,500 threshold is not automatically determinative of “high risk” or “low risk”

The IRS begins by clarifying that tax liability of $1,500 or more will not, by itself, disqualify a taxpayer from Streamlined. Streamlined’s instructions inadequately explain this. They state “[a]bsent any high 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 and processed in a Streamlined manner.” The FAQs clarify, stating that taxpayers who pass the $1,500 tax liability threshold are not disqualified from Streamlined. Exceeding the threshold “may,” however, result in a “high compliance risk” label and trigger second (or more) look-see from the IRS. Risk determination remains a facts and circumstances based inquiry, and will be made by examining the risk factors mentioned above. A taxpayer with tax exceeding $1,500 who is labeled higher risk “may” be subject to penalties and examination; that is, the taxpayer may not qualify for Streamlined.

Examples: Tom and Dick [and Harry]

The following are two examples of the ambiguity inherent in Streamlined and the $1,500 tax liability limit. Tom and Dick will serve as our fictitious taxpayers. At first glance, Dick appears to qualify, but Tom does not. Tom has very simple returns, but owes $30,000 of tax in 2011. Dick owns his own business and has complex returns, full of schedule Cs, K-1s, and other letter labeled pieces of paper. Dick has tax liability numbers on his side, however, and owes less than $1,500 of tax for the past three years. According to the FAQs, Tom should qualify for Streamlined, Dick is not so lucky. Tom’s sole source of income for each of the past three years was from wages, except in 2011. In that year, Tom earned his typical wages and received a substantial inheritance in an individual retirement account. He withdrew $100,000 from that account, which resulted in a $30,000 tax bill. Tom should qualify for Streamlined regardless of the $30,000 tax liability because he otherwise had very simple returns and the withdrawal was relatively easy to account for. Comparatively, Dick is an entrepreneur with multiple operational and asset holding companies. Dick’s tax due was less than $1,500 for each year reported. Dick should not qualify because his returns contained many schedules and forms, requiring substantially more effort for the IRS to sort out. While the result may seem logical, before the new FAQs, Tom and Dick might have thought the opposite. Tom owed $30,000 in 2011 and could have reasonably concluded that he flunked Streamlined. Poor Tom burned through the $1,500 limit 20 times over! Dick owed less than $1,500 in tax and could have reasonably concluded that he qualified for Streamlined. Alas, Tom and Dick would probably be wrong. After the FAQs, Tom and Dick have (hopefully) achieved some form of enlightenment, but they are by no means 100% sure whether they qualify. Maybe Harry has better facts.

The taxpayer may opt out of OVDI and OVDP and seek to enter Streamlined

The FAQs move on to address a concern we voiced earlier (which you may find by clicking here): whether it is possible to opt out of another offshore voluntary disclosure program for Streamlined. Based on the instructions for Streamlined, taxpayers who have entered another voluntary disclosure program cannot opt out into Streamlined. This is because a taxpayer must not have filed a US tax return since January 1, 2009 to qualify for the Streamlined procedure. Taxpayers who have entered another voluntary disclosure program are required to file returns for at least the past three years. Thus, the Streamlined procedure – by its terms – does not allow taxpayers to opt out of another voluntary disclosure program for Streamlined. The new FAQs tell us otherwise. Taxpayers who have been accepted into an offshore voluntary disclosure program may elect to opt out into Streamlined, even if they entered into a closing agreement with the IRS. To opt out, the taxpayer must inform the IRS in writing.

What happens if I opt out?

The new FAQs go on to address some consequences of opting out, and how the IRS will determine a taxpayer’s eligibility for Streamlined after opting out. The election to opt out is irrevocable. The IRS agent handling a taxpayer’s submission under the offshore voluntary disclosure program may make the risk determination and close the taxpayer’s case under Streamlined if the agent concludes Streamlined is appropriate. Presumably, the agent will help steer the taxpayer in the right direction before opting out (which has been true for us). The IRS will make its determination based on all tax returns provided; it will not restrict itself to the three-year look-back that would otherwise be required under the normal Streamlined procedures to determine eligibility for taxpayers who opt out. Taxpayers will not be required to resubmit the items for Streamlined that were previously submitted under the voluntary disclosure program.

