By Steven R. Diamond, CPA
George C. Huff, Petitioner v. Commissioner of Internal Revenue, Respondent 135 T.C. No. 10
Generally, a U.S. citizen or resident who has income from sources within the U.S. Virgin Islands or income effectively connected with a trade or business in the U.S. Virgin Islands is required to file an income tax return with both the United States and the U.S. Virgin Islands.
However, an individual who qualifies as a bona fide resident of the U.S. Virgin Islands will generally have no U.S. tax liability as long as the taxpayer reports all income from all sources to the U.S. Virgin Islands.
The question put before the U.S. Tax Court in this case is whether the Tax Court has jurisdiction to re-determine federal income tax deficiencies of a U.S. citizen who claims to be a bona fide resident of the U.S. Virgin Islands and therefore exempt from filing and payment requirements of U.S. income tax returns and taxes.
Mr. Huff (petitioner) is a U.S. citizen and resided in Florida when he filed his Tax Court petition in May 2009. He claims to have been a bona fide resident of the U.S. Virgin Islands at the close of tax years 2002, 2003, and 2004, and he filed territorial income tax returns with the Virgin Islands Bureau of Internal Revenue (BIR) for those years.
In February 2009, the Commissioner issued a notice of deficiency to the petitioner for taxes and penalties for years 2002-2004. Attached to the notice of deficiency was Form 4549-A with the following explanation:
“It is determined that during the taxable years 2002-2004 you were not a bona fide resident of the U.S. Virgin Islands (USVI). It is also determined that you participated in a tax avoidance scheme which involved improperly claiming to be a resident of the USVI and superficially recasting U.S.-source income as USVI source income in order to inappropriately and invalidly claim a tax credit of 90% under the USVI Economic Development Program. It has also been determined that all transactions between NASCO Corporate Finance Consultants, LLC (NASCO) and American Benefits Institute, Inc. (ABI), Employers International, Inc. (EI), Professional Advisory Group, Inc. (PAG) and George C. Huff, including any entity controlled or owned in whole or in part by George C. Huff, are part of a series of step/sham transactions devoid of economic substance and will not be recognized for U.S. federal income tax purposes. These step/sham transactions were part of a larger tax avoidance scheme and were entered into solely in an attempt to superficially recharacterize U.S.-source income as USVI-source income in order to inappropriately and invalidly claim a tax credit of 90% under the USVI Economic Development Program.”
In addition to filing a petition with the U.S. Tax Court, petitioner filed a complaint petition for redetermination of income taxes against the Commissioner of Internal Revenue in the U.S. District Court, District of the Virgin Islands, St. Thomas, and St. John Division.
The Virgin Islands is an insular area of the United States and is neither one of the 50 states nor the District of Columbia. It is generally treated as a foreign country for U.S. tax purposes.
In 1921, Congress set up a mirror tax system which effectively substituted United States for Virgin Islands so that an individual or corporation in the Virgin Islands pays taxes to the BIR under the same circumstances as the individual or corporation would pay taxes to the IRS. Under the mirror tax system, both individuals and entities were required to file two tax returns, paying tax to the BIR on income from the Virgin Islands and filing a tax return with the IRS, paying tax on worldwide income and taking a credit for tax paid to the Virgin Islands.
In the Tax Reform Act of 1986, the mirror tax system was modified so that an individual who is a bona fide resident of the U.S. Virgin Islands and incurs income tax obligations to both the U.S. and the U.S. Virgin Islands may satisfy his reporting and payment requirements by filing and paying only to the U.S. Virgin Islands if he satisfies each of following three requirements of IRC Sec. 932(c)(4):
- Is a bona fide resident of the Virgin Islands at the close of the taxable year,
- Who, on his return of income tax to the Virgin Islands, reports all income from all sources and identifies the source of each item shown on such return, and
- Who fully pays his tax liability referred to in Sec. 934(a) to the Virgin Islands with respect to such income.1
If the individual fails to meet any of the requirements, then a federal income tax return must be filed with the IRS and the individual may be liable for taxes in both the U.S. and the U.S. Virgin Islands.
