This is cross posted from the RenounceUScitizenship blog.

“Trust is like a vase.. once it’s broken, though you can fix it the vase will never be the same again.”

This post should  be read with a previous post: “The taxpayer, the IRS and the “professionals” – where to go from here“.  This post will suggest why,  given the IRS shift in policy on March 1, 2011 lawyers had difficulty advising clients  whether to enter OVDI (2011). With the exception of the most extreme cases (clear tax evasion at one end vs. Ambassador Jacobson’s 70 year old Gramma at the other), lawyers neither trusted nor understood the IRS. They could not. This post will suggest why. At the outset, it is important to recognize that “hindsight is always twenty twenty” and during the desperate summer of 2011, nobody had the benefit of hindsight.

The facts and issues are summarized by the conclusion of Taxpayer Advocates directive to the IRS on August 16, 2011:

The IRS’s perceived reversal burdened taxpayers, wasted resources, violated longstanding IRS policy, opened the IRS to potential legal challenges, and was not properly disclosed as required by FOIA.  It also damaged the IRS’s credibility with taxpayers as well as the practitioner community.  As a result, the IRS is likely to have more difficulty gaining participation in any future settlement initiatives.  This erosion in trust for the IRS among taxpayers and practitioners is also likely to have a negative impact on IRS’s mission and voluntary tax compliance more generally.”

1. From the perspective of the taxpayer:

The decision to enter OVDI had absolutely nothing to do with taxes that may have been owing. It was completely driven by the perception of FBAR (and possibly other “information return”) penalties. It was the FBAR penalties that were the most fearsome.

2. From the perspective of the IRS:

OVDP (2009) and OVDI (2011) were programs that were designed for people who where using “offshore” vehicles to avoid or evade taxes. This is consistent with the stated objective of OVDI 2011 as stated in OVDI FAQ 2.

“The objective remains the same as the 2009 OVDP – to bring taxpayers that have used undisclosed foreign accounts and undisclosed foreign entities to avoid or evade tax into compliance with United States tax laws.”

Note that this focuses on the use of foreign entities to avoid or evade tax . Furthermore, the IRS has made it clear that another important objective was to bring taxpayers back into the tax system. (If you are thinking an amnesty is a good idea, I agree.)

The IRS assumed that anybody entering the program was a criminal and  was admitting to being a criminal. Once entering  the program a taxpayer was presumed to have acted “willfully”. (For those people OVDI was a pretty good deal.) Note that this focuses on the use of foreign entities to avoid or evade tax into compliance.

It is quite obvious that only criminals had any incentive to enter OVDI. For everybody else, it was a question of: Yes,  I want to be in compliance. But, I can’t use OVDI.

3. From the perspective of the lawyers:

Part A – The Mind of the lawyer in 2009:

OVDP (2009) was NOT (at least at the beginning) a program that was understood to presume criminality. The lawyers understood  the OVDP information, including FAQ 35, including to allow for the consideration of “reasonable cause” and “non-willfulness”:

“Voluntary disclosure examiners do not have discretion to settle cases for amounts less than what is properly due and owing.  These examiners will compare the 20 percent offshore penalty to the total penalties that would otherwise apply to a particular taxpayer.  Under no circumstances will a taxpayer be required to pay a penalty greater than what he would otherwise be liable for under existing statutes.”

S. 5314 of the FBAR is an “existing statute” that bars the IRS from imposing FBAR penalties if “reasonable cause” is demonstrated and the FBAR is filed. Furthermore, the maximum “non-willful” penalty is $10,000. Quite obviously the “non-willful” penalty of $10,000 or a complete abatement of penalties due to “reasonable cause” could be much better than 20% of the value of your assets.

Again: the lawyers understood “liable for under existing statutes” to include considerations of  “reasonable cause” and “non-willfulness”. They counseled their clients accordingly.

Well, at least until March 1, 2011 …

On March 1, 2011, (two years into OVDP) the IRS simply began taking the position that FAQ 35 did NOT allow for considerations of “reasonable cause” and “non-willfulness”. This was interpreted to be a change in the rules and was characterized as a “bait and switch”.  “Reasonable cause” and “non-willfulness” could be  considered on an “opt out”. As you can imagine this upset a number of people. (Lawyer Asher Rubenstein has written a good analysis of this.)Taxpayers were understandably afraid to subject themselves to the perceived “IRS thuggery and arbitrariness” on an opt out. Non-willful taxpayers who may have had “reasonable cause” paid far higher penalties than they thought they would have to pay. So much for OVDP 2009. The IRS can do what it wants. Why would a taxpayer pay the non-willful penalty instead of “opt out”? Here is what the IRS said about the “opt out” option:

