Before reading this blog, I make the following disclaimer. If it is getting close to lunch time and you can hear your stomach growling, you might want to put off reading this until after lunch. Readers who disregard this warning are doing so at their own risk.

Calculating the offshore penalty within the Streamlined Domestic Offshore Procedures can be tricky. It’s not as simple as tying your shoes. Before delving into the tricky part, let’s cover three basic concepts:

(1) The offshore penalty under the streamlined domestic offshore procedures is 5%.

(2) The 5% penalty is calculated based upon the value of foreign financial assets that would have otherwise formed the basis of the civil miscellaneous penalty under the Offshore Voluntary Disclosure Program.

(3) The base to which the 5% penalty applies is the “highest aggregate balance/value of the taxpayer’s foreign financial assets” during the period covered by the disclosure.

Now for the tricky part: interpreting “highest aggregate balance/value.” Because this is the value to which the 5% rate must be applied in order to arrive at the offshore penalty, I like to refer to it as the “base.” Determining the base is the most critical part of determining the offshore penalty. It is the beef in a quarter-pounder. It is the parmesan cheese in the creamy dish of fettucine alfredo. But, as many taxpayers have come to realize, this is easier said than done. As one astute taxpayer stated, determining the highest aggregate balance/value is a “riddle wrapped in a mystery inside an enigma.”

There are two ways of interpreting “highest aggregate balance/value.” First, by chopping it up into four separate words in the same way that a butcher would chop up a large sausage into chipolatas. But don’t worry, you need not decide between potatoes and cherry tomatoes as the side dish. After “chopping” it up, you need only apply the common-sense definition of each word, in a numerical context that is – and not a culinary one – in order to arrive at the overall meaning of the phrase. After all, we are talking about bank accounts and financial assets.

Sound painful? Tell me about it. I’ve spent many a night sitting at my computer racking my brain trying to understand the meaning of this cryptic phrase while the account statements of dozens of offshore accounts stared me back in the face in currencies that I could barely even pronounce. I kept thinking, “there must be a better way.” And there was.

Instead of carving this phrase up into four chipolatas (or words) and deciding what context of each word fits best within the overall meaning of the phrase so that it might easily be understood, I realized that I was making this more difficult than it needed to be. Very simply, I was overthinking things. I realized how much easier it would be to treat these four words as a complete phrase with one overall definition.

In other words, instead of chopping it up into small chipolatas that can only be eaten one at a time and that no doubt require additional servings to satisfy a hungry stomach, it was more satisfying to treat it as a four-inch long Weisswurst (i.e., white sausage) that could fit neatly inside a hotdog bun and which was guaranteed to satisfy your appetite for hours to come. The foreign asset equivalent being a single catch-all phrase with a single definition. Sound refreshing. Or, better yet, mouth-watering?

There was nothing novel about this discovery. As a matter of fact, it was right under my nose. Indeed, IRS publications pertaining to the new Streamlined Domestic Offshore Procedures lay out how to determine the highest aggregate balance/value in very simple terms.

Notwithstanding this, there still seems to be a lot of confusion. In fairness to taxpayers who are trying to get it right, this confusion has nothing to do with them. At the same time, determining the highest aggregate balance/value is very technical and falls within the province of tax professionals: namely, international tax preparers.

If I could put my finger on what I believe to be the cause of the confusion, it would be this: taxpayers are juxtaposing the way in which the “highest aggregate balance/value” is determined under OVDP with the way that it is required to be determined under the new Streamlined Domestic Offshore Procedures.

As those who sit on the frontlines of international tax compliance know all too well (a special “shout out” to international tax preparers, the unsung heroes of the voluntary disclosure system), determining “highest aggregate balance/value” under OVDP differs from determining “highest aggregate balance/value” under the Streamlined Domestic Offshore Procedures. This only muddies what are already murky waters.

A simple comparison of the two highlights this discrepancy. In both OVDP and in streamlined, the framework for determining the highest aggregate balance/value is a three-step process. However, only two of the three steps are the same: steps two and three. Step one, on the other hand, differs.

What are these steps? Let’s begin with OVDP. Step one requires isolating the highest balance of all of the taxpayer’s foreign financial accounts and the highest value of all of the taxpayer’s foreign financial assets – subject to the offshore penalty – for each year during the disclosure period. Assuming that the taxpayer has an offshore bank account, the highest value of the taxpayer’s account would be the highest balance in the account – i.e., the high water-mark – during the tax year.