The term “bona fide resident of the Virgin Islands” is not defined in the Code but Congress authorized the secretary to promulgate regulations for determining Virgin Islands residency. For the years at issue however, regulations had not been written defining a “bona fide resident of the Virgin Islands.” But in Notice 2004-45, the Commissioner stated the determination will turn on the facts and circumstances of the individual’s intent with respect to the nature and length of his stay in the Virgin Islands.
A Virgin Islands taxpayer may petition the District Court to re-determine a Virgin Islands tax deficiency determined by the BIR in the same manner a U.S. taxpayer may petition the U.S. Tax Court. The District Court has exclusive jurisdiction over the income tax laws applicable to the Virgin Islands except the ancillary laws relating to the income tax enacted by the legislature of the Virgin Islands.2
In order to encourage economic development in the Virgin Islands, Congress permitted the Virgin Islands to reduce certain taxes. Pursuant to that, the Virgin Islands’ government enacted several investment incentives, including the Virgin Islands Industrial Development Program (EDP). The EDP granted participating companies substantial benefits including a ninety percent exemption on local income taxes, a ninety percent exemption on taxation of dividends, and a 100 percent exemption on gross receipts taxes.
In 2004, the IRS determined that certain tax advisors were encouraging taxpayers to take highly questionable and often meritless positions to claim the benefits of the EDP. The IRS stated the promoters of these plans claim that individuals who participate in the plan can continue to work in the U.S. and still be a bona fide resident of the Virgin Islands; Virgin Islands income includes income from services performed in the U.S.; for purposes of determining source of income, the Virgin Islands includes the U.S.; and non-Virgin Islands income can be treated as effectively connected with the conduct of a trade or business within the Virgin Islands even if under equivalent circumstances that type of income would not be considered effectively connected with the conduct of a U.S. trade or business. The Commissioner determined that the petitioner participated in these types of transactions.
The Tax Court may exercise jurisdiction only to the extent authorized by Congress, but the Court has authority to determine whether it has jurisdiction over a particular case.
The petitioner took the position that the deficiencies relate to a Virgin Islands tax matter and the Tax Court lacks jurisdiction. The petitioner referred to IRC Sec. 932 and Sec. 934 and claimed that jurisdiction over the underlying issues belongs to the District Court pursuant to the provisions of 48 U.S.C. Sec. 1612(a). The petitioner stated that 48 U.S.C. Sec. 1612(a) grants exclusive jurisdiction to the District Court with regard to Virgin Islands income tax laws and that the Tax Court and any other court lacked jurisdiction with respect to income tax laws applicable to the U.S. Virgin Islands. Petitioner also maintained that even though an individual may have both federal and Virgin Islands tax obligations under IRC Sec. 932, this does not affect the exclusive jurisdiction of the district court.
The Tax Court went on to state that U.S. citizens are subject to federal taxation on their worldwide income, and as a U.S. citizen, petitioner is required to file a federal income tax return and use his worldwide income to calculate his federal income tax. However, if the petitioner satisfied all three requirements of IRC Sec. 932(c)(4), then the amount of gross income reported on his Virgin Islands tax return is not includible in determining gross income for purposes of the petitioner’s federal income tax. The Tax Court stated that the petitioner’s gross income for purposes of calculating his income tax liability to the United States would be zero, and therefore petitioner would have no gross income for federal income tax purposes and would not need to file a federal income tax return. But if petitioner did not satisfy all three requirements of IRC Sec. 932(c)(4), then he would have been required to file a federal income tax return for each of the three years at issue. Whether petitioner actually satisfied all the requirements of IRC Sec. 932(c)(4) is in dispute and is a matter in which the Tax Court has jurisdiction to decide. Because the subject matter of the petition is within the Tax Court’s jurisdiction, the Tax Court denied petitioner’s motion to dismiss for lack of jurisdiction. EA
1 IRC Sec. 932(c)(4)
2 48 U.S.C. Sec. 1612(a) (2006)
Steven R. Diamond is a CPA with a tax practice located in Westport, CT. His practice is limited to compliance issues and representation before the IRS. He has his M.S.M. degree in taxation from Florida International University and is admitted to practice before the United States Tax Court. Diamond also taught a course preparing EAs and CPAs to take the Tax