NO DEDUCTIONS FOR NONRESIDENT ALIEN FOR U.S. RENTAL INCOME

By Anthony M. Sileo, CPA, KPMG Peat Marwick

This Tax Court case involved a nonresident alien individual who sustained net rental losses, after considering deductions and operating expenses, from his U.S. real estate properties. The nonresident alien also sustained a capital loss from the sale of U.S. real property. The IRS informed the foreign taxpayer of the requirement to file U.S. income tax returns to report the gross rental income and associated deductions. However, the foreign taxpayer failed to file the U.S. tax returns on a timely basis. As a result, the IRS disallowed all of the deductions including the loss on sale and taxed the nonresident alien on his gross rental income. In addition, to throw course salt on the wound, the Tax Court upheld IRS penalties for late filing and underpayment of estimated tax. Welcome, Mr. Espinosa to the friendly U.S. taxing jurisdiction!

Background

IRC section 874(a) generally provides that nonresident alien individuals may take into account otherwise allowable deductions and credits only if they file "true and accurate" returns containing all of the information necessary for the Treasury secretary to calculate the deductions and credits claimed. The provision, designed to address the government's concern over its ability to effectively tax the income connected to a nonresident alien individual's U.S. trade or business, conditions the benefit of otherwise allowable deductions upon the foreign taxpayer's proper filing of an accurate income tax return.

Conspicuously absent from the text of the code provision, however, is language specifying "when" the true and accurate return must be filed by the nonresident alien to avoid loss of deductions under IRC section 874(a). Regulation section 1.874-1(b)(1), as amended in 1990, clarified this issue somewhat by providing, in part, that for taxable years ending after July 31, 1990, a nonresident alien's return is late, for IRC section 874(a) purposes, if it is filed after the earlier of the dates, which is 16 months after the return's normal due date pursuant to IRC section 6072 or the date the IRS mails a notice to the foreign individual advising him that his tax return has not been filed and that deductions will be disallowed. Prior case law, while sparse, suggests that a nonresident alien taxpayer cannot avoid the application of IRC section 874(a) by filing a return after the IRS has both prepared substitute returns for the taxpayer and issued a statutory notice of deficiency.

Although in most cases, IRC section 874(a) may be viewed as a tool which enables the government to reduce the potential for tax evasion by nonresident alien individuals, its application may, at times, produce rather harsh results . . . just ask Guillermo Baez Espinosa. In the recent case, Espinosa v. Commissioner, the Tax Court held that Espinosa, a nonresident alien individual, was not entitled to deductions pursuant to IRC section 874(a). Specifically, the court opined that the filing of returns by Espinosa after the IRS prepared substitute returns and notified him that his deductions were being disallowed, but before the issuance of a statutory notice of deficiency, was insufficient to avoid the application of IRC section 874(a). What was unique, and somewhat unfortunate about the Espinosa case, however, was that Espinosa's failure to timely file his income tax returns did not stem from an intent to evade his obligation to pay U.S. income taxes. In fact, for each of the taxable years at issue, the IRS did not dispute that, but for the application of IRC section 874(a), Espinosa would not have paid taxes because his otherwise allowable deductions exceeded the gross income he received from U.S. activity. However, due to the application of IRC section 874(a), Espinosa was taxed on the gross rental income he received during the taxable years in dispute and held liable on several additions to tax penalties.

Facts

Guillermo Baez Espinosa was a calendar year, nonresident alien individual who owned two rental properties within the U.S.--one located in Austin, Texas and the other located in Ruidoso, New Mexico. During the taxable years 1987 through 1991, the rental property located in Austin, Texas generated an annual loss because the expenses, including the depreciation associated with property, exceeded the rental income produced by it. Similarly, for the taxable years 1987 through 1989, the rental property located in Ruidoso, New Mexico produced an annual net loss. In February 1990, Espinosa sold his interest in the Ruidoso property and sustained a loss because the adjusted basis in the property exceeded the amount realized by $13,315.

Although in a net loss posture with respect to the properties from 1987 to 1991, Espinosa was still required to file Federal income tax returns because the rental activity was treated as effectively connected with a trade or business in the United States. Espinosa did not object to the treatment of his rental income as being effectively connected with a U.S. trade or business. In fact, when Espinosa finally filed his tax returns for the years 1987 through 1991, he made the election under IRC section 871(d) to treat the rental income as effectively connected with a U.S. trade or business. At any rate, consistent with regulation section 1.6012-1(b)(1)(I) and IRC section 6072(c), Espinosa was required to file income tax returns for the years 1987 through 1991, each of which was due on June 15 of the year following the close of the preceding taxable year.

