Recently the Brager Tax Law Group obtained over 6,500 pages of documents related to the Offshore Voluntary Disclosure Program ("OVDP") from the IRS through a Freedom of Information Act ("FOIA") request.  The list of documents can be viewed here.

We have previously blogged about the substantial penalties that the IRS can impose if foreign information returns are not properly filed.  We have a resource page that lists many of these information returns along with their associated monetary penalties.  We also have blogged how the statute of limitations is affected by failure to file such returns.  We have even created a video on how to prepare FinCEN Form 114 (the "FBAR").

The information released by the IRS included training material on discovering offshore tax avoidance and the application of related penalties.  The training material included a case study based off of an actual structure discovered by the IRS which illustrates many of the topics we have discussed on this blog.  Below is an IRS graphic of the structure and cash flow along with the IRS description of the scheme, which resulted in the imposition of penalties exceeding 2 million dollars:

Here we go….the Taxpayer owned a Domestic Corporation which is in the manufacturing field. The Corporation purchases much of its materials and supplies from Asian vendors.

The individual shareholder set up an Foreign Corp which is shown as FC1 in an offshore jurisdiction.

The shareholder then arranged for a fictitious Inspection Services to supposedly inspect the materials purchased from his foreign suppliers.  An unrelated Management Company, who was retained by FC1 , produced and mailed out invoices to the U.S. Corp on behalf of FC1 for these inspection services.  The U.S. Corporation remitted payments to FC 1 for the amounts shown on the false invoice.

Once the payments were sent from the domestic corp to the FC1, FC1 deposited the payments into an account located in Foreign Country C shown as Offshore Bank C. When the funds reached $50,000 in Offshore Bank C they were swept to an account located in a different foreign country which we will refer to as Offshore Bank B.  When the funds at Offshore Bank B reached $100,000 they were then transferred to and account in a third foreign country which we will call Offshore Bank A.

The Offshore Bank A credited the funds to an account owned by a Shiftung, which is akin to a Foreign Grantor Trust. It is denoted on the diagram as FTR A, it is organized in the same country as Offshore Bank A.  The Shiftung was titled a Foreign Foundation. The U.S. Taxpayer was the grantor/first beneficiary of the Shiftung.

Since the U.S. Taxpayer was the grantor/first beneficiary of the Foreign Foundation A and exercised direction and control over the funds within the offshore bank account A, he could access and repatriate the funds at will.

Over the course of 8 years the taxpayer was able to divert through his False Invoicing scheme $5 million.  He repatriated only $100,000.00.  The remainder of the funds remained on deposit for “a rainy day or for his retirement”. Unfortunately, the taxpayer passed away before he could partake in his ill gotten gains.

Rights to the account passed to his 3 sons in equal parts.  The U.S. Corporation and the Shareholder were examined by the IRS twice during the 8 year period and the scheme remained undetected.

The False Invoicing case was an actual IIC Case.  It was technically and procedurally challenging. It required the involvement  and input from IRS Management,  The Tax Attaché, a Fraud Technical Advisor, IRS Counsel, and the Department of Justice.  Together with the support and cooperation of all parties  the case was brought to a successful conclusion.

Even though the taxpayer had not diverted any funds during the years under examination we were able to assess tax was assessed  on the income generated from the Offshore Accounts.  The Accuracy Penalty was also assessed though the fraud penalty was very seriously considered.  However due to the small amount of unreported income and the fact that the taxpayer was deceased a decision was made not to apply the Fraud Penalty.  

The largest assessments from the Examination were not the tax assessment but rather the penalty assessments.  The IRS proposed Willful FBAR penalties for each open year after review and consultation with FBAR Counsel.  The actions of the taxpayer to divert the funds and his affirmative and confirmed instructions to hold statements, his refusal to complete a W-9 and other documented instructions to the Bank clearly illustrated that the taxpayer was aware of the FBAR filing requirements and willfully acted to avoid complying with them.  The total FBAR penalty exceeded $925,000.00. 

Information return penalties were also assessed for failing to file Form 3520 and 3520-A’s.  The Form 3520 penalties were over $175,000 and the Form 3520-A penalties were $1,100,000.00. 

Total penalties proposed exceeded $2.2 million.

The value of the account in the year of examination was around $2.2 million due to the market decline in 2008.  Therefore the total penalties wiped out in full the funds remaining.   The  Executors were not in agreement and requested to go to Appeals on all penalties.  The cases were sent to Appeals where the proposed assessments were upheld IN FULL!!  No amounts were conceded!  Subsequent to the Appeals decision the Executors agreed.  The Appeals Officer stated in the Memorandum that the actions of the taxpayer were so egregious and deliberate that a finding of Reasonable Cause was impossible.  She further stated that the development of the case was clearly documented and “Based upon such a thorough evaluation and gathering of all the salient facts a finding in the taxpayer favor would be deplorable.”

The emphasis is our own.  Note that where the IRS description above refers to a "Shiftung," it is likely referring to a Liechtenstein stiftung.  This type of entity is typically treated as a foreign trust for U.S. tax purposes. 

We will post other interesting information that we come across as we continue to go through the released documents.