“If the offshore penalty is unacceptable to a taxpayer, that taxpayer must indicate in writing the decision to withdraw from or opt out of the program.  Once made, this election is irrevocable.  An opt out is an election made by a taxpayer to have his or her case handled under the standard audit process.  It should be recognized that in a given case, the opt out option may reflect a preferred approach.  That is, there may be instances in which the results under the applicable voluntary disclosure program appear too severe given the facts of the case.  There will be other instances where this is less clear.  In the latter cases, the Service will look to ensure that the best interests of the Service and the integrity of the voluntary disclosure program remain intact.  In these cases, it is expected that full scope examinations will occur if opt out is initiated.  It is expected that opt out will be appropriate for a discrete minority of cases.   Moreover, to the extent that issues are found upon a full scope examination that were not disclosed by the taxpayer, those issues may be the subject of review by Criminal Investigation.  In either case, opting out is at the sole discretion of the taxpayer and the taxpayer should not be treated in a negative fashion merely because he or she chooses to opt out.”

Would you opt out under these circumstances?

This is bettered described by Taxpayer Advocate in the following language:

“On March 1, 2011, more than a year after the 2009 OVDP ended, after learning that examiners were spending the time to compare the 20 percent penalty to what would be due under existing statutes, the IRS “clarified” its seemingly unambiguous statement in FAQ #35.

The March 1 memo directed examiners to stop accepting less than the 20 percent offshore penalty under the 2009 OVDP regardless of whether a taxpayer would pay less under existing statutes, except in narrow circumstances.  Even in those few cases where the IRS was supposedly still applying FAQ #35, it generally did not consider reasonable cause and assumed the violation was subject to the maximum penalty for willful violations unless the taxpayer could prove that the violation was not willful.

Thus, in the absence of evidence, taxpayers who would be subject to the lower penalty for non-willful violations (or given a warning letter or overlooked) outside of the program would be subject to the 20 percent penalty inside the program.  Moreover, the IRS did not provide any guidance to taxpayers regarding what evidence they could use to establish non-willfulness or reasonable cause.”

But the story gets even worse. This great IRS “bait and switch” took effect on March 1, 2011. This means that taxpayers who had been processed prior to March 1, 2011 DID have the benefit of “reasonable cause”. This exacerbated the level of unfairness. From that moment on the IRS made it clear that it simply could not be trusted. As proof of that, AND THIS IS A BOMBSHELL (assuming this to be true), according to the results of a request under the Freedom of Information Act (are you ready for this):

“According to the IRS, all of the 3,000 applications to the 2011 OVDI came in after the 2009 OVDP deadline and before the IRS’s announcement of the 2011 OVDI on March 1, 2011.  IRS  response to TAS information request (July 13, 2011).  Thus, it appears that the 2011 OVDI may not have received any significant number submissions after the IRS’s reversal became known.”

In case you missed this, the March 1 shift in IRS policy appears to have made people reluctant to enter OVDO 2011.

Part B – The mind of the lawyer in 2011:

The IRS “bait and switch” of 2011 made people very distrustful of the IRS. It underscored the IRS presumption that OVDI was a program designed for criminals. That didn’t mean that other people couldn’t participate. But, it did mean that participation in OVDI 2011 meant that you were knocking on the door of the IRS and presenting yourself to be a criminal. Hence, it is reasonable to expect that you would be treated as a criminal. Of course you could always opt out and be subjected to the “standard audit”.

Why would any poor U.S. citizen living outside the United States  who didn’t know about and couldn’t imagine that an FBAR requirement existed get involved in this. To add to the ridiculousness, if one entered OVDI 2011 the taxpayer had to calculate their own penalty and include a check. This reminds me of:

– if the Chinese government shoots one of its  citizens  the family has to pay for the bullet (maybe the Obama administration should consider this next time they kill a U.S. citizen abroad);

– Jesus being forced to carry how own cross to the crucificion.

How could any lawyer recommend that anybody but a tax evader enter this program? (If you are a lawyer reading this please comment.)

4. From the perspective of Taxpayer Advocate – Calling in the Cavalry:

Now back to the OVDP 2009 AKA “The Great IRS “Bait and Switch”.  But, if you really want to fight the IRS you need somebody with the legislative authority. Believe it or not (and like most of you I had never heard of this until recently) there is a “Taxpayer Advocate in the IRS”. (The IRS probably views Taxpayer Advocate as a tumor inside the IRS.) In any case, Taxpayer Advocate agreed that the change in the IRS position with respect to FAQ 35 was a classic “bait and switch” and cried foul! they wanted to help the taxpayers. Now Taxpayer Advocate has a couple of “big sticks” available. They are “Big Stick – TAO” and “Big Club – TAD”.

