• pay all taxes and interest due and waive claims for refunds or interest abatements;

• agree to recapture taxes (with interest) associated with any disallowed contributions to any self-employment retirement plan she funded for post-2003 years;

• pay a penalty for the year with the highest tax deficiency;

• provide an income verification statement from her employer;

• document all deductions and credits claimed on those tax returns with respect to compensation from her employer; and

• agree to file on a correct and consistent basis for all later years.

The IRS announcement contains additional procedural requirements relating to payment of the amounts due and the possibility of additional requests for information.

As originally issued, the announcement required individuals wishing to accept the settlement initiative to do so by Feb. 20, 2007. The IRS subsequently extended that deadline to June 30, 2007.

Absent a further extension, covered taxpayers who do not accept the settlement initiative face the likelihood of a rigorous tax audit. Depending on the facts, that audit could result in (among other things) one or more of the following consequences:
• the assessment of tax deficiencies, interest, and penalties for all open tax years (not just the most recent ones) regarding any unpaid taxes, disallowed deductions, and invalid contributions to retirement plans;

• the preparation of so-called statutory returns for years in which no returns were filed (these are prepared by the IRS on the basis of the information it has and are usually unfavorable to taxpayers);

• the assessment of penalties and excise taxes for amounts wrongfully contributed to or earned in invalid retirement plans; and

• in cases of willful or intentional conduct, civil or criminal prosecution.

In an unusual action for the agency, the IRS conducted a series of on-site meetings at embassies and consulates to explain its view of the state of the law, answer questions, and encourage personnel to seriously consider accepting the settlement initiative. The IRS reportedly warned its audiences that it would vigorously pursue diplomatic personnel who it believed violated their tax obligations and who did not come forward as provided by the announcement.


On the one hand, it seems uncontroversial that exemptions granted to foreign governments and their instrumentalities do not translate into a free pass to their personnel to shortcut or ignore their tax liabilities. Affected individuals who thought otherwise may be happy to seize upon the settlement initiative as a way to come in from the cold with comparatively benign consequences.

On the other hand, many affected personnel did the best they could to follow the law and made reasonable assumptions about what their status permitted them to do (such as establish SEP-IRAs), often with professional tax advice.

In spite of that, the statutory case for the IRS position seems strong: SEP-IRAs are permissible only for individuals who have “self-employment income,” and the tax code expressly excludes compensation for services to a foreign government from that term. The IRS announcement, however, makes no reference whatsoever to that exclusion and does not base the disallowance of SEP-IRAs on it. Instead, the IRS resorts to a “common-law employee” analysis that has no foundation in the code.

The reason for adopting this unusual rationale may be found in a cryptic reference to self-employment (SECA) tax (essentially, FICA for the self-employed) in the IRS announcement. The agency appears to be leaving itself the option of asserting liability for unpaid SECA tax, even though SECA taxpayers are statutorily permitted to form SEP-IRAs. Any such effort by the IRS to have its cake and eat it too may be vulnerable to challenge.

In sum, the impact of the announcement will vary with the situation and past conduct of affected individuals. Although prompt acceptance of the settlement initiative may be a sensible choice for any individuals who defaulted substantially on their tax obligations (nonfilers, nonpayers, and taxpayers who claimed inappropriate deductions), others who acted in good faith and with professional advice will find the decision a closer call.

What seems clear, however, is that the IRS is serious about this issue. And it has identified a number of individuals — by name, or at least by function within specific embassies and consulates — who it believes may be appropriate targets for audit and enforcement action if they do not accept the initiative by June 30. Thus, keeping one’s head down and hoping to be missed in any subsequent examinations would probably be an unwise strategy.

Richard E. Andersen is a partner in the New York office of Arnold & Porter. The author acknowledges the valuable contribution of Barbara Yuen. The views expressed are his own and do not constitute tax advice.