Foreign Earned Income Exclusion: Testing for "Abode"

The Judicial Test for “Abode” – Should it be sharply modified?

Summary: “Abode” is not defined in the tax code or regulations. The “Comparative Domestic Ties” test fashioned judicially to probe for the existence of a US abode is too poorly developed. In its present state, that test does not enable taxpayers to know if they qualify to exclude foreign earned income in too many cases. Example: US citizens returning from Iraq and Afghanistan.

To exclude income earned abroad from a return under IRC §911 these requirements must be met: (1) The taxpayer must have a foreign “tax home” (i.e., it’s the place where for purposes of IRC §162 the taxpayer is living and working), and (2) the taxpayer must meet either the “bona fide residence” or the “physical presence” requirements. This provision of the law is very confusing and complicated – probably unnecessarily so. There are confusing rules about how many full days the taxpayer has spent in a foreign country under the “physical presence” test. And since most folks don’t live in a foreign country for the exact period of 1/1 through 12/31, they will likely have earned income in two taxable years. As a result, they will become entangled with the process of trying to proportionalize the income earned in two separate years. Even the wordy, lengthy explanations offered in IRS Pub 54 do little to clarify the requirements and provisions of §911. And the regulations do not resolve some of the existing confusion. For persons who take their families, relocate to another country, become thoroughly submerged in that new culture, open accounts, send their children to foreign schools and etc. for an extended period, it is easier to meet the requirements. For those who take a job in another country, and who maintain significant contacts with the United States during the period, you might need a crystal ball and some good luck to meet the first requirement: having a foreign tax home.

“Abode” is not defined in the statute or regulations:

It is §911(d)(3) that raises a very significant and confusing barrier to being able to establish a foreign tax home. Under that provision, the statute and the regulations state that an individual shall not be considered to have a tax home in a foreign country for any period for which the individual's ABODE is in the United States. This provision lays a sharp slap on the face of persons who, for example, have met the “physical presence” test by living away from their families and US soil for at least 330 days out a consecutive 12-month period. Ordinary humans often form the impression that when they have been away from the US for so long as to meet that requirement, they can exclude all the income they earned abroad during that period. In fact, some I have spoken with think of it in terms of “fairness” – being gone so long, they feel they should be entitled to exclude the income. Like cold water, the “abode” limitation seems to shock the senses of many.

How does a US citizen living abroad establish a non-US abode for purposes of §911? The answer is not found in any definition for “abode” in the statute or the regulations. And Pub 54 does not provide much of an explanation. So, we turn to case law to find out what the courts say about a person’s “abode” for guidance. In those cases, we find the courts noting that there is no definition for “abode” expressed in the statute or the regulations. Therefore, the courts fashioned a very loose and poorly defined probe that is applied to determine whether a taxpayer had a US abode while they were living abroad.

Testing for Abode: Comparative “Domestic-type” Contacts

It was the U.S. Tax Court that first ventured into the difficulty of ascertaining whether a person living abroad had an abode in the US. Once the court had fashioned the test it became the standard applied as the probe in other forums. For example, in Harrington v. Comm’r, 93 TC 297 (1989), the Tax Court writes:

“In prior section 911 cases, we have examined and contrasted the taxpayer's domestic ties (i.e., his familial, economic, and personal ties) to the United States with his ties to the foreign country in which he claims a tax home in order to determine whether his abode was in the United States during any particular period. Lemay v. Commissioner, TC Memo 1987-256 affd. 837 F.2d 681 (5th Cir. 1988); Bujol v. Commissioner, TC Memo. 1987-230, affd. without published opinion 842 F.2d 328 (5th Cir. 1988); Hummer v. Commissioner, TC Memo. 1988-528; Bosarge v. Commissioner, TC Memo. 1989-15; Benham v. Commissioner, TC Memo. 1989-215; and Moudy v. Commissioner, TC Memo. 1989-216. Even though a taxpayer may have some limited ties to a foreign country, if his ties to the United States remain strong, we have held that his abode remained within the United States, especially where his ties to the foreign country were transitory or limited. In Lemay v. Commissioner, 837 F.2d 681 (5th Cir. 1988), affg. a Memorandum Opinion of this Court the Fifth Circuit to which an appeal in this case would lie, adopted and applied this domestic ties analysis.” (emphasis supplied) Harrington, supra @ 308, 308.

It is the Tax Court’s test that is being applied in other forums; and that test is conducted by examining the evidence of a taxpayer’s “domestic-type” ties with the US as compared and contrasted to the taxpayer’s connections with the foreign jurisdiction. The continuing problem for taxpayers is that the test is not well-developed judicially – and until many cases presenting wide variations in facts are decided, the uncertainties of this “domestic-ties” test will remain.

