IRS Barred from Assessing Tax on Virgin Islands 1040s.
(Parker's Federal Tax Bulletin: June 8, 2013)

The territorial returns filed by a U.S. citizen who was a resident of the U.S. Virgin Islands were properly filed returns that met his federal tax filing obligations and began the statute of limitations for the assessment of taxes. Appleton v. Comm'r, 140 T.C. No. 14 (5/22/13).

Arthur Appleton, a U.S. citizen, was a permanent resident of the U.S. Virgin Islands in 2002, 2003, and 2004. He filed territorial income tax returns with the U.S. Virgin Islands Bureau of Internal Revenue (VIBIR) and paid tax to the Virgin Islands for each of those three years. He did not, however, file separate income tax returns with the IRS, asserting an exemption under Code Sec. 932(c)(4). He claimed that, for those three years, he was entitled to income tax benefits provided under the Virgin Island Industrial Development Program through his interest in a purported Virgin Islands partnership. The VIBIR forwarded copies of Arthur's returns to the IRS.

More than three years after the filing of the returns with the VIBIR, the IRS determined that Arthur did not qualify for the Code Sec. 932(c)(4) gross income exclusion and issued a notice of deficiency. As the basis of the income tax deficiencies, the IRS asserted that Arthur actively participated in an arrangement that lacked economic purpose and economic substance and that was created to improperly claim a 90 percent credit against income tax liabilities similar to those positions described in Notice 2004-45.

The Virgin Islands is classified as an unincorporated territory and generally not a part of the United States for tax purposes. The tax law of the Virgin Islands is a mirror tax system in which the Virgin Islands uses the Internal Revenue Code with Virgin Islands substituted for United States. Code Sec. 6091 and its regulations require that taxpayers living in a possession of the U.S. file their tax returns as designated on the return forms or instructions issued for those forms. The instructions to Form 1040 specifically state that the form is to be filed with the VIBIR.

Code Sec. 932 coordinates U.S. and Virgin Islands income taxes for individuals who are bona fide residents of the Virgin Islands. The section provides that those individuals must file their income tax returns with the Virgin Islands and exempts both U.S. source income and Virgin Island source income from U.S. tax. If the requirements of Code Sec. 932(c)(4) are not met, then the individual is required to file federal tax returns, and his or her income would no longer be excluded for purposes of calculating his or her U.S. tax liability.

Code Sec. 6012 provides that every individual having for the tax year gross income that equals or exceeds the exemption amount, with certain exceptions, must file an income tax return. Generally, under Code Sec. 6501(a), taxes must be assessed by the IRS within three years of the due date the return or the date the return is filed, whichever is later. The IRS argued that Arthur did not satisfy all the requirements of Code Sec. 932(c)(4) and hence was required to file U.S. federal tax returns. Since he did not properly file federal returns as required by Code Sec. 6012, the IRS said the statute of limitations for assessing tax deficiencies had not begun.

The Tax Court held that Arthur properly filed his tax returns with the Virgin Islands, and the statute of limitations began when he filed those returns. The court noted that the Internal Revenue Code does not define what constitutes a return. The court looked to case law and the four-part test in Beard v. Comm'r, 82 T.C. 766 (1984), aff'd, 793 F.2d 139 (6th Cir. 1986), to determine whether the returns filed by Arthur with the VIBIR were properly filed for purposes of starting the statute of limitations. The court concluded that the tests in Beard were satisfied.

OBSERVATION: The four-part test in Beard uses the following criteria to determine if a document filed by a taxpayer qualifies as a valid return for purposes of beginning the statute of limitations: (1) The document must contain sufficient data to calculate tax liability; (2) the document must purport to be a return; (3) there must be an honest and reasonable attempt to satisfy the requirements of the tax law; and (4) the taxpayer must have executed the documents under penalties of perjury.

The court also rejected the IRS's position that the returns filed by Arthur did not satisfy his federal reporting requirements because the U.S. and Virgin Islands were separate taxing jurisdictions and Arthur had separate obligations to each jurisdiction. The court said that position was undermined by Notice 2007-19, effective for the three years in issue, which states that bona fide residents of the Virgin Islands who earn less than $75,000 may satisfy their federal filing requirements by the single filing of a return with the VIBIR.

The court concluded that the form instructions and regulations applicable to the years in issue provided that filing returns with the VIBIR was the proper procedure to file a federal income tax return for bona fide residents of the Virgin Islands and was sufficient to start the statute of limitations for the assessment of tax. Therefore, Arthur established that the statute of limitations expired before the date the IRS mailed the notice of deficiency. As a result, the IRS deficiency assessments were barred.

Staff Editor Parker Tax Publishing

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