By November 1992, Espinosa had yet to file tax returns for the taxable years in question. Consequently, on November 13, 1992, the commissioner mailed a letter to Espinosa requesting a response as to why tax returns for 1987 through 1991 had not been filed. At this time, the commissioner also warned Espinosa that if he did not respond by December 1, 1992, the commissioner would file substitute returns for him. Espinosa failed to respond to this IRS inquiry. The commissioner, on January 12, 1993 again wrote to Espinosa and reiterated the previous request for a response concerning the status of Espinosa's Federal tax returns. In addition, Espinosa was warned that if he failed to respond to the inquiry within 20 days, his tax liability for the years 1987 through 1991 would be computed based solely upon the information currently in the commissioner's possession.

Despite this second warning, Espinosa failed to respond to the commissioner's request. Consequently, on February 3, 1993, the commissioner notified Espinosa that substituted income tax returns had been prepared by the IRS for the years 1987 through 1991. On March 23, 1993, the commissioner informed Espinosa that, pursuant to IRC section 874(a), his tax liability for the years in dispute had been determined based solely upon the gross income received from the rental properties ignoring otherwise allowable deductions. Originally, the commissioner, aside from computing Espinosa's tax liability based upon the gross rental income, determined that Espinosa was liable for tax on the amount realized from the sale of the Ruidoso property without regard to property's adjusted basis. The commissioner later conceded, however, that IRC section 874(a) does not prohibit a nonresident alien individual from utilizing the basis to determine gain or loss from the disposition of property. The commissioner maintained, and the court later agreed, that IRC section 874(a) still denies the nonresident alien the benefit of any resulting loss if the property's adjusted basis exceeds the amount realized on disposition.

On October 7, 1993, Espinosa finally submitted tax returns for the years 1987 through 1991. On each return, Espinosa elected under IRC section 871(d) to have the rental income generated by the properties be treated as effectively connected with a trade or business within the U.S. More importantly, each return reflected a net taxable loss because Espinosa offset each year's rental income with the corresponding deductions incurred in producing the rental income.

On January 13, 1994, the IRS issued a statutory notice of deficiency for the taxable years 1987 through 1991. The deficiency for each year stemmed from the commissioner's determination that Espinosa was not entitled to any deductions. In addition to the tax liability, the commissioner also determined that Espinosa was liable for civil penalties for the failure to timely file tax returns pursuant to IRC section 6651(a)(1) and the failure to pay estimated tax pursuant to IRC section 6654.

Legal Analysis

The primary issue presented in the Espinosa case concerned whether the filing of the 1987 through 1991 tax returns by Espinosa after the IRS prepared substitute returns and provided notification that deductions were being disallowed, but before the notice of deficiency was issued, was sufficient to avoid the sanctions imposed by IRC section 874(a). Espinosa argued that because IRC section 874(a), on its face, did not contain an explicit date on which the returns must be filed for the purpose of obtaining the benefit of otherwise allowable deductions, his filing of the 1987 through 1991 tax returns before the notice of deficiency was issued was sufficient to avoid IRC section 874(a) punishment.

Although IRC section 874(a) does not contain language which limits the time period for when a nonresident alien individual may file a return, regulation section 1.874-1(b), as amended in 1990, establishes very specific return filing deadlines for the purpose of avoiding IRC section 874(a) sanctions. This time limitation applies to the taxable years of nonresident alien individuals ending after July 31, 1990. According to regulation section 1.874-1(b)(1), "[i]f a return was filed for [the] immediately preceding taxable year, or if the current taxable year is the first taxable year of the nonresident alien individual for which a return is required to be filed, the required return . . . must be filed within 16 months of the due date, as set forth in IRC section 6072." Regulation section 1.874-1(b)(1) further provides that if no return had been filed for the preceding taxable year, "the required return . . . must have been filed no later than the earlier of the date which is 16 months after the due date, as set forth in IRC section 6072(a) . . . or the date the IRS mails a notice to the nonresident alien individual advising [him] . . . that the current year return has not been filed and that no deductions or credits . . . may be claimed by the nonresident alien individual."

Prior to 1990, regulation section 1.874-1 did not establish a specific return filing deadline. The absence of such a requirement coupled with the fact that the taxable years 1987 through 1989 were not covered within the scope of amended Regulation 1.874-1(b), forced the Espinosa court to turn to a series of cases involving the predecessor to IRC section 882(c)(2) to ascertain whether Espinosa timely filed his 1987 through 1991 tax returns for IRC section 874(a) purposes. IRC section 882(c)(2), a provision similar in intent and purpose to IRC section 874(a), disallows otherwise allowable deductions to foreign corporations which fail to file true and accurate returns with the secretary. After a thorough review, the Tax Court could not find a case dealing with the application of IRC section 874(a) or its predecessors in the context of an untimely filed return. However, because of the similarity between IRC section 882(c)(2) with respect to foreign corporations, and IRC section 874(a) with respect to nonresident aliens, the court interpreted the two provisions in pari materia.