For example, in the Fifth Circuit’s Lemay opinion mentioned by the Tax Court above in Harrington, the Fifth Circuit considered the relative contacts between the taxpayer and the two jurisdictions. There, the taxpayer worked on an oil rig in the territorial waters of Tunisia. After working 28 days, Lemay returned to the US to be with his family for 28 days. In Tunisia, he was provided living quarters by his employer, and had very little contact with local citizens and the culture. Commenting with approval upon the Tax Court’s application of its domestic-ties test, the Fifth Circuit writes:

“In the instant case, the tax court . . . determined Lemay to have strong economic, familial and personal ties to his residence in Lake Charles and, therefore, concluded that Lemay's "abode" remained in the United States in 1982. We do not perceive error in this conclusion. While the regulations do provide that the maintenance of a dwelling in the United States does not necessarily mean that an individual's abode is in the United States, Lemay did more than merely maintain his dwelling in Lake Charles, Louisiana. Lemay spent approximately half of his time with his family in Louisiana. He voted in Louisiana, maintained a bank account in Louisiana, and possessed a Louisiana driver's license. The combination of these factors, when contrasted with Lemay's transitory contacts with Tunisia, support the conclusion that Lemay's "abode" remained in Louisiana in 1982.”

Okay. Maybe Lemay looks like an easy case. There was much more significant “domestic-type” contact with the US than with Tunisia. The problem with Lemay is that the court could not tell us anything about how it would tend to compare and contrast situation where taxpayers show greater contacts with the foreign jurisdiction. And we still know nothing about what happens where there are domestic-type ties with both jurisdictions. We do not have a clue as to what happens when the domestic ties to both jurisdictions appear equal. Does that mean that the tie goes to the US abode? We don’t know what happens where foreign ties are greater in number. Are ANY significant domestic ties to the US the trump card that will always establish a US abode? Lemay looks easy because this taxpayer had little to do with Tunisia, and both courts found the following to be significant evidence of “abode” in the US while he was working outside this country: (1) 28 days away, 28 days home – so there was apparently significance in “frequency” of returns to the US. (2) Bank account maintained in the US. (3) Voted in the US. (4) Had a state driver’s license. (5) He maintained a dwelling in Louisiana where his family lived and where he returned every 28 days.

Shifting the abode: What it takes is still a mystery

Even if this taxpayer had traveled to other foreign countries rather than return to his family every 28 days, we don’t have a clue from the courts as to whether that would have had any significant effect upon the outcome. He would still have had a house, family, accounts and a voting registration inside the US – factors that we can reasonably expect the Fifth Circuit and the Tax Court would have found sufficient to establish an abode in the US. Would it have made a difference if he had set up an offshore bank account to receive paychecks and automatically transfer support to his family? Probably not. He would have still been sending his money home to care for his family – clearly a “domestic” tie with US soil. What if he had surrendered his driver’s license? That too would probably have made no difference because he wasn’t driving in Tunisia – the man worked offshore and lived in company-provided quarters. Perhaps the abode can be shifted by constructing many sorts of “domestic-looking” contacts with the foreign jurisdiction. However, where US ties are continued the courts may still hold that the US-abode continues and the §911-exclusion is not available. We are left wondering if reducing ties with the US to some lower number than ties to the foreign country would tip the balance. The test is not yet sufficiently developed by the courts. Until the judicially-developed test is more thoroughly explored and applied by the courts, the test will remain unclear. At present, it is not useful as a tool to help us predict with any certainty how the courts will stack up the comparative contacts between the jurisdictions.

Example: U.S. Citizens in Iraq and Afghanistan

Thousands and thousands of Americans have been paid for services performed while they live in those countries. It is clearly safe to generalize their domestic contacts: (1) They have homes and families in the US they will return to. They have absolutely no intention of staying in those dismal places any longer than required. (2) They return to homes and families in the US on R&R. They do not take R&R in war zones. (3) Their paychecks are direct-deposited into US banks and not banks in those countries. (4) They vote in US elections as absentees. They do not vote in any foreign elections. (5) They still have driver’s licenses, and they still own cars that are in the US. If they drive anything in those countries, it is equipment belonging to their employers, and it is driven only in connection with their jobs. Are these domestic-type activities sufficient to compel the courts to conclude that there is US abode because of the continuing existence of those domestic-type ties to the US?

Let’s create a list of things US citizens in those countries might be doing, and examine if such activities are domestic-type activities. Military and civilian personnel perform an enormous array of duties while the live and work in Iraq and Afghanistan. They jeopardize their own lives to protect the lives of citizens of those nations. Arguably, that “protection” is something that connects them deeply and intimately with the citizens of those nations. Protecting the lives of the humans around you seems to have a “domestic” flavor even though the task is completed also as a matter of vocation-related requirements. They distribute “humanitarian” items like food, medicine, health care and the like to local citizens. They form strong, life-long friendships with other US citizens they serve with as they live in those foreign jurisdictions – that seems like a “domestic” as distinguished from a “vocational” tie even though the task is performed as part of a job. They become acquainted with, and sometimes form friendships with, local citizens in areas where they serve or patrol as they perform those functions. Again, that seems to exude deep personal connection with the foreign nation and its citizens – a condition that seems clearly more “domestic” and personal than “vocational.” They apprehend criminals and remove them from among the citizens of those nations. Doesn’t that seem like a profound connection with life in those nations that is associated exclusively with the well-being of all humans in the vicinity – a “domestic” sort of connection? They rescue injured children and provide protection and treatment for them. They build schools, keep the electricity on, deal with water and sewage treatment, re-build homes, set up crime-watch programs for neighborhoods, provide critical training of all kinds, and otherwise become thoroughly entangled in the lives of the citizens of those countries. And though such things are done as a matter of duty – it’s all job-connected – the entire list of contacts and connections with those foreign countries seems to simultaneously display a “domestic” quality because of the intertwinement with the citizens of those foreign nations.

