There’s Always Time for Coffey and Taxes

When is a tax return not a tax return? What does it mean for a return to be properly filed with the IRS? When is a nonfiler not really a nonfiler?

These seem like basic questions that should be easily answered under a modern tax system. In most cases they are — but not universally. Things get complicated when tax authorities obtain records from someone other than the taxpayers or their agents, as can happen with information exchange between national revenue bodies.

Consider the case of a U.S. citizen who tries to establish residence in a different taxing jurisdiction and complies with the local filing requirements in the host country. What consequences follow when the foreign authorities share that person’s tax return with the IRS through a formalized information exchange mechanism? The IRS is bound to learn specific things about the taxpayer. This knowledge, whether actual or constructive, has implications for application of the three-year statute of limitation period under section 6501.

This scenario played out in Coffey v. Commissioner,¹ in which a taxpayer thought she was a bona fide resident of the U.S. Virgin Islands and filed joint tax returns with her husband with the Virgin Islands Bureau of Internal Revenue (VIBIR), but not with the IRS.² You might think that renders the couple nonfilers from the IRS’s perspective, but things aren’t so simple.

The IRS gained possession of the Coffeys’ tax returns (parts of them, at least) through an information exchange procedure, and eventually hit them with deficiencies and penalties. The ensuing litigation has given our federal courts the opportunity to opine on what constitutes a tax return and when it should be considered filed with the IRS. There are lessons to be learned from Coffey, although its influence is limited to the Eighth Circuit for the time being. Lots of tax information is being exchanged these days under the Foreign Account Tax Compliance Act, so it may just be a matter of time until the same issues pop up in other circuits.

But Section 932 Says . . .

The Coffey case features four consolidated disputes involving members of the same family. Judith and James Coffey were a married couple involved in scholastic publishing.³ In 1985 they formed an S corporation, Rainbow Educational Concepts Inc. (REC), for which Judith served as president and James served as vice president. The Tax Court opinion describes REC as a successful enterprise, generating about $1.5 million in profits per year that passed through the couple’s joint return.

Things were going fine for about 15 years. Then, at some point in the early 2000s, the Coffeys began looking for ways to reduce their income tax burden. This caused them to consider relocating their family to the Virgin Islands, where it’s possible (though not easy) to obtain an exemption from U.S. income taxes under section 932. While the instinct to lower one’s tax bill is understandable, the chosen path would soon prove problematic.

The United States and the Virgin Islands are distinct taxing jurisdictions, although both use the same IRS forms. Complexity arises in determining where those forms must be filed, and how a taxpayer’s income will be apportioned between the two systems. The IRS produces a specific document (Form 8689) to assist with the apportionment calculation. Depending on the details, some Virgin Islands residents need only file with the VIBIR while others must file with both the VIBIR and the IRS. Similarly, some Virgin Islands nonresidents need only file with the IRS while others must file with both the IRS and VIBIR.⁴ Easy as pie, right?

According to IRS Publication 570, individuals who satisfy the criteria for bona fide Virgin Islands residence need only file with the VIBIR and can basically ignore the IRS. That being said, it’s never a good idea to ignore the IRS completely. In essence, the Coffey litigation is about a family who based their tax planning on the assumption that a key member of the household was a bona fide Virgin Islands resident, while the IRS thought otherwise.

Apart from the exemption under section 932, a secondary appeal of the Virgin Islands’ tax system is the Economic Development Program (EDP), which offers significant benefits to bona fide residents relating to income derived from Virgin Islands sources or income effectively connected with the conduct of a Virgin Islands trade or business. For the tax years in question (2003 and 2004), those benefits included a 90 percent exemption from local income taxes, a 90 percent exemption on dividend taxes, and a 100 percent exemption from the local gross receipts tax. As the Tax Court pointed out, the availability of these tax savings was not a secret. Section 934(b) permits the Virgin Islands to offer these tax incentives, subject to some restrictions.

By 2003, the Coffeys’ relocation was well underway. Judith severed ties with REC and became a partner in a Virgin Islands-based partnership, later known as StoneTree Group LLLP. The partnership performed professional services for REC subject to a noncompete agreement. This effectively meant that StoneTree could work only for REC, so that Judith was effectively transformed from an employee of REC to an outside consultant for REC, while being employed by StoneTree. Judith was not the only partner in StoneTree, as evidenced by the company’s Schedule K-1.

