Court Upholds Validity of Closing Agreement Waiving Foreign Earned Income Exclusion

(Parker Tax Publishing October 2023)

The Court of Federal Claims upheld the IRS's disallowance of a refund claimed by a taxpayer who signed a closing agreement in which he agreed not to claim the Code Sec. 911 foreign earned income exclusion for income he earned while working in Australia, and later filed an amended return to request a refund as a result of the Code Sec. 911 exclusion. The court rejected the taxpayer's arguments that the closing agreement was not binding; the court found that the taxpayer's arguments were nearly identical to those advanced by the taxpayer in Smith v. Comm'r, 159 T.C. 3 (2022), where the Tax Court upheld the validity and enforceability of closing agreements. Baney v. U.S., 2023 PTC 262 (Fed. Cl. 2023).

Background

Ramon Baney is a United States citizen and a retired United States Air Force veteran with more than twenty years of military service. His spouse, Marion Baney, is an Australian national and former permanent resident of the United States. In 1995, while stationed at Hickam Air Force Base (n/k/a Joint Base Pearl Harbor-Hickam) in Oahu, Hawaii, Ramon accepted a position as an engineer/senior systems controller with TRW, Inc., a United States Department of Defense contractor at the Joint Defense Facility Pine Gap (Pine Gap) near Alice Springs, Australia. The original job offer was for a renewable two-year expatriate assignment.

Prior to the Baneys' 1996 relocation to Australia, TRW required Ramon to execute a closing agreement under Code Sec. 7121. In executing the agreement, Baney waived his right to elect a foreign earned income exclusion under Code Sec. 911 in preparing and filing his United States federal income tax returns for tax years 1996 through 1998. In exchange for his agreement to pay United States federal income taxes on his TRW-earned salary, Ramon would not be concomitantly subject to the foreign resident income tax assessed by Australia, progressively ranging from 32.5 to 45 percent.

In 2002, Northrop Grumman acquired TRW and required that Ramon continue executing closing agreements every two years as a condition of his contract extensions and continuing employment. Throughout his tenure with TRW/Northrop Grumman, Ramon executed at least ten closing agreements covering tax years 1996 through 2019. Relevant here, in October 2015 Ramon executed a closing agreement covering tax years 2015 through 2017. In waiving and foregoing his right to claim the Code Sec. 911 foreign earned income exclusion -- and agreeing to pay United States federal income tax in lieu of the Australian foreign resident income tax - Ramon formally declared, among others things, that he read and fully understood the closing agreement, voluntarily signed it, and recognized the contract was "necessary to receive an . . . exemption from Australia[n] tax and the related exemption from Australian tax installment deductions." The closing agreement was thereafter executed by Acting Director, IRS Treaty Administration Jennifer Best in May 2016.

Consistent with the October 2015 closing agreement, the Baneys reported on their joint tax returns for 2016 and 2017 Ramon's total Northrop Grumman salary and did not elect the foreign earned income exclusion under Code Sec. 911 or file a Form 2555, Foreign Earned Income. The Baneys received a refund for 2016. On their 2017 return, the Baneys reported a loss from the sale of rental property on Form 4797 (Sales of Business Property). The reported loss contributed to the refund the Baneys received for 2017.

On an amended return for 2016, the Baneys claimed the foreign earned income exclusion for Ramon's Northrop Grumman earnings and received an additional refund. They also filed an amended return for 2017 claiming the Code Sec. 911 exclusion, but this time the IRS disallowed the claimed refund, explaining: "The closing agreement that you entered into with the Internal Revenue Service provides that you irrevocably waived any right you had to make any election under section 911(a) of the IRC."

The Baneys brought an action in the Court of Federal Claims, challenging the IRS's disallowance of their refund claim for 2017. The government answered by asserting a counterclaim seeking to recover the 2016 tax refund remitted to the Baneys. Thereafter, in the course of discovery, the government determined that the Baneys double-counted their rental property loss for 2017 and filed a second counterclaim seeking to recover the overpayment.

Analysis

The Court of Federal Claims found that the Baneys were not entitled to claim the foreign earned income exclusion under Code Sec. 911 regarding Ramon's Northrup Grumman salary during 2016 and 2017.

The Court of Federal Claims found the Baneys' case to factually indistinguishable from Smith v. Comm'r, 159 T.C. 3 (2022), in which the Tax Court examined the validity and enforceability of Code Sec. 7121 closing agreements. In Smith, the Tax Court addressed four principal questions presented in this case, concluding: (1) closing agreements are valid and enforceable interpretations of the governing treaty between the United States and Australia; (2) the Director of the IRS Treaty Administration possesses the requisite (delegated) authority to enter into closing agreements on behalf of the IRS; (3) United States government contractors may require prospective and current employees to execute closing agreements as conditions of their employment and facilitate their execution on behalf of the IRS; and (4) claims of government malfeasance (i.e., material misrepresentations and duress) with regard to the execution of Pine Gap Closing Agreements were unfounded. The Court of Federal Claims concluded that, since Smith was directly on point and persuasive, it would adopt its principal findings and legal conclusions in summarily rejecting the Baneys' claims.

The Court of Federal Claims found, as an initial matter, that the Baneys' assertion that Pine Gap closing agreements were not binding contracts because they lacked an offer and mutual exchange of consideration was frivolous. The court noted that closing agreements are authorized under Code Sec. 7121 and that courts have "universally accepted" them as enforceable contracts. The court also rejected the Baneys' assertion that the Acting Director of the IRS Treaty Administration lacked the requisite authority to sign the closing agreement. The court noted that in Smith, the Tax Court held the Director of the IRS Treaty Administration was specifically delegated this express authority. The sole difference between Smith and this case, the court observed, was that the IRS official who signed the contested closing agreement here served in an acting capacity as opposed to a permanent appointment. However, the court found that it is the substantive role, rather than the title, that governs. The fact that Director Best was in an acting role was in the court's view irrelevant. The court found nothing to suggest she did not perform the same duties or possess the same delegated authorities in her acting capacity.

The court rejected the Baneys' malfeasance arguments. The court noted that Ramon executed ten closing agreements over twenty years, giving him ample time to reflect on Northrop Grumman's employment condition. The court also found that Marion's failure to sign the October 2015 closing agreement did not render it void other otherwise unenforceable. In the court's view, the absence of Marion's signature on the agreement at issue was counterbalanced by the fact that she intermittently signed at least six (of the ten total) previous closing agreements. Further, the Baneys' original joint tax return for years 2016 and 2017 reported Ramon's total Northrop Grumman salary and did not elect the foreign earned income exclusion under Code Sec. 911 or include a Form 2555. The court reasoned that in signing and filing these returns under penalty of perjury, the Baneys implicitly acknowledged their rights and obligations under the Pine Gap closing agreements. Thus, Marion's failure to sign the closing agreement executed by Ramon in 2015 did not void or otherwise invalidate the agreement.

The court also agreed with the IRS that the Baneys over-reported the loss on the sale of their investment property by failing to reduce their basis in the property by the amount of the depreciation deductions they took for years 2014-2017, resulting in an erroneous refund for 2017. The court found that under Code Sec. 6532(b), the statute of limitations for the government to recover the erroneous refund was five years, since the Baneys misrepresented (by omission) their claimed depreciation deductions on their 2017 Form 4797. The court concluded that the government's counterclaim was thus timely, as it was filed in February 2023 to recover an erroneous refund issued to the Baneys in March 2018.

For a discussion of closing agreements, see Parker Tax ¶263,160. For a discussion of the statute of limitations on the recovery of erroneous refunds, see Parker Tax ¶261,180.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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