Unreported Foreign Financial Assets? Part I: Consider Streamlined Filing Compliance Procedures
When a U.S. person owns a foreign financial asset, certain tax reporting obligations can arise. If the asset is a non-U.S. foreign bank account, you may need to disclose that account by filing an IRS Form 8938, Statement of Specified Foreign Financial Assets, as well as a Financial Crimes Enforcement Network (FinCEN) Form 114, Report of Foreign Bank and Financial Accounts (FBAR).
If the asset is stock in a non-U.S. corporation, you may need to report that stock on Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. If the asset is an interest in a foreign partnership, you may need to report that interest on Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships. If the asset is a foreign trust that makes annual distributions, you may need to report that asset and distribution income received on Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts. If the asset is a passive foreign investment company that makes distributions, you may need to report that asset and distribution income received on Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.
Once you realize that you should have reported a foreign financial asset but failed to do so, three questions typically arise. First, does an IRS voluntary disclosure program exist for unreported foreign financial assets? Second, does any IRS voluntary disclosure program cover unreported foreign financial assets that also generated unreported income? Third, if the IRS has not contacted you yet, then what risks and penalties (if any) potentially apply for each failure to report?
Penalties & Programs for Unreported Foreign Financial Asset
The IRS continues to audit and penalize U.S. taxpayers for failing to file international information returns. Take FBARs as an example. On June 24, 2021, the IRS updated the FBAR portion of the Internal Revenue Manual for examiners. This update coincided with greater IRS enforcement and litigation over FBARs that should have been filed by taxpayers but were not. On January 28, 2021, the FinCEN also increased penalty amounts for taxpayers who should have filed an FBAR but failed to do so.
Penalties deter violators and serve as the “stick” to foreign financial asset reporting. Although exact amounts depend on each taxpayer’s unique facts and circumstances, U.S. persons who must file an FBAR but fail to do so risk incurring civil and criminal penalties. Keeping with the policy of deterrence, civil penalties for willful, i.e., reckless or intentional, FBAR violations are considerably higher than penalties for nonwillful, i.e., negligent or accidental, violations. For each willful FBAR violation, the civil penalty can be assessed up to 50 percent of the balance amount in the account(s) at the time of the violation. Meanwhile, costly civil penalties apply to taxpayers who should have filed other international information returns—such as Forms 3520, 5471, 8621, 8865, 8938, etc.—but failed to do so.
By contrast, voluntary disclosure programs represent the “carrot” to foreign financial asset reporting. In late 2018, the IRS phased out the Offshore Voluntary Disclosure Program and replaced it with the Streamlined Filing Compliance Procedure (SFCP). Individuals who should have filed an FBAR or other international information return and who should have reported income from a foreign financial asset but failed to do so should consider the SFCP programs.
Streamlined Filing Compliance Procedure Programs
Eligible taxpayers filing under the SFCP can be shielded from certain penalties. Depending on which program the taxpayer qualifies for, SFCP programs minimize or eliminate accuracy-related penalties, information return penalties, FBAR penalties, failure-to-file penalties, and failure-to-pay penalties.
Broadly, taxpayers seeking eligibility for the SFCP must satisfy six criteria. First, the taxpayer must be an individual or estate. Second, the taxpayer must certify his, her, or its conduct in failing to file the FBAR(s) or international information return(s) was “nonwillful.” Third, the taxpayer must have zero civil examinations—or criminal investigations—initiated by the IRS into any taxable year. Fourth, the taxpayer must have a valid taxpayer identification number (TIN) or a completed TIN application. Fifth, the taxpayer must avoid submitting an Offshore Voluntary Disclosure Program voluntary disclosure letter after July 1, 2014. Sixth, if the taxpayer has previously filed a delinquent or amended tax return, then he or she must pay those penalty assessments prior to filing under the SFCP.
The SFCP contains two programs with unique benefits and risks: (1) the Streamlined Domestic Offshore Procedure (SDOP) and (2) the Streamlined Foreign Offshore Procedure (SFOP).
Streamlined Domestic Offshore Procedure – U.S. Taxpayers Residing Inside the U.S.