In the meantime, Judith started to do many of the things necessary to become a Virgin Islands resident. She acquired a home on St. Croix, she bought a car and obtained a Virgin Islands driver’s license, and she registered to vote in local elections. Her husband, James, did not claim to be a Virgin Islands resident — but could effectively be treated as one. Under section 932(d), if a married couple are joint filers and the spouse with the greater adjusted gross income is a Virgin Islands resident, the other spouse will also be treated as one. James’s residency status thus piggybacked on Judith’s.

The EDP regime was working fine for the Coffeys, at least initially. For 2003 it reduced their income tax liability from $450,000 to less than $100,000. For 2004 it cut their income tax liability from $500,000 to less than $50,000. These figures are taken from the couple’s Form 1040, which was filed with the VIBIR for the tax years in question. A material fact in the dispute is that the Coffeys never filed their 2003 and 2004 tax returns with the IRS. They believed they were not required to, per IRS Publication 570 and section 932(c)(2).

Similarly, the Coffeys did not file their 2005 and 2006 tax returns with the IRS, instead filing them with the VIBIR. Those two tax years are not at issue because the couple did not claim EDP tax credit for those years. There’s no explanation as to why the Coffeys stopped claiming the generous EDP tax credit after 2004. It’s curious, because the EDP regime presumably influenced their decision to relocate to the Virgin Islands.

One factor that may have dimmed taxpayers’ appetite for the EDP regime was IRS Notice 2004-45. This was the IRS’s way of announcing to the world that it was concerned the EDP regime held potential for abusive tax avoidance. The Tax Court described this skepticism as follows:

The referenced example could be a loose description of Judith. She quit her S-corp job to perform similar services for REC in the capacity of a partner with StoneTree — while claiming the substantial tax benefits made available through the EDP regime and the exemption under section 932. This is why the Coffeys were audited in the first place. They chased a tax avoidance scheme that seemed perfectly legitimate but didn’t quite pull it off. The IRS determined the couple fell under section 932(a)(2), rather than section 932(c)(2). Note that Notice 2004-45 was released after the couple decided to pursue Virgin Islands resident status.

How did the U.S. government learn of the Coffeys’ Virgin Islands tax returns for the years between 2003 and 2006, given that the couple never filed them with the IRS? The feds got it through automatic information exchange, the prevalence of which has grown by leaps and bounds in recent years. Here, the IRS did not obtain the Coffeys’ returns through FATCA, or through a traditional treaty-based (on request) exchange mechanism. The United States and the Virgin Islands are parties to a tax implementation agreement (TIA)⁶ that was signed in 1987 and has been in effect since 1989.

Among other things, the TIA provides that the VIBIR will supply the IRS with copies of “reports of individuals” when the information is relevant to U.S. tax enforcement and administration. The TIA also provides that the VIBIR will permit the IRS to examine Virgin Islands tax returns as necessary. The requirements of the TIA are not entirely one-sided. It includes provisions for the “covering over” of some taxes collected by the IRS that properly belong to the Virgin Islands’ treasury. This can occur when a bona fide Virgin Islands resident has taxes withheld by a U.S. withholding agent, for instance, on foreign remittances. Section 7654 requires that taxes collected by the IRS “be covered into the treasury” of the relevant U.S. territory or possession.

The TIA explains why the VIBIR looked at the Coffeys’ Form 1040 and decided the IRS should see it. Curiously, the VIBIR didn’t send the IRS the entire tax return — just the first two pages. The pages were sent to the IRS’s Philadelphia service center, where they were time-stamped to reflect the agency’s receipt.

The 2003 return was timely filed in the Virgin Islands in October 2004; it was stamped received by the IRS on February 8, 2005, and selected for audit in August 2005. The 2004 return was timely filed in the Virgin Islands in October 2005; it was stamped received by the IRS on March 27, 2006, and selected for audit in May 2006. These dates are significant because the dispute is ultimately about determining whether the IRS’s notice of deficiency was time-barred. The task before the court is to resolve what constitutes a tax return and when is it considered filed — which are routine inquiries under normal circumstances.

Meticulous Compliance

The Coffeys were no longer living in the Virgin Islands when they filed suit to challenge the IRS’s deficiencies for 2003 and 2004; they had moved to Arkansas. The Virgin Islands government soon joined the lawsuit as an intervener, supporting the taxpayers’ defense efforts. Together, they brought a motion for summary judgment claiming the statute of limitations had expired.

The Tax Court initially denied the motion on the ground that a material fact was unresolved — namely, whether the Coffeys were bona fide Virgin Islands residents. The court reasoned that this status would be determinative of whether the taxpayers were required to file returns in both jurisdictions or just in the Virgin Islands. The Coffeys moved for reconsideration, claiming the court erred in ignoring two vital points:

• that a subjective good-faith belief in one’s residence status is what controls for purposes of the statute of limitations — as opposed to objective residence status that may control for other purposes, such as entitlement to tax credits under the EDP regime; and

• that even if they were required to file returns in both jurisdictions, that condition was satisfied by virtue of the VIBIR’s sending portions of the Virgin Islands return to the IRS as required by the TIA.

