Tax court ruling limits options for U.S. expatriates
A 1989 decision by the U.S. Tax Court has redefined what constitutes a timely tax return and election of the foreign earned income exclusion by U.S. taxpayers working overseas. The ruling may affect thousands of American expatriates who have failed to file tax returns in recent years
James H. Larkin II, Managing partner CPA,
MANY U.S. CITIZENS residing overseas either know a fellow expatriate who has not filed a U.S. tax return for one or more years or they have heard related stories. Indeed, the Internal Revenue Service (IRS) recognizes this problem as one of the most frequently encountered by Americans overseas. In a recent study, the IRS's Bryan L. Musselman found that hundreds of thousands of expatriates are failing to file tax returns. For the tax year 1986, alone, he estimates in excess of 900,000 required returns were not filed.l
This article explores alternatives available to a U. S. expatriate confronted with these circumstances in light of Faltesek vs. Commissioner, 92 T.C. No. 78, decided by the U.S. Tax Court in June 1989. Present day rules governing taxation of U.S. residents overseas were enacted in the Economic Recovery Tax Act (ERTA) of 1981. Despite five years of constant Congressional modification prior to ERTA, our present-day rules have been left generally undisturbed for nearly 10 years.
The IRS, under the auspices of the Treasury Department, normally promulgates regulations interpreting each legislative act affecting the Internal Revenue Code (IRC). Once final regulations are issued, they become the official interpretation of a particular act by Treasury. Regulations so promulgated under the 1981 ERTA were the concern of Faltesek vs. Commissioner. The focal point of the adjudication centered on the timing requirements contained in the regulations, which were not provided for by Congress, but rather, by Treasury.
ERTA contained two pertinent provisions relating to the Faltesek decision. IRC Section 911 (a), which in part provides that the foreign earned income exclusion is available only " at the election" of a qualified individual" and IRC Section 911 (d) (9), which provides that the Secretary of the Treasury shall prescribe those regulations "as may be necessary or appropriate" to carry out Congress' intended purpose (emphasis added).
Final regulations issued by Treasury on Jan. 23, 1985, addressed the " at the election" aspect of IRC Section 911 (a). Despite numerous objections, Treasury interpreted this "at the election" phrase to mean " at the timely election." By adding " timely, " Treasury added a weapon to its compliance arsenal where clearly none was provided for, nor sanctioned, by Congress. As Bechtel Power Corp.'s M. E. Martello noted in his response, ". . . it appears that the Treasury may be attempting to legislate policy and usurp the function of the Congress by instituting this penalty. . "2
Electing an exclusion. The official Treasury interpretation is contained in Reg. Sec. 1.911-7 (a) (2) (i). A valid timely election to claim the benefit of the foreign earned income exclusion may be made in one of three ways. The regulations are explicit that an election is timely only if it is: (1) contained in a timely filed original return; (2) contained in a timely filed amended return; or (3) contained in a delinquent return filed within one year of its original due date, e. g., by Apr. 15, 1991 for a 1989-calendar-year return originally due Apr. 15, 1990. Clearly, in this author's opinion, this is not what Congress intended. Treasury merely seized the opportunity to enhance its own house.
In America, one seeks redress in a court of law when confronted with such a dilemma. Thus, Mr. William J. Faltesek took to task the validity of Treasury Regulation 1.911-7 (a) (2) (i) in the United States Tax Court. The sole issue was whether the "timing" limitation to elect the exclusions of foreign earned income were beyond the regulatory authority granted to the Secretary under IRC Section 911 (d) (9). In essence, was this regulation both necessary or appropriate, and within the purpose and intent of the will of Congress?
Tax court logic. Justice Raum delivered the opinion for the court, wherein "(they held) that the regulation . . . (is) valid, whether regarded merely as interpretive or as legislative in character, notwithstanding that, in (their) view,
(the regulation is) quite clearly legislative, and (is) therefore, entitled to greater weight than interpretive regulations." So Mr. Faltesek, who, according to the facts of the case did not file his 1982 and 1983 returns until 1987, was up the proverbial creek.