The voluntary disclosure period is the most recent eight tax years for which the due date has already passed. For example, for taxpayers who submit a voluntary disclosure prior to the due date – or properly extended due date for the 2013 tax year – the disclosure must include each of the tax years 2005 through 2012 in which they have undisclosed OVDP assets.

Step two contemplates that the taxpayer has more than one offshore account and/or foreign financial asset in any given year during the disclosure period. If so, the highest balance of every foreign account and the highest value of every foreign financial asset – subject to the offshore penalty during that respective tax year – must be tallied up for that year.

Before moving to step three, this is a good time for a slight digression. Although it might appear as though a foreign account does not need to be reported if its highest balance falls below $ 10,000 (USD), this is not entirely true. Beware of the maximum aggregate value rule! The following example demonstrates how the rule operates.

Assume that John has three foreign accounts, the highest balances of which never exceeds $ 10,000 (USD). The highest balance in each account is $ 9,000. Although no account by itself triggers an FBAR reporting requirement because no single account exceeds the $ 10,000 reporting threshold, together they do. Indeed, the highest aggregate balance of the three accounts is $ 27,000. Therefore, all three accounts must be reported on an FBAR, even though none of them alone would trigger an FBAR reporting requirement.

Step three requires selecting the one year from among all of the years in the disclosure period where the aggregate balance/value of all foreign financial accounts and all foreign financial assets was the greatest. That figure, in turn, becomes the highest aggregate balance/value, or “base,” to which the offshore penalty is calculated at the applicable rate (i.e., 27.5% or 50%).

Let’s turn now to the three steps for determining the highest aggregate balance/value under the streamlined procedures. As indicated above, the first step for determining the highest aggregate balance/value under the streamlined procedures differs from the first step under OVDP. Unlike OVDP, it is not the high water mark of the offshore account or the highest value of a foreign financial asset that carries the day. Instead, it is the year-end account balances of all foreign accounts and the year-end asset values of all foreign financial assets – subject to the offshore penalty, of course – that must be isolated. By “year-end,” the IRS is specifically referring to December 31st.

And herein lies the problem. The balance in an offshore account as of the last day of the tax year may, or may not be, the highest balance in the account for that year. What does this mean for you? If your streamlined submission calculated the offshore penalty based on the highest balance of your offshore account during the disclosure period as opposed to the highest year-end account balance during the disclosure period, you may have grossly overstated your offshore penalty.

Step one under the streamlined procedures differs in another key respect from step one under OVDP. And that relates to the disclosure period. While the disclosure period under OVDP is the most recent eight tax years for which the due date has already passed, the disclosure period under the streamlined procedures is defined as the years in the “covered tax return period” and the “covered FBAR period.”

What are the years in the “covered tax return period” and the “covered FBAR period?” The covered tax return period is defined as the most recent three years for which the U.S. tax return due date (or properly applied for extended due date) has passed. Generally speaking, for a submission made in October of 2014, the covered tax return period would include tax years 2011, 2012, and 2013.

The covered FBAR period includes the most recent six years for which the FBAR due date has passed. Generally speaking, for a submission made in October of 2014, the covered FBAR period would include tax years 2008, 2009, 2010, 2011, 2012, and 2013.

The last two steps for determining the highest aggregate balance/value under the streamlined procedures is the same as under OVDP. Step two contemplates that the taxpayer has more than one offshore account and/or foreign financial asset in any given year during the disclosure period. If so, the year-end balance of every foreign account and the year-end value of every foreign financial asset – subject to the offshore penalty during that respective tax year – must be tallied up for that year.

Step three requires selecting the one year from among all of the years in the disclosure period where the aggregate balance/value of all foreign financial accounts and all foreign financial assets – as of the last day of the tax year – was the greatest. That figure, in turn, becomes the highest aggregate balance/value, or “base,” to which the offshore penalty is calculated, at a rate of 5%.

Below is an example. It is a simple example that is designed to drive home the point. Assume that John has one undisclosed offshore account: Account A with ABC Bank. The chart below describes the period in which John held this account, the interest income generated, the highest account balance for each year, and the end-of-year balance for each year. Assume for purposes of this example that the $ 1,000,000 was in the account before 2006 and was not unreported income in 2006.

Account A:

Let’s calculate John’s offshore penalty assuming that he applies to OVDP.

