Taxpayer Granted Refund where IRS Substitute Returns Failed to Account for Foreign Taxes Paid.

(Parker Tax Publishing APRIL 2016)

A federal district court determined that although a decedent had failed to file U.S. tax returns while working abroad, his estate was entitled to a nearly $1.6 million refund because the IRS's substitute returns failed to account for foreign tax credits and the foreign earned income exclusion. Estate of Herrick v. U.S., 2016 PTC 122 (D. Utah 2016).

Austin Herrick, a U.S. citizen, lived and worked in the Philippines during 2000 to 2006. Herrick mistakenly believed that he would not owe any U.S. taxes on the income he earned in the Philippines because of the high rate of tax he paid on that income in the Philippines. Herrick did not file U.S. tax returns from 2000 through 2006.

Because Herrick failed to file his tax returns, the IRS prepared substitute tax returns for 2000 through 2006. The IRS's substitute tax returns did not take into account the foreign taxes Herrick paid. The IRS determined that Herrick owed approximately $1,330,000 in U.S. taxes and then levied that amount from his investment accounts.

After Herrick died in 2011, the administrator of his estate learned of the tax issues and had U.S. income tax returns prepared and filed for 2000 through 2006. Unlike the IRS-prepared substitute returns, these returns took into account Herrick's foreign taxes paid. Herrick's estate then sought a refund of the levied amounts in a federal district court, based on the application of the foreign-earned income exclusion under Code Sec. 911, and tax credits under Code Sec. 901 for the Philippines taxes Herrick paid.

Generally, U.S. citizens are taxed in the United States on their worldwide income. Under Code Sec. 911, U.S. taxpayers living and working overseas are, under certain circumstances, permitted to adjust their U.S. tax liabilities by excluding some of their foreign-earned income. In addition, Code Sec. 901 provides a credit for foreign taxes U.S. citizens pay, so that taxpayers are not taxed twice on the same income.

With regard to the Code Sec. 901 foreign tax credit, the district court noted that the estate was required establish the actual amount of taxes Herrick ultimately paid to the Bureau of Internal Revenue of the Philippines ("BIR") before the credit could be applied and accurately calculated. The court found that records the estate provided relating to Herrick's tax filings in the Philippines, along with certifications from the BIR with respect to the taxes he paid, were sufficient evidence of the taxes Herrick paid in the Philippines. Accordingly, the court determined the estate was entitled to apply the foreign tax credit to Herrick's 2000 - 2006 tax returns.

With regard to the Code Sec. 911 foreign-earned income exclusion, the IRS argued that under Reg. Sec. 1.911-7(a)(2)(i) the exclusion is only available if a taxpayer makes an election on a timely filed income tax return, on an amendment to a timely filed return, or within one year after the due date of the return. The court noted that it was undisputed that Herrick did not timely file his U.S. tax returns, and the estate did not file his returns until well beyond one year after the due dates, However, the court said, the IRS's argument ignored Subsection (D) of Reg. Sec. 1.911-7(a)(2)(i), which allows a taxpayer to make the foreign earned income exclusion in certain situations after the time periods referenced by the IRS expire.

Reg. Sec. 1.911-7(a)(2)(i)(D), the court stated, would apply in the instant case if there was still some tax liability Herrick owed and the estate made the Code Sec. 911 election before the IRS discovered that Herrick did not make the election himself. Because Herrick had outstanding U.S. tax liabilities for interest and dividend income, and because the IRS did not apply the foreign earned income exclusion when it filed the substitute tax returns, the court found there was no evidence that the IRS discovered that Herrick failed to elect the exclusion and concluded that the estate timely made a Code Sec. 911 election.

Accordingly, the district court determined the estate was entitled to a refund plus interest of $1,588,641.

For a discussion of the foreign earned income exclusion, see Parker Tax ¶78,600.

For a discussion of the foreign tax credit, see Parker Tax ¶101,900.

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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