Generally speaking, most tax litigation deals with factual situations and interpretive issues. It is not commonplace to challenge the validity of a Treasury regulation. On the other hand, when a regulation seems to exceed its intended purpose, it most certainly should be challenged. Whether the Faltesek decision was well-reasoned is beyond the scope of this article. Certain aspects, however, are somewhat suspect and deserve mention.
Justice Raum carefully articulates why the challenged regulation is both necessary and appropriate, is within the purview of the Secretary and is generally a well-conceived and reasonable regulation. He states that "Congress made it abundantly plain that the extended benefits that it was conferring we open-ended. It did not open the floodgates. At the very beginning of Section 911 (a), the exclusion provided was stated to be available only "at the election of the taxpayer...."
Justice Raum goes on to say, "As to the election itself, Section 911 (e) provided that it was to apply to the taxable year for which it was made and to all subsequent taxable years, unless revoked. But Section 911 (e) explicitly indicated that upon a revocation, that taxpayer may not make another election before the sixth taxable year thereafter. Plainly, Congress was concerned about persons who might be working from time to time in various foreign countries imposing different types of income tax, or none at all, and who might attempt from time to time to switch back and forth between the Section 901 foreign tax credit and the Section 911 (a) exclusion. The provisions of Section 911 (e) (2) strongly suggest that Congress was determined not to permit the playing of such games with the IRS, particularly since the IRS could thus be faced with increased difficulties in administering the law."
Shallow reasoning. The troubling aspect of the court's reasoning is not necessarily with the reported decision, but, rather, with what appears to be its shallowness. In order for the judge's reasoning to be sound, it appears the unstated assumption is that a taxpayer has alternatives from which he can pick and choose, i.e., the foreign tax credit or the foreign earned income exclusion. Presumably, if a taxpayer does not have such choices, there need not be such concern with the timeliness issue. An example would be if an individual were assigned to a no-tax country, such as Saudi Arabia, for five years. Clearly, the individual would have no alternative but to elect the foreign earned income exclusion. Thus, there is no "choice" for the court to be concerned with. The decision, however, is silent with respect to this factual situation.
In the court's view, it was clear that Congress did not want a taxpayer to have the luxury of choices and the opportunity of "playing such games." Therefore, the court sustained the validity of the regulation, thus barring a taxpayer, in the words of the court, from any "ex post facto or retroactive tax planning."
WEIGHING THE OPTIONS
Something, however, is wrong with either the decision or, more appropriately, the regulations themselves. Assume two hypothetical taxpayers, Adams and Baker, are residents, respectively, in Dubai and Abu Dhabi. Both hypothetical taxpayers transfer overseas during 1990. Adams files his 1990 return in a timely manner and duly makes the aforementioned election. Baker receives advice from his fellow expatriate, ad hoc tax advisor that he is tax-exempt and fails to file any return for not only 1990, but until the end of his assignment in 1996. Adams fails to file any return subsequent to 1990 until completion of his foreign assignment in 1997.
Adams lucks out. To summarize, Adams files in 1990 and fails to file for the following seven years, while Baker never files during his entire seven-year foreign assignment. Both taxpayers are confronted with apparent similar circumstances, i.e., failure to file for seven consecutive years during their respective overseas assignments. The distinguishing characteristic is, of course, that Adams did file his 1990 returns in a timely manner and elected the benefits of Section 911. As the court duly noted pursuant to IRC Section 911 (e), once the election is made, it remains in effect for all subsequent years unless revoked.
The impact of the court's decision in Faltesek, and its seemingly inconsistent treatment, is at once visible when applying the decision to Adams and Baker. For illustrative purposes, assume each hypothetical taxpayer is married and has taxable income of $70,000 (absent the foreign earned income exclusion). In each year, the tax rate remains at 28%. The cumulative individual tax liability would amount to $137,200 (7 x $70,000 x 28%).
