Making Sense of the FBAR Penalty Mitigation Guidelines

Making Sense of the FBAR Penalty Mitigation Guidelines: Four Easy Steps For Knocking The FBAR Calculation Out of the Park

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This blog is intended for the taxpayer who plans on making a “quiet disclosure” of his unreported foreign financial assets and finds it necessary to estimate his FBAR liability in case of a doomsday scenario. By “doomsday scenario,” I’m referring to a situation where the IRS selects one or more years for examination, culminating in the assertion of onerous FBAR penalties.

No discussion of FBAR penalties would be complete without a discussion of the penalty mitigation guidelines. What are the penalty mitigation guidelines? Some background information is in order. FBAR penalties have varying upper limits, but no floor. For example, the maximum nonwillful FBAR penalty is $ 10,000. And the maximum willful FBAR penalty is the greater of (a) $ 100,000 or (b) 50% of the total balance of the foreign account.

Because FBAR penalties do not have a set amount, the IRS has developed penalty mitigation guidelines to assist examiners in exercising their discretion for asserting these penalties. The mitigation guidelines apply to both willful and nonwillful penalty amounts.

Under the guidelines, the penalty amount is tied to a fixed, pre-determined “maximum aggregate balance” for all accounts. For example, under the nonwillful penalty guidelines, if the maximum aggregate balance for all accounts to which the violations relate does not exceed $ 50,000, a Level I Nonwillful penalty applies. The corresponding penalty is $ 500 for each violation, not to exceed a total of $ 5,000 in penalties.

Level I willful FBAR penalties contain the same $ 50,000 threshold. However, unlike the Level I Nonwillful penalty, the corresponding Level I willful penalty is the greater of (1) $1,000 per violation or (2) 5% of the maximum balance during the year of the account to which the violations relate for each violation. Determining the “maximum aggregate balance” for all accounts is a two-step process:

(1) First, determine the maximum balance at any time during the calendar year for each account.

(2) Second, add the individual maximum balances to find the maximum aggregate balance.

Are the penalty mitigation guidelines etched in stone? The simple answer is “no.” They are only intended as an aid for the examiner in determining an appropriate penalty amount. Indeed, the examiner may determine that a lesser penalty amount than the guidelines provide is appropriate. Or, the examiner might determine that the penalty should be increased.

Are there any preconditions that one must satisfy in order to qualify for the penalty mitigation guidelines? Yes, but they are not difficult to meet. Under IRM 4.26.16-2, a person qualifies for penalty mitigation if he meets the following four conditions:

1.The person has no history of criminal tax or BSA convictions for the preceding ten years and has no history of prior FBAR penalty assessments;

2.No money passing through any of the foreign accounts associated with the person was from an illegal source or used to further a criminal purpose;

3.The person cooperated during the examination; and,

4.IRS did not determine a fraud penalty against the person for an underpayment of income tax for the year in question due to the failure to report income related to any amount in a foreign account.

In order to appreciate how the guidelines work in practice, two examples will be helpful:

Example 1:

Assume that John has an undisclosed offshore account with a maximum account balance of $ 40,000 (USD) in tax year 2012. He decides to make a quiet disclosure. Assume that he otherwise satisfies the conditions for penalty mitigation. The best way of analyzing this problem is to do so in three-steps:

Step 1: Is the account subject to FBAR reporting? Under the FBAR rule, a U.S. person must file an FBAR if that person has a financial interest in or signature authority over any financial account(s) outside of the U.S. and the aggregate maximum value of the account(s) exceeds $ 10,000 at any time during the calendar year. Here, the maximum value of the account in 2012 is $ 40,000, which exceeds $ 10,000. Therefore, John had a duty to file an FBAR.

Step 2: Does John satisfy the threshold requirements for penalty mitigation? Yes.

Step 3: What level applies? Because the maximum balance of John’s account never exceeded $ 50,000, he qualifies for a Level I mitigation penalty for tax year 2012. Keep in mind that Level I covers maximum aggregate balances up to and including $ 50,000.

Step 4: What is John’s penalty under the mitigation guidelines? Because it is unknown whether the IRS will treat John’s failure to disclose his offshore account as a nonwillful violation or as a willful violation, it is a good idea to calculate his FBAR penalty under both the nonwillful mitigation guidelines and the willful mitigation guidelines.