In the first case analyzed by the Espinosa court, Anglo-American Direct Tea Trading Co. v. Commissioner, [38 B.T.A. 711 (1938)], the Board of Tax Appeals held that a foreign corporation was entitled to deductions although it submitted its tax returns three days after the revenue agent prepared substitute returns. Importantly, the Board of Tax Appeals noted that the revenue agent did not notify the foreign corporation that he prepared overdue returns, and the foreign corporation did file the returns before the notice of deficiency was issued. Similarly, in an unpublished memorandum opinion from the Board of Tax Appeals dated October 5, 1938, the Board of Tax Appeals, in Mills Spence & Co. v. Commissioner, using Anglo-American Direct Tea Trading Co. as a springboard, held that a foreign corporation was entitled to deductions when it filed its tax returns after notification from the IRS but before the IRS filed substituted returns or issued a statutory notice of deficiency. However, in Taylor Sec. Inc. v. Commissioner, [40 B.T.A. 696 (1939)] and Blenheim Co. v. Commissioner, [125 F.2d 906 (4th Cir. 1942) aff'g 42 B.T.A. 1248 (1940)], the Board of Tax Appeals and the Fourth Circuit respectively held that a foreign corporation was not entitled to otherwise allowable deductions because its tax return was filed after the commissioner had both filed substitute returns and issued statutory notices of deficiency. Importantly, the Blenheim court opined that "the preparation of a return by the commissioner a reasonable time after the date it was due terminates the period in which the taxpayer may enjoy the privilege of receiving deductions by filing its own returns. . ."

After considering these other cases, the Espinosa court concluded that there must exist a terminal date beyond which a taxpayer cannot file a tax return to avoid the application of IRC section 874(a). The court reasoned that "if no cut-off point existed, taxpayers would have an indefinite time to file a return, and [IRC section 874(a)] would be rendered meaningless." To hold otherwise, according to the court, would create a situation where nonresident alien individuals would be better served by "filing no return whatever, and then waiting until such time, if any, as the commissioner discovers their existence and acquires sufficient information about their income." Yet, despite determining that there must be a filing deadline for IRC section 874(a) purposes, the court did not address the validity of amended regulation section 1.874-1(b) and declined to adopt a bright-line rule governing when a return is delinquent under IRC section 874(a). The only taxable years in dispute which would have been covered by regulation section 1.874-1(b) were the years 1990 and 1991. As for the year 1990, the return, filed on October 7, 1993, was clearly delinquent under the regulation because it was filed more than 16 months after June 15, 1991, the date the return would have been timely pursuant to IRC section 6072. As for the year 1991, the Espinosa court, in dicta, explained that the 1991 return was not timely pursuant to the regulation because, although within the 16 month window, it was filed well after the IRS notified the taxpayer that both a return had not been filed and otherwise allowable deductions were being disallowed. However, consistent with the factual predicates in Blenheim and Taylor Sec. Inc., the court opined that a return is clearly delinquent if it is filed after the IRS has filed a substitute return and issued a statutory notice of deficiency, especially if the taxpayer was notified by the IRS of the failure to file and possible application of IRC section 874(a).

Turning to the facts of Espinosa, the court concluded that the filing of Espinosa's returns for the taxable years 1987 through 1991, after the IRS had prepared substituted returns, but before the notice of deficiency was mailed, was insufficient to avoid IRC section 874(a) punishment. The court noted that Espinosa had ample opportunity to comply with inquiries from the IRS concerning his failure to file income tax returns for five years. Instead, Espinosa chose to ignore the IRS's requests and warning of possible IRC section 874(a) sanctions and waited eight months from the time the IRS actually prepared the substituted returns to file his own returns for the taxable years 1987 through 1991. In so holding, the court rejected Espinosa's contention that a taxpayer may avoid IRC section 874(a) by submitting returns prior to the issuance of a notice of deficiency. The court reasoned that the congressional intent behind IRC section 874(a) would not be furthered by a rule that permits the taxpayer to "wait and see what information the commissioner puts on the substituted return before the taxpayer has to file a return of his own." Although the Tax Court recognized that the application of IRC section 874(a) in this case "may appear draconian," the court opined that if it were "to hold otherwise, [it] would essentially reward the [taxpayer] for ignoring the repeated requests that he comply with the filing requirements imposed by the code."

