When Is a Tax Return "Filed"?

In Notice 2004-45, 2004-2 C.B. 33, the IRS put taxpayers who were asserting to be bona fide residents of the U.S. Virgin Islands (USVI) and who were not following the requirements of meeting the applicable bona fide residency guidelines on notice of being subject to IRS scrutiny. By becoming bona fide residents of the USVI, these taxpayers were able to convert U.S.-source income (which is subject to federal tax) into USVI-source income that is not subject to federal tax and is eligible for a 90 percent USVI tax credit (EDP Credit).

Under the Internal Revenue Code in effect during the pre-2005 years, a U.S. citizen who was a "bona fide resident of the Virgin Islands at the close of the taxable year" was not required to report his gross income on a U.S. federal tax return, as long as he fully reported such income on a USVI tax return¹ and paid any taxes due to the U.S. Virgin Islands' Bureau of Internal Revenue (VIBIR). SeeI.R.C. § 932(c) (2004). U.S. citizens who were not bona fide residents of the USVI but who had income from USVI sources were required to file a return with both the USVI and the United States. SeeI.R.C. § 932(a).

Under I.R.C. § 6501(a), the period for assessing tax runs until "3 years after the return was filed." In this context, "the term 'return' means the return required to be filed by the taxpayer." I.R.C. § 6501(a). And in I.R.C. § 6501(c)(3), Congress expressly provided for an indefinite limitations for unfiled returns.

U.S. Tax Court: Coffey v. Comm'r, 150 T.C. 60 (2018)

In Coffey, the tax years at issue were 2003 and 2004. The Coffeys filed only USVI returns, claiming Judith Coffey was a bona fide USVI resident for both 2003 and 2004. Their returns consisted of completed Forms 1040 filed with the USVI, their USVI and federal Forms W-2, and numerous other schedules and forms. The returns claimed the EDP Credit for both years.

The Coffeys did not file returns with the IRS. However, for each year, the VIBIR sent the IRS the first two pages of their USVI income tax returns and their USVI and federal Forms W-2 about five months after receiving these documents, which the IRS stamped, recorded and processed. The VIBIR sent these documents to the IRS so that the Coffeys' prepayments to the IRS could be remitted to the USVI, with any overpayment refunded to the Coffeys. See I.R.C. § 7654(a) (taxes collected by the IRS from bona fide USVI residents are "covered into the Treasury" of the USVI).

The IRS audited these documents by deploying a rotating team of stateside-based IRS revenue agents to the USVI to examine all income tax returns filed with the VIBIR, conducting follow-up through an IRS national office-drafted extensive Information Document Request and convening interviews of American citizens selected for IRS examination.

The IRS issued notices of deficiency to the Coffeys in 2009, more than three years after receiving the documents from the VIBIR. The Coffeys filed a motion for summary judgment invoking the three-year statute of limitations in I.R.C. 6501(a). Their argument was simple and straightforward: Assuming the Coffeys were non-residents of the USVI, returns were filed with the IRS either at the time the returns were filed with the VIBIR or when the Philadelphia IRS Service Center received the partial return from the VIBIR. The U.S. Tax Court (USTC) agreed with the Coffeys and granted their motion for summary judgment.

Eighth Circuit: Coffey v. Comm'r, 987 F.3d 808 (8th Cir. 2021)

On appeal, the U.S. Court of Appeals for the Eighth Circuit applied summary judgment standards. Thus, for purposes of the appeal, the facts were construed in favor of the IRS and the Coffeys were deemed USVI nonresidents. The Eighth Circuit then strictly applied the statute – the Internal Revenue Code states that a USVI nonresident must "file" a "return" with both the United States and the USVI. See I.R.C. § 932(a)(2). The Eighth Circuit disagreed with the USTC and held that the Coffeys did not file their return with both the IRS and the VIBIR.²

The Eighth Circuit held that a taxpayer must show "meticulous compliance" with all filing requirements in the Internal Revenue Code or its regulations to begin the statute of limitations. "Returns are "filed" if "delivered, in the appropriate form, to the specific individual or individuals identified in the Code or Regulations." Comm'r v. Estate of Sanders, 834 F.3d 1269, 1274 (11th Cir. 2016) (citations omitted).³ Being that the VIBIR was not the Coffeys' agent, the Coffeys did not "file" returns with the IRS.⁴

The Coffeys presented various forceful arguments to demonstrate that filing with VIBIR was indeed a filing with the IRS. These arguments were as follows:

• Through a Tax Implementation Agreement, since 1987 the USVI was required and had routinely provided the IRS with information about any taxpayer "who files an income tax return with the Virgin Islands claiming for the first time to be a Virgin Islands resident" – such as Judith Coffey.
• The Code required implementing regulations as to key definitional terms such as where and with whom to file the income tax returns if an individual was a resident or a non-resident of USVI.
• During the years at issue, the were no implementing regulations. The Coffeys relied on instructions from the VIBIR and their good faith interpretation of the instructions.
• Implementing regulations were issued in 2008. Although the regulations applied on a prospective basis only, they treat residents and non-residents of USVI the same by considering the filing with the VIBIR to be sufficient as filing with the IRS directly.
• Consequently, the Coffeys believed that they had acted in good faith by filing with the VIBIR alone.

The Eighth Circuit dismissed the Coffeys' argument by finding that there was no good faith language in I.R.C. § 6501(a). Thus, as non-residents of the USVI, the statute required dual filings.

USTC v. Eighth Circuit

Why did two courts arrive at different conclusions when interpreting the same provision? I.R.C. § 6501(a) states: "Except as otherwise provided in this section, the amount of any tax imposed by this title shall be assessed within 3 years after the return was filed ... . For purposes of this chapter, the term 'return' means the return required to be filed by the taxpayer." The USTC emphasized the term "return" whereas the Eighth Circuit emphasized the term "filed."

A reading of the USTC decision indicates that the court viewed the relationship between the VIBIR and the IRS as one of agency, i.e., the VIBIR was an agent of the IRS due to the EDP Credit and funds emanating to the USVI. Nearly identical tax forms and tax laws reinforced the agency concept. Thus, the majority of the USTC believed that either the filing with the VIBIR or the transmission of the Coffeys' documents to the IRS was a filing of the return. The Eighth Circuit focused on the term "filed" under I.R.C. §§ 932 and 6501. Because the Coffeys were deemed non-residents of the USVI, they – not the VIBIR – were required to personally file a return with the IRS under a strict reading of I.R.C. §§ 932 and 6501.

A viable interpretation of the Eighth Circuit decision is that the court reasoned that if the Coffeys desire the benefits of I.R.C. § 932, they must prove that they were truly residents of the USVI, not just have a good faith belief that they were residents of the USVI.

Puerto Rico Implications

In 2019, Act 60-2019 (the Act) amended the island's tax incentives regime.⁵ The provisions of the Act provide for a full exemption from Puerto Rican income taxes on interest and dividends from local sources, as well as a more limited exemption for capital gains accrued and realized after an individual becomes a resident. Those individuals who become residents of Puerto Rico and establish qualifying businesses must be paid reasonable compensation for services they provide to those companies; if so, those individuals will be exempt from local tax on any dividends they receive.

The Act requires that the individual benefiting from the incentives be physically present on the island for at least 183 days of a tax year and the payment of an annual fee of $5,000 and annual contributions to nonprofits of $10,000. Qualifying companies are subject to a 4 percent tax rate on revenues from export services. A bona fide resident of Puerto Rico would not have to pay federal taxes on his or her locally sourced income under I.R.C. §§ 933 and 937.

IRS publication Topic No. 901, "Is a Person with Income from Puerto Rico Required to File a U.S. Federal Income Tax Return?," states as follows:

If you're a bona fide resident of Puerto Rico during the entire tax year, you generally aren't required to file a U.S. federal income tax return if your only income is from sources within Puerto Rico. However, if you also have income from sources outside of Puerto Rico, including from U.S. sources, you're required to file a U.S. federal income tax return if such amount is above the U.S. filing threshold. Nevertheless, a bona fide resident of Puerto Rico with a U.S. filing obligation, generally won't report Puerto Rican source income on a U.S. income tax return.

Thus there is an incentive for new Puerto Rican residents to source much, if not all, of their income as being derived from Puerto Rico. Not surprisingly, in January 2021, the IRS Large Business & International (LB&I) Division added Puerto Rico Act 22, the "Act to Promote the Relocation of Individual Investors to Puerto Rico," as an active campaign to determine whether the requirements of I.R.C. § 937, Residence and Source Rules Involving Possessions, were being met.

Conclusion

Applying the lessons learned from Coffey, filing a return solely with Puerto Rico will not prevent the IRS from challenging a taxpayer's good faith belief as to Puerto Rican residency.

