USVI – Residing or Vacationing (and What if You Pay Income Tax While only Vacationing)

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I am sitting in my dining room writing, and there is freezing rain outside, I’ve got a terrible cold, and my wife is cleaning up some child’s vomit.  I can’t help but think how nice it would be to live somewhere much warmer, that wasn’t as affected by these seasonal illnesses ….  And, wouldn’t it be all the better if I paid far less in taxes?  Maybe I should trade Love Park for Love City (nickname of St. John’s, USVI—which is apparently giving people money to come visit)?

The United States Virgin Islands have shown up in a lot of tax procedure cases over the last decade (like a ton!, there are only around 100,000 residents, and it seems like there is an important case every week).  So why is that the case?

Well, it is, for some, a legal tax shelter.  Normally, a US Citizen must file his or her return with the Service on a specified date, and the Service must assess tax within three years of filing a return, but if no return is filed the period of limitations remains open indefinitely.  See Section 6501.  To be filed, “the returns must be delivered…to the specific individual…identified in the Code or Regulations.” See Allnut v. Comm’r.  This normally means somewhere with the Service.  The USVI however operates a “separate but interrelated tax system.” Huff v. Comm’r.  Bona fide USVI residents are required to only file tax returns with the USVI Bureau of Internal Revenue (“VIBIR”).  See Section 932(c)(2).  If the taxpayer is not a bona fide resident, but has USVI source income, the taxpayer must file with the VIBIR and the Service.  In an effort to bring businesses to the USVI, an economic development program was implemented in USVI, which allows for a reduction of USVI tax on certain USVI residents up to 90% of their income tax.  Not sure how much economic development it has spurred, but a lot of rich people began trying to be bona fide USVI residents (or at least claimed they were), and the IRS took exception.

Below is a discussion of a few cases relating to claims of USVI residency.  One will review the requirements of residency, and why parking a boat may not be enough. It also highlights the interesting SOL issue of whether a USVI return starts the limitations period when the taxpayer is not a USVI resident.  The final case below investigates what happens if a non-resident pays tax to USVI (claiming to be a resident) and the refund statute of limitations has passed after there has been a determination that the person was not a resident.

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Parking Your Yacht and Staying at Ritz–Not Residency

In Commissioner v. Estate of Travis L. Sanders, the Eleventh Circuit reversed the Tax Court and remanded for additional fact findings regarding whether or not the decedent had ever been a resident of the USVI (and from the tone of the case, the Court gave fairly clear indication that the Tax Court should find he was not a resident).    The Tax Court opinion in Sanders can be found here.  The issue in the case was whether the filing of a USVI return started the statute of limitations, which the Court decided hinges on whether he was a resident of USVI.  As stated above, this has been a hot topic over the last few years, which we have not covered much on PT.

In Sanders, the taxpayer made his money on surge protectors (I think high end, not the consumer ones your computer is plugged into).  The more protectors he sold, the more his balance sheet surged.  In 2002, Mr. Sanders began spending some (but not much) time in the USVI.  From ’02 to ’04, the years in question, Mr. Sanders stayed at the Ritz, and then parked his yacht on the islands and stayed on the boat.  He spent somewhere between 8 and 18 days on the islands in ’02, between 49 and 78 days in ’03, and between 74 and 109 days in ’04.  He kept his FL home, never established a personal mailing address in the USVI, his girlfriend (eventually wife) remained in FL, his minor child lived in FL, and he spent considerable time at the company HQ in FL.

As to his work at the surge company, he became a limited partner in a USVI company, which employed him, and then contracted his services to the company he had created.  Mr. Sanders took the position that this was USVI source income, and that he was a USVI resident.  He then claimed the income was exempt from United States taxes (and it was potentially entitled to a 90 percent tax credit under USVI tax laws – hence the set up).

The IRS said this Caribbean dream was a little too dreamy, and in 2010 issued a notice of deficiency, alleging Mr. Sanders was not a bona fide USVI resident and that the set up was, as Jack Townsend would say, a b@!! $&!1 tax shelter.  Unfortunately, our Captain Sanders died in 2012, and did not get to see if his scheming worked.  In August, the Eleventh Circuit didn’t weigh in on the BS’iness of the tax shelter, but did overturn the Tax Court as to whether the statute of limitations prohibited the assessment.  Why did the courts disagree?

How to qualify as a USVI resident has changed somewhat over recent years, and, the discussion to follow regarding the statute of limitations on filing with VIBIR may no longer apply, as the Service and VIBIR entered into an information sharing agreement in ’07, and following that the Service agreed to treat certain returns filed with VIBIR as starting the statute of limitations regardless of whether the person was actually resident of USVI.

This was prior to ’07, and the Service took the position that Mr. Sanders was not a bona fide resident of the USVI in the years in question, and therefore the return he filed with VIBIR did not start the running of the statute of limitations in the United States.  Mr. Sanders (and the USVI government) argued he was a bona fide resident, and the statute had run.