(1) Step 1: Isolate the highest balance of all of John’s foreign financial accounts and the highest value of all of John’s foreign financial assets, subject to the offshore penalty, for each year during the disclosure period. Here, John has an offshore account and no foreign financial assets. Recall that the OVDP disclosure period is the most recent eight tax years for which the due date has already passed. That would be tax years 2006 through 2013. The highest balances in Account A for 2006 through 2013 are listed in column four of the above chart.

(2) Step 2: The highest balance of every foreign account – during each respective tax year – must be tallied up for that year. Because John did not have any more than one offshore account at any given time during the disclosure period, this step does not apply.

(3) Step 3: The highest aggregate balance of all foreign financial accounts from each tax year in the disclosure period must be compared and the year in which the aggregate balance was the greatest must be selected. That figure, in turn, becomes the highest aggregate balance, or “base,” to which the offshore penalty is calculated at the applicable rate (i.e., 27.5% or 50%). Here, there was only one account: Account A. And Account A’s highest balance during the disclosure period was in 2013, when it reached $ 1,275,000.

Because the highest aggregate balance during the disclosure period was $ 1,275,000, that figure becomes the “base,” or the amount that is used to calculate the offshore penalty. Assuming that ABC Bank did not make it onto the dreadful list of banks that trigger an even more onerous offshore penalty rate than 27.5% (i.e., 50%), John’s offshore penalty under OVDP would be $ 350,625 (.275 x $ 1,275,000).

Let’s assume now that, instead of applying to the OVDP, John makes a streamlined submission. Let’s compare the highest aggregate balance/value under OVDP with the highest aggregate balance/value under the streamlined procedures.

(1) Step 1: Isolate the year-end account balances of all foreign accounts and the year-end asset values of all foreign financial assets during the disclosure period (i.e., the “covered tax return period” and the “covered FBAR period”). Here, John has an offshore account and no foreign financial assets. Recall that the “covered tax return period” includes the most recent three years for which the U.S. tax return due date (or properly applied for extended due date) has passed. And the “covered FBAR period” includes the most recent six years for which the FBAR due date has passed. To simplify matters, the look-back period is six years, beginning with tax year 2008 and ending with tax year 2013. Account A’s year-end balances for tax years 2008 through 2013 are listed in column five of the above chart.

(2) Step 2: The year-end balance of every foreign account – during each respective tax year – must be tallied up for that year. Because John did not have any more than one offshore account at any given time during the disclosure period, this step does not apply.

(3) Step 3: The aggregate balance of all foreign financial accounts – as of the last day of the tax year – must be compared and the year in which the aggregate balance was the greatest must be selected. That figure, in turn, becomes the highest aggregate balance, or “base,” to which the offshore penalty is calculated, at a rate of 5%. Here, there was only one account: Account A. And the year in which Account A had the highest end-of-year balance was in 2013. That year it was $ 1,225,000.

Because the highest end-of-year balance during the disclosure period was $ 1,225,000, that figure becomes the “base,” or the amount that is used to calculate the offshore penalty. Note how the highest end-of-year balance is different than the highest account balance. Although both occurred in the same tax year, here tax year 2013, the fact remains that the end-of-year balance in 2013 was $ 50,000 less than the highest account balance for that same year.

Therefore, John’s offshore penalty under the streamlined procedures would be $ 61,250 (.05 x $ 1,225,000). As is obvious, I have not delved into the issue of which option is best for John. That, of course, depends on a thorough analysis of “willfulness” along with determining John’s eligibility under the remaining eligibility factors for the streamlined program.

However, I leave you with a few parting words as they relate generally to the willfulness determination:

• Should John elect to make a streamlined submission, he would be barred from later applying to the Offshore Voluntary Disclosure Program. Therefore, he must choose wisely. To the extent that the IRS challenges his submission, John would be subject to a myriad of penalties that could leave him with nothing more than the shirt on his back.

• The importance of consulting with a tax attorney to get advice on whether you are an appropriate candidate for the streamlined procedures cannot be overstated. The improper use of the Streamlined Procedures can be a major trap for the taxpayer who deliberately or incorrectly elects the Streamlined Procedures.

• A tax attorney will conduct a risk-based analysis, taking into consideration the issue of willfulness, and provide you with practical and sound advice in this climate of aggressive targeting of taxpayers with undisclosed foreign assets. Needless to say, this analysis should be undertaken by skilled counsel and not left to chance or guess work.