Big Stick – TAO: Taxpayer Advocate Order: This usually is used in relation to  single taxpayer

Big Club – TAD:  Taxpayer Advocate Directive: This is used to correct a more general problem.

On August 16, 2011 Nina Olsen (the head of Taxpayer Advocate) issued a TAD against the IRS. (It is the most well written and well organized analysis of this issue that I have been able to find. Read it. You will learn a lot.) But, for those of you who do NOT want to become “OVDP Historians” the TAD of August 16, 2011 really says:

IRS you have cheated. You duped taxpayers into entering OVDP because they thought they could raise arguments of “reasonable cause” and “non-willfulness” without doing an “opt out”. You are like a slimy salesman who does a classic bait and switch. We are directing you (because we have the authority) to give taxpayers the benefit of “reasonable cause” and “non-willfulness” without an “opt out”.

 In “Taxpayer Advocate Speak”, Taxpayer Advocate directed the IRS to:

“Immediately direct all examiners that when determining whether a  taxpayer would be liable for less than the “offshore penalty” under “existing statutes,” as required by 2009 OVDP FAQ #35 (described below), they should not assume the violation was willful unless the taxpayer proves it was not.  Direct them to use standard examination procedures to determine whether a taxpayer would be liable for a lesser amount under existing statutes (e.g., because the taxpayer was eligible for (a) the reasonable cause exception, (b) a non-willful penalty because the IRS lacked evidence to establish its burden to prove willfulness, or (c) application of the mitigation guidelines set forth in the IRM) without shifting the burden of proof onto the taxpayer.”

Well hey, the IRS, like most big bullies, is always up for a fight. They are not going to be kicked around by Taxpayer Advocate. On August 30, 2011 they issued their response. When you can spend the taxpayers money on the finest lawyers that money can buy, you can come up with a pretty good response. Actually I congratulate the IRS on their choice of lawyers. Whoever wrote their response did a good job. Actually, a very good job. I  recommend it to you – an excellent example of lawyering. (Also a good example of why people don’t like lawyers).

Without boring you with the $750 per hour details, the response of the IRS was:

No, no and more no. FAQ 35 does not allow for the consideration of “reasonable cause” or “non-willfulness”. If you don’t like it then, you just opt out!

So, the stage has been set for a big brawl – featuring one division of the IRS (the good cop) versus another division of the IRS (the bad cop). We need a referee to settle our differences. Who is this referee to be? Yes,  you guessed it – the IRS Commissioner himself –  Douglass Shulman

5. The Perspective of Doug Shulman:

Or rather, what’s a poor IRS Commissioner to do? He is required to settle this fight by January 26, 2012. So, keep your eyes and ears open! This dispute is of great interest to lawyers, accountants, taxpayers, the good cop. the bad cops and everybody else. It is no surprise that this has been the subject of:

– a great thread on Jack Townsend’s blog; and

– a fascinating article in Tax Notes

He has two options:

1. Side with Taxpayer Advocate the “good cop”

2. Side with his own people the “bad cop”

As “Just Me” explains neither option is desirable for Mr. Shulman.  So, what should he do? The answer depends on his “long term” objectives. If his “long term” objective truly is to bring people back into the tax system he will side with “good cop”. If his objective is something else, then he will side with the “bad cop”. Neither  decision would surprise me. To date, Commissioner Shulman has given little indication that he understands most U.S. citizens with foreign bank accounts are NOT criminals. That does not bode well for the “good cop”. As a recent blog post at Roth CPA (by the way this is a great blog) noted:

“It’s not encouraging that the decision rests in the hands of Commissioner Shulman, who hasn’t lifted a finger to intervene in a process that has infamously treated Americans abroad and U.S. residents with foreign accounts as presumed criminals, hitting minor and harmless violations of obscure rules with absurd fines.”

I suspect that Mr. Shulman’s perception of this may be that:

One the one hand, Mr. Shulman states that:

“Collecting additional revenue for past misdeeds – as important as that may be – is not the main consideration here. It’s equally important that we’re bringing U.S. taxpayers back into the system…back into compliance… so they properly report and pay their taxes for years to come.”

http://renounceuscitizenship.wordpress.com/2011/11/09/bringing-u-s-taxpayers-into-the-system/

and on the other hand:

“… the biggest problem with the administration of the OVDP was the deeply entrenched view of the IRS that the people who entered the program were tax evaders. Lack of consistency also proved to be a problem for OVDP participants, especially those who sought refuge from penalties under FAQ 35 …”

– a lawyer quoted in the Tax Notes article

A decision in favor of Taxpayer Advocate could be the first step on a long long road of restoring some trust. The IRS simply cannot function without it.

You can expect an update on or around January 26, 2012. Until then, keep thinking about the obligations of U.S. citizenship!