But those contacts may not be sufficient to negate the existence of a US abode. Under the law, an individual shall not be considered to have a tax home in a foreign country for any period for which the individual's ABODE is in the United States. This law seems to operate on the assumption that an individual cannot have two abodes. They can have only one abode at a time. And the way the law in this matter developed, it seems clear that from now on the courts will operate on the view that an abode is identified by probing for “domestic” contacts as distinguished from “vocational” contacts. As expressed by the Fifth Circuit in Lemay, and also expressed in the various Tax Court opinions:

“'Abode' has been variously defined as one's home, habitation, residence, domicile or place of dwelling. Black's Law Dictionary 7 (5th ed. 1979). While an exact definition of 'abode' depends upon the context in which the word is used, it clearly does not mean one's principal place of business. Thus, 'abode' has a domestic rather than vocational meaning, and stands in contrast to 'tax home' as defined for purposes of section 162(a)(2).

“. . . The Bujol court reasoned that the taxpayer's economic, familial, and personal ties to Louisiana, and his lack of contact with the foreign country dictated a conclusion that the taxpayer's ‘abode’ remained in the United States.”

It appears that the courts’ lists of “domestic” things will continue to include property ownership, family location, where you keep your bank accounts, which jurisdiction issued your licenses, where you are registered to vote, where you go to religious services attended by local citizens and etc. In cases thus far decided, such items have remained the most important factors to be considered. Whether we like it or not, the courts will likely continue to ask, “Where are your economic, familial, and personal – as distinguished from ‘vocational’ – ties?” And the answer so far has been determined by reference to asset location, family location, licenses, voting and the like.

A Potential Storm of Cases May be Brewing

As these US Citizens come home and prepare returns claiming the exclusion of their income earned abroad while living in Iraq and Afghanistan, there could emerge a firestorm of confrontation between those taxpayers and the US government. Unless the courts move toward a test that is more focused on defining “abode” as the place where, for the time being, a taxpayer exists to meet the conditions of the daily life encounter outside the US, our jurisprudence will continue to focus on location of houses and other assets, family, voting registration, licenses and the like. The fact that citizens are thoroughly investing their lives in another country for and with another people may be of little significance if the test for a taxpayer’s abode is not modified.

Foreign Earned Income Exclusion: What a Mess

Foreign Earned Income Exclusion: It Takes a Member of the Priesthood to Understand It

26 USC §911 permits U.S. citizens and resident aliens to exclude more than $80,000 of the income they earn while living outside the United States. An exclusion that big, even if allocated to the number of days abroad in two calendar years, can provide a pretty big tax break. One of the bases for excluding that income exists when a person has a foreign tax home and has been outside the U.S. and physically present in a foreign country or countries for at least 330 full days out of any consecutive 12-month period. Tax Court cases have typically determined that taxpayers whose "abode" remains in the U.S. cannot have a foreign tax home under section 911(d)(3). Therefore, even when a taxpayer lives on foreign soil, the courts are likely to determine that under 911(d)(3) the abode remains in the U.S. where the taxpayer's family lives, where the taxpayer's bank accounts are located, where the taxpayer's residence to which he intends to return after temporary absence is situated in the U.S., continuing to own a car located on U.S. soil and other such connections. However, if taxpayers can clear that initial hurdle, the rest of the requirements prescribed by 911, and the IRS Pub 54 that explains those requirements, are fairly difficult to comprehend.

To illustrate the confusing complexity of the remaining requirements, I offer this account. Recently, there arose a situation involving a close friend who has earned income from employment while living in a foreign country. He needed to know two things: (1) the first full day of the 330-day period so he could compute exactly how many full days he was in a foreign country, and (2) after he returned to the United States, he needed to know when he must again leave the United States and when he could return in order to fulfill the 330-day requirement.

IRS Pub 54 covers the requirements of the exclusion provided in §911, but the language is a little tough to decipher. The problem in my friend’s situation was that by the time that midnight of the day of his departure arrived, the plane was over foreign soil; but during several hours following, the plane was over international waters and finally reached another foreign airspace the day after departure. One interpretation of the explanations of Pub 54 is that the first day in a foreign country did not start at midnight of the day of departure. Pub 54 seems to express the view that since the plane was over international waters in international airspace after midnight, the first day did not start at midnight of the day of departure. Instead, the language of Pub 54 seems to conclude that the first full day of the 330-day period did not start until the second midnight following the day of departure. So, Pub 54 might be understood to say that since the period after midnight of the day of departure was partially flying over international waters in international airspace, the day was a non-foreign day.