If the examiner determines that John’s failure to disclose his offshore account was not willful, then the Level I nonwillful mitigation guidelines apply. The nonwillful mitigation penalty corresponding to Level I is $500 for each violation, not to exceed an aggregate penalty of $5,000 for all violations.

Here, John’s nonwillful FBAR mitigation penalty for tax year 2012 would be $ 500.

On the other hand, if the examiner determines that John’s failure to disclose his offshore account was willful, then the Level I willful mitigation guidelines apply. The willful mitigation penalty corresponding to Level I is the greater of (a) $ 1,000 or (b) 5% of the maximum balance during the year of the account to which the violation relates.

In order to determine which amount is greater, (a) or (b), it is necessary to determine what 5% of the maximum balance of John’s offshore account was for tax year 2012. Here, the maximum balance of John’s offshore account was $ 40,000 in 2012. And five percent of $ 40,000 is $ 2,000. Because five percent of the maximum account balance is by far the greater value – i.e., $ 2,000 is greater than $ 1,000 – and the willful mitigation penalty is the greater of (a) or (b), John’s willful mitigation penalty for tax year 2012 would be $ 2,000.

Example 2:

Assume now that John has three undisclosed offshore accounts with three different banks: (1) Lloyd’s Bank, (2) Barclay’s, and (3) Hargraves. The maximum balances in each account for tax year 2012 are as follows:

(1) Lloyd’s: $ 10,000 (USD)

(2) Barclay’s: $ 30,000 (USD)

(3) Hargraves: $ 40,000 (USD)

John decides to make a quiet disclosure. Assume that he otherwise satisfies the conditions for penalty mitigation.

As in example one, we apply the same three-step framework:

Step 1: Are the accounts subject to FBAR reporting? Under the FBAR rule, a U.S. person must file an FBAR if that person has a financial interest in or signature authority over any financial account(s) outside of the U.S. and the aggregate maximum value of the account(s) exceeds $ 10,000 at any time during the calendar year.

Here, the maximum value of each account in 2012 is as follows: $ 10,000, $ 30,000, and $ 40,000, respectively. The aggregate maximum value is obtained by tallying up all three values, which equals $ 80,000. Because $ 80,000 exceeds $ 10,000, John had a duty to file an FBAR.

This is a good time to pause to discuss the aggregate maximum value rule and the impact it has on the disclosure of John’s Lloyd’s account. Although, at first blush, it might appear as though John’s Lloyd’s account does not trigger an FBAR reporting requirement because its maximum balance does not exceed $ 10,000, nothing could be farther from the truth.

While the maximum balance of the Lloyd’s account alone might not trigger an FBAR reporting requirement, the fact remains that when combined with the other two maximum account balances, it does. And under the aggregate maximum value rule, that’s all that counts. Indeed, the maximum balances of all three accounts — when tallied — far exceed the $ 10,000 reporting threshold. Therefore, even the Lloyd’s account must be reported on an FBAR.

Step 2: Does John satisfy the threshold requirements for penalty mitigation? Yes.

Step 3: What level applies? If you said Level I, you would have fallen into a trap. Keep in mind that it is the “maximum aggregate balance” for all accounts that determines the penalty amount under the guidelines, the operative word being, “aggregate.”

As previously discussed, determining the maximum aggregate balance is a two-step process: Step one includes determining the maximum balance at any time during the calendar year for each account. And step two requires adding the individual maximum balances to find the maximum aggregate balance.

The maximum balances of each account are: (1) $ 10,000, (2) $ 30,000, and (3) $ 40,000, respectively. After tallying up the individual maximum balances of all three accounts, the total comes to $ 80,000. Thus, the maximum aggregate balance is $ 80,000.

Because the maximum aggregate balance of John’s three accounts is $ 80,000 and because the maximum aggregate balance for Level I penalties cannot exceed $ 50,000 at any time during the year, John does not qualify for Level I penalties. Instead, he qualifies for Level II. Thus, John gets bumped up to Level II as a result of the aggregation rule. Recall that Level II covers maximum aggregate balances between $ 50,000.01 and $ 250,000.

