The IRS uses the threat of severe FBAR penalties to frighten taxpayers into the Offshore Voluntary Disclosure initiatives (OVDI).  Thanks to a document uncovered by Showdown, we now know that the IRS is bluffing.  This is an example of bad faith.

UPDATE:  This post has been invalidated by more recent action by the IRS.  It turns out that the IRS isn’t bluffing at all:  Please now see:

Eighth Amendment’s no excessive fines clause circumvented through plea bargaining

By all accounts it seems that the government is prepared to exercise exhorbitant fines against people, and is therefore willing to risk an Eighth Amendment law suit.  The practice of accepting huge fines under a plea bargain agreement, however, is protecting the government in many cases.

Original Post:

In the 2011 OVDI FAQ, the IRS gives the most substantial reasons that a taxpayer should enter the program:

Q3. Why should I make a voluntary disclosure?

A3. Taxpayers with undisclosed foreign accounts or entities should make a voluntary disclosure because it enables them to become compliant, avoid substantial civil penalties and generally eliminate the risk of criminal prosecution. Making a voluntary disclosure also provides the opportunity to calculate, with a reasonable degree of certainty, the total cost of resolving all offshore tax issues. Taxpayers who do not submit a voluntary disclosure run the risk of detection by the IRS and the imposition of substantial penalties, including the fraud penalty and foreign information return penalties, and an increased risk of criminal prosecution.

Later, in the same FAQ, they explain what the possible penalties are:

Q12. How does the penalty framework work?  Can you give us an example?

A12. Assume the taxpayer has the following amounts in a foreign account over a period of six years. Although the amount on deposit may have been in the account for many years, it is assumed for purposes of the example that it is not unreported income in 2003.

Year	Amount on Deposit	Interest Income	Account Balance
2003	$1,000,000	$50,000	$1,050,000
2004		$50,000	$1,100,000
2005		$50,000	$1,150,000
2006		$50,000	$1,200,000
2007		$50,000	$1,250,000
2008		$50,000	$1,300,000

(NOTE: This example does not provide for compounded interest, and assumes the taxpayer is in the 35-percent tax bracket, files a return but does not include the foreign account or the interest income on the return, and the maximum applicable penalties are imposed.)

If the taxpayer comes forward and has their voluntary disclosure accepted by the IRS, they face this potential scenario:

They would pay $386,000 plus interest. This includes:

• Tax of $105,000 (six years at $17,500) plus interest,
• An accuracy-related penalty of $21,000 (i.e., $105,000 x 20%), and
• An additional penalty, in lieu of the FBAR and other potential penalties that may apply, of $260,000 (i.e., $1,300,000 x 20%).

If the taxpayer didn’t come forward and the IRS discovered their offshore activities, they face up to $2,306,000 in tax, accuracy-related penalty, and FBAR penalty.  The taxpayer would also be liable for interest and possibly additional penalties, and an examination could lead to criminal prosecution.

The civil liabilities potentially include:

• The tax and accuracy-related penalty, plus interest, as described above,
• FBAR penalties totaling up to $2,175,000 for willful failures to file complete and correct FBARs (2003- $100,000, 2004 – $100,000, 2005 – $100,000, 2006 – $600,000, 2007 – $625,000 and 2008 – $650,000),
• The potential of having the fraud penalty (75 percent) apply, and
• The potential of substantial additional information return penalties if the foreign account or assets is held through a foreign entity such as a trust or corporation and required information returns were not filed.

Note that if the foreign activity started more than six years ago, the Service may also have the right to examine additional years.

In this very frightful example, the IRS makes absolutely no distinction between account holders:  The full-blown penalty could apply to anyone with an account adding up to $1,000,000.  Moreover, this penalty could greatly exceed the funds that are in the account.  The FBAR penalties alone are $2.175 million for an account with only 1.3 million in it.

Let’s say you are an ordinary Canadian resident or even an ordinary US resident.  You have your offshore account with a million dollars in it, like they say.  But let’s imagine that this money is yours, and that you earned it through legitimate business and it is not drug money or derived from any other criminal venture.  What are your chances of receiving this extortionate FBAR penalty?  Zero.  That’s right.  There is zero chance that the IRS will apply this level of penalty to your case.  Why?  Because the IRS knows about the Eighth Amendment.  Showdown referred in a comment to an IRS document (p. 80-81) which says (emphasis mine):

Even before Congress increased FBAR penalties in 2004, the IRS published tiered penalty mitigation guidelines in the internal revenue Manual (IRM), directing examiners to apply less than the statutory maximums.  In 2008 the IRS updated these guidelines, explaining that the maximum FBAR penalty amounts can “greatly exceed an amount that would be appropriate in view of the violation.”  It required examiners to apply even lesser penalties or a warning letter in lieu of penalties in many cases.  It explained that applying multiple FBAR penalties is to be “considered only in the most egregious cases.”  Because the statute only specifies “maximum” FBAR penalty amounts that the IRS “may” impose, it would be inconsistent with the statute for the IRS to assert the maximum penalty amounts in every case.  Some have gone so far as to suggest that in the absence of these taxpayer-favorable IRM provisions, the FBAR penalties can be so disproportionate as to violate the Excessive Fines Clause of the Eighth Amendment to the U.S. Constitution.  Thus, examiners have long been required (under “existing statutes,” as implemented by the IRM) to assert FBAR penalties of significantly less than the statutory maximums in all but the most egregious cases.

It seems unlikely, if the money is legitimate, that the IRS would charge a penalty at all.  If taxes are owed, perhaps a small FBAR penalty.  But in case the penalty is confiscatory, the IRS is well aware that the Eighth Amendment protects the taxpayer.  I will soon post some more about the Eighth Amendment, but it is sufficient at this point to say that fines must be proportionate to the crime and to the damage done to the government, and if the tax code already applies fines and interest against unpaid taxes, it seems unlikely to me that the IRS would risk applying any FBAR fine to foreign accounts because the Supreme Court could possibly strike down the entire FBAR law as unconstitutional under the Eighth Amendment.

In other words, the IRS is bluffing about the maximum penalties.  Unless you are crook, they will be afraid to apply it to you.  Thus, the IRS threatens the maximum penalty in bad faith, having the intention of scaring people into the Overseas Voluntary Disclosure programs wherein the taxpayer agrees to what seems to be a more reasonable fine of 20, 25, or 27.5%–when in fact, outside of the OVDI, the IRS would be afraid, in my opinion, to apply even such “reasonable” fines to law abiding citizens who have some minor tax irregularities.