IRS Regulation on Required Time to Make Foreign Earned Income Exclusion Election is Reasonable

An important fact in dealing with the foreign earned income exclusion is that, per Reg. §1.911-7(a)(2)(i)(D), a taxpayer who fails to file his/her return more than one year after the original due date is risking the loss of the ability to exclude that income if the IRS discovers the fact that no election was made.  In the case of McDonald v. Commissioner, TC Memo 2015-169 the taxpayer discovered she had made this costly mistake.

The Tax Court summarized the general rules in IRC §911(d) as follows:

To qualify for the FEIE, the taxpayer must satisfy a three-part test: (1) the taxpayer must be a U.S. citizen who is a bona fide resident of a foreign country for an entire taxable year or physically present in a foreign country during at least 330 days out of a 12-month period, sec. 911(d)(1); (2) the taxpayer must have earned income from personal services rendered in a foreign country, sec. 911(d)(2); and (3) the taxpayer’s tax home for the period must be outside of the United States, sec. 911(d)(3).

However, as the Court notes, a qualifying taxpayer must, per IRC §911(a), elect to have the exclusion apply.  The IRC does not provide a time by which the election must be made, but IRC §911(d)(9) gives the IRS the right to write regulations to implement this provision.

Those regulations provide some detailed rules for when this election must be made.  Specifically Reg. §1.911-7(a)(2)(i) provides the following relatively complicated hierarchy of when the election can be made:

(i) In general.

In order to make a valid election under this paragraph (a), the election must be made:

(A) With an income tax return that is timely filed (including any extensions of time to file),

(B) With a later return filed within the period prescribed in section 6511(a) amending the foregoing timely filed income tax return,

(C) With an original income tax return that is filed within one year after the due date of the return (determined without regard to any extension of time to file); this one year period does not constitute an extension of time for any purpose--it is merely a period during which a valid election may be made on a late return, or

(D) With an income tax return filed after the period described in paragraphs (a)(2)(i)(A), (B), or (C) of this section provided--

(1) The taxpayer owes no federal income tax after taking into account the exclusion and files Form 1040 with Form 2555 or a comparable form attached either before or after the Internal Revenue Service discovers that the taxpayer failed to elect the exclusion; or

(2) The taxpayer owes federal income tax after taking into account the exclusion and files Form 1040 with Form 2555 or a comparable form attached before the Internal Revenue Service discovers that the taxpayer failed to elect the exclusion.

 (3) A taxpayer filing an income tax return pursuant to paragraph (a)(2)(i)(D)(1) or (2) of this section must type or legibly print the following statement at the top of the first page of the Form 1040: “Filed Pursuant to Section 1.911-7(a)(2)(i)(D).”

In this case the taxpayer had not filed a return for 2009.  The IRS prepared a substitute for return (SFR) in 2012 and issued a notice of deficiency.  The taxpayer then filed a Form 1040 and took advantage of the foreign earned income tax exclusion on Form 2555.  The exclusion eliminated most, but not all, of the taxpayer’s income.  She sent in a check fo the balance due with this return.

The IRS, however, noted that she had a return with a balance due, that was over one year late and she had not filed the Form 1040 with the Form 2555 before the IRS contacted her due to her failure to file a return.  Thus the taxpayer did not meet any of the conditions cited above.

Since she had clearly not complied with the regulation, the taxpayer argued that the regulation was not valid.  She argued the regulation was not valid under two separate theories:

  • The statute creates the only legal standard she should have to satisfy; or
  • The twelve-month standard is arbitrary and neither necessary or appropriate to carry out the purposes of §911.

To check the validity of a regulation, the Court must consider whether Congress had, in the statute, specifically addressed the issue in an unambiguous form.  If that is the case, then the statute’s language controls.

If there is an ambiguity, then the next question is whether that interpretation is a reasonable interpretation to resolve that ambiguity.  This generally referred to as the Chevron test (based on the case of Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984)).

The Court notes that while the provision authorizing the IRS to write regulations to implement this statute does not itself mention determining timing, IRC §7805(d), which is titled “Matter of Making Elections Prescribed by Secretary” specifically holds that “Except to the extent otherwise provided by this title, any election under this title shall be made at such time and in such manner as the Secretary shall prescribe.”  Thus, the fact that IRC §911(d) does not mention timing means that, per §7805(d), the IRS is authorized to determine that timing.

So now we have to decide if the IRS’s options are reasonable.  The Court notes, citing Faltesek v. Commissioner, 92 TC at 1212-1213, that it had previously held that, rather than being arbitrary, the rules were “generous” because they provided multiple alternatives for making the election.  In writing the regulation, the IRS had added the options beyond the simple “one year” test to give relief to taxpayers who ran into complexities dealing with overseas issues. 

That is, in the Court’s view, the complexity of options here give the taxpayers more of a chance to properly elect than a “simple” hard and fast one year deadline.  The Court was not inclined to find the IRS, by giving relief provisions, was acting “unreasonably” even though it created a rather complex set of options.

What this means, from a practical standpoint, is that clients need to treat this as an election that requires a timely filed return.  Note that if the original return is timely filed, the election can be made at any time (at least so long as the taxpayer still has a right to file a claim for refund).  If the taxpayer misses the original due date, then a one year clock starts running. 

And if that date is missed, then a taxpayer who otherwise owes even $1 of tax with the election in place is in a race to file a return before the IRS takes any action based on the fact the taxpayer had not filed a return.