From Chipolatas to Weisswurst: A Recipe For Whipping Up The Streamlined Offshore Penalty In Three Easy Steps

Calculating the miscellaneous offshore penalty within the Streamlined Domestic Offshore Procedures can be tricky. Before delving into the tricky part, let’s cover two basic concepts:

1. The miscellaneous penalty under the streamlined domestic offshore procedures is 5%.
2. The base to which the 5% penalty applies is the “highest aggregate balance/value of the taxpayer’s foreign financial assets” during the period covered by the disclosure.

Now for the tricky part: interpreting “highest aggregate balance/value.” Because this is the value to which the 5% penalty must be applied in order to arrive at the miscellaneous offshore penalty, I like to refer to it as the “base.” Determining the base is the most critical part of determining the offshore penalty. It is the beef in the quarter-pounder. It is the parmesan cheese in the creamy dish of fettuccine alfredo. But, as many taxpayers have come to realize, this is easier said than done. As one astute taxpayer stated, determining the highest aggregate balance/value is a “riddle wrapped in a mystery inside an enigma.”

There are two ways of approaching “highest aggregate balance/value.” First, by chopping it up into four separate words in the same way that a butcher would chop up a large sausage into chipolatas. But don’t worry, you need not decide between potatoes and cherry tomatoes as the side dish. After “chopping” it up, you need only apply the standard definition of each word, in a numerical context that is – and not a culinary one – in order to arrive at the overall meaning of the phrase. After all, we are talking about bank accounts and financial assets.

I’ve spent many a night sitting at my computer racking my brain trying to distill the meaning of this cryptic phrase while the account statements of dozens of my clients stared back at me in currencies that I could barely even pronounce. I kept thinking, “there must be a better way.” And there was.

Instead of carving this phrase up into four chipolatas (or words), identifying the precise definition of each word, and then substituting that word for its predicate, I realized that I was making this more difficult than it had to be (shocking, I know). I realized how much easier it would be to read these four words as a complete phrase – as if they were in complete harmony with one another – instead of becoming fixated on finding the precise meaning of each individual word. This brings to mind the expression: “Can’t see the forest for the trees.”

In other words, instead of chopping the phrase up into small chipolatas that can only be eaten one at a time and that no doubt require additional servings to satisfy a hungry stomach, it was far easier to treat it as a four-inch long Weisswurst (i.e., white sausage) that could fit neatly inside a hotdog bun and which was guaranteed to satisfy a hungry stomach for hours to come. The foreign asset equivalent is a single catch-phrase.

There is nothing novel about this discovery. In fact, IRS publications pertaining to the new Streamlined Domestic Offshore Procedures lay out how to determine the highest aggregate balance/value in explicit detail.

Nevertheless, determining the highest aggregate balance/value is no small feat – it is as tedious and monotonous a task as counting the grains of sand on a beach. For this reason, it should be left to the experts: namely, international tax preparers.

The 5-percent penalty for the streamlined domestic offshore procedures can be calculated in three steps. First, identify the assets included in the penalty base. These assets include:

• For each of the six years in the covered FBAR period, all foreign financial accounts (as defined in the instructions for FinCEN Form 114) in which the taxpayer has a personal financial interest that should have been, but were not, reported on an FBAR;
• For each of the three years in the covered tax return period, all foreign financial assets (as defined in the instructions for Form 8938) in which the taxpayer has a personal financial interest that should have been, but were not, reported on Form 8938;
• For each of the three years in the covered tax return period, all foreign financial accounts/assets (as defined in the instructions for FinCEN Form 114 or IRS Form 8938) for which gross income was not reported for that year.

Once the assets in the penalty base have been identified for each year, we can move to step two. In step two, the taxpayer enters the value of his or her personal financial interest in each asset – as of December 31 of the applicable year – on Form 14654, Certification by U.S. Person Residing in the U.S. for Streamlined Domestic Offshore Procedures. A familiar question that comes up in step two is, “What about those years in which a foreign financial account was FBAR compliant and/or those years in which a foreign financial asset was both Form 8938 and Form 1040 compliant?” For those years, the amount entered on the form is zero.

Once the asset values have been entered, they must be added up for each year. After comparing the totals for each year, select the highest aggregate amount. This amount is the base to which the 5-percent penalty applies.

The cause for much confusion as of late lies in taxpayers mistakenly assuming that the “highest aggregate balance/value” under streamlined domestic is determined the same way as the "highest aggregate valance/value" under OVDP.

This is a recipe for disaster because determining the “highest aggregate balance/value” for purposes of determining the miscellaneous penalty under OVDP is radically different from determining the “highest aggregate balance/value” for purposes of determining the miscellaneous penalty under the Streamlined Domestic Offshore Procedures (please see my other blog for a detailed explanation of the differences).

While determining the “highest aggregate balance/value” differs depending on which program the taxpayer elects, the steps that must be taken to arrive at the “highest aggregate balance/value” are similar. For both OVDP and streamlined domestic, the framework for determining the highest aggregate balance/value consists of three steps. The only step that differs is Step 1.