A U.S. taxpayer must be prepared to demonstrate that he or she is a bona fide Puerto Rican resident and was present in Puerto Rico for at least 183 days during the taxable year. See Treas. Reg. § 1.937-1(c)(1).⁶ The determination of whether a taxpayer is a bona fide resident is analyzed via 11 factors. See Sochurek v. Comm'r, 300 F.2d 34, 38 (7th Cir. 1962); Bergersen v. Comm'r, 109 F.3d 56, 62 (1st Cir. 1997).⁷ Those 11 factors are:

1. Intention of the taxpayer
2. Establishment of his home temporarily in the foreign country for an indefinite period
3. Participation in the activities of his chosen community on social and cultural levels, identification with the daily lives of the people and, in general, assimilation into the foreign environment
4. Physical presence in the foreign country consistent with his employment
5. Nature, extent and reasons for temporary absences from his temporary foreign home
6. Assumption of economic burdens and payment of taxes to the foreign country
7. Status of resident contrasted to that of transient or sojourner
8. Treatment accorded his income tax status by his employer
9. Marital status and residence of his family
10. Nature and duration of his employment; whether his assignment abroad could be promptly accomplished within a definite or specified time
11. Good faith in making his trip abroad; whether for purpose of tax evasion

Section 937 was amended to provide greater clarity as to determining bona fide residence of U.S. possessions. Specifically, an individual is a bona fide resident of a U.S. possession if 1) such person is present in the possession⁸ for at least 183 days during the year, 2) such person does not have a tax home⁹ outside the possession during the year, and 3) such person does not have a closer connection¹⁰ to the United States or a foreign country than to the possession.

The lesson from Coffey is significant: If the taxpayer fails to meet these tests, the statute of limitations will remain open under I.R.C. § 6501(c)(3) if the taxpayer has failed to file a federal income tax return with the IRS even if the taxpayer has a good faith belief as to being a Puerto Rican resident.

Notes

¹ The USVI "administers a 'mirror code' of the Internal Revenue Code that substitutes 'Virgin Islands' for the 'United States.'" I.R.C. §§ 932(c)(2), 7654(a), and 48 U.S.C. § 1397. The USVI tax return were Forms 1040, U.S. Individual Tax Return, repurposed for use as the Virgin Islands return without any changes.

² The Eighth Circuit initially rendered its opinion on Dec. 15, 2020. On Feb. 10, 2021, the Eighth Circuit granted the Coffeys' petition for rehearing and vacated its December 2020 opinion. On Feb. 12, 2021, the Eighth Circuit reaffirmed its earlier December 2020 opinion.

³ Co-author William Sharp served as lead trial counsel of record in Estate of Sanders v. Comm'r, 144 T.C. 63 (2015), vacated and remanded by 834 F.3d 1269 (11th Cir. 2016) remanded to T.C. Memo 2018-104 (2018).

⁴ The Eighth Circuit stated:

Heckman v. Comm'r, 788 F.3d 845, 847 (8th Cir. 2015) defeats the Coffeys' argument that the VIBIR sending the documents to the IRS began the statute of limitations. The IRS received actual knowledge of the Coffeys' information, not a filing. It is undisputed that the Coffeys did not intend to file tax returns with the IRS, but only with the VIBIR. Coffey, 150 T.C. at 80. The Coffeys did not meticulously comply with federal filing requirements for USVI nonresidents. ... That the IRS actually received the documents, processed and audited them, and issued deficiency notices is irrelevant for statute of limitations purposes. See Heckman, 788 F.3d at 847-48. The IRS's actual knowledge did not create a filing. The statute of limitations in section 6501(a) begins only when a return is filed. Because the Coffeys did not meticulously comply with requirements to file with the IRS, the statute of limitations never began

⁵Act 20 was combined with another tax incentive, Act 22, into Act 60.

⁶ If the taxpayer is a non-resident alien, the individual must meet the 183 test under 7701(b)(3)(A). See Treas. Reg. § 1.937-1(c)(2) and Lujan v. Comm'r, T.C. Memo. 2000-365.

⁷ Other circuits group the 11 factors into the following four categories: 1) the taxpayer's intent to remain in the place of residency for "an indefinite or at least substantial period of time;" 2) the taxpayer's physical presence; 3) the taxpayer's social, family and professional relationships; and 4) the taxpayer's own representations. See Vento v. Dir. of Virgin Islands Bureau of Internal Revenue, 715 F.3d 455, 466-68 (3d Cir. 2013); Comm'r v. Estate of Sanders, 834 F.3d 1269 (11th Cir. 2016).

⁸ Guam, American Samoa, the Northern Mariana Islands, Puerto Rico or the USVI.

⁹ Determined under the principles of I.R.C. § 911(d)(3) (without regard to the second sentence thereof).

¹⁰ Determined under the principles of I.R.C. § 7701(b)(3)(B)(ii).

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