I have been thinking a lot about the Voluntary Disclosure Program and enforcement of tax violations by the IRS. The recent guilty plea by Jack Barouh clarified things for me a bit. Yeah, I’m a slow learner. It took 29 years of practice and watching 7 guilty pleas go by for me to see this.

Two mistakes by Mr. Barouh

I see two major errors (I’m being polite here — the correct word would be “crimes”) made by Jack Barouh:

  • The skimming problem — Mr. Barouh skimmed money from his business and didn’t report it for income tax purposes; and
  • The hiding problem — he then hid the money he skimmed, using a variety of methods.

The true crime — tax evasion

To my mind the serious offense is the fact that he skimmed money from the business and that he didn’t pay tax on that money. That’s tax evasion, pure and simple. And ultimately the objective for law enforcement is to make sure that people fully report all of their income — no skimming allowed, thank you very much.

The skimming problem is the one that is harmful to society. We’re all chipping in to support the government by way of our taxes, and people who use self-help to opt out will be punished. Fair enough.

It is extremely hard for the government to find and catch people who skim money from their businesses. It takes time, human effort and ingenuity, and hard, hard work on the part of the Special Agents in Criminal Investigations — and others in the Service — to find these people and develop enough evidence to convict them. It frequently takes a bit of luck, too — a random piece of information pops up at audit, an informant presents himself to the Service with valuable information, etc. Bottom line, though — if it were left to pure detective work by the Service, more people would get away with more bad stuff.

The artificial crime — “hiding” offenses

Once Mr. Barouh had that pot of “black money” gained from skimming money from his business, he had to put it somewhere. That’s the “hiding” problem.

By creating a whole host of anti-hiding laws, the government gives itself a variety of ways to convict someone that they couldn’t otherwise toss into prison. You didn’t check the box at the bottom of Schedule B. You didn’t file Form TD F 90-22.1. You should have filed Form 5471 or Form 3520. You didn’t do this. You didn’t do that. These more technical violations are easier for the government to prove, and are easier to use to gain a conviction. I simplify, but that’s the idea.

These “anti-hiding” rules are not so much a direct way to prevent tax evasion as they are a method for making it easier to prosecute someone who has engaged in tax evasion. The simplest analogy that everyone knows is the conviction of Al Capone on tax evasion charges rather than bootlegging or other criminal offenses.

It is sufficient for the integrity of tax policy, in other words, that Mr. Barouh and his type go to jail. The precise technical method by which the Department of Justice achieves that aim is less important for the purposes of furthering tax policy.

That’s why I call it an “artificial” crime. The failure to file Form TD F 90-22.1, of itself, does not cause the Treasury to lose tax revenue. The failure to file Form TD F 90-22.1 just helps the government prosecute someone who is egregiously in the wrong.

Over-zealous enforcement of the “hiding” offenses

Mr. Barouh created his own problems by his tax evasion. He will now have the opportunity to make amends to society by paying massive fines and spending some quality time in prison.

The anti-hiding laws are what they are. “God grant me the serenity to accept the things I cannot change, etc. etc.” I don’t beef with them, although I DO think they create unnecessary and unproductive complexity in too many situations — for the Service and for taxpayers alike. Never mind that.

The tax system has run amok, however, in the recently aggressive application of the anti-hiding laws.

Laws designed to catch and convict the Jack Barouhs of the world are now entrapping normal people — regular U.S. citizens living abroad, elderly immigrants, etc. — who face losing their life savings to the Voluntary Disclosure Program. People with legally earned and already-taxed money are faced with catastrophic and life-altering fines.

In my experience the people in the field at the IRS — Special Agents at Criminal Investigations, Revenue Agents assigned to audit these cases — are sensitive to the realities of the situation, but feel helpless to make nuanced resolutions of cases–their hands are tied by lack of guidance from Washington DC.

The Voluntary Disclosure Program was designed to flush Jack Barouh-category taxpayers out of the bushes and into compliance. For Jack, paying the “20% of highest balance” penalty would have been a God-send. I’m guessing, but I would think that for every Jack Barouh who entered the Voluntary Disclosure Program, the Service got 100 ordinary citizens. Small potato people. Small undisclosed balances in offshore bank accounts, small unreported income.

Harsh penalties box you in

Having announced a policy of imposing harsh and non-negotiable penalties, the IRS cannot now be seen to back off and enforce “failure to file Form TD F 90-22.1” penalties in a sane manner. I’m imagining thought bubbles above some bureaucratic heads here: “If we don’t impose a ‘20% of highest balance’ penalty, taxpayers will think we are wimpy and will no longer fear or respect the IRS.”

On the other hand, sticking with the harsh penalties will have a deterrent effect. For every normal taxpayer who is hit with a harsh penalties, 100 bystanders will see that good-faith compliance is promptly rewarded with pain. They will not come forward voluntarily.

