Streamlined Domestic Offshore Procedures: The 5 Percent Option for U.S. Residents

Not every American with a foreign account problem lives abroad. Some came back. Some never left and inherited an account from a parent overseas. Some are green card holders who kept savings in their home country. For non-willful taxpayers who do not meet the foreign non-residency test, the IRS offers the Streamlined Domestic Offshore Procedures.

It is not penalty-free. It is close to the most predictable deal in this area of law.

Who qualifies

On top of the general streamlined rules (individuals and estates only, a valid taxpayer identification number, non-willful conduct, and no IRS civil examination or criminal investigation already underway), the IRS lists four specific requirements for the domestic version:

• You fail to meet the non-residency requirement that applies to the foreign version. Because joint filers must both meet that test, a couple where either spouse fails it looks here.
• You previously filed a U.S. tax return, if required, for each of the most recent three years for which the return due date has passed.
• You failed to report gross income from a foreign financial asset and pay tax as required, and may have failed to file an FBAR or information returns such as Forms 3520, 5471 or 8938.
• Those failures resulted from non-willful conduct, meaning negligence, inadvertence, mistake, or a good faith misunderstanding of the law.

The second requirement is the one that knocks people out. The domestic procedure is for amending returns you filed, not for filing returns you never filed. If you are a U.S. resident with unfiled years, this is not your program, and you need a different strategy.

What you submit

The IRS instructions for the domestic procedure call for:

• Amended returns on Form 1040X for each of the most recent three years for which the due date has passed, with any required information returns.
• Delinquent FBARs for each of the most recent six years for which the FBAR due date has passed, filed electronically with FinCEN.
• Form 14654, Certification by U.S. Person Residing in the U.S., including the non-willful certification and a narrative.
• Payment of the tax, interest and the 5 percent penalty.

How the 5 percent penalty works

The IRS calls it the miscellaneous offshore penalty. It equals 5 percent of the highest aggregate balance or value of your foreign financial assets that are subject to the penalty during the covered period.

The covered period combines the three tax years covered by the amended returns (the covered tax return period) and the six years covered by the FBARs (the covered FBAR period). Here is the method the IRS describes:

• For each year, add up the year-end account balances and year-end asset values of all the foreign financial assets that are subject to the penalty.
• Look at all the years in the covered period.
• Pick the highest year. The penalty is 5 percent of that number.

Which assets are subject to the penalty? The IRS lists three triggers. An asset is in the base for a covered FBAR year if it should have been, but was not, reported on an FBAR for that year. It is in the base for a covered tax return year if it should have been, but was not, reported on Form 8938 for that year. And it is in the base if it was properly reported, but the gross income from it was not reported for that year.

The IRS notes the base includes financial accounts held at foreign financial institutions, foreign mutual funds, and foreign hedge funds and private equity funds, among other assets.

A worked example

A U.S. resident inherited a brokerage account in Germany. She reported nothing for six years: no FBARs, no Form 8938, and no dividends on her returns. The year-end values over the six FBAR years were $210,000, $225,000, $240,000, $260,000, $250,000 and $255,000.

Every year is in the base, because the account should have been on an FBAR each year and its income was not reported. The highest year-end value is $260,000. The miscellaneous offshore penalty is 5 percent of $260,000, or $13,000, plus tax and interest on the three amended years.

Now change one fact: in the earliest three FBAR years, she had filed accurate FBARs, and those years fall outside the three amended return years. Those years would not be in the base for FBAR reasons. The computation has to be done carefully year by year, because the base depends on what was and was not properly reported for each year.

What the 5 percent buys

According to the IRS, taxpayers who comply with the domestic instructions will not be subject to accuracy-related penalties, information return penalties or FBAR penalties for the covered years. The protection does not apply if an examination finds the original return was fraudulent. Penalties already assessed for those years are not abated.

Compare that to the alternatives. A willful FBAR penalty can reach 50 percent of an account balance per violation. Form 8938 penalties start at $10,000 per year. Even non-willful FBAR penalties, after Bittner, can add up to a meaningful number across six years. For many non-willful taxpayers, 5 percent of the single highest year is the cheapest certainty available.

What happens after you file

The general streamlined rules apply to the domestic version too. The IRS says it will not acknowledge receipt of streamlined returns, and the process does not end with a closing agreement. The returns are processed like any other return. They can be selected for audit under the IRS's existing selection processes, and if the facts warrant it, they may be subject to examination, additional civil penalties and even criminal liability.

That is why the certification has to be accurate. The penalty protection rests on eligibility, and eligibility rests on non-willful conduct. If an examination later shows the conduct was not what the certification said, the protection is not something you can count on.

After you submit, the IRS expects you to stay compliant. Future returns, Forms 8938 and FBARs are filed under the regular rules, on time, every year.

If you already fixed some years quietly

Some people discover the problem and start amending returns or filing FBARs on their own before they learn about streamlined. The IRS says taxpayers who previously filed delinquent or amended returns outside of these programs may still use the streamlined procedures if they follow the instructions, but any penalties already assessed on those filings will not be abated. Read quiet disclosure risks before you file anything else on your own.

When domestic streamlined is the wrong tool

A final note on the math. Because the penalty base is a single year's highest aggregate value, it pays to get the year-end values right for every year in the covered period. Use the year-end statements, document the exchange rates, and check whether each asset truly belongs in the base for each year before you compute anything.

• When there is no unreported income. If every dollar of foreign income was reported and only the forms were missing, the domestic program's eligibility requirement, a failure to report gross income from a foreign financial asset, is not met. Look at delinquent international information returns and late FBAR options.
• When you did not file returns at all. The domestic procedure requires previously filed returns for the three years.
• When the conduct may have been willful. Streamlined offers no criminal protection. The IRS points those taxpayers to the IRS Criminal Investigation Voluntary Disclosure Practice.
• When you might qualify for the foreign version. If you or both spouses meet the non-residency test in any one of the three years, the foreign version with no penalty may be available.

Picking the right door matters more than anything else in this process. Let's talk before you pick one.