Let’s begin with OVDP. Step one requires isolating the highest balance of all of the taxpayer’s foreign financial accounts and the highest value of all of the taxpayer’s foreign financial assets – subject to the offshore penalty – for each year during the disclosure period. To the extent that the taxpayer has an offshore bank account, the highest value of the taxpayer’s account would be the highest balance in the account – i.e., the high watermark – during the tax year.

The voluntary disclosure period under OVDP is the most recent eight tax years for which the due date has already passed. For example, the disclosure period for a taxpayer who makes a voluntary disclosure prior to the due date – or properly extended due date – for the 2013 tax year would necessarily include tax years 2005 through 2012.

Step two contemplates that the taxpayer has more than one offshore account and/or foreign financial asset in any given year during the disclosure period. If so, then the highest balance of every foreign account and the highest value of every foreign financial asset – subject to the offshore penalty – must be tallied up.

Step three requires selecting the single year from among all of the years in the disclosure period that the aggregate balance/value of all foreign financial accounts and all foreign financial assets was the greatest. That figure, in turn, becomes the highest aggregate balance/value, or “base,” to which the offshore penalty is calculated at the applicable rate (i.e., 27.5% or 50%).

Turning to the steps for determining the highest aggregate balance/value under the streamlined procedures, as previously indicated the first step for determining the highest aggregate balance/value under streamlined differs from the first step under OVDP. Unlike OVDP, it is not the highest balance of the foreign account or the highest value of a foreign financial asset in a given year that carries the day.

Instead, the end-of-year account balances of all foreign accounts and the end-of-year asset values of all foreign financial assets must be isolated. Keep in mind that the term, “foreign financial assets” under streamlined domestic includes a broader base of foreign assets than it does under OVDP. If the universe of “foreign financial assets” were represented, metaphorically by all the fish in the sea, the fisherman who casts the wide net would be labeled, “streamlined domestic.” By “year end,” the IRS is specifically referring to December 31st.

Herein lies the confusion. The balance in an offshore account as of the last day of the tax year is not necessarily the same as the highest balance in that account during the year. What does this mean for you? If you calculated the miscellaneous offshore penalty under streamlined domestic using the highest aggregate maximum balance of your offshore accounts during the disclosure period as opposed to the highest aggregate year-end account balances during the disclosure period, you may have grossly overstated your offshore penalty.

Step one under the streamlined procedures differs in another key respect from step one under OVDP: the disclosure period. While the disclosure period under OVDP is the most recent eight tax years for which the due date has already passed, the disclosure period under the streamlined procedures is not as simple to discern. For starters, there are two such periods, as opposed to only one. The streamlined disclosure period is defined as the years in the “covered FBAR period” and the years in the “covered tax return period.”

How does the IRS define “covered FBAR period” and “covered tax return period?” The covered FBAR period consists of the most recent six years for which the FBAR due date has passed and includes all foreign financial accounts (as defined in the instructions for FinCEN Form 114) during that six-year period in which the taxpayer had a personal financial interest that should have been, but was not, reported on an FBAR.

For example, for a submission made in October of 2014, the covered FBAR period would include tax years 2008, 2009, 2010, 2011, 2012, and 2013. 2013 would represent the latest year for which the FBAR due date had passed because the taxpayer’s 2013 FBAR was due on June 30, 2014, just three months before the taxpayer made the submission. Having identified 2013 as the latest year, determining the remaining five years in the covered FBAR period is as easy as pie. One need only count backwards from 2013.

The covered tax return period consists of the most recent three years for which the U.S. tax return due date (or properly applied for extended due date) has passed. For each of the three years in that period, it includes:

• All foreign financial assets (as defined in the instructions for Form 8938) in which the taxpayer had a personal financial interest that should have been, but was not, reported on Form 8938; and
• All foreign financial accounts/assets (as defined in the instructions for FinCEN Form 114 or IRS Form 8938) for which gross income was not reported for that year.

For example, for a submission made in October of 2014, the covered tax return period would include tax years 2011, 2012, and 2013. 2013 would represent the latest year for which the U.S. tax return due date has passed because the taxpayer’s 2013 tax return (1040) was due on April 15, 2014, five and-a-half months before the taxpayer made the submission. Having identified 2013 as the latest year, determining the remaining two years in the covered tax return period is as easy as pie. One need only count backwards from 2013.

The last two steps for determining the highest aggregate balance/value under the streamlined domestic procedures is the same as under OVDP. Step two contemplates that the taxpayer has more than one offshore account and/or foreign financial asset in any given year during the disclosure period. If so, then the year-end balance of every foreign account and the year-end value of every foreign financial asset – subject to the offshore penalty – must be tallied up for that year.

Step three requires selecting the single year from among all of the years in the disclosure period that the aggregate balance/value of all foreign financial accounts and all foreign financial assets was the greatest. That figure, in turn, becomes the highest aggregate balance/value, or “base,” to which the miscellaneous offshore penalty is calculated, at a rate of 5%.

