The Streamlined Domestic Penalty: What Is the 5% Actually 5% Of? The Assets That Were Never Reported, at Their Highest Year-End Value

Short version: Streamlined Filing Compliance Procedures Explained

The domestic streamlined track's one penalty is described in a single sentence on Form 14654 and misunderstood in most first meetings. It is 5% of the highest aggregate balance or value, at any year-end in the covered period, of the foreign financial assets that were subject to the penalty. An asset is subject to the penalty for a year if it should have been reported on an FBAR or Form 8938 and was not, or if it produced income that was not reported on the return. An asset that was reported correctly with its income reported correctly is not in the base. The base is built year by year, the aggregate is computed at each year-end, and the highest aggregate is the base for the 5%.

Key takeaways

• The rate: 5%, once, not per year.
• The base: the highest aggregate value of the "foreign financial assets subject to the miscellaneous offshore penalty," measured at year-end for each year in the covered tax return period (three years) and the covered FBAR period (six years), taking the single highest year-end aggregate.
• An asset is subject to the penalty for a year if, for that year, it should have been but was not reported on an FBAR (if the account was an FBAR-reportable account) or on Form 8938 (if the 8938 was required), or its gross income was not reported on the return. One failure for a year puts the asset's year-end value in that year's aggregate.
• Excluded: assets reported correctly on the FBAR and 8938 with income correctly reported; assets that are not foreign financial assets (directly held real estate, for example); and the asset in years it did not exist.
• Year-end value: the December 31 balance for accounts; fair market value at year-end for other assets, in US dollars at the year-end rate.
• RRSPs: an RRSP that was on the FBAR each year with its income properly deferred under the treaty is not in the base; one that was omitted from the FBAR is, at its year-end value, even though its income was properly deferred.

Building the base

For each of the six FBAR years (and the three return years, which are within them), list every foreign financial account and asset the taxpayer held at year-end. For each, ask: was it reported on that year's FBAR (if an FBAR was required)? On Form 8938 (if required)? Was its income on the return? If any answer is no, the asset's year-end value is in that year's aggregate. Sum the year's aggregate. Repeat for each year. The base is the largest of the six aggregates. The penalty is 5% of it.

Because the test is per asset per year, the same account can be in the base in one year and out in another (reported on the FBAR in some years, omitted in others). Because the base is the highest single year-end aggregate, an account closed before the highest year does not raise it, and an account opened after the highest year does not either.

What is in and what is out

In: a TFSA never reported (its year-end value each year); a Canadian brokerage account omitted from the FBAR; a Canadian bank account whose interest was not reported even if the account was on the FBAR; a Canadian mutual fund account whose PFIC income was not reported; an RESP never reported; a Canadian corporation's shares if Form 8938 required them and they were omitted (at fair market value); an RRSP omitted from the FBAR (the treaty deferral protects the income, not the reporting).

Out: an RRSP reported on the FBAR and 8938 every year with the deferral properly claimed; a Canadian account that was on the FBAR and whose interest was reported; a Canadian home (not a financial asset); a Canadian pension plan interest that is not an account; US accounts.

A Canadian who moved to the US, put the RRSP on the FBAR from the first year on a preparer's advice, but never mentioned the TFSA or the taxable brokerage account, has a base consisting of the TFSA and the brokerage account, not the RRSP.

Year-end, not maximum

The FBAR reports each account's maximum value during the year; the streamlined penalty uses the year-end value. An account that peaked mid-year and was drawn down by December 31 enters the base at the December 31 figure. The IRS's instructions specify "year-end" for accounts and "year-end fair market value" for other assets.

The years

The covered FBAR period is the six most recent years for which the FBAR due date has passed; the covered tax return period is the three most recent years for which the return due date has passed. The base is computed across all six years (the FBAR period includes the return period). An account omitted from the FBAR in year one of the six, but reported thereafter, is in the base only for year one's aggregate.

Currency

Values are converted to US dollars at the Treasury year-end exchange rate for the year (the same rate used for the FBAR).

Contrast with the foreign track

SFOP has no penalty. A taxpayer who qualifies for SFOP (330 days outside the US in one of the three years) pays nothing beyond tax and interest. The 5% applies only to SDOP filers, which is why the residency test matters as much as it does.

Worked example

A Toronto couple moved to Chicago six years ago. Their US preparer put the RRSPs on the FBAR from year one and deferred the income; nobody mentioned the TFSAs (his $95,000, hers $88,000 at their highest year-ends), a joint Canadian brokerage account ($210,000 at its highest, income never reported), and a Canadian savings account ($30,000, on the FBAR but interest omitted). They filed 1040s every year; they fail the 330-day test every year (they live in Chicago). SDOP.

• Base, by year. Year one: TFSAs $150,000 + brokerage $180,000 + savings $30,000 = $360,000 (savings in the base because interest was omitted). Year four (the highest): TFSAs $183,000 + brokerage $210,000 + savings $28,000 = $421,000. RRSPs excluded every year (reported, deferred).
• Penalty. 5% of $421,000: $21,050.
• Contrast. Had the brokerage account's income been reported and the account been on the FBAR, the base would be the TFSAs alone: $183,000; $9,150.
• Submission. Three amended 1040s adding the TFSA income, the brokerage income (with 8621s for any Canadian funds in it), and the savings interest, with Forms 3520/3520-A for the TFSAs; six amended FBARs adding the TFSAs and the brokerage account; Form 14654 with the penalty computation and the narrative; payment of tax, interest, and the $21,050.

Official sources

The IRS states that eligible taxpayers must "have previously filed a U.S. tax return (if required) for each of the most recent 3 years" and pay a Title 26 miscellaneous offshore penalty equal to "5 percent of the highest aggregate balance/value of the taxpayer's foreign financial assets that are subject to the miscellaneous offshore penalty during the years in the covered tax return period and the covered FBAR period." — Internal Revenue Service, U.S. Taxpayers Residing in the United States, https://www.irs.gov/individuals/international-taxpayers/us-taxpayers-residing-in-the-united-states

Practitioner note

The 5% is on what was hidden, not on what was held, and for most Canadian movers the RRSP was on the FBAR and is out of the base. We build the base account by account and year by year before the client decides anything, because the number is usually smaller than the client fears and occasionally larger, and either way it is the number that decides between SDOP and the alternatives.

See also: If you are a US citizen or green card holder in Canada catching up, start with what you still owe the IRS, and browse every cross-border tax topic guide, organized by situation.

Next step

Fairlight prepares the SDOP penalty base computation by asset and year, the amended returns and FBARs, and Form 14654. See cross-border pricing or book a call.