This is a good time to pause to make an important point. Although no single account by itself exceeds the $ 50,000 threshold, the fact remains that the sum total or aggregate does. And that’s all that is required to trigger level 2 penalties. In other words, no single account has to contain a maximum balance that exceeds $ 50,000 in order to trigger level 2 penalties, so long as the aggregate of them all exceeds $ 50,000.

Step 4: What is John’s penalty under the mitigation guidelines? Because it is unknown whether the IRS will treat John’s failure to disclose his offshore accounts as a nonwillful violation or as a willful violation, it is a good idea to calculate his FBAR penalties under both the nonwillful mitigation guidelines and the willful mitigation guidelines.

If the examiner determines that John’s failure to disclose his offshore accounts was not willful, then the Level II nonwillful mitigation guidelines apply. The nonwillful mitigation penalty corresponding to Level II is $ 5,000 for each account violation, not to exceed 10% of the maximum balance in the account during the year. Ten percent is the cap.

Let’s begin with John’s Lloyd’s account, the maximum balance of which is $ 10,000. Because $ 5,000 exceeds $ 1,000, or 10% of the maximum balance of the Lloyd’s account in tax year 2012, John’s nonwillful mitigation penalty for Lloyd’s would be capped at $ 1,000.

Next up is John’s Barclay’s account, the maximum balance of which is $ 30,000. Because $ 5,000 exceeds $ 3,000, or 10% of the maximum balance of the Barclay’s account in tax year 2012, John’s nonwillful mitigation penalty for Barclay’s would be capped at $ 3,000.

Last but not least is John’s Hargraves account, the maximum balance of which is $ 40,000. Because $ 5,000 exceeds $ 4,000, or 10% of the maximum balance of the Hargraves account in tax year 2012, John’s nonwillful mitigation penalty for Hargraves would be capped at $ 4,000.

If you’re keeping track, John’s total nonwillful FBAR penalties under the penalty mitigation guidelines for tax year 2012 is $ 8,000 (i.e., $ 1,000 + $ 3,000 + $ 4,000). Of course, the examiner might find that John’s failure to disclose his offshore accounts was willful, in which case the Level II willful mitigation guidelines would apply. The willful mitigation penalty corresponding to Level II is the greater of (1) $ 5,000 per violation or (2) 10% of the maximum balance during the calendar year for each Level II account.

Let’s begin with John’s Lloyd’s account. In order to determine which amount is greater, (a) or (b), it is necessary to determine what 10% of the maximum balance of the Lloyd’s account was for tax year 2012. Here, the maximum balance of the Lloyd’s account was $ 10,000 in 2012. And ten percent of $ 10,000 is $ 1,000. Because the latter is less than $ 5,000 – i.e., $ 1,000 is less than $ 5,000 – and the willful mitigation penalty is the greater of (a) or (b), John’s willful mitigation penalty for the Lloyd’s account would be $ 5,000.

Next up is John’s Barclay’s account, the maximum balance of which is $ 30,000. Ten percent of $ 30,000 is $ 3,000. Because the latter is less than $ 5,000 – i.e., $ 3,000 is less than $ 5,000 – and the willful mitigation penalty is the greater of (a) or (b), John’s willful mitigation penalty for the Barclay’s account would also be $ 5,000.

Last but not least is John’s Hargraves account, the maximum balance of which is $ 40,000. Ten percent of $ 40,000 is $ 4,000. Because the latter is less than $ 5,000 – i.e., $ 4,000 is less than $ 5,000 – and the willful mitigation penalty is the greater of (a) or (b), John’s willful mitigation penalty for the Hargraves account would also be $ 5,000.

If you’re keeping track, John’s total willful FBAR penalties under the penalty mitigation guidelines for tax year 2012 is $ 15,000 (i.e., $ 5,000 + $ 5,000 + $ 5,000).

This example serves an important purpose. It teaches two concepts. First, that FBAR penalties are determined per account, not per unfiled FBAR. And second, that penalties apply for each year of each violation. Taken together, this means that FBAR penalties can be aggregated, one on top of the other, catapulting one’s liability into the stratosphere.