Below is an example. It is a simple example that is designed to highlight the differences between calculating the miscellaneous offshore penalty under streamlined and OVDP. Assume that John has one undisclosed offshore account: Account A with ABC Bank. The chart below illustrates the following: the period during which John held this account, the interest income generated, the highest account balance for each year, and the end-of-year balance for each year. Assume for purposes of this example that $ 1,000,000 was in the account before 2006 and was not unreported income in 2006.

Account A:

Let’s calculate John’s offshore penalty assuming that he applies to OVDP.

(1) Step 1: Isolate the highest balance of all of John’s foreign financial accounts and the highest value of all of John’s foreign financial assets, subject to the offshore penalty, for each year during the disclosure period. Here, John has one foreign account and no foreign financial assets. Recall that the OVDP disclosure period is the most recent eight tax years for which the due date has already passed. That would be tax years 2006 through 2013. The highest balances in Account A for 2006 through 2013 are listed in column four of the above chart.

(2) Step 2: The highest balance of every foreign account – during each respective tax year – must be tallied up for that year. Because John only had one foreign account during the disclosure period, this step does not apply.

(3) Step 3: The highest aggregate balance of all foreign financial accounts from each tax year in the disclosure period must be compared and the year in which the aggregate balance was the highest must be selected. That figure, in turn, becomes the highest aggregate balance, or “base,” to which the offshore penalty is calculated at the applicable rate (i.e., 27.5% or 50%). Here, there was only one account: Account A. And Account A’s highest balance during the disclosure period was in 2013, when it reached $ 1,275,000.

Because the highest aggregate balance during the disclosure period was $ 1,275,000, that figure becomes the “base,” or the amount that is used to calculate John’s offshore penalty. Assuming that ABC Bank did not make it onto the dreadful list of banks that trigger an even more onerous offshore penalty rate than 27.5% (i.e., 50%), John’s offshore penalty under OVDP would be $ 350,625 (.275 x $ 1,275,000).

Assume now that, instead of applying to the OVDP, John makes a streamlined submission. Let’s compare the highest aggregate balance/value under OVDP with the highest aggregate balance/value under the streamlined procedures.

(1) Step 1: Isolate the year-end account balances of all foreign accounts and the year-end asset values of all foreign financial assets during the disclosure period (i.e., the “covered tax return period” and the “covered FBAR period”). Here, John has an offshore account and no foreign financial assets. Recall that the “covered tax return period” includes the most recent three years for which the U.S. tax return due date (or properly applied for extended due date) has passed. And the “covered FBAR period” includes the most recent six years for which the FBAR due date has passed.

The fact that we are dealing with an unreported foreign bank account triggers the “covered FBAR period.” Therefore, John’s look-back period is six years, beginning with tax year 2008 and ending with tax year 2013. Account A’s year-end balances for tax years 2008 through 2013 are listed in column five of the above chart.

(2) Step 2: The year-end balance of every foreign account – during each respective tax year – must be tallied up for that year. Because John only had one foreign account during the disclosure period, this step does not apply.

(3) Step 3: The aggregate balance of all foreign financial accounts – as of the last day of the tax year – must be compared and the year in which the aggregate balance was the greatest must be selected. That figure, in turn, becomes the highest aggregate balance, or “base,” to which the offshore penalty is calculated, at a rate of 5%. Here, there was only one account: Account A. And the year in which Account A had the highest end-of-year balance was in 2013. In that year it was $ 1,225,000.

Because the highest end-of-year balance during the disclosure period was $ 1,225,000, that figure becomes the “base,” or the amount that is used to calculate the offshore penalty. Note how the highest end-of-year balance is different than the highest account balance. Although both occurred in the same tax year, here tax year 2013, the fact remains that the end-of-year balance in 2013 was $ 50,000 less than the highest account balance for that same year.

Therefore, John’s offshore penalty under the streamlined domestic procedures would be $ 61,250 (.05 x $ 1,225,000). As is obvious, I have not delved into the issue of which option is best for John. That requires a thorough analysis of “willfulness” along with determining John’s eligibility under the remaining eligibility factors for the streamlined program.

However, I leave you with a few parting words as they relate generally to the willfulness determination:

• Should John elect to make a streamlined submission and if things were to go awry with that submission, he would be barred from later applying to the Offshore Voluntary Disclosure Program. Therefore, he must choose wisely. To the extent that the IRS challenges his submission, John would be subject to a myriad of penalties that could leave him with nothing more than the shirt on his back.
• The importance of consulting with a tax attorney to get practical and sound advice on the seminal question of whether you are a suitable candidate for the streamlined procedures cannot be overstated. The improper use of the Streamlined Procedures can be a major trap for the taxpayer who deliberately or incorrectly elects the Streamlined Procedures.
• A tax attorney will conduct a risk-based analysis, taking into consideration the issue of willfulness, and provide you with practical and sound advice, mindful of the hostile environment that exists for taxpayers with undisclosed foreign assets and the extent to which the government has gone to aggressively pursue such taxpayers. Needless to say, this analysis should be undertaken by a skilled tax attorney and not left to chance.