The Court did not determine whether Mr. Sanders was or was not a bona fide resident, and remanded for further fact finding.  It was clear from the tenor of the opinion that based on the facts before the Court it strongly (very, very, very strongly) disagreed with the Tax Court conclusion that Mr. Sanders was a resident.

The more important holding, although not new law, was that the statute of limitations for filing his US Federal tax return would only run due to the VIBIR filing if Mr. Sanders was a bona fide resident (requiring a substantive finding of fact), and there was no good faith exception to this requirement implied in the statute.

In discussing the good faith exception, the Eleventh Circuit reviewed the meaning and use of the term bona fide and found it required objective proof.  The Court did note there are some fairness concerns in not having such an exception, but said that was not sufficient to read such an exception into the statute.  In addition, it noted that “entwining of the merits of a case with the statute of limitations is not uncommon in tax cases.”  The Eleventh Circuit rejected the good faith exception, holding filing with VIBIR only triggers the statute if the taxpayer is a bona fide resident (not merely that the taxpayer believes he is).

As to the bona fide residency, as mentioned above, the Eleventh Circuit gave a pretty heavy indication as to its feelings as to residency.  The Court stated that “[b]ecause the Tax Court never decided the nature and extent of Sanders’s physical presence, it cannot have properly weighed this factor.”  Further, “[e]ven Sanders’s own estimate that he spent 18 days in the USVI…places him on the island for only a small portion of time,” and “he had no personal home on the islands for any part of [the years in question].”  And, “[l]iving in a condominium partially owned by one’s employer (and which is not even available for every visit) does little to evidence an intention to reside there indefinitely…”, but the Court did note that moving the boat to the island and connecting it to utilities was slightly more indicative of residence; although, noted this was less strong evidence than a fixed home.  There were various other similar quotes, making it fairly clear the Court did not think Sanders was a bona fide resident.

Although I’ve discussed this type of planning in the past with clients for both USVI and PR (and other more exotic jurisdictions), this type of planning has a more common analogous state level planning topic; which is selecting a state level income tax residence (in my practice, it is usually someone in NY, NJ, MA, and less often PA, considering a move to FL).  Obviously, the analysis is different, but the advice is the same; you can’t just say you think you are a resident, you have to take meaningful steps that can prove you are.

Also, interesting to note, at least to me, that the Chief Justice of the Eleventh Circuit was appointed by George H. W. Bush, who once claimed residency in Texas while staying a limited number of days per year in the Houstonian, which Texas accepted and Maine, DC, and other states never questioned.  Perhaps the Houstonian is more homey than the Ritz.

Where Does My Entity Reside?

The Third Circuit had an interesting, albeit unsurprising, holding in the end of October relating to USVI residency of entities.  In VI Derivatives, LLC v. United States, the Third Circuit affirmed the district court’s denial of the taxpayer’s motion to dismiss for lack of subject matter jurisdiction, holding that res judicata barred the challenge to subject matter jurisdiction.  In VI Derivatives, various LLCs were challenging their residency, but the lower court had previously already determined the residency of the entity owners (the Ventos, more on them in a minute).  In that holding, the Court indicated there was no separate determination to be made regarding the entities, “Because those partnerships are pass-through entities…, they do not have residencies separate from their owners.”  When the entities filed a motion to dismiss for lack of subject matter jurisdiction based on residency, the District Court denied the motions, holding res judicata barred the challenge because the residency decision on the owners constituted a final judgement on the merits, which was not appealed.  The Third Circuit agreed.

For those of you who follow tax procedure closely, especially offshore matters, the Ventos are turning into a familiar family.  Cases pertaining to the capital gains ($180MM) generated from the sale of Richard’s Vento’s business have generated interesting holdings regarding USVI residency, summons enforcement, and FOIA (and probably others that I am forgetting).

And…

VI Non-Residents Cannot Claim FTC For VI Income Paid

Not a shocking holding either.  In Vento v. Comm’r, the Tax Court reviewed the case of Renee Vento (daughter of Richard), who claimed foreign tax credits on her United States return for tax she paid in the USVI.  In the year the tax arose, Renee lived in the US.  For the tax year, she filed her income tax return with VIBIR including the payment of tax claiming to be a USVI resident, and the IRS transferred her estimated US payments to VIBIR.  Later, the IRS and Courts determined she was not a USVI resident, and a notice of deficiency was issued.  An agreed assessment was determined, with Renee treated as a US resident.  Renee apparently sought a refund on the VIBIR return, but this was likely denied due to the passing of the statute of limitations.  Renee then attempted to seek credits on her US return under Section 901 for payments she made to VIBIR (and the IRS payments that were converted to VIBIR payments) for the tax year in question.  Renee also claimed that for the IRS or the Court to hold otherwise would unfairly subject her to double taxation in the US and USVI.

