Welcome to The Friday Edition
, the biweekly newsletter on international tax things, because, well, that’s what I do in my day job.
This episode is for people who are aware that they have a tax problem. You might be running a business and know that there are a lot of unfiled forms (Form 5471 is a favorite) you need to take care of. Or you might not have filed tax returns for years. Or you earned income but did not report it for taxes.
In one way or another you have reached the jumping-off point. You have realized there is a problem, and you need to solve it. Maybe you’re still looking for magic,1
but the sanity module in your brain is telling you the time for magic is over, and it’s time for unpleasant action.2
Something is off, you know it, and it makes you uneasy and stressed. You know you need to fix the problem and you want to. But you don’t know how, and you don’t know where to start. You’re stuck.
But First, Thanks
First, a hat-tip to Paul Jarvis, who wrote a massively useful blog post about putting on workshops
, and to a tax lawyer colleague (hello C.D.) with whom I had a long video call earlier this week to discuss exactly this type of project. They inspired this episode of The Friday Edition
I have a definite framework for projects like this, but it is not a plan by any means. To quote the inestimable Sig Rinde, the process for solving big hairy problems is not like planning an assembly line. It is a Barely Repeatable Process
. We can chart a general course from the start to the desired end result, but we can’t predict the precise actions needed to get there.
And sometimes, we can’t get to the desired end result no matter how hard we work. 🙁
Live Through the Suck
Getting from here to there is a heroic task. Be willing to live through the suck. You will
get to the other side. And life will be better on the other side. That’s my professional and personal experience.
- Professional = I watched this happen to other people.
- Personal = I experienced it as a multi-year nonfiler of income tax returns, so I have personally lived through the suck.
Fog, Donald Rumsfeld, and Procrastination
Fear and procrastination thrive with when we are not clear about what needs to be done. When you have a nebulous ball of
What do I do?
surrounding your tax problems, the default action is inaction. Which, of course, increases your stress level.
Donald Rumseld famously talked about knowns and unknowns:
“[T]here are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.3
- Known knowns.
I didn’t report some income. I know I can solve it by filing an amended tax return, and I can guess how much it will cost in taxes.
- Known unknowns.
I didn’t file an FBAR to report a foreign bank account. I know how to fix the problem, but I don’t know what the penalty will be when I file late. The unknown is the penalty that might be assessed.
- Unknown unknowns.
I didn’t file an FBAR to report a foreign bank account. What cascading events of horrors exist that I don’t even know about once I raise my hand and tell the IRS that I exist? This is where fear and dread live. You know there are dragons at the edge of the world. But where is the edge of the world, and are the dragons thirsty for human blood?
From Fog to Clarity
Clarity dispels fear, dread, and stress.
For tax problems, there is a marvelous clarifying moment when a nonfiler sees the actual tax number. This is what you owe for those multiple years of tax returns. There is a marvelous clarifying moment when an entrepreneur sees a corporate structure cleanup with a number attached to it:
The worst that can happen is a penalty of $X.
You might not like the number. But it’s a number.
Hard work quantifies the known unknowns. Within a range, you know the high/low penalty outcomes.
Experience helps quantify the unknown unknowns. Other people (like us) have been down this road before you. They can help you see possible collateral damage resulting from the
clean up your life
project, and help you route around it.
You need clarity.
The Value of Planning
You need to plan what you are going to do.
Plans are worthless, but planning is everything.
Carl von Clausewitz:
No campaign plan survives first contact with the enemy.
Everyone has a plan ’til they get punched in the mouth.
You need a plan of action. You will fix the tax returns for which years? What are your reporting positions on the individual items on the tax returns? How will you file the completed tax returns? If there is an audit, are you ready to defend each point?
Your plan is guaranteed to change. This happens as the tax returns are prepared. The tax bill goes up or down. Additional facts come to light — unknown unknowns — as we dig up documents.
But you need a plan.
Until proven otherwise, we will do the following. . . .
Ask Questions at the Right Time
You don’t go to an architect and say you want a house, how much will it cost? It’s too early. You need to specify the type of house, size, etc.
How do I fix my tax problems? It’s a good question, but it is too early to answer.
How much will it cost me to fix my tax problems? It’s a good question, but too early to answer.
Again, it is too early to tell. You cannot choose a strategy until you know what the facts are.
These are appropriate questions, but they must be answered at the appropriate time.
Will I go to prison
can be answered early in the project.
Will you recommend the Offshore Voluntary Disclosure route to fix my problem?
should be answered late in the project, after most of the facts are in.
Again, you need a plan.
Emergency Room Triage
If you’re not feeling up to par, you go to the Mayo Clinic and get a complete head-to-toe examination. What is wrong? What’s the cure? Aspirin or amputation? 🙂
For tax it is the same. Your first step is a diagnosis and recommendation for a cure. This provides clarity.
Here is how we do it.
How Many Years?
We usually look at the last eight years of income tax returns (or lack thereof). Why eight? Because the
Come to Jesus
choices are probably:
- Three years of tax returns (Streamlined Procedure or just get people back in the system);
- Six years (there’s some pretty serious stuff going on); or
- Eight years (we’re looking at the voluntary disclosure program).
If you choose the OVDI process, the review will show you the full picture. If you choose to fix your problem another way, you know what will happen in the other years if the IRS gives you some push-back.