For various reasons, that interpretation was presenting a serious problem for my friend in establishing plans to return to the United States. A case was located that supports an opposite construction of the matter. The case is Struck, TCMemo 2007-42. In this case a taxpayer had a job working on a yacht owned by other persons. For purposes of §911, the government treated each day partially spent in international waters as a non-foreign day. The Tax Court disagreed. Interpreting Regs. §1.911-2(d)(2) and (3), the court establishes the view that when a person travels from one foreign country to another foreign country, and part of the day is spent in international waters, the day still counts as a foreign day because the taxpayer was physically present in a foreign country for the full day. The key is that the taxpayer was traveling from the territorial waters of one foreign country, through international waters, and arrived in the territorial waters of another foreign nation within the same 24-hour period.

The Tax Court writes, “Under section 911, a foreign country includes airspace, lands, and territorial waters under the sovereignty of a country, territory, or possession other than the United States. Farrell v. United States, 313 F.3d 1214, 1216 [90 AFTR 2d 2002-7799] (9th Cir. 2002); Arnett v. Commissioner, 126 T.C. 89, 93-95 (2006), affd. 473 F.3d 790 [99 AFTR 2d 2007-492] (7th Cir. 2007); sec. 1.911-2(g) and (h), Income Tax Regs.” Furthermore, the Tax Court writes, “Although section 911(d)(1)(B) states that an aggregate of 330 full days of physical presence in a foreign country or countries is required, the regulations thereunder define a ‘full day’ to include partial days of travel in or on international airspace, land, or waters from one foreign location to another foreign location. Therefore, a day involving travel in international waters between foreign locations in increments of less than 24 hours is treated as a full day in a foreign country. Sec. 1.911-2(d)(2) and (3), Income Tax Regs.”

Based on Struck the first full day started at midnight of the day of departure and not at midnight of the next day. The plane was over foreign soil at midnight because it was in the airspace of a foreign nation. After midnight, the plane left that foreign airspace and entered airspace over international waters. Some hours later that day, the plane re-entered other foreign airspace over foreign soil and finally landed in yet another foreign country. The plane was in a foreign country at midnight, traveled over international waters en route to another foreign country, and arrived there before midnight of the day following departure. Therefore, the first full day in a foreign country started at the first midnight after departure.

Okay. So we solved the mystery of determining the first full day in a foreign country. Next came the problem that my friend was going to return to the United States before he had been physically present in a foreign country for 330 full days out of the consecutive 12-month period. On that point, Pub 54 is crystal clear. “You can count days you spent abroad for any reason. You do not have to be in a foreign country only for employment purposes. You can be on vacation time.” Thus, shortly after my friend returns to the United States, he is going to be able to fill up the 330-day period abroad by applying some of the tax he saves under §911 and taking a nice vacation – just long enough to complete the 330-day requirement.


Hear our voice: The tax laws are incomprehensible


Gracious! What a horrendously complicated body of rules exists as a result of §911. It is so complicated that citizens will often tend to forget the benefits of the exclusion and just include the whole amount of foreign earned income on their returns. It is the complexity of the rules and the various computations that are required that scare people away. Many folks fear being penalized if they get some part of the whole complicated mess wrong. The complexity creates fear of becoming trapped even after a good faith effort is made to explore the benefits and to meet the requirements. In other cases, the complexity of the scheme causes some good-faith taxpayers to claim the exclusion when they do not meet the confusing requirements. They often are penalized for negligence when in reality the law is so complicated that an ordinary, literate human can reasonably be expected to misunderstand the statute. How many laymen do you suppose know how to research the tax law in order to find cases that will provide the guidance they need? The whole scheme is so complicated that taxpayers are forced to approach and compensate some member of the priesthood of accountants and lawyers who spend their lives comprehending the mysteries of these scriptures. Is that the kind of system we should have?

IRS Fast Track Mediation 2 - A Tool For Taxpayers

A tax examination is opened. As the taxpayer’s representative you have produced the evidence, cited the law, and pointed to the appropriate conclusion. If you are convinced your position is correct, and the examining agent remains entrenched in a different view, it is beginning to look like your client is now going to be forced to endure yet another delay. It begins to appear you will have resort to a formal protest to Appeals. But there are some procedures you may invoke when it is preferable to expedite closing the case. Before any 30-day letter is issued, you could take steps to immediately advance your case. In fact, when your facts present a compelling case for the conclusion you advocate, the earlier in your case that you make use of two informal procedures, the more likely the case will be resolved favorably and much faster. Those two procedural avenues are manager-conferences and Fast Track Mediation; they should be used at the very earliest appropriate moment possible to advance your client’s best interest.

