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Expatriates — Thinking You Don’t Owe Tax?  No Excuse for Late Filing of Tax Returns

Many times I will hear individuals living and working overseas say that they did not file a US tax return because they believed they did not owe any tax.  This is usually based on the assumption that the Foreign Earned Income Exclusion (FEIE)  and Foreign Housing Exclusion (FHE) benefits of Internal Revenue Code Section 911 will shelter them from owing any taxes.  Many are under the mistaken belief that if their compensation is below the exclusion amounts, they need not file a tax return at all.  This is incorrect.  In order to claim the FEIE and FHE benefits, an election must be made on the individual’s US income tax return. More detail on the FEIE and FHE are here.

Others may know they must file a tax return to claim the Section 911 benefits, but will believe that they don’t owe tax or will be due a refund (e.g., based on overpayments of estimated taxes).  On account of such beliefs, the individual may not file a tax return on time or even request an extension of time to file it. The penalty for failing to file a timely tax return turns on whether tax is ultimately owed.  The penalty is calculated as high as 25% of the tax due.  (More info from the Internal Revenue Service (IRS) on failure to file and failure to pay penalties.)   If the overseas taxpayer believes he does not owe tax or that he is due a refund he may not feel the need to file by the June 15 tax filing deadline.

Duh, You Made a Mistake?

The Tax Court case of Parekh v Commissioner decided in November demonstrates what can happen when the taxpayer is mistaken in his calculations, and in fact does owe tax. Mistakes about whether tax will be owed are very easy to make especially when taxpayers live and work overseas.  For many such expatriates, US taxes are complex and may result in unexpected US tax liabilities due to foreign (i.e., non-US) investments. For example, ownership in foreign corporations can trigger surprise taxes due to “Subpart F” income even if the corporation in which the taxpayer holds shares has made absolutely no distribution to him; so-called PFIC investments (typically foreign mutual funds) can bring about very high taxes even if the taxpayer thinks his mutual fund investments have yielded only a loss, and dealing with foreign trusts (whether funding them or receiving distributions from them) can yield some very nasty tax surprises.

Can the late filing penalty be excused based on “reasonable cause” if the reason for the lateness  is due to the taxpayer believing that a late filing would not really matter because he thought he was due a refund or owed no tax?

What is “Reasonable Cause?”

If the taxpayer can show that he” exercised ordinary business care and prudence and was nevertheless unable to file the return within the prescribed time, then the delay is due to a reasonable cause.” & Admin. Regulations Sec. 301.6651-1(c). The IRS Internal Revenue Manual at section 20.1.1.3.2.2 et seq. provides significant detail in fleshing out the factors examined in the “reasonable cause” inquiry.

Ordinary business care and prudence means the taxpayer has made provisions for business obligations to be met when reasonably foreseeable events occur.  Of course, some events are not reasonably foreseeable —  Death, serious illness, or unavoidable absence of the taxpayer, or a death or serious illness in the taxpayer’s immediate family, may establish “reasonable cause”.  The occurrence of fire, casualty, natural disaster or similar events are similarly not reasonably foreseeable and may amount to “reasonable cause”.  The Tax Court in Parekh, looking to precedent, recited other possible events that may qualify – unavoidable postal delays, the timely filing of a return with the wrong IRS office, a taxpayer’s unavoidable absence from the United States, or reliance on erroneous advice from a competent tax adviser or IRS officer.

Facts and Circumstances Test

Whether relief is granted based on reasonable cause is based on an examination of all the facts and circumstances surrounding each individual case. The IRS instructs its agents to check the preceding tax years (at least three) for payment patterns and the taxpayer’s overall compliance history. The same penalty, previously assessed or abated, may indicate that the taxpayer is not exercising ordinary business care.

In the Parekh case, the taxpayers, husband and wife, were about 15 months late in filing their 2012 tax return; no extension was ever requested. In addition, the taxpayers had a prior history of late filing and were late on subsequently filed tax returns, to boot. Clearly, they did not appear to meet the profile of diligent taxpayers meeting their tax filing deadlines.  The taxpayers in Parekh argued that the late filing was due to various factors that should amount to “reasonable cause” – for example, past returns had generated a refund; taxpayer had unexpected domestic and international travel due to job changes and family illness. However, the Tax Court disagreed, especially since the late return for the tax year at issue was not complex. The Tax Court stated:

“Even if we were to credit petitioner husband’s testimony about his heavy travel schedule, it is inconceivable that he could not have found two days in which to fulfill petitioners’ filing obligation, as opposed to filing that return 15 months late. His response at trial–that ‘he didn’t think his tax return was something he had to do that very minute’–suggests that he did not take petitioners’ timely filing obligation seriously. (emphasis added). If petitioners truly intended to satisfy that obligation but were incommoded by problems suddenly arising in spring 2013 they could have requested an automatic six-month extension of time to file, as they eventually did for their 2014 taxable year. See sec. 6081. Their failure to request such an extension suggests, once again, that the real reason they filed late was their belief that the filing deadline did not matter because they were expecting a refund.

The Take-Away

“I thought I was getting a refund” or “I thought I did not owe any tax” will likely flunk the “reasonable cause” test to abate penalties for late tax return filings. Of course, all the factors involved in a particular case will be examined, but the Parekh cases is a head’s up.  Taxpayers overseas should not be complacent in letting filing deadlines lapse. US taxes are very complex when it comes to persons living and working abroad who may have unexpected US tax liabilities due to their foreign investments. While the complexity of such cases may help the overseas American establish “reasonable cause”, it’s always best to play it safe and avoid the issue of late filing penalties altogether.

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