On February 15, 2022, the IRS announced that IRS Form 14457, Voluntary Disclosure Practice Preclearance Request and Application, and the accompanying instructions to the form had been revised. Because the revisions provide clarification on certain issues that caused confusion during the submission process, the revisions are welcome news to many tax professionals, including this writer. The revisions are discussed more fully below.
Introduction to the Voluntary Disclosure Practice.
A full primer on the IRS’s Voluntary Disclosure Program (“VDP”) can be found here. In short, the VDP permits non-compliant taxpayers an opportunity to come forward, file missing or amended returns correcting prior year reporting, and pay the government taxes that are owed. In exchange, the taxpayer making the disclosure receives what is akin to amnesty, provided the taxpayer meets all of the eligibility requirements of the VDP. This can result in significant reduction of criminal risks and exposure for the non-compliance in addition to significant reductions in civil penalties associated with the non-compliance (in some cases).
The requirements of the VDP are many. However, at a minimum, the disclosure must be truthful, timely, and complete. Each of these terms is a term of art, and the IRS strictly requires adherence to each requirement. A taxpayer’s failure to comply with the rules of the VDP can render the submission invalid—resulting in significant risks of criminal prosecution and/or additional civil penalties. Put simply, attention to detail and knowledge of the various requirements of the VDP is a must if a taxpayer wishes to make a proper and successful disclosure.
IRS Form 14457.
The older version of the IRS Form 14457 was released in April 2020 (“Old Form 14457”). As indicated above, the newer version and instructions were released on February 15, 2022 (“New Form 14457”). The differences in the Old Form 14457 and the New Form 14457 are discussed below.
The Disclosure Period. Generally, the disclosure period—or the period in which the taxpayer must file correct returns—is 6 years. Under the Old Form 14457, the disclosure period was 6 years from the date Part II of the Old Form 14457 was submitted to the IRS. Under the New Form 14457, the 6-year lookback period is 6 years from the date Part II of the Form 14457 is received by the IRS. Thus, taxpayers who mail Part II of the Form 14457 should be cautious of deadlines associated with certain tax filings.
Virtual Currency. Virtual currency has been a hot topic amongst tax professionals and the IRS for several years. Indeed, the IRS now asks in tax returns whether the taxpayer and/or spouse has holdings in virtual currencies at any point during the tax year. The reason is simple: the IRS suspects many taxpayers have failed to report all income associated with their virtual currency holdings on the often-false assumption that the IRS will never be able to identify it. However, with the IRS bearing down on virtual currency taxation non-compliance and using more and more methods to uncover virtual currency holdings, such as the use of John Doe summonses, taxpayers are now wisely attempting to disclose their non-compliance for fear of criminal prosecution and/or imposition of draconian civil penalties. To keep up, the IRS has revised the New Form 14457 in Part I to have a specific section dedicated to virtual currency disclosures and information associated with the taxpayer’s virtual currency activities.
The instructions to the New Form 14457 provide additional color on the information the IRS seeks with respect to these assets:
‘Virtual Currency’ is a dynamic area, and for purposes of this form the term encompasses assets beyond what many define as virtual currencies.
Provide details for all noncompliant virtual currency you owned or controlled or were the beneficial owner of, either directly or indirectly. The listing must cover the entire disclosure period, including assets acquired or disposed of during the disclosure period and including those held through entities. Additionally, if you used a ‘mixer’ or ‘tumbler’ in connection with your virtual currency or any virtual currency transaction, identify the mixer or tumbler used and explain why you used it.
For purposes of preclearance, a noncompliant virtual currency is an asset that should have been reported on a federal income tax return or other required federal information return and was not previously reported.
Civil Penalties. One of the more significant revisions to the New Form 14457 relates to civil penalty guidance under the VDP. Generally, for income taxes, the IRS imposes a 75-percent fraud penalty on the highest year of income in the 6-year lookback period. Those rules do not change with the New Form 14457. Rather, the New Form 14457 provides clearer guidance on civil penalties associated with: (1) taxable entities and individual fraud; (2) estate tax penalties; (3) gift tax and generation-skipping transfer tax penalties; and (4) employment tax penalties.
Taxable Entities/Individual Fraud. The New Form 14457 instructions provide guidance on the civil penalty structure when a disclosure involves fraud by a taxable entity (e.g., C corporation) and an individual related to the taxable entity (e.g., a shareholder). Under the new guidance, the 75-percent fraud penalty applies equally to both the taxable entity and the related party. Moreover, the instructions note that this civil penalty applies to the taxable entity regardless of whether the entity submits a separate New Form 14457 or not.
Estate Tax Penalties. The New Form 14457 instructions provide that the 75-percent penalty will be reduced for all voluntary disclosures associated with estate tax issues. For example, if an executor files a Form 706 that undervalues significant assets, the executor would be required to pay the estate tax and a 50-percent civil penalty on the valuation omission. The same rule applies if the executor files a late Form 706 where one was otherwise required.