Procedural Mandate: Managerial Involvement

The Internal Revenue Manual (“IRM”) unequivocally mandates managerial involvement in unresolved disputes. For example, at IRM, Section 4.10.8.10(4) it is written, “Managerial involvement is required in unagreed cases. A field group preliminary (30-day) letter generally should not be issued to the taxpayer unless the manager has contacted the taxpayer and/or representative to attempt to resolve the tax controversies and reach an agreement.” And at IRM, Section 4.10.7.5.3.1(1) IRS employees are instructed, “Taxpayers who disagree with any of the proposed adjustments will be informed of their right to discuss the proposal with the examiner’s group manager.” The opportunity to have these discussions with a manager is required to be extended as soon as the examiner submits to you the detailed proposal setting forth the examiner’s determination. It seems to be a common experience among representatives that they are rarely, if ever, contacted by a manager who is actively seeking to comprehend a dispute in order to resolve the matter at the examination level, despite the clear mandates of the IRM. Furthermore, it seems to be a common experience that representatives are not informed of the right to a manager’s conference until that notice appears in the 30-day letter – a common error by IRS employees that directly breaches the clear mandates of the IRM.

There is no remedy available to you when the IRS issues a 30-day letter without ever having advised you of the right to confer with the examiner’s manager. You are stuck with having to formally protest the determinations and waiting around for a conference with Appeals. Therefore, when the evidence and the law strongly compel the conclusion that the taxpayer’s position should be sustained, your best opportunity to bring the matter to a faster resolution is to involve persons other than an entrenched examiner in the resolution of the controversy. It is up to you to actively insist that examiners promptly deliver the detailed proposal required and described in IRM 4.10.8.10.2. After analyzing the proposal, you must next actively insist upon a manager’s conference. That conference presents an opportunity to go through a dry run where the examiner’s conclusions will be presented to another person for comparison with your own presentation of the evidence, law, and logical conclusions.

Procedural Mandate: Fast Track Mediation (“FTM”)

Do you know about FTM? Has any examiner ever notified you of the taxpayer’s right to FTM? It is becoming my view that many (maybe most) examiners do not know about the IRM provisions concerning FTM and therefore do not provide timely notice of that right – if ever. FTM started as a procedural experiment. IRS leadership is always interested in expediting the process of producing correct conclusions for very good reasons. The pilot programs involving FTM provided a record sufficient to cause the matter to be made a permanent part of the procedural alternatives that can be used to move disputes to faster conclusions. When the procedure was converted from a trial-project to a permanent fixture, the IRS issued Publication 3605. It is a short, clear statement describing FTM, identifying cases eligible for FTM, and stating how to make use of the process.

In addition to Pub 3605, the IRM was augmented by specific mandates to advise taxpayers of their right to FTM. At IRM 4.14.7.5.3.1(2) it is stated, “Examiners are required to inform all taxpayers about the Fast Track Mediation (FTM) program. All examiners must offer taxpayers the opportunity to use FTM on all unagreed cases that meet the criteria as described in Publication 3605 …” In the Examining Officer’s Guide, Unagreed Reports, at “IX. Fast Track Mediation” the IRM expresses, “Fast Tract Mediation was fully implemented on a national basis on June 1, 2002.” It is further stated that “SBSE employees MUST offer taxpayers the opportunity to use FTM on all unagreed cases that meet the criteria. Publication 3605, Fast Track Mediation, explains the process. FTM is not meant to replace the managerial conference, nor does it replace normal Appeal rights.”

Armed with the language of the IRM you will be in a position to seize the advantages of the opportunities available through conferring with managers and through FTM. But if representatives do not assert a taxpayer’s right to each of these informal processes, the opportunity will be lost.

Reasons to use manager’s conferences followed by FTM

As mentioned above, when the elements of the case most persuasively demonstrate that the taxpayer’s position should be sustained and the examiner persists in refusing to concede the point, you do not need to idly await the arrival of a 30-day letter and head for Appeals. Where the client’s best interests will be maximized by achieving a proper resolution in shorter time, you can remove unilateral decision-making power from the examiner and involve the judgment of other persons in the process. In most cases it will be most appropriate to first engage the examiner’s manager. Remember, this should be done before a 30-day letter is issued. Once that letter issues, there is often a strong institutional resistance to withdrawing that 30-day letter. In that situation, you will not likely have much chance of success at convincing a manager to withdraw the 30-day letter that the manager just approved and issued in the name of the Area Director. Therefore, at the earliest stages of the examination, when all evidence and authority supporting the taxpayer’s position have been submitted to the examiner, persist in the request for the examiner to deliver the examiner’s written determinations. If the proposed determination is incorrect, immediately proceed to request a conference with the manager. For every incorrect determination, proceed to discuss the matter with the manager. If conferences with the manager do not produce a correct result, proceed to request that the matter be submitted to FTM. Follow the steps outlined in Pub 3605. And if you encounter any resistance to the exercise of that right, be sure to point to the mandates expressed in the IRM and Pub 3605.