In other words, the Coffeys and the Virgin Islands argued that it’s not necessary that the taxpayers directly submit their returns to the IRS, as long as somebody else does. That’s a novel theory that could have far-reaching consequences for automatic information exchange. It emphasizes the IRS’s receipt and possession of the return (or return information) rather than who provides it to them.

There are implications here for FATCA. It’s hard to imagine this doctrine of constructive filing, if accepted by federal courts, would be confined to information exchange that occurs under the auspices of the U.S.-Virgin Islands TIA. One would think the concept should naturally extend to information exchange occurring under any similar bilateral instrument, such as one of the myriad intergovernmental agreements that facilitate FATCA. There are parallels between the TIA and an intergovernmental agreement — both are tools for the systematic transmission of tax-relevant information from non-U.S. sources to the IRS.

Normally the statute of limitations under section 6501 isn’t triggered until a taxpayer files a U.S. return. It follows that the section 932 regime for bona fide Virgin Islands residents creates a peculiar trap for the unwary. Because there’s no U.S. return, the limitation period never begins to run — there’s no outer time constraint on when the IRS can bring an assessment for back taxes.

Note that this unfortunate scenario occurs only when the individual was mistaken about Virgin Islands residence status. How likely is that? As it turns out, the criteria for establishing bona fide residence are strictly applied. One requirement is to “report all income and its sources” on the Virgin Islands tax return. The slightest miscue or omission will cause the person to flunk the bona fide residence status test, pushing them into section 932(a)(2).

Congress eventually saw the problem and instructed Treasury to fix it.⁷ The relief arrived with Notice 2007-19 and Notice 2007-31, which were too late for the Coffeys.

The earlier notice distinguished between bona fide Virgin Islands residents based on their income level. For taxpayers earning less than $75,000, the statute of limitations was triggered when their return was filed with the VIBIR. For taxpayers earning $75,000 or more, the statute was triggered when they filed a protective zero return with the IRS. If they never filed a zero return, the statute wouldn’t begin to run.

Notice 2007-19 was a clunker for several reasons. The income threshold is completely arbitrary; and why would a person be thinking in terms of filing a zero return with the IRS when section 932(c)(2) said otherwise?

Notice 2007-31 was an improvement. It adopted a rule that applied to all taxpayers regardless of income level. If they claimed to be bona fide residents of the Virgin Islands and filed returns only with the VIBIR, the limitation period would run from the filing of that return — even though it wasn’t filed with the IRS. No need for superfluous zero returns.

However, the IRS decided to apply the latter notice for tax years beginning after December 31, 2006. For earlier tax years, it applied the earlier notice — although it wasn’t released until 2007. The Coffeys had reported income exceeding $75,000. Accordingly, the IRS maintains that the section 6501 statute of limitation would not have been triggered until the Coffeys filed zero returns for 2003 and 2004 — which they never did because the idea wouldn’t have crossed their minds until Notice 2007-19 was released years later.

The IRS argued at trial that a smart taxpayer would have filed a protective return with the IRS in any event, despite being subjectively confident of being a bona fide Virgin Islands resident. As an academic exercise, I’m curious what percentage of Tax Notes readers would consider themselves “smart” under that standard. The Tax Court called the idea “far-fetched.”⁸

Subsequent regulations under section 932 were issued in 2008.⁹ They tracked the latter notice from 2007. If those regulations were applied to 2003 and 2004, we’d have an open-and-shut case in favor of the taxpayers. The clock would have started ticking from the moment the Coffeys filed their joint return with the VIBIR and expired three years later. Viewed in that light, the taxpayers’ undoing was that Notice 2007-31 did not apply to tax years at issue.

The Tax Court was divided on what to make of all this, producing a majority opinion, a concurrence, and a dissent.