Gift Tax and Generation-Skipping Transfer Tax Penalties. For Form 709 related issues, the New Form 14457 provides that the 6-year disclosure period does not apply—instead, the taxpayer must file all required Forms 709 that are outstanding. In these cases, the 75-percent fraud penalty applies to the year with the highest tax liability; if there is only one year, the 75-percent penalty is reduced to 50 percent.
Employment Tax Penalties. For employment tax non-filings or incorrect filings, the 75-percent fraud penalty applies to the tax quarter of the voluntary disclosure with the highest employment tax liability. Although the accuracy-related penalties and delinquency penalties will not apply (i.e., late filing and late payment), the IRS may impose the failure-to-deposit penalty under section 6656. Special rules also apply to the computation of the employment taxes. Significantly, the instructions warn that acceptance into the program and the subsequent signing of a closing agreement does not obviate the taxpayer’s obligations to file Forms W-2 and Forms W-2c with the Social Security Administration.
Disclosure of Notices of Deficiency. The New Form 14457 requires the taxpayer to provide information as to whether the taxpayer, his or her spouse, or a related entity have received a notice of deficiency (“NOD”) from the IRS “for any year in the anticipated disclosure period.” In the event there has been a NOD issued, the New Form 14457 also asks for a copy of the NOD.
Prior to New Form 14457, there was an open question as to whether a taxpayer qualified under the timeliness requirement of the VDP if the taxpayer had received a NOD, particularly if the NOD resulted from substitute-for-return procedures under the IRS’s automated underreporter process. This was primarily because of the IRS’s definition of “timely,” which meant that the taxpayer had made a disclosure (Part I) prior to any of the following events: (1) the IRS commencing a civil investigation or criminal investigation against the taxpayer; (2) the IRS receiving information from a third party regarding the taxpayer’s noncompliance; and (3) the IRS acquiring information from other sources, such as search warrants, grand jury subpoenas, etc. Thus, a taxpayer could make the contention, under the timely requirement, that a civil investigation had not been commenced when the IRS’s automated underreporter computer simply issued a NOD to the taxpayer, as it commonly does when the statute of limitations for assessment is near.
The instructions of the New Form 14457 provide much clearer guidance on this issue—and also the IRS’s rationale for asking the new question regarding the NOD:
IRS civil campuses conduct automated information return matching which may result in the issuance of a notice of deficiency. If a taxpayer receives a notice of deficiency from an automated substitute for return unit, that notice of deficiency will render a voluntary disclosure untimely because the IRS has formally notified the taxpayer of the taxpayer’s failure to file an income tax return. The failure to file an income tax return would go to the very essence of a voluntary disclosure for a nonfiler. On the other hand, automated underreporter units may issue notices of deficiency relating to specific income reported by third parties. A notice of deficiency issued by an automated underreporter unit will not automatically render a voluntary disclosure untimely. Rather, the IRS will analyze the notice of deficiency and make a preliminary timeliness determination while processing Form 14457, Part I. The IRS will also analyze and compare the issue identified in the notice of deficiency with the facts provided in Form 14457, Part II. If the issue in the notice of deficiency does not relate to the issues motivating the voluntary disclosure, then the preliminary timeliness determination will stand. The narrative with Form 14457, Part II must address any notices of deficiency issued and any nexus between the issue in the notice of deficiency and the voluntary disclosure.
Disclosure of Tax Litigation (Past and Present). The New Form 14457 also asks the taxpayer to disclose if the taxpayer, his or her spouse, or any related entities are currently litigating (or have litigated in the past) any federal tax matters for any year in the anticipated disclosure period in either the United States Tax Court, the United States Court of Federal Claims, or any United States District Court. In these instances, the taxpayer is required to identify certain specifics associated with the case.
The instructions in the New Form 14457 provide the IRS’s rationale for asking for this information. Similar to the NOD question above, the IRS considers certain prior or ongoing litigation relating to the years of the disclosure as nonqualifying factors under the timeliness requirement.
Waiver of CDP Rights for Less-Than-Full Payment. Taxpayers can enter the VDP and make less than full payment of all taxes, provided the taxpayer can meet its burden to establish that it lacks the ability to do so. The New Form 14457 provides the same requirement. However, the New Form 14457 instructions provide additional language that indicates that if the taxpayer cannot full pay, the taxpayer must waive all rights to a Collection Due Process (CDP) hearing under sections 6320 and 6330 for all tax periods addressed in the closing agreement.
Submission of Part II. Under the Old Form 14457, the taxpayer was required to sign and mail Part II of the form to the IRS. This often created a logistical headache for tax professionals, particularly if the deadline was close and the client was located overseas or far from the tax professional’s office. Under the new guidance in the New Form 14457, the IRS now accepts submissions by fax or mail, including scans and copies of the taxpayer’s signature under Part II of the form.
The New Form 14457 and revised instructions provide much-needed clarity to cloudy issues that have plagued tax professionals for some time. However, with new clarification also comes new questions. For example, what will IRS-CI look to in determining whether a NOD disqualifies a taxpayer from the VDP under the timeliness requirement? Expect additional clarity on issues such as these as the IRS continues to tinker with the VDP moving forward.