Voluntary Disclosure to the IRS

There are two types of voluntary disclosure with the IRS: (1) informal; and (2) formal (negotiated).

An example of informal is simply filing late tax returns, determining the interest and penalties and including a check for the tax interest and penalties. By filing the returns, before any contact with the IRS, the hope is that no one will question those late filings (other than maybe to recalculate interest and penalties). This is extremely dangerous for substantial sums of money (and practitioners do not know how to define "substantial" nor can the IRS state what this term means). It may also be dangerous where many years of unreported accounts are involved. Failure to file for offshore accounts can make the word "dangerous" even more dangerous. Generally, if only two or three years are involved, we file late returns under the informal procedure.

Most informational tax returns, such as Form 3520 (tax returns for foreign trusts) and 5471 (tax returns for foreign corporations), are handled informally. However, if hiding income is involved, this can lead to another investigation (upon the filing of an informal return). This additional investigation may be tax fraud, tax evasion and/or money laundering. Thus, the practitioner must be very careful about filing these returns without first contacting the IRS. The IRS Manual and the Chief Counsel's Manual require the disclosure of the taxpayer's name; however, in the initial discussions, the IRS does not request that the practitioner divulge the name of the taxpayer.

Let's assume that a significant number of years of unreported income is involved. The question then arises as to the number of years that the IRS will review. The IRS generally looks at six years of back records (unless the number of years is less).

The next question is whom the practitioner should contact at the IRS. The contact can be with just about any person because the matter will eventually get to the correct person according to the IRS. However, I think simply contacting the IRS Service Center for the person who wants to come forth with the IRS is dangerous, notwithstanding the statement from the IRS that the matter will eventually get to the right person. It is highly recommended that the practitioner contact and deal directly with his contacts at the IRS, who works solely in international matters. In most instances, this contact at the IRS is the correct person so the matter does not have to go through a series of other persons to end up in the hands of someone at the IRS that the practitioner does not know.

Formal or negotiated voluntary disclosure involves contact with the IRS (before contact by the IRS). Let's say, however, that one spouse in a divorce action threatens to turn over the other spouse to the IRS. The other spouse then goes to the IRS. Is this voluntary? Assuming there has been no contact from the IRS, this is voluntary. Nonlegal sources of income cannot be involved, however.

In the same example, one partner threatens to turn the other partner over to the IRS. If the other partner goes to the IRS before contact from the IRS, this is voluntary disclosure. Again, nonlegal sources of income cannot be involved.

Another question involves a person who has an unreported account that was used to discharge debit or credit card purchases. This person then learns about the "John Doe" summonses case in Miami. Can he now make voluntary disclosure to the IRS? For example, such a person learns about the "John Doe" summonses in the newspapers and now needs "religion" in a hurry. The IRS says there is no specific answer to this question other than that the Criminal Investigation Division looks at numerous factors to determine whether voluntary disclosure is involved.

In order to have a formal (negotiated) disclosure, "nonlegal source income" must not be involved. In other words, if the income from which the taxes were paid originated from a nonlegal source, negotiation is not available. For example, improper fees received by a physician from Medicare are from a nonlegal source. Referral fees paid to a person who is not entitled to such fees is from a nonlegal source. The IRS says that usurious (high rates of interest) income is a nonlegal source of income. Thus, nonlegal sources of income cannot go through the formal (negotiated) process. For nonlegal sources of income, the taxpayer must hope for the best with informal filing (of late returns and by payment of the taxes, interest and penalties).

Generally, in a formal voluntary disclosure, the IRS does not audit or examine the financial records and other information provided by the client and relies upon the information that it receives through the practitioner representing the taxpayer.

Practitioners must be concerned with the conspiracy statute under Title 18 U.S.C. Section 371. The practitioner has a serious problem if he continues to represent a client when that client continuously delays or backs off the formal (negotiated) process. The practitioner can be indicted for committing a conspiracy against the United States government.

A person who has committed tax fraud or tax evasion, as well as potentially money laundering, and decides to "come clean" with the IRS with respect to unreported offshore accounts, one of their main concerns is for his comments to be privileged. Such a person does not want comments to his advisor being repeated in court nor does he want the information gathered by his professional being subject to a subpoena.

Certain communications and the work product of an attorney are subject to the "attorney-client privilege." This also extends to "tax matters," for accountants, under the "accountant-client tax privilege." However, legal matters that are associated with taxation issues are not subject to the accountant-client privilege. To use a simple example showing the association of legal issues with tax issues, consider the following. The U.S. estate tax laws treats property held jointly as tenants-in-common differently from jointly held property with rights of survivorship. The tax laws look to state law to determine whether the property is owned as tenants-in-common or with rights of survivorship. When one owner of tenants-in-common property dies, his interest passes into probate, and then according to his will and, when one joint tenant with rights of survivorship dies, the decedent's interest passes outside of probate to the surviving joint tenant, by operation of law. The determination under state law of how the property is held is a legal issue and is not covered by the accountant tax privilege. In addition, money laundering and tax crimes, including tax fraud and tax evasion, are not subject to the accountant-client privilege. This means that the taxpayer who has committed tax fraud or tax evasion, or money laundering must retain the lawyer as counsel in order to protect the complete attorney-client privilege that covers legal matters, tax matters and other crimes. However, the lawyer can then retain the services of an accountant in order to preserve the statements and communications by the accountant pursuant to the attorney-client privilege. Thus, a U.S. person who wants to "come clean" with the IRS, makes a mistake by first approaching the accountant. Such a person must obtain legal counsel so that legal counsel can then retain the services of an accountant. By handling this properly, the communications and the work product of the lawyer are not subject to being divulged to third parties, including courts. [See U.S. v. Kovel, 296 F.2d 918 (2nd Cir., 1961).]

For further comments about the accountant-client priviledge of confidentiality, see "Limits on Client Confidentiality and the Account-Client Priviledge".