Are you the adventuresome family that wants to make a lot of money and pay no tax? No this isn’t a scam or bogus advertisement, but a realistic assessment of US tax law focused on relocating your business to the Virgin Islands; Specifically the US Virgin Islands, (the Islands) about 40 miles east of Puerto Rico, a short flight from most East coast cities, comprising four main islands, St Thomas, St John, Saint Croix and Water Island, as well as dozens of smaller islands. If you are a bona fide resident (BFR) of U.S. Virgin Islands for the entire taxable year, under IRS Code Section 932 your income is 90% tax free. Perhaps you think this is too good to be true? Hang on to your rum and coke mon because not only is this true but you can also 1031 tax free exchange over to the islands via Section 932 even though Section 1031 says you can’t do that. But before you pack your family and head over to on ocean worthy yacht stay with us here on TaxView with Chris Moss CPA to see just how difficult the IRS makes their Island residence tax traps to trip up your trip before you ever leave town.
The question comes down to this: Are you a BFR of the US Virgin Islands? You say yes, the IRS says no as was the case in Huff v IRS US Tax Court (2010) (Huff 1). Huff lost a Motion to Dismiss in that case, but was back to Court in Huff v IRS US Tax Court (2012). (Huff 2). The facts in the case are simple: George Huff claimed to be a BFR of the Islands with his income excluded under Section 932(c)(4). Huff filed his 2002, 2003 and 2004 tax returns with the US Virgin Islands Bureau of Internal Revenue (BIR) claiming no tax owed. The IRS audited claiming that Huff was not a BFR and owed tax, over a quarter million dollars to more exact. Huff appealed to US Tax Court in Huff v IRS US Tax Court (2010).
Judge Jacobs points out in Huff 1 that Congress created a “mirror tax” (Mirror) system for the Islands in 1921. The Islands tax law had major changes in 1954 and 1986 Tax Reform Act, but the Mirror still remains intact. What allows you entry into the Mirror is your BFR status, but the term “Bona Fide Resident” is not defined by IRS Code Section 932. Nor is it given any definition by the Joint Committee on Taxation.
Just so you know, there have been what amounts to thesis like research in various law journals on what makes you a BFR. The IRS requires completion of Form 8898 which you file to let the Government know when you begin or end a BFR but gives you little guidance on exactly when you begin as a BFR. Due to the lack of definition of BFR, bogus Virgin Island tax shelters surfaced with the help of corrupt tax advisors in the early 21st century. The IRS issued Notice 2004-45 to attack these tax scams. In 2004 Congress added Section 937(a) providing for a minimum 183 day residency requirement which mirrors the US substantial presence test of 183 days as well. Final regulations were issued by the IRS in 2006 but little Court provided case law had been provided at that time to help taxpayers and their tax counsel in BFR determinations prior to filing tax returns.
Huff could not have agreed more. After his 2010 motion to dismiss was denied in Huff 1, he headed on back to Court again in Huff 2 and filed a motion to allow the Virgin Islands to intervene on his behalf. Judge Jacobs denied the motion and Huff appealed to the United States Court of Appeals for the 11th Circuit in Huff v Commissioner (11th Circuit) decided February 20, 2014. The 11th Circuit reversed Judge Jacobs and remanded the case back down to US Tax Court in what will most likely become Huff 3 with instructions to grant the Virgin Islands intervention status as an intervening party. As of this publication date, Huff 3 has yet to be decided on the merits. However, there is new case law which seems to predict a Huff victory over the IRS as we look at Appleton v IRS US Tax Court (2013).
Arthur Appleton claimed to be a BFR in 2002, 2003 and 2004 of the US Virgin Islands and filed his tax returns with the BIR in accordance with Section 932(c)(4). Appleton claimed tax free income through a Virgin Islands partnership under Section 932(c)(2). The IRS and BIR jointly audited Appleton and BIR made no adjustments but IRS said Appleton did not qualify for tax free treatment under Section 932 because under Notice 2004-45 he had participated in scam that lacked economic purpose. IRS assessed Appleton back tax of over a $1Million plus another $1Millon in penalty and interest, claiming Appleton was a nonfiler who should have filed his tax return in the United States. Appleton appealed to US Tax Court in Appleton v IRS US Tax Court (2013) claiming he did file tax returns as required to the BIR and the statute of limitations had indeed expired. Appleton furthermore filed a Motion for Summary Judgment claiming there was no genuine issue of any material fact in dispute.