Mediation through FTM is not binding upon either the taxpayer or the examiner. The mediator will be an Appeals Officer who is specially trained in helping the parties to achieve a settlement. Mediation sessions will occur before a 30-day letter is issued. If no acceptable resolution is achieved, a 30-day letter will follow and representatives may then formally protest the determinations. But even if the correct outcome is not produced through the mediation, the process will probably yield some strong benefits. First, the sessions will provide the opportunity to have a “dress rehearsal” – a chance to present your highly organized submission of evidence and authorities that support the taxpayer’s position. Second, you will have obtained a comprehensive look at the examiner’s abilities as a witness. You will be able to detect elements affecting the examiner’s views that were not disclosed in the proposal that was submitted to you. If the examiner harbors erroneous views or assumptions, the mediator’s involvement will likely help uncover those matters. The sessions will provide an opportunity to informally discover flaws and weaknesses in the examiner’s processes and conclusions. In the event such flaws are revealed you should consider reducing everything to writing in the nature of informal interrogatories (call them requests for help in understanding the position) and informal requests for admission. Promptly prepare and mail the requests to the examiner, stating clearly that you are seeking to resolve the dispute and that the examiner’s answers are of critical importance to that process. The process may have the effect of “turning on the light” and producing the correct outcome that you have been seeking. But if the matter proceeds to a 30-day letter, your case will be much more thoroughly informed in all respects; and, you will have been able to assess how the taxpayer’s position is likely to play in a formal protest.

A Strong Caveat:

On the other hand, where the examiner has gathered the facts, applied sound authorities, expressed a position having merit that requires consideration, and has presented all those matters in a timely proposal, a manager-conference and FTM can still operate to expedite an appropriate resolution of the case. But in this situation, where the evidence and authorities are not so absolutely persuasive in support of the taxpayer's position, it is almost an utter waste of time to insist upon a complete concession from the examiner. Where the examiner's determination expresses merit, the intended purpose of the informal resolution procedures is to work toward settlement - not concession. Thus, if an acceptable settlement is produced by the informal processes, taxpayers can much more expeditiously bring the entire controversy to a close. Expedited resolution is the reason why these informal procedures are made part of the process. And where the process produces a settlement that falls within the range of reasonableness, there is not much to be gained by pounding out a set of informal interrogatories.

Where the examiner's position fairly and in detail expresses the facts provided by the taxpayer's own responses to inquiries from the examiner, and the examiner's proposal demonstrates reliance upon appropriate authorities, your interrogatories will have already been answered. The examiner will have completed the task of expressing conclusions and reasons for those conclusions. In those situations, unless there is some compelling and legitimate reason to reject any settlement that emerges from the informal procedures, a representative must evaluate whether to accept the posited resolution or abandon the process and head for appeals on a 30-day letter.

Remainder Sales: Still a non-abusive tool

A View on Remainder Sales - Still a useful, non-abusive tool
The Fifth Circuit Court of Appeals decision in Wheeler, 116 F. 3d 749 (5th Cir. 1997), resulted in the affirmation of what was previously a somewhat controversial estate planning technique. The decision implanted the following principles into our jurisprudence: The exchange of a remainder interest in property for other property of equal value is a transfer for adequate and full consideration for purposes of federal gift and estate tax law. At death, the life interest retained in the exchange is not includable in the gross estate, and IRC §2036 has no application.

Wheeler was decided seven years after the enactment of the new §2702. But the remainder sale in Wheeler occurred years before the enactment of §2702. Congress clearly intended to terminate the use of remainder sales used for the purpose of insulating the entire value of a retained life estate from the reach of the taxing statutes. However, close analysis of the language of the statutes suggests that Congress left alive the opportunity to sell a remainder interest coupled with a marital gift of the life estate. If constructed properly, the front-end-loading effect of §2702 is not activated.

What §2702 does:

This provision operates to create a “deemed” gift of the entire value of a retained life estate. Assume the same situation as in Wheeler. Dad sold the remainder interest in his land to his sons and carried the note. The price was equal to the appraised value of the land multiplied by the appropriate factor promulgated in IRS Publication 1457 based on the §7520 interest applicable to the date of the transaction (plus another $10,000 just to be sure the price was adequate and full). Thus, Dad received absolutely full and adequate consideration for the value of the remainder that was transferred. The sons paid off the debt. According to the Fifth Circuit, the retained life estate was not part of the Dad’s estate.

The government had argued that “adequate and full consideration” had to be the value of the entire fee – i.e., that a price reflecting only the value of a remainder interest was not adequate and full consideration. Clearly, the concern was that the life interest portion still possessed at Dad’s death would completely escape taxation. Rejecting that argument, the Fifth Circuit reasoned that the decision is driven by the function and purpose of the actuarial rules. It was reasoned that under the valuation scheme mandated by the law, the investment of the remainder-sale proceeds at the then-applicable §7520 rate would actuarially restore the value of the life interest to the gross estate. Thus, it could be fairly said, that if both the actuarially-restored value was taxed in addition to the value of the retained life interest, value would be taxed twice.