Baker gets squeezed. Because Adams made the election in 1990, despite not filing for the next seven years, he is allowed to file all delinquent returns in 1998, claim the foreign earned income exclusion, and he owes nothing. While Baker, on the other hand (not taking into account the possibility of a delinquent filing of his last year overseas), is liable for the entire $137,200, plus penalties and interest, which easily could exceed $68,000. Adams, $0; Baker, $205,200! And the U.S. Tax Court would have us believe the decision is well-reasoned.
Before proceeding, a word of caution is in order. In IRS publication 54, the advice to a delinquent overseas taxpayer is "(to) . . . file the late returns as soon as possible...."3 This advice, in light of Faltesek, certainly is misplaced. If you are in this position, contact a professional tax advisor who is knowledgeable in this area of tax law for professional assistance.
Going back to Adams and Baker, we find Baker in the same position as Faltesek. Adams, however, has filed his delinquent returns, got a clean bill of health from the revenuer and has returned to work in mainstream U.S.A. He, of course, paid no income tax for the same seven years that Baker will probably need to declare bankruptcy over.
Using tax court logic to beat the rules. If we alter Adams' facts slightly, the Faltesek decision becomes even more suspect. Assume Adams moves to Scotland for 1991 and 1992, then transfers to Belgium for 1993, back to Dubai in 1994, and again back to Scotland in 1995, 1996 and 1997. Adams now, indeed, has the very essence of opportunity for which the court was concerned. He can ex post facto and retroactively tax plan, albeit within limits, his seven delinquent years overseas.
Adams would analyze the beneficial tax consequences of the foreign earned income exclusion versus the foreign tax credit on an overall seven-year basis. He would find the cumulative foreign tax credit more advantageous because of the high foreign tax rates in Scotland and Belgium. Curiously enough, the regulations are silent with respect to any timing requirements of the revocation of election. Consequently, in 1998 he would elect out of the Section 911 benefit for 1992 and subsequent tax years. The foreign tax credit carryovers would absorb his 1994 U.S. income tax liability as a consequence of his Dubai residency, and he would have a cumulative foreign tax credit carryover into 1998 and beyond. Ironically, if he again transferred overseas, he could start the process over again, since the five years (for reelection without consent) would have lapsed in 1997.
Baker's alternatives are somewhat limited. To prevail on a further challenge of the regulations' validity would take pervasive arguments and force the court to reverse itself. This is a highly dubious avenue of pursuit. There is, however, one viable option of relief available within the context of private letter rulings.
Private letter rulings are issued to taxpayers by the IRS in response to a variety of issues. Under Reg. Sec. 1.9100, a private ruling may be requested, seeking relief from the failure to make a "timely" election required under the IRC. Congress provided this mechanism to allow the IRS an administrative means within which to interpret the law;
but not without strings. Private letter rulings are not to be cited or used as precedent. They are to be relied upon only by the private citizens to whom they are issued. This procedure would seem to suggest a one-way street for the IRS- the opportunity to apply its own brand of justice.
Under Reg. Sec. 1.9100-1 (a), the IRS commissioner is given discretion to grant a reasonable extension of time to taxpayers for the making of a delinquent election, provided certain criteria are satisfied. Absent litigation, the only technical remedial avenue available to Baker is seeking relief through a private letter ruling. There are two possible outcomes when one asks to make a delinquent election of the foreign earned income exclusion through a ruling request. Either the request will be granted, or it will be denied. It is the latter about which we need be concerned.
One might ask how relief can be granted under Reg. Sec. 1.9100 (a), when the court in Faltesek declared the regulations promulgated under Section 911 to be " . . . clearly legislative, " and, thus, to be accorded greater weight than mere interpretive regulations. In other words, taxpayers, these regulations are tantamount to the law itself. In deference to the court, the IRS does not think so. It continues to grant extensions of time pursuant to Reg. Sec. 1.9100 and has done so in at least three instances subsequent to Faltesek.4
These exceptions, of course, do not count, as they may not be relied upon, nor be cited, as precedent. As precedent for what? Certainly, if one is denied relief, they can be cited as examples of the "lack of equal protection under the law" or as being fundamentally at odds with one taxpayer's "due process under the law" as compared to another. The government's posture in this regard seems best borne out by the expression "having your cake and eating it, too," or "talking out of both sides of one's mouth."