And here is where an important distinction must be made between the cumulative effect of FBAR civil penalties and the one-time offshore penalty under OVDP. Contrary to popular belief, the offshore penalty under OVDP is not determined by aggregating the penalty for each year during the disclosure period.

Instead, the offshore penalty under OVDP is determined by isolating the highest year’s maximum aggregate account balance during the period covered by the voluntary disclosure (i.e., the most recent eight years for which the due date has already passed), and using that balance as the “base” to calculate a single offshore penalty at the applicable rate (generally, 27.5%).

Below is a chart summarizing the FBAR penalty mitigation guidelines, for both willful and nonwillful violations:

Normal FBAR Penalty Mitigation Guidelines for Violations Occurring After October 22, 2004 – Per Person Per Year
Non-Willful (NW) Penalties
To Qualify for Level I-NW – Determine Aggregate Balances If the maximum aggregate balance for all accounts to which the violations relate did not exceed $50,000 at any time during the year, Level I – NW applies to all violations. Determine the maximum balance at any time during the calendar year for each account. Add the individual maximum balances to find the maximum aggregate balance.
Level I-NW Penalty is $500 for each violation, not to exceed an aggregate penalty of $5,000 for all violations.
To Qualify for Level II-NW – Determine Account Balance If Level I-NW does not apply and if the maximum balance of the account to which the violations relate at any time during the calendar year did not exceed $250,000, Level II-NW applies to that account.
Level II-NW Penalty is $5,000 for each Level II-NW account violation, not to exceed 10% of the maximum balance in the account during the year
To Qualify for Level III-NW If Level I-NW does not apply and if the maximum balance of the account to which the violations relate at any time during the calendar year was more than $250,000, Level III-NW applies to that account.
Level III-NW is $10,000 for each Level III-NW account violation, the statutory maximum for non-willful violations.
Willfulness Penalties
To Qualify for Level I – Determine Aggregate Balances If the maximum aggregate balance for all accounts to which the violations relate did not exceed $50,000, Level I applies to all accounts . Determine the maximum balance at any time during the calendar year for each account. Add the individual maximum balances to find the maximum aggregate balance.
Level I Penalty is The greater of $1,000 per violation or 5% of the maximum balance during the year of the account to which the violations relate for each violation.
To Qualify for Level II – Determine Account Balance If Level I does not apply and if the maximum balance of the account to which the violations relate at any time during the calendar year did not exceed $250,000, Level II applies to that account .
Level II Penalty is per account The greater of $5,000 per violation or 10% of the maximum balance during the calendar year for each Level II account .
To Qualify for Level III If the maximum balance of the account to which the violations relate at any time during the calendar year exceeded $250,000 but did not exceed $1,000,000, Level III applies to that account .
Level III Penalty is per account. The greater of (a) or (b): (a) 10% of the maximum balance during the calendar year for each Level III account, or (b) 50% of the closing balance in the account as of the last day for filing the FBAR .
To Qualify for Level IV If the maximum balance of the account to which the violations relate at any time during the calendar year exceeded $1 million, Level IV, the statutory maximum, applies to that account.
Level IV Penalty is per account the statutory maximum The greater of (a) or (b): (a) $100,000, or (b) 50% of the closing balance in the account as of the last day for filing the FBAR.

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3 Comments

  1. Part 2: Be careful what you “Fix For” – Mr. Kentera meets Mr. #FBAR in the “Twilight Zone” | Citizenship Counselling For U.S. Citizens in Canada and Abroad
    2017-02-05 14:19:10

    […] For more about FBAR penalties and the “FBAR Penalty Mitigation Guidelines”, see the discussion by Michael Deblis here. […]

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    2017-02-05 19:00:30

    […] For more about FBAR penalties and the “FBAR Penalty Mitigation Guidelines”, see the discussion by Michael Deblis here. […]

  3. Part 2: Be careful what you “Fix For” – Mr. Kentera meets Mr. #FBAR in the “Twilight Zone” | alliance for the defeat of citizenship taxation
    2017-02-06 23:31:33

    […] and the “FBAR Penalty Mitigation Guidelines”, see the discussion by Michael Deblis here.   What happened was that Mr. and Mrs. Kentera “signed up” to pay an FBAR penalty […]

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