IRS Proposes Meaningful Reforms to Criminal Investigation Voluntary Disclosure Practice

The IRS' Criminal Investigation Voluntary Disclosure Practice (VDP) has long served as the principal pathway for taxpayers with potential criminal tax exposure to self-correct their past noncompliance and pay outstanding tax liabilities with interest and penalties and, in return, receive the IRS's commitment not to recommend criminal prosecution.

The fundamental premise of the VDP is straightforward and mutually beneficial: Taxpayers avoid criminal prosecution, and the IRS collects back taxes, closes part of the tax gap and promotes future compliance. As the IRS itself acknowledged in announcing the proposed changes, the revised procedures are intended to "improve its processes" and "further incentivize non-compliant taxpayers to come into compliance." Yet for years, and particularly after the IRS and U.S. Department of Justice dramatically intensified offshore tax enforcement efforts beginning around 2009, the structure of the VDP, combined with the threat of the 50 percent willful Foreign Bank and Financial Accounts (FBAR) penalty, effectively operated as a significant disincentive for many taxpayers to use the program at all.

Prior VDP Structure and Its Chilling Effect on Compliance

To understand why the proposed changes matter, it is important to appreciate how dramatically the penalty landscape shifted over the past two decades. Prior to 2009, practitioners could routinely resolve offshore noncompliance cases for a single, one-time FBAR penalty of $10,000, and even the most egregious matters could typically be resolved with up to six $10,000 FBAR penalties – a penalty profile that was proportionate and reasonable in light of the program's compliance objectives.

That calculus changed fundamentally with the launch of the IRS' Offshore Voluntary Disclosure Program (OVDP) and successive iterations of the offshore voluntary disclosure initiative beginning in 2009. Under those programs, and subsequently under the general VDP framework that followed, taxpayers voluntarily disclosing offshore noncompliance faced the prospect of a willful FBAR penalty equal to 50 percent of the highest aggregate account balance for the year with the highest undeclared assets. In addition, the program imposed a 75 percent civil fraud penalty on the year with the highest tax understatement. The combined effect was an extraordinarily punitive penalty profile, one that in many cases could result in a taxpayer voluntarily disclosing noncompliance and facing penalties that approached or even exceeded the value of the underlying unreported accounts.

This penalty structure created a perverse incentive. Rather than encouraging noncompliant taxpayers to come forward, the 50 percent willful FBAR penalty and 75 percent civil fraud penalty made many taxpayers and their advisors conclude that the risks of disclosure were too high relative to the benefits.

Key Proposed Changes

Revised Penalty Framework

The centerpiece of the proposed reforms is a fundamental restructuring of the penalty framework. Under the proposed framework, the IRS would:

• apply failure-to-file penalties on delinquent returns for each year in the six-year disclosure period (but would not apply failure-to-pay penalties)
• apply a 20 percent accuracy-related penalty on amended returns for each year in the disclosure period, replacing the prior 75 percent civil fraud penalty that was assessed on the year with the highest tax understatement
• apply penalties for delinquent or amended FBARs on a per-year basis, subject to annual inflation adjustments
• apply penalties of up to $10,000 per return, per year, for delinquent or amended international information returns (IIRs)

The transition from a 75 percent civil fraud penalty to a 20 percent accuracy-related penalty is a meaningful and welcome change. Beyond the obvious reduction in penalty exposure, this change also removes the stigma associated with a civil fraud determination and its potential collateral consequences in non-tax matters, a concern that has historically weighed on taxpayers and their counsel.

FBAR Penalty Structure: The Critical Ambiguity

The proposed treatment of FBAR penalties is, however, the area of greatest uncertainty and practitioner concern. Under the current VDP, taxpayers with unreported foreign accounts face a single willful FBAR penalty equal to 50 percent of the highest aggregate balance of the undisclosed accounts for the year with the highest account value, a potentially enormous penalty that, as discussed above, has historically chilled program participation.

The proposed framework would move to a per-year FBAR penalty, subject to annual inflation adjustments. The IRS' announcement strongly implies that the per-year penalty would be imposed at the non-willful FBAR penalty level (currently $10,000 per year, subject to inflation adjustments), not the willful level. However, when pressed for additional guidance, the IRS acknowledged that the proposal leaves open fundamental questions regarding FBAR penalties. The agency noted that it has not yet finalized whether penalties would apply, how they would be structured or what levels would ultimately be imposed.