The IRS responded by arguing that Renee was not a USVI resident, and therefore the payments were not compulsory, so no credits could be issued.

The Tax Court agreed with the Service.  It found that Renee had no USVI source income, and therefore there was no obligation to pay tax, so the payments to VIBIR were not “taxes paid”.  Section 901(b)(1) allows a credit for “the amount of any income…tax paid or accrued during the taxable year to any…possession of the United States.”  The Court found that the holdings regarding residency did not appear to give much credence to Renee’s position, which it found undercut her argument that she had a reasonable basis for paying VIBIR.  The Court also found that Renee had not exhausted all of her potential remedies to reduce her liability to USVI.  As such, the Tax Court found Renee did not meet her burden of showing that she had validly paid tax to USVI.

Before getting to the equity argument, the Court did note that Congress did not intend that taxes paid to USVI be eligible for the foreign tax credit.  The Court viewed the coordination rules under Section 932(c) as eliminating the potential for double taxation that the FTC usually solved.  Further, the Regulations specifically state that for FTC purposes, USVI income of a Section 932(a) taxpayer is treated as income from sources within the United States.  See Reg. 1.932-1(g)(1)(ii)(B).  The Court did also note that Renee’s situation may allow her to “slip through the crack in the statutory framework,” as under the literal terms she did not earn any USVI income, but it did not believe Congress would have intended that result.  The Court did not, however, hold on this rationale, as the “taxes paid” reasoning was sufficient.

The holding ends with some statements pertaining to the equity argument:

Whatever sympathy we might have for petitioners, however, does not compel us to allow them a credit against their U.S. tax liabilities to which they are not legally entitled.16 To the extent that petitioners pay tax on the same income to both the United States and the Virgin Islands, they must seek a remedy elsewhere; they cannot find it in section 901.

Foot note 16 states:

Our sympathy for petitioners would be tempered to the extent that tax avoidance motives prompted their claims to Virgin Islands residence. While the limited record before us is silent regarding petitioners’ motivations, our agreement to base our decision on the parties’ stipulations and admissions under Rule 122 does not require us to ignore the District Court’s observation in VI Derivatives, LLC v. United States…, aff’d in part, rev’d in part sub nom. Vento v. Dir. of V.I. Bureau of Internal Revenue… that “the timing of the [Vento] family’s decision to ‘move’ to the Virgin Islands is suspicious.” According to that court, Vento family members realized a significant gain as a result of a transaction that occurred at the beginning of 2001. Becoming Virgin Islands residents for that year held out the prospect of more than $9 million in tax savings to the family.

Sounds a bit like unclean hands.  Don’t argue equity after your tax fraud-ish behavior.  A bit harsher than the original taxpayer friendly Sanders holding before the Tax Court.

While reading the case, I wondered if the taxpayer could have made an argument about the amounts paid to the US that were “covered into” USVI (payments) pursuant to Section 7654.  That is the provision that makes the US pay over any tax collections it has to the possession.  I believe USVI intervened in this case (although I could be confusing my USVI residency cases), and the US was clearly a party.  It would seem both were on notice that their transfer of funds was potentially incorrect.  I have done no research on this, so the notion could be completely off base, but it was my initial thought while reading.

Stephen Olsen About Stephen Olsen

Stephen J. Olsen’s practice includes tax planning and controversy matters for individuals, businesses and exempt entities for the law firm Gawthrop Greenwood, PC.

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Comments

  1. Joseph M. Erwin says:

    Dear Stephen,
    First, a disclaimer: I am directly or indirectly involved in all three of the cases you review here. But I will only comment on the VI Derivatives case.
    You, like the Third Circuit, completely misstate the nature of the case. The “residency” of the LLCs was never challenged at any level. It was never argued or briefed by either party until our petition for rehearing.
    The challenge of VI Derivatives and VIFX was to the jurisdiction of the District Court. The jurisdictional challenge was that the 1987 Temporary TEFRA Regulation issued under IRC 6233 was invalid because the IRS did not follow the Administrative Procedure Act. Section 6233 made the FPAA procedures applicable to sham entities “to the extent provided by regulations.” The notices of deficiency asserted these LLCs were shams. No valid regulation; no valid FPAA. No valid FPAA, no jurisdiction. This failure to adhere to the APA was first noted by Professor Andy Grewal in an article in Daily Tax Report in 2013 and commented on in this blog on Nov. 24, 2014.
    Again, the “residency” of the LLCs was and is irrelevant — except as a made-up reason for the Court to hold against the LLCs. This is what also happened in the last iteration of Petaluma on the same jurisdictional challenge. There, Judge Srinivasan came up with an incredibly novel interpretation of “effective date” that is grammatically absurd and was not argued by either the US or the taxpayer.
    Regards,
    Joe

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