After satisfying the six SFCP criteria above, taxpayers seeking SDOP eligibility must meet three more rules. First, the taxpayer must fail to meet both nonresidency tests described by the IRS on its website titled “Eligibility for the Streamlined Foreign Offshore Procedures.” For joint return filers, at least one spouse must fail to meet both nonresidency tests. Second, the taxpayer must have previously filed a U.S. tax return—when required—for each of the most recent three years where the return due date (including extensions) has passed. Third, the taxpayer must have failed to report gross income from a foreign financial asset and to pay tax on that asset. Individuals and estates remain eligible for SDOP when—in addition to satisfying the above SDOP eligibility rules—they also fail to file an FBAR or some other required international information return(s), such as Forms 3520, 5471, 8621, 8865, or 8938.
Taxpayers seeking SDOP-specific benefits must comply in two ways. First, if applicable, these taxpayers must file certain delinquent FBARs electronically (e-filing). Second, after e-filing FBARs, these taxpayers must submit several items in paper to the IRS. Paper items include, among other things, amended tax returns, a Form 14654 certification, and a nonwillful conduct statement.
Complying with the SDOP generates costs, incurs risks, and creates benefits. For costs, complying with the SDOP means the taxpayer must pay a 5 percent “Title 26 Miscellaneous Offshore Penalty,” full outstanding tax due amounts, and full interest amounts from amended tax returns. For risks, if the taxpayer’s FBAR or information return violation was willful, or if the taxpayer’s original tax return was fraudulent, then that taxpayer loses audit protections under the SDOP. For benefits, complying with the SDOP means the taxpayer is not subject to accuracy-related penalties, information return penalties, and FBAR penalties. In addition, should the SDOP package come under IRS audit—assuming a nonwillful violation and no tax return fraud—the taxpayer remains shielded from these penalties.
Streamlined Foreign Offshore Procedure – U.S. Taxpayers Residing Outside the U.S.
Like the SDOP, taxpayers seeking SFOP eligibility must meet two more rules after satisfying the six SFCP criteria. First, the taxpayer must meet either of the nonresidency tests described in “Eligibility for the Streamlined Foreign Offshore Procedures.” For joint return filers, both spouses must meet at least one of the two nonresidency tests. Second, the taxpayer must have failed to report income from a foreign financial asset and to pay tax on that asset. Similar to the SDOP, individuals remain eligible for SFOP when—in addition to meeting the above two SFOP eligibility rules—they also fail to file an FBAR or some other required international information return(s).
Taxpayers seeking SFOP-specific benefits must comply in two ways. First, if applicable, these taxpayers must e-file certain FBARs. Second, after e-filing FBARs, these taxpayers must submit several items in paper to the IRS. For example, paper items include—among other things—delinquent or amended tax returns, a Form 14653 certification, and a nonwillful conduct statement.
Complying with the SFOP creates costs and raises risks but also brings benefits. For costs, complying with the SFOP means the taxpayer must pay full outstanding tax due and interest amounts from delinquent or amended tax returns. Unlike the SDOP, there is no 5 percent Title 26 Miscellaneous Offshore Penalty for SFOP filings. For risks, if the taxpayer’s FBAR or information return violation was willful, or if the original tax return was fraudulent, then that taxpayer loses audit protections under the SFOP. For benefits, complying with the SFOP protects the taxpayer from failure-to-file penalties, failure-to-pay penalties, accuracy-related penalties, information return penalties, and FBAR penalties.
Readers should take away three things about foreign financial asset reporting. First, taxpayers must file information returns, e.g., FBARs, Form 3520, Form 5471, Form 8621, Form 8865, Form 8938, etc., once reporting thresholds are crossed, especially if a foreign financial asset generates income. Second, taxpayers with a reporting obligation and unreported foreign financial assets create civil as well as criminal penalty risks for each violation depending on the level of culpability, e.g., willful or nonwillful. Third, taxpayers who fail to report income from all foreign financial assets, fail to also file related informational returns for each asset, wish to avoid costly penalties, and are not yet under IRS audit or criminal investigation should consider the SFCP programs.
Readers also should note three things about the SFCP programs. First, the SFCP features two programs: (i) the SDOP for U.S. taxpayers residing inside the U.S. and (ii) the SFOP for U.S. taxpayers residing outside the United States. Second, a taxpayer must meet not only the SFCP’s six eligibility criteria but also SDOP-specific or SFOP-specific eligibility rules. Third, filing under either the SDOP or SFOP creates certain risks and offers certain benefits. Most prominently, assuming no return fraud or willful violations, an eligible taxpayer filing under either the SDOP or SFOP can be shielded from various filing and return-specific penalties.
Contact your BKD Trusted Advisor™ or submit the Contact Us form below to evaluate whether you are eligible for either the SDOP or SFOP.