When §2702 operates upon facts presented in Wheeler, a different result arises. Now, where Dad sells the remainder to sons and retains for himself the life estate, the statute deems that the transaction resulted in the transfer of the entire fee; and, since the value received only equal the price of the remainder portion, the value of the life interest is deemed to have been transferred as a gift. Thus, Dad’s sale is taxed as part sale (the remainder portion) and part taxable gift (the life interest portion). But §2702 is not applicable where Dad does not retain a life interest. §2702 only operates where there is a retained interest. See, Treas. Regs. §25.2702-2(d) example 3. Still remaining is the issue of whether Dad can simultaneously sell the land to sons for the value of the remainder only, and still make a gift to Mom that qualifies for a marital deduction.

Marital Deduction for gift of life estate?

The policy of the federal taxing statutes is to not tax gratuitous transfers to a spouse. That way, when the values are accumulated in the spouse’s estate they are taxed upon the spouse’s demise. So, where assets that will be included in the spouse’s estate are transferred gratuitously (either inter vivos or testamentary) the law provides a marital deduction so that the value transferred in not taxed at the time of transfer. And in general, that is why a gift of a terminable interest such as a life estate is not thought of as being eligible for a marital deduction. A common view is that if the asset transferred will be excluded from the spouse’s estate, then there should be no marital deduction at the time of the gift.

However, the statute that precludes a marital deduction for a gift of a life interest followed by a remainder to any person contains a clear and unequivocal exception. Under §2523 it is provided that no marital deduction shall be allowed where the donor retains or else transfers an interest that will become possessory upon the death of the donee-spouse. But, there is a big parenthetical exception to that rule. Under §2523, there is no deduction if the donor transfers the remainder to any person other than the donee spouse for less than an adequate and full consideration. Based on the language of the statute there is reason to conclude that where the donor gives the life interest to the donee-spouse and sells the remainder to the children, the gift to the donee-spouse qualifies for a marital deduction.

Tax outcomes:

The tax consequences would appear to be favorable to the taxpayer. First, because the donor transfers both the life interest and the remainder, retaining no interest in himself, the provisions of §2702 are not applicable. Second, the sale of the remainder must be taken into account for the seller’s income tax return. Third, the value of the life estate gifted to the donee-spouse qualifies for the marital deduction provided under §2523(a) because the interest that succeeds the donee-spouse’s life interest was transferred for an adequate and full consideration. Fourth, when the donee-spouse dies, the life interest will not be includible in the gross estate.

Not abusive – Wheeler is supportive: Such a transaction should not result in the taxation of the gratuitous transfer of the life interest to the donee-spouse when the reasoning of Wheeler is brought into the analysis. According to that judicial pronouncement, the mathematical assumption underlying the federal valuation scheme is that the proceeds from the sale can grow at the rate presumed by the law for the balance of the seller’s actuarially-presumed life expectancy. Over that period, the growth will compound its way right back to the full equivalent of the value of the entire fee. It’s as though it is to be presumed that is what will happen – that the proceeds will in fact compound to that equivalent value. Thus approached, the value of the life estate should not be taxed because its equivalent value will have been restored to the estate. And not a single authority has challenged or sought to displace that formulation at any time since Wheeler was decided. To the contrary, the reasoning has been expressly adopted and reinforced in the Ninth Circuit. It seems that it is probably unshakably part of our law: the actuarial-based valuation scheme presumes that the proceeds will grow to the point of completely restoring the whole value of the entire fee in the seller’s estate.

In the Fifth and Ninth Circuits there would be no economic basis for asserting that a marital deduction should not be allowed. The assumption is that the proceeds of the remainder sale will appreciate for the balance of the seller’s life and completely restore the value of the life interest to the seller’s gross estate. It will be taxed in that estate. Therefore, there is no economics-based reason to tax the value of the gift to the spouse. Rather, under Wheeler one is compelled to conclude that to do so would result in the unjust taxation of the same value twice – once upon transfer to the spouse and again when the appreciated value from the remainder sale is taxed in the donor-seller’s gross estate.

Tension between 2523 and 2702?:

While §2702 would tax the value of a retained life interest upon sale of the remainder to members of the seller’s family, it would tax it as a deemed gift to the remaindermen. And if the buyer of the remainder is the seller’s spouse, §2702 would require that the transaction be treated as also including a transfer of the value of the life interest – a deemed transfer of the whole. But the application of §2702 should not produce any taxable transfer because the value of the whole should be deemed transferred to the donee-buyer-spouse in this family-only transaction. And since the remainder is not transferred to any person other than the spouse, it is clear that a marital deduction shall be allowed under §2523. There is nothing in §2702 that would conflict with allowance of a marital deduction where a life estate is actually or “deemed” transferred to a spouse. Treas. Regs. §25.2702-2(d) example 3 seems to support that view.