Judge Jacobs still handling the Huff remand was assigned Appleton’s Motion for Summary Judgment. The Court points out that section 932(c)(2) directs bona fide residents of the Virgin Islands to file income tax returns with the Virgin Islands BIR and section 932(c)(4) exempts both U.S. source income and Virgin Islands source income from U.S. taxation if all of the requirements of section 932(c)(4) are met. Assuming for purposes of Summary Judgment that these requirements of 932(c)(4) were not met, then Appleton would fall back into the regular IRS income tax filing system that covers most all other American taxpayers. Appleton claimed that in the “Where to file” section in the 1040 instructions a footnote said: Permanent residents of the Virgin Islands should mail to: V.I. Bureau of Internal Revenue, 9601 Estate Thomas, Charlotte Amalie, St. Thomas, VI 00802 when filing their Form 1040 individual income tax returns. However the Government countered to Judge Jacobs that anyone with common sense would have known to file Form, 1040 with zeroes on it to the Philadelphia Service Center. The Court found the IRS arguments unpersuasive and ultimately granted Appleton’s Motion for Summary Judgment. Appleton wins, IRS loses.
Considering the outcome in Appleton, you would think the IRS would have stopped litigating these statute of limitation cases. But if Appleton was not enough to stop the IRS then surely the Estate of Travis Sanders v IRS (2015) just decided last week in February of 2015, with the US Virgin Islands intervening, sent a strong signal to the IRS to reconsider its BFR strategy. The facts in Sanders are simple: In 2002 Sanders became a professional consultant for a company organized in the Islands which required Sanders to become a resident there. Sanders filed his 2002 2003 and 2004 income tax returns with BIR not the IRS. The IRS audited and claimed Sanders was not a BFR sending Sanders a bill for over $600,000 in back taxes claiming the statute of limitations had not run since no returns were ever filed with the IRS. The Estate of Sanders appealed to US Tax Court in Sanders v IRS US Tax Court (2015). Judge Kerrigan who frequently cites Appleton and Huff 2 clearly supports Sanders in what amounts- finally- to a case which actually gets around to defining the true meaning of residency in the US Virgin Islands.
Citing Sochurek v IRS 300 F.2d 34 (7th Circuit 1962), the Court looks towards 11 factors to determine your claimed residency. Applying Sochurek factors and arranging these factors in “groups” as the Court did in Vento v BIR 715 F.3d 455 (3rd Circuit 2013), the Court concludes that Sanders was in fact a bona fide resident of the Islands because he intended to remain indefinitely or at least for a substantial period, citing Vento v BIR 715 F.3d 455 (3rd Circuit 2013) at page 470. Sanders wins IRS loses.
What does this all mean for anyone interested in doing tax free business in the US Virgin Islands? First, regarding forward 1031 and reverse 1031 tax free investments in the Virgin Islands, tune in next week on TaxView with Chris Moss CPA when we explore in more detail your tax free 1031 roadmap to the US Virgin Islands. Second, while your tax attorney may want to wait and see what happens in Huff 3, in my view, Sanders, Sochurek and Vento are all your tax attorney needs to bullet proof your tax return before filing a Section 932 Form 1040 in 2015. Finally, regardless of what happens in Huff 3-whenever,if ever, that may be- your tax attorney will use Appleton, Sanders, Sochurek and Vento to defend your tax return positions in compliance with Section 932 from adverse IRS audit attack if the Government should happen to select your return for examination.
Thank you for joining us on TaxView with Chris Moss CPA.
See you next time on TaxView with a 1031 tax free excursion to the Islands mon. Perhaps I will see you there soon?
Chris Moss CPA