The majority opinion, written by Judge Mark V. Holmes, held that the Coffeys were saved by information exchange. It bought the argument that the government was effectively in receipt of the Coffeys’ return once a copy of the first two pages of the Form 1040 arrived at the IRS service center. That wasn’t a complete return by any stretch of the imagination. Although it included copies of the taxpayers’ Forms W-2, it left out their schedules and an original signature. Despite all that, the majority believed it was sufficient under the standard prescribed in Beard, which distinguishes honest and reasonable efforts from empty returns submitted by tax protestors.¹⁰

The majority pointed out that the information contained in the few pages received was sufficient for the IRS to conclude that the Coffeys should be audited, so it was adequate enough for their internal risk assessment. The few pages also contained far more information about the Coffeys’ economic life and income profile than the hypothetical zero return the IRS was separately expecting to be filed under like circumstances. If a zero return, completely devoid of information, would be sufficient to trigger the statute of limitations, then why not a partial return and accompanying W-2s that provide far greater detail? If the IRS must receive a full and complete return to start the clock running, what does that imply about the reasonableness of the government’s own regulations as applied to pre-2007 tax years?

The concurring opinion, written by Judge Michael B. Thornton, agrees only with the result. It holds that the limitation period was triggered when the taxpayers filed their returns in the Virgin Islands, irrespective of subsequent information exchange. Under this view, there’s no need to determine whether the transfer of the returns from VIBIR to the IRS meets the Beard standard for the filing of a return. Beard becomes irrelevant. That’s consistent with the rule the IRS applies to post-2006 tax years. The concurring opinion basically applies Notice 2007-31 retroactively, presumably because it seems like a fair result. Otherwise, the limitation period is open ended. The concurring opinion shares in the majority’s view that requiring taxpayers to file a protective zero return (as a means of triggering the limitation period) is a bizarre concept. The court is reluctant to assign great significance to a frivolous act.

The dissent, written by Chief Judge L. Paige Marvel, approached the statute of limitation issue from yet another perspective. Rather than focusing on what the IRS received from the VIBIR, and whether that should constitute a return, the dissent prioritizes the act of filing itself. Think verbs instead of nouns. The dissent notes that neither the taxpayers nor anyone authorized to act on their behalf filed a return with the IRS. Under that view, the limitation period doesn’t begin to run without an actual intention to file a return with the IRS. The transmission of a person’s tax return to the IRS (in full or in part) by another jurisdiction’s revenue body is simply not the same thing as receiving the document directly from the taxpayer or authorized agent. The record indicates that the Coffeys weren’t aware of the TIA or the sharing of taxpayer information between the two jurisdictions. Given the lack of intent, how can such an exchange count as the filing of a tax return? The majority believed the government conceded away this issue when it argued that a taxpayer’s subjective intent was irrelevant for purposes of determining the limitation period. The dissent is of the view that the issue can’t be conceded and is essential to determine whether a proper filing has been made.

On Appeal

The Eighth Circuit had little difficulty dispensing with the legal arguments that the Tax Court’s majority and concurring opinions found convincing. The starting point for its analysis is the plain language of section 932(a)(2), which states that a nonresident of the Virgin Islands (with some Virgin Islands-source income) must file returns with the governments of both jurisdictions. For purposes of the appeal, the Coffeys are assumed to be nonresidents of the Virgin Islands. They had to file a return with the IRS, and they didn’t.

The Eighth Circuit was unwilling to equate the IRS’s actual knowledge of some pertinent details of the taxpayer’s return, acquired through information exchange, with the filing of a return. It found authority for that in the Heckman decision, also from the Eighth Circuit.¹¹ In Heckman, the taxpayer failed to report taxable income, which the IRS later learned of through an unrelated audit. The IRS issued an assessment for the unreported income, but not until more than three years after the return was filed. The taxpayer argued that the assessment was time-barred, citing the IRS’s actual knowledge. The court held that the limitation period begins only when a return is filed, and specifically rejected the idea that actual or constructive knowledge is the equivalent of filing a return.

The word “FATCA” doesn’t appear anywhere in the Tax Court or the Eighth Circuit opinions, but I suspect the courts are mindful of the broader tectonic shifts in international taxation. We now live in an era of automatic information exchange between national tax authorities, a considerable change from the situation just 10 years ago. Do you really want to have limitation periods begin to run from the moment the IRS receives a batch of tax information from a foreign government?

I’m sure taxpayers wouldn’t mind such an outcome, but is that what Congress intended? As Chief Judge Marvel wrote in her dissent, “I am concerned, however, that the opinion of the Court opens doors regarding what constitutes a valid return filed by the taxpayer that should not be opened.” That speaks volumes about why the case turned out as it did. I doubt the IRS will ever give ground on the sensitive matters of what constitutes the filing of a tax return. There’s too much at stake.

As for me, I think the Coffeys are unfortunate. It’s true they tried to take advantage of a few tax avoidance tools — section 932 and the EDP incentives — but these were legitimate schemes approved by the respective governments. There was nothing underhanded about what they did. In hindsight, they probably wish they’d never been tempted to chase the expected tax savings.