Letter Rulings: None of the letter rulings I have been able to find dealing with issues under §2523 express any thought concerning the parenthetical “consideration-based exception” provided in §2523(b)(1). The rulings briskly pass by the matter because the facts presented do not involve transferring the remainder to other persons in a genuine sale for adequate and full consideration. Of course, that does not unequivocally establish the proposition that the IRS might attempt to deny a marital deduction even where the remainder is sold for an adequate and full consideration to persons other than the donee-spouse. But that is where the reasoning applied in Wheeler seems to constitute such strong support for the proposition that the transaction should be treated as a sale of the remainder (having immediate income tax consequences to the seller-donor) and a tax-deductible gift to the donee spouse.

Wheeler adopted as correct in Magnin (9th Circuit):

Just before Wheeler was published, the Tax Court published its opinion in Magnin, TCMemo 1996-25. There, the Tax Court held that a sale of a remainder is a transfer for less than adequate and full consideration where the value received is less than the value of the entire property. Shortly after the Tax Court released that opinion, the Fifth Circuit published Wheeler which announced a rule that was completely contrary to the Tax Court’s position in Magnin. According to the Fifth circuit’s analysis, every time property removed from a transferor’s estate is joined by receipt of property that has equal value, the transfer is for adequate and full consideration. That set the stage for the appeal of the Magnin case to the Ninth Circuit where there was presented the unequivocal conflict between the Tax Court and the fifth Circuit.

Though Wheeler involved the sale of a remainder in realty and Magnin involved the relinquishment of the remainder interest in closeheld stock in exchange for a life interest in the same closeheld stock owned by the transferor’s father, the Ninth Circuit relied upon and followed the sound reasoning of Wheeler and rejected the principle expressed by the Tax Court in its opinion in Magnin, 184 F. 3d 1074 (9th Cir. 1999). Since that flurry of activity from 1996 to 1999, the issue has never again been raised in any court. Perhaps the government knows that Wheeler – wholly adopted and followed in the Ninth Circuit – expressed the correct view of the law: an exchange of equally valued things is always a transfer for adequate and full consideration.

The clear governing principle that must be met is that the remainder must be sold for a price that is absolutely the full value. Both courts correctly point out that the actuarial tables are built upon the presumption that there the property received for the life estate grows at the rate prescribed under §7520, then the growth reproduces exactly the same value includable in the gross estate that would have been included if there had been no transfer.

Caveat:

Seller-financed sale creates an interest: Where the seller carries the purchase-money note secured by liens against the property, there exists the contingent possibility that the seller-donor might again become the owner in the event of default and foreclosure. It is possible that the existence of that contingent interest is sufficient to remove the transaction from the scope of the parenthetical exception based on transfer for adequate and full consideration. The language of the statute seems to require that whoever owns the remainder must be a person who purchased it for full value, thereby completely cutting off the seller-donor’s interests in the property. For that reason, to make use of this remainder-sale/marital gift technique, it seems quite advisable to arrange for third-party financing by some means.

On the Dialog Concerning Our Tax System

During almost 20 years as a lawyer employed by the IRS my practice brought a very wide range of experience in the substance and the administration of the United States tax law (Title 26 United States Code). It is the complexity and the arrangement of our law that puts it beyond the ability of almost everyone to understand. Federal tax law is a large and detailed universe of statutes, regulations, case law, manuals, notices, bulletins, memoranda and etc. Humans cannot attend to the tasks that occupy their lives and also learn the law that affects so much of what we do. Furthermore, the tax law operates upon provisions established by the laws of each state governing property, business, commerce or all kinds, and relationship of all kinds. It is no wonder that there is now a virtual priesthood comprised of lawyers and accountants that citizens must approach and compensate in order to assure they have complied with the law and are being treated with justice.

For the purpose of sharing knowledge that may contribute to seeking justice, reaching correct outcomes, and illustrating substantive and procedural components of that complex body of law, this blogspot will from time-to-time express my thoughts, opinions and conclusions. Articles from other persons will be posted at time, and links to other blogs will be added when helpful. Nothing posted in this blog will ever constitute legal advice or counsel, and will never solicit employment. Each person's unique circumstance must be addressed by that person's advisors. These posts will address estate and gift tax matters, often expressing my views on the mis-development of the federal law. Sometimes comments will address procedural opportunities that are too often overlooked by, and perhaps unfamiliar to, tax professionals to whom people turn when examinations arise. These posts are intended to add the power of expanded knowledge to all of us. It is best accomplished through dialog, and you are invited to post your questions, replies and insights for the benefit of all of us.

Fast Track Mediation 1

Recent events have revealed that there are apparently many IRS examiners and many taxpayer representatives who do not know about Fast Track Mediation. The process is briefly described in IRS Publication 3605. Both taxayers and the government can derive very strong benefits from the process. And according to several provisions contained in the Internal Revenue Manuals, examiners are officially obligated to advise a taxpayer of the right to informal resolution procedures which include conferences with a manager and Fast Track Mediation. In the near future there will appear a posting that describes the process, cites provisions in the IRM's relating to the process, and describes the benefits of pursuing that informal resolution opportunity.