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Tax Law

Foreign Earned Income Exclusion Timely Election Rules Upheld

The Tax Court recently upheld the validity of Treasury Regulations Section 1.911-7(a)(2) in a case where the taxpayer sought application of the foreign earned income exclusion (FEIE) under IRC Section 911, but was denied the exclusion because she had failed to make a timely election pursuant to Section 1.911-7(a)(2). [McDonald v. Commissioner, TC Memo 2015-169]. In the case, the taxpayer worked overseas in 2009 but did not file an income tax return for that year. [Id]. In 2010 the IRS prepared and filed for the taxpayer a substitute for return (SFR) for 2009, and in April 2012 the IRS issued a notice of deficiency (NOD) for 2009. [Id]. The taxpayer did not challenge the NOD, but instead filed a return for the 2009 tax year in May 2012. The taxpayer attached to the return a Form 2555, “Foreign Earned Income” form, claiming an exclusion for a portion of her income earned in 2009, and included a payment. [Id]. The IRS audited the taxpayer’s return and issued a second NOD in which the Service denied the taxpayer’s claimed foreign earned income exclusion on the grounds that:

1)    the taxpayer did not make a valid election and did not file Form 2555 with a timely-filed return;

2)    did not elect to exclude the foreign income on a prior return; and

3)    did not otherwise comply with the procedure for making a valid election to exclude the foreign income under  Section 1.911-7(a)(2).

The sole issue in the case was whether the taxpayer was entitled to the FEIE. The taxpayer’s claim that she was entitled to the exclusion was based primarily on her argument that Section 1.911-7(a)(2) was invalid. [Id]. The FEIE is provided for in IRC Section 911, which states: “At the election of a qualified individual (made separately with respect to paragraphs (1) and (2)), there shall be excluded from the gross income of such individual, and exempt from taxation . . . for any taxable year – (1) the foreign earned income of such individual, and (2) the housing cost amount of such individual.” [IRC Section 911(a)]. [Id]. The procedural rules for making an election are provided in Regulations Section 1.911-7. Regulations Section 1.911-7(a)(2) provides for the requirement of a return when making an election under IRC Section 911. As discussed by the court, Regulations Section 1.911-7(a)(2)(i) establishes the timing requirements under which a valid FEIE election can be made, and the regulation provides four alternative timing methods via which a taxpayer can make a valid election. [Id].

The court held that the Secretary had the statutory authority to impose a deadline for electing the FEIE. The court found that the Secretary had the authority under IRC Section 7805(d) to prescribe when the election was to be made. [Id]. The court also held that the regulation’s deadline was reasonable. [Id]. The court noted that the court had addressed and rejected the same challenge to Section 1.911-7(a)(2)in a prior case [Faltesek v. Commissioner, 92 T.C. 1204 (1989) ] where the  court had held that the alternative periods in Section 1.911-7(a)(2)(i)(A) through (C) were not unreasonable or arbitrary and “were within the specific authority granted to the Secretary under section 911 as well as the Secretary’s general authority to promulgate regulations under section 7805.” [Id].

The court concluded that:

. . . the Secretary’s interpretation and implementation of the statute is valid, because it reasonably implements Congress's specific grant of authority in section 911(d)(9) to prescribe regulations that are necessary and appropriate to carry out the purposes of the statute, and Congress's general grant of authority under section 7805(d) to prescribe rules for the time and manner of making elections under the Code. The regulation provides taxpayers with four alternative methods by which they can timely elect the FEIE. The fact that the Secretary could have chosen longer periods within which to permit the election is of no consequence, because the alternative methods with four varying periods are reasonable. [Id].

Accordingly, the court ruled in favor of the Service and granted the Service summary judgment in the case. [Id]. The court’s clear and concise opinion presents an interesting example of the burden a taxpayer faces when challenging the validity of a treasury regulation.