Nonresident alien's deductions on return filed after "terminal date."

The Tax Court, in Guillermo Baez Espinosa, 107 TC No. 9 (1996), held that a nonresident alien was not entitled to deductions under Sec. 874(a), because he filed his return only after the IRS had issued two filing requests and prepared a substitute return. The case illustrates the necessity for foreign nationals to file U.S. tax returns by the last chance deadline in order to claim deductions.

Guillermo Baez Espinosa, a nonresident alien, owned two rental properties located in Austin, Texas. During the years 1987 through 1991, the rental property had annual rental losses. Espinosa failed to file tax returns for those years. In November 1992, the Service notified him that it would prepare substitute returns for him if he did not file the returns in two weeks. Espinosa did not file the returns and the IRS sent a second request. Espinosa again did not file his returns and in February 1993 the Service notified Espinosa that it had prepared substitute returns (which were computed without the benefit of deductions).

Espinosa filed his 1987 through 1991 returns in October 1993, and elected to treat the rental income as effectively connected with a U.S. trade or business under Sec 871(d). Espinosa claimed deductions against his rental income and reported losses for each year. The IRS later issued a notice of deficiency, determining that, although Espinosa had made an election under Sec. 871(d), he was not entitled to the benefit of deductions because he had not timely filed his returns. The Service determined that Espinosa's gross rental income was subject to tax at graduated rates and that Espinosa was liable for additions to tax for failure to file tax returns pursuant to Sec. 6651(a)(1) and for failure to pay estimated tax pursuant to Sec. 6654.

If an election is made to treat rental income as effectively connected, the tax is computed pursuant to Sec. 871(b), on net rental income at graduated rates, provided the taxpayer has filed a return as required by Sec. 874(a). Sec. 874(a) provides that "a nonresident alien individual shall receive the benefit of the deductions and credits allowed to him in this subtitle only by filing or causing to be filed with the Secretary a true and accurate return, in the manner prescribed in subtitle F (section 6001 and following, relating to procedure and administration), including therein all the information which the Secretary may deem necessary for the calculation of such deductions and credits." Although Espinosa filed a return for the years in question, the issue is whether the returns submitted in October 1993 satisfy the requirements of Sec. 874(a).

The court concluded that, although Sec. 874(a) contains no explicit time limit within which a nonresident must file an income tax return, for tax years ending after July 31, 1990, the regulations explicitly create a timely filing requirement. Regs. Sec. 1.874-1(b)(1) states that the required return for the current tax year must have been filed no later than the earlier of the date that is 16 months after the due date (as set forth in Sec. 6072) for filing the return for the current tax year, or the date the IRS mails a notice to the nonresident alien individual advising him that the current year return has not been filed (last chance filing deadline). The court also relied on prior case law (Blenheim Co., 42 BTA 1248 (1940), and Taylor Sec., Inc., 40 BTA 696 (1939)) that established a terminal date after which a taxpayer could no longer claim the benefit of deductions by filing a return. Finally, the court concluded, citing Blenheim, Taylor and Ardbern Co., 41 BTA 910 (1940), that absent some equitable considerations, a taxpayer cannot claim the benefit of deductions by filing a return after the Service has prepared a substitute return and issued a deficiency notice. The court did not believe that the congressional intent in enacting Sec. 874(a) would be furthered by a rule that always lets a taxpayer wait and see what information the IRS puts on a substitute return before the taxpayer has to file a return of his own.

In conclusion, the court held that the policy behind Sec. 874(a) "dictates that there is a cut-off point or terminal date after which it is too late to submit a tax return and claim the benefit of deductions." If no cut-off point existed, taxpayers would have an indefinite time to file a return, and these provisions would be rendered meaningless: "To hold otherwise would render the entire provisions of the statute a nullity." The court therefore found no "reason to reward" Espinosa for filing his returns only after receiving a second warning by the IRS.

From Julie Burbach and Art Fisher, CPA, Washington, D.C.