We will poke and prod a bit at the earlier years, too. There might be some things there that matter (like acquisition cost for assets). But more than likely we will leave those years alone.
Data We Use
We use rough data from you. Estimates, guesses where necessary. Real data where easily available. Why? We know the numbers are going to be wrong. If we get estimates in the right neighborhood, we are happy.
The primary objectives for the emergency room triage stage of the project are speed and direction. We want to know — as quickly as possible — where things stand, and which way we should march. We don’t care so much if we are $20,000 or $50,000 wrong in our estimates.
Back to Donald Rumsfeld. We work on the known/unknowns by talking to you about:
. Stuff you know about that is bothering you.
. Stuff your brain reminds you about as you lie down to go to sleep at night and you can’t put your finger on anything but you keep thinking these thoughts.
. We may see correlations that you can’t see, just from experience. We can start to bring them to light now, but really they won’t be dispelled until the tax returns are prepared.
From this exercise, we come out with the following results:
- Estimated tax cost.
- Estimated interest cost.
- Estimated penalties: high/low/probable.
- An Issue Matrix™4. This is a year by year grid showing what needs to be done on each tax return for each year for every reported item on that tax return. It is a complete roadmap for tax return preparation.
- Our best guess for how to get you from where you are now to closed tax years: OVDI, Streamlined Procedure, or just file.
This strategy choice is a strong opinion, weakly held. As we go through the process, we will be looking for facts that make us change our opinion about the optimum strategy.5
And trust me, during the data collection and tax return preparation phase of this project, we will find stuff. 🙂
On Risk Assessment
Tax risks come from three things:
- The amount of additional taxable income to be reported, which creates an additional tax liability to be paid;
- The size of the assets involved, which make you look big and interesting (also, some penalties are a function of asset size); and
- The paperwork requirements (forms not filed almost always have stiff penalties for the failure to file).
In this triage stage, we are trying to understand the approximate magnitude of unreported income. From this we make some heroic guesses about the eventual tax cost, penalties, and interest charges involved.
We are looking at hidden or unreported assets, the reporting requirements, and the likely penalties for failure to report the assets.
Finally, we look at forms (like the FBAR) required but not filed. There is no tax associated with these forms, but failure to file carries a penalty. What are the penalties?
The Issue Matrix
I call it the matrix because that’s what we called it the first time we used it. It was a giant six-year cleanup problem with a multi-million dollar number attached to it. We wanted to keep our guy out of jail, and we wanted to stay sane.
Create a giant grid in a spreadsheet. Along the top, write the years you are going to fix. These are the columns. Rows are the reporting positions you are going to take on each item of income and expense that you find in the triage phase. There will be all sorts of moving parts here. Even with a single asset, you might have a different reporting position one year compared to the next.
Until proven otherwise, the Issue Matrix is what you plan to do when preparing the income tax returns.
You will update your matrix as you move through the tax return preparation phase. New facts will pop up that make things more complicated, and you change your strategy as those new facts reveal themselves.
The Issue Matrix is magic. You can start to get a feel for the magnitude of the job. That corporation in the British Virgin Islands. Are you going to treat it as the sham it really was? File a Rev. Proc. 92-70-style Form 5471 for it? Or go full blown Form 5471? This might change from year to year.
The matrix is a roadmap for the person working on the tax return. And you have a roadmap showing the items where legal analysis and an opinion letter will be required to cut through the murk. It is also your organizing document for assembling backup data for workpapers and audit defense. Be Prepared.®6
From the client’s perspective, the matrix is useful because it allows us to start to estimate the magnitude of the tax return preparation job. And this means we can start to offer budget estimates and time estimates.
Good for the lawyer. Good for the accountant. Good for the client. It’s all good.
I won’t tackle a big multi-year cleanup job again without an issue matrix.
You cannot overestimate the amount of work involved. It is not unusual for us to have two people full-time on one of these projects, with a couple of others dipping in and out as necessary. Typically, we will have two CPAs and an attorney working away on this.
There will also be others involved to a lesser or greater extent, and this means project management. Regular status meetings where everyone meets and talks through the agenda. Slack channels. A dedicated conference room or spare office as a war room.
Expect maybe 15%-20% of the time spent on this project to be spent on project management. It is critical. One person will find some obscure fact. This fact may be critical to someone else’s decision. As the person paying the bills, the client may complain about being billed for one person to talk to another person. Sorry. It’s the way things work.
Strive to have two people know the same fact at all times.
That’s an overview of the work to be done before you start work.
I will talk about the
part of the job in a future episode of The Friday Edition
. Tax return preparation. Hard legal analysis for uncertain facts or uncertain law. Hard judgment calls with minimal legal or factual basis, but significant downside for a wrong choice. And the moment of truth: signing and sending the tax returns.
Obv. this ain’t legal advice. And it’s incomplete. If you have a tax mess, you need to talk to someone who has gone through it before and can help you fix the problem.
My suggestion is to make a decision, ask someone for help, and start running hard. Don’t stop until you have filed your tax returns. Time is not your friend: information decays and disappears, interest and penalties accrue, and the government’s ability to find previously-hidden facts continues to improve.
Get it done. You’ll feel better. I know I did when I got the tax bill for my non-filed tax return years. I went from fear and stress, to
OK. Let’s set up a payment plan and pay this thing off.
Which I did.
See you in a couple of weeks.