In the alternative, Espinosa argued that the filing deadline imposed by IRC section 874(a) and amended regulation section 1.874-1(b) conflicts with the nondiscrimination clause contained within the United States-Mexico Income Tax Treaty of September 18, 1992, because a similar filing requirement does not serve as a prerequisite for deductions for U.S. residents. The Espinosa court did not, however, address the merits of this argument because the U.S.-Mexico Income Tax Treaty was not yet effective during the taxable years 1987 through 1991. Finally, the court also rejected Espinosa's contention that the IRS acted unreasonably in failing to grant a waiver of the filing deadlines for IRC section 874(a) purposes primarily because there was no evidence presented by Espinosa to establish that a waiver was requested in the first place. With respect to this final contention, regulation section 1.874-1(b)(2) provides that "the filing deadlines . . . may be waived by the district director or assistant commissioner (international) in rare and unusual circumstances if good cause for such waiver, based upon the facts and circumstances, is established by the nonresident alien individual." The Espinosa court was convinced, however, that even if Espinosa had requested such a waiver, that the facts and circumstances of this case did not suggest that good cause existed for the granting of the waiver.

Observations

The Espinosa opinion represents the harsh tax repercussions that potentially await nonresident alien individuals who choose, for whatever reason, not to file income tax returns relating to income generated from U.S. activity. From Espinosa's perspective, the result was particularly harsh because he had a net loss for each of the taxable years in dispute. As such, Espinosa was not the generic "tax evader" Congress envisioned when it enacted IRC section 874(a). Yet, it is difficult to criticize the Tax Court's opinion in light of Espinosa's failure to respond to numerous inquires from the IRS regarding the delinquent returns.

Clearly, the Espinosa holding establishes that a nonresident alien individual who has been repeatedly warned by the IRS of the consequences for not filing a return may not, pursuant to IRC section 874(a), take advantage of otherwise allowable deductions by filing the delinquent tax return after the IRS has prepared substituted returns, but before a statutory notice of deficiency has been issued. Interestingly, the Tax Court did not base this decision on the return filing deadline imposed by regulation section 1.874-1(b) as amended in 1990 and opted not to comment on its validity. Instead, the Espinosa court opined that the issue of whether a return is timely filed must be determined on a case-by-case basis. Despite this observation, nonresident alien individuals deriving income from a U.S. activity should abide by the filing deadline imposed by regulation section 1.874-1(b). Failure to do so exposes the nonresident alien, as in Espinosa, to the harsh reality of being taxed on gross income without reaping the benefits of otherwise taxable deductions.

Although not an issue in Espinosa, nonresident alien individuals who conduct limited activity in the U.S. and who do not believe income received is effectively connected with a U.S. trade or business, may still unknowingly expose themselves to IRC section 874(a). That is, a nonresident alien individual whose U.S. source income is not effectively connected with a U.S. trade or business is not generally required to file a U.S. tax return. Yet, if the IRS later determines that the income was, in fact, effectively connected with a U.S. trade or business, the nonresident alien individual may lose the benefit of otherwise allowable deductions pursuant to IRC section 874(a) if a true and accurate return was not filed on a timely basis. To circumvent the application of IRC section 874(a) in this situation, the nonresident alien should file a "protective return." Specifically, regulation section 1.874-1(b)(4) permits the nonresident alien to file a protective return, within the time limitations imposed by regulation section 1.874-1(b)(1), "to protect the right to receive the benefit of deductions and credits attributable to gross income" if the IRS later determines that all or part of the gross income was effectively connected with a U.S. trade or business. Regulation section 1.874-1(b)(4), however, is somewhat vague regarding what the nonresident alien must include in the protective return. The nonresident alien individual "is not required to report any gross income as effectively connected with a U.S. trade or business or any deductions or credits." However, the return should contain an attached statement indicating why the return is being filed.

Lastly, another important but unresolved issue stemming from Espinosa concerns the validity of IRC section 874(a) and regulation section 1.874-1(b) in light of the various income tax treaties between the U.S. and foreign governments. Specifically, as argued by the taxpayer in Espinosa, the operation of IRC section 874(a) may conflict with the nondiscrimination clauses contained in U.S. income tax treaties which mandate that U.S. residents and nonresident aliens be treated equally for tax purposes. Perhaps taxpayers facing potential IRC section 874(a) sanctions who are resident in one of our U.S. trading partners could argue that the nondiscrimination clause of the relevant income tax treaty overrules application of IRC section 874(a). However, until resolved by litigation, this will be an open issue. *

Editor:
Lawrence A. Pollack, JD, LLM, CPA
KPMG Peat Marwick LLP