The reporting obligations of US taxpayers who have foreign accounts are complex and confusing. Taxpayers who have foreign assets may have to file FBAR (FinCEN 114) or FATCA (Form 8938), or both, or neither, depending on the valuation. So, frequently a taxpayer finds they have inadvertently failed to file a required tax form. That is where the Streamlined Domestic Offshore Procedures (SDOP) come in. They are a set of rules to allow a taxpayer who non-willfully failed to file certain tax forms.
Only certain taxpayers qualify. To qualify for SDOP, a taxpayer must:
be a US resident;
certify that the failure to file was non-willful;
have filed returns for the most recent 3 years;
have unreported income from a foreign asset;
have failed to file informational returns such as FBAR or Form 8938; and
not be currently under audit.
A taxpayer who meets all those requirements can use the SDOP to become compliant. The taxpayer needs to
file amended returns, including any informational forms such as Form 8938;
file any delinquent FBARs for the prior 6 years;
file Form 14654 certifying the non-compliance was non-willful;
pay the additional tax on the previously unreported income and any interest; and
pay the offshore penalty.
The cost to using SDOP is the offshore penalty which is equal to 5% of the highest aggregate value of the taxpayer’s foreign assets. The first step to calculating the 5% penalty is to identify the penalty base by comparing the accounts that should have been reported but were not for each year. For instance, a taxpayer will need to tally all of the foreign financial accounts that should have been but were not included in their FBAR for each of the last 6 years. For the last 3 years, the taxpayer will need to tally all foreign assets that should have been but were not included in Form 8938, and the taxpayer will need to tally all foreign assets for which gross income was not reported for each year for the last 3 years.
An example will show how the 5% offshore penalty is calculated. Let’s say a single taxpayer living in the United States for the last 2 years failed to report a foreign bank account on an FBAR, failed to report a foreign partnership interest on Form 8938, and failed to report interest income from a foreign bond on his 1040. On December 31 Year 1, the bank account had a balance of $80,000. On December 31 Year 1, the partnership interest had a balance of $75,000. On December 31 Year 1, the bond had a value of $20,000. So, the aggregate for Year 1 assets is $175,000.
On December 31, Year 2 the values are as follows: $20,000 for the bank account, $100,000 for the partnership interest, and $25,000 for the bond. So, the aggregate for Year 2 assets is $145,000. Because the value of the assets in Year 1 is greater than Year 2, the penalty is based off the Year 1 amount. The amounts are not added together or averaged, but only the year with the highest amount is used. So, the penalty in this case is 5% of $175,000, which is $8,750.
Filing under the SDOP is generally greatly preferred over paying noncompliance penalties. In the above example, there may be delinquent FBAR penalties for $10,000 per year AND delinquent Form 8938 penalties for another $10,000, in addition to interest. Missing two years of reporting means that the penalties could be $40,000 plus interest, so paying “only” $8,750 is the preferred option.
Before making a disclosure, taxpayers should consult with an experienced tax professional to evaluate their eligibility, calculate the penalty correctly, and prepare a complete and credible non-willfulness certification.