This ambiguity is significant and must be resolved in the final program terms. If the non-willful $10,000 per-year FBAR penalty applies, the proposed regime would represent a dramatic and rational improvement over the current structure and one that is far more consistent with the historical pre-2009 approach under which offshore compliance matters could be resolved for modest, per-year FBAR penalties. If, on the other hand, the IRS ultimately imposes willful FBAR penalties on a per-year basis across all six disclosure years, the cumulative penalty exposure could equal or exceed what some taxpayers faced under the prior structure, a result that would recreate the deterrence problem in a different form.

Disclosure Period and Application Procedure

The proposed program retains the six-year disclosure period for delinquent and amended returns. Taxpayers who receive conditional approval must (within three months of that approval) 1) file all required amended or delinquent income tax returns, international information returns and FBARs, 2) pay all applicable taxes, penalties and interest in full, and 3) execute all required closing agreements. Taxpayers must also submit a signed closing agreement waiving statutes of limitations, agree to accuracy-related penalties and, where applicable, sign an FBAR agreement. Applications will be submitted electronically via Form 14457, Voluntary Disclosure Practice Preclearance Request and Application. Importantly, the disclosure must identify all years of noncompliance and provide a full and accurate description of the taxpayer's willful noncompliance, underscoring that the VDP remains a program designed for taxpayers with willful exposure who seek to self-correct before the IRS identifies them.

Full Payment Requirement: A Long-Standing Feature

The proposed framework retains the full payment requirement, consistent with prior VDP programs, demanding that taxpayers pay all outstanding taxes, penalties and interest within three months of conditional approval, without the possibility of an installment agreement or offer in compromise. Some practitioners have raised concerns that this requirement creates access barriers for taxpayers who cannot immediately satisfy the full obligation. However, this concern is substantially mitigated if the IRS confirms that the revised framework carries a non-willful FBAR penalty profile and the 20 percent accuracy-related penalty, a combination that would dramatically reduce the total payment burden relative to the prior program.

Purpose of the VDP: Bringing Taxpayers into Compliance

It bears emphasis that the fundamental purpose of the VDP is, and has always been, to bring noncompliant taxpayers into the tax system, not maximize penalty revenue from those willing to self-correct. When the penalty structure of the program is so severe that it discourages participation, the program fails on its own terms. Taxpayers who do not come forward remain noncompliant, the IRS collects nothing, and the tax gap widens. The proposed reforms reflect a recognition by the IRS that recalibration is needed. The reduction from a 75 percent civil fraud penalty to a 20 percent accuracy-related penalty, potential move to per-year, non-willful FBAR penalties, and streamlining of the administrative process are all steps in the right direction. A more proportionate penalty profile will, as a matter of basic incentive economics, encourage more taxpayers to come forward voluntarily, rather than waiting to be identified through Foreign Account Tax Compliance Act reporting, John Doe summonses or foreign bank disclosures.

In Holland & Knight's view, the following additional refinements would further strengthen the program's effectiveness and fairness: 1) explicit confirmation that FBAR penalties will be imposed at the non-willful level under the revised framework, 2) clarity that taxpayers may, consistent with past IRS practice, request relief in appropriate hardship circumstances, 3) the introduction of an administrative appeals mechanism for taxpayers who dispute the IRS' determination of tax, penalties and interest, and 4) greater clarity regarding the treatment of IIR penalties, including whether examiner discretion will apply in appropriate cases.

Takeaways

The IRS' proposed revisions to its Criminal Investigation VDP represent a meaningful step toward a framework that more effectively incentivizes compliance. The comment period closed on March 22, 2026, and final guidance is expected to take effect six months after publication.

If implemented with clarity and fairness, particularly with respect to FBAR penalties and the full payment requirement, the reduced penalty profile has the potential to encourage disclosures from taxpayers who previously viewed the program as prohibitively punitive. Noncompliant taxpayers and their advisers should monitor developments closely and consult experienced tax counsel to assess their options under the proposed VDP framework and other available remediation programs, including the Streamlined Filing Compliance Procedures for non-willful taxpayers.

As evolving standards around willfulness continue to underscore, early and informed action guided by experienced counsel remains the most reliable path to resolution. For additional information or guidance, please contact the author.

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the authors of this publication, your Holland & Knight representative or other competent legal counsel.