Shame on the Internal Revenue Service (IRS). In a classic case of the pot calling the kettle black, the IRS, in its incessant hunt for “undisclosed” offshore accounts, has been caught with something of its own that was “undisclosed”. US lawyers, James Gifford and Milan Patel, of the Anaford AG law firm in Switzerland recently learned of an undisclosed (or, shall we say, “secret”) IRS national policy. The policy was unearthed through the dogged determination of pursuing an IRS Freedom of Information Act (“FOIA”) request.
The IRS’ previously secret policy metes out a very harsh treatment to certain estates that have entered into the Offshore Voluntary Disclosure Program (“OVDP”). The policy selectively denies certain estates that had entered into OVDP a deduction for the in-lieu or “miscellaneous offshore penalty” assessed in the OVDP under Title 26.
OVDP “Miscellaneous Offshore Penalty”
It may be recalled that those entering OVDP are required to pay various penalties. One penalty in particular is “in lieu” of all other penalties that may apply to their undisclosed foreign assets and entities and is called a Title 26 miscellaneous offshore penalty (MOP). The MOP is generally equal to 27.5% of the highest aggregate value for the foreign entities and assets during the 8-year Offshore Voluntary Disclosure period. The penalty can rise to 50% in cases when a taxpayer held an account at an institution listed as a facilitator. A current list of the foreign financial institutions or facilitators can be found here.
Estates and OVDP — Estate Tax Deduction Selectively Denied
When someone dies owning an unreported financial account, the heirs and executors of the estate are faced with a serious problem. Many turn to the OVDP to solve it. When criminal issues are involved, those who don’t turn to the OVDP usually regret their actions later.
For purposes of determining estate tax liability, certain expenses are deductible from a decedent’s gross estate pursuant to Internal Revenue Code Section 2053. Deductible items include administration expenses incurred in the collection of assets, payment of the decedent’s debts, and distribution of the decedent’s property. These administration expenses would normally include the MOP.
According to Anaford’s discovery through its FOIA request, it appears that since at least 2013 and possibly as far back as 2009 with the inception of the IRS’ Offshore Voluntary Disclosure Initiatives, “the IRS instituted an undisclosed nationwide policy that the MOP is not deductible as an administration expense by an estate except in the limited situation where only the decedent was ‘cognizant’ of the foreign accounts or assets.”
According to internal IRS emails obtained by Anaford under the FOIA request dated March 17, 2016, available here, the IRS national policy states:
“If anyone other than the decedent (which would include a surviving spouse, children, siblings, accountant, attorney, or anyone else with a material interest) was cognizant of the existence of the offshore account, and the executor/personal representative failed to disclose the existence of the account (or, did not file a Form 706) by the due date of the return, then we will not allow a reduction to the gross estate for the related OVDI offshore penalty.”
A Dirty Little Secret?
The IRS recently acknowledged that it has not published any guidance on what appears to be its nationwide policy concerning deductibility of the MOP by an estate involved in the OVDP. Tax Notes article posted on March 28, 2016 (“IRS Inconsistent in Denying Estate Tax Deduction for OVDP Penalty”). This is noteworthy, because the IRS’ OVD Initiatives have been criticized previously by practitioners for being shrouded in secrecy. According to the lawyers at Anaford, “it appears the IRS has not followed any public procedures for creating this policy or informed applicants to the OVDP of this policy.”
Anaford’s lawyers believe the policy “overtaxes and overreaches” and correctly note that it is the role of the US Congress (and not the IRS) to enact laws determining what is taxable and what is deductible. It is not within the purview of the IRS to deny a deduction, otherwise valid, based on the agency’s bureaucratic whim. “The IRS is denying a deduction, which Congress says should be allowed, simply because a confidante of the deceased, such as an accountant or attorney, knew of the account.” This policy directly harms the heirs, simply because, for example, his attorney may have known of the account but the account was not reported on the estate tax return by the executor. Aside from the valid points raised by Anaford, one must also ask the serious question about the chilling effect this IRS policy may have on the attorney-client privilege.
Anaford notes that to date, the IRS has not been resolving these cases in a fair manner. As a result, litigation “may be an unfortunate necessity”. Now that the issue has seen the light of day, however, we can be hopeful that the IRS will reconsider its position.
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