It is unclear under the new FAQs whether a taxpayer must have been accepted into another disclosure program prior to Streamlined’s effective date, which was September 1, 2012. In its answer to frequently asked question number three, the IRS uses language suggesting that a taxpayer can opt out for Streamlined only if they were accepted into a disclosure program prior to the date Streamline became effective. The remaining FAQs do not contain this restriction. Thus, another uncertainty has been created.

Taxpayers may have their cases reexamined under Streamlined even if they completed another offshore voluntary disclosure program (e.g. OVDI or OVDP)

The new FAQs allow a taxpayer to retroactively opt out for Streamlined. Taxpayers who have previously participated in another offshore voluntary disclosure program and entered into a closing agreement (Form 906) with the IRS can have their case reconsidered under Streamlined. Taxpayers who believe that they qualify for Streamlined may provide a statement to that effect to the IRS with their contact information, the name of the revenue agent handling their case, and a copy of their closing agreement. An examiner will subsequently determine whether the case should be considered under Streamlined, based on all the facts and circumstances. This generous option can be incredibly useful for taxpayers who paid substantial civil penalties under a prior program, as Streamlined exempts all qualifying persons from civil penalties. Therefore, those who qualify will receive a refund of the penalties imposed by those other programs.

Should I consider entering Streamlined?

The decision to opt out is ultimately a cost-benefit analysis: you should opt out if the cost of opting out is less than the benefit of the penalties that are abated. For those who clearly qualify for Streamlined, the decision is relatively easy. The decision can be daunting for those whose qualification is questionable. If you fall in the latter boat, it’s wise to ask the IRS agent handling your case to help make a preliminary determination regarding eligibility. We have found that agents are willing to do so. This allows you to test the waters before opting out. If you are eligible, you should opt out if it makes sense for you; for example, if the benefits exceed the costs. If your eligibility is less certain, waiting to make a decision until you are required to close your case is generally the prudent course of action.

If you want to utilize Streamlined you should weigh the factors identified in the instructions for Streamlined. The presence of the following factors may increase your compliance risk, and thus reduce your chances of qualifying for Streamlined:

  1. Returns submitted contain a claim for refund;
  2. Material economic activity in the US;
  3. Failure to report all income to your country of residence (i.e., Canada);
  4. Foreign financial bank account report (FBAR) penalties have been assessed or you have received an FBAR warning letter;
  5. Financial  interest or authority over a financial account outside of Canada;
  6. US source income; or
  7. Indications of sophisticated tax planning or avoidance.

This inquiry must be based on all the facts and circumstances. As previously discussed, Streamlined offers civil amnesty only; if you are successfully admitted into Streamlined you are not out of the frying pan yet. You may still be subject to criminal penalties. Remember to keep in mind that if you apply for Streamlined and are rejected, you are disqualified from using the current offshore voluntary disclosure program. If rejected, you also let the IRS know that you are a late filer, which will increase the risk of audit.

Conclusion: some clarity, but uncertainty remains

Although the new FAQs eliminate some uncertainty, the Streamlined procedure remains imprecise. Many questions are left unanswered and at least one new question has been raised. The Streamlined procedure has been shrouded in uncertainty since its inception. Hard and fast rules are hard to discern, and the mushy standards governing eligibility give the IRS enormous leeway for interpretation. It is nearly impossible to determine who will be eligible for Streamlined unless the taxpayer has very simple returns. Further, taxpayers and practitioners do not know which compliance risk factors will be given the most weight.

Taxpayers who fail to qualify for Streamlined forfeit the protection of the current OVDP, open themselves up to audit, and give the IRS substantial ammunition for pursuing penalties. Furthermore, taxpayers who qualify for Streamlined are not guaranteed amnesty from criminal prosecution. This uncertainty sets a serious trap for late filers residing in Canada. This runs counter to the policy expounded by Streamlined’s instructions; namely, to encourage compliance by reducing penalty exposure and the costs of compliance. Streamlined is supposed to make it easier for late filers to become compliant. The uncertainty surrounding Streamlined can be the antithesis of encouragement for many who do not have the simplest of tax situations, and late filers may believe that imitating the ostrich by sticking their heads in the sand is their best option. This uncertainty blatantly defies the program’s purported purpose. Although the new FAQs are a step in the right direction, the IRS should provide taxpayers with more guidance on Streamlined.