The IRS can’t enforce the harsh penalties (I deem the “20% of highest balance” penalty to be extravagently harsh) without ill effects, and it can’t wimp out, either. This is a management failure. This is like when the traffic cops in Pasadena (where I live) decide to be obsessive-compulsive about parking tickets. By doing so they create a whole new group of people who say “I will never come to Pasadena to shop ever again.” Smart cops. Got their promotions.

Harshness and uncertainty reduces voluntary compliance

At the moment there is a vacuum of certainty about the enforcement posture of the IRS in the arena of offshore accounts. There are many, many people who want to do the right thing — report their goofups, pay up on back taxes, do the right paperwork, get clean.

Yet they don’t do it.

  • Think of the retired public school teacher who bought a condominium in Baja California for $200,000 cash and didn’t know about the requirement for filing Form 3520 because she owns the condo through a fideicomiso. Are you going to tell her that she has a potential $70,000 penalty if she voluntarily cleans up that paperwork failure?
  • Think of the British immigrant who left a small ISA behind when he came to the United States. He couldn’t cash it out in Britain without penalty — he’s not retirement age. Are you going to tell him that he faces Form 3520, Form 3520-A, and Form TD F 90-22.1 penalties in the tens of thousands?
  • Think of the woman who received a $200,000 gift from her parents overseas to use as the down payment for a house. How will she react when faced with a potential $50,000 penalty for failing to file Form 3520 to report a simple nontaxable gift?

Yet that is the current enforcement climate we live in today. Uncertainty, murky enforcement standards, and fear.

The first question and answer in the IRS’s FAQs on the Voluntary Disclosure Program says that they introduced the program with the full knowledge that uncertainty as to penalties had deterred voluntary disclosure.

Q1. Why did the IRS issue internal guidance regarding offshore activities now?

A1. The IRS has had a voluntary disclosure practice in its Criminal Manual for many years. Once IRS Criminal Investigation has determined preliminary acceptance into the voluntary disclosure program, the case is referred to the civil side of IRS for examination and resolution of taxes and penalties. Recent IRS enforcement efforts in the offshore area have led to an increased number of voluntary disclosures. Additional taxpayers are considering making voluntary disclosures but are reportedly reluctant to come forward because of uncertainty about the amount of their liability for potentially onerous civil penalties. In order to resolve these cases in an organized, coordinated manner and to make exposure to civil penalties more predictable, the IRS has decided to centralize the civil processing of offshore voluntary disclosures and to offer a uniform penalty structure for taxpayers who voluntarily come forward. These steps were taken to ensure that taxpayers are treated consistently and predictably. [Emphasis added.]

That has not happened. We still have “potentially onerous civil penalties” except we have the implicit promise that “20% of high balance” is the FLOOR on what your “potentially onerous civil penalties” will be. We have a completely opaque, unpredictable environment for people who have messes they would like to clean up.

In short, the six month “amnesty” (the IRS doesn’t call it that, but the real world does) made the situation worse, not better.

Modest suggestion

The IRS and the Department of Justice can — and should — chase and convict the Jack Barouh-type taxpayers. But there should be a completely different approach for regular people.

I suggest that the IRS identify and expedite many run-of-the-mill Voluntary Disclosure Program cases in which the taxpayers experience the following results:

  • Pay the back taxes on unreported income, plus interest, plus a modest late payment penalty. Treat this unreported income just like any other normal audit.
  • Impose the MINIMUM penalty under the guidelines for non-willful failure to file FBAR forms as outlined in the Internal Revenue Manual, or at least make it cheap for the taxpayer.
  • Tell the taxpayer to “Go and sin no more” much in the same way you have a consent degree from the Securities and Exchange Commission.

The IRS will achieve this result while standing firm behind their “we’re going to unwaveringly impose the 20% penalty with no negotiations, take it or leave it” position by hiding behind the fig leaf given by the FAQs:

A35. 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. If the taxpayer disagrees with the IRS’s determination, as set forth in the closing agreement, the taxpayer may request that the case be referred for a standard examination of all relevant years and issues. At the conclusion of this examination, all applicable penalties, including information return penalties and FBAR penalties, will be imposed. If, after the standard examination is concluded the case is closed unagreed, the taxpayer will have recourse to Appeals. See Q&A 34. [Emphasis added].

See, the IRS gave itself an “out.” These cases can be proactively settled by the IRS as regular audits, with minimal (maybe zero) penalties.

Publicize this, IRS people. Heavily. Break your arm because you’re patting yourself on the back with such vigor. 🙂

By doing so the IRS will demonstrate that normal taxpayers with normal problems will have nothing to fear. The Jack Barouhs of the world won’t be getting a hall pass. The immigrant grannies will be able to breathe a bit. The integrity of the enforcement system will be enhanced, not harmed, if the IRS brass understands the difference between those two categories of taxpayers.