If we accept the premise that the subject regulations are valid, as the court has so indicated, how can the IRS grant exceptions as to their applicability on an ad hoc basis to selected taxpayers? No matter how the argument is framed, the response will be that IRC Section 6110 (j) (3) grants the extraordinary authority to the commissioner to pick and choose those taxpayers to whom an exception applies. This probably will remain so until an unfortunate Mr. Baker applies for a ruling request, is denied relief, and decides to test the constitutionality of this process.
RULING REQUEST COMPONENTS
There are four essential facets to a ruling request seeking relief from the (now valid) timing requirements of Reg. Sec. 1.911-9 (2). The ruling request must be based on (1) good cause; (2) the timing element must not be prescribed by law; (3) it must be requested within a reasonable period of time; and (4) the granting of the request must not prejudice the interests of the government.
Good cause. The standard of "good" lies somewhere between "reasonable" and "excellent." Precisely what constitutes good cause most probably is left up to the advocate who summarizes a particular taxpayer's factual situation. Reliance on the improper advice of a professional probably would constitute sufficient basis to satisfy the good cause standard.
Another argument could be fashioned on the premise that the taxpayer was so immersed in the foreign environment as to have had no contact with the U. S. for many years and, thus, have no basis of awareness of filing requirements. If the government were to counter that such an argument was weak, and at best less than convincing, try the Ollie argument!
Most of the world, particularly U.S. citizens, became aware of Oliver North as a consequence of live U. S. Senate hearings for weeks on end. And yet, the 12 jurors picked for his recent trial purportedly had no knowledge of his alleged conduct. If 12 such jurors could be found, it is certainly reasonable to assume one could have been sufficiently immersed in a foreign environment so as to have lost touch with the U.S. and its tax return filing requirements.
Timing element not prescribed by law. The law, or statute, does not prescribe any timing restrictions. This was the focal point of the Faltesek controversy.
Request within reasonable period. Assuming that good cause is established for filing late, asking for the ruling request as soon as one becomes aware of the filing requirement ought to constitute "within a reasonable period" of time. Within a reasonable period of time does not necessarily mean from the original due date of the return. On the flip side, waiting six months to ask for a ruling once one becomes aware of the filing requirement probably would not be viewed as within a reasonable period.
Prejudice the interests of the government. This aspect of a ruling request certainly is the most susceptible to interpretation. Precisely which interests the framers of this section were concerned with is not clear. A reasonable assumption would be that the interests they did not want prejudiced were either financial in nature or concerned with the overall tax administration and judicial processes. This, however, would not seem to be the case, as apparently neither of these interests were prejudiced by the granting of the three requests noted above.
The Faltesek decision will have to be distinguished by a taxpayer who has no "choice," about which, the court need be concerned. Without distinguishing Faltesek in this regard, the court is likely to continue to sustain the "timely" requirement.
Without litigation, there are two basic choices available to the U. S. citizen overseas who finds himself in the uncomfortable position of failing to file his tax return in a timely manner. These are either to pay the tax together with penalties and interest, or seek relief through a ruling request.
The prejudicial interest issue will have to be carefully addressed in a ruling request. Perhaps one could argue it is the interests vested within the Constitution that the framers were concerned about. By not granting the requested exception, they would seriously undermine those delicate principles which guarantee each of us due process and equal protection under the law. After all, we only are asking for relief from a timing requirement that our elected legislators never mandated in the first place.
1 "Study: Overseas taxpayers aren't filing," USA Today, International Edition, Sept. 6, 1989.
2 Martello M. E., Response to proposed regulations (48 FR. 33007), Sept. 19, 1983, p6
3 Tax Guide for US Citizens and Resident Aliens Abroad, IRS Publication 54, p. 26, 1989.
4 PLR 8941067, July 1989; PLR 90002064, October 1989; PLR 9013072, Jan. 2, 1990.,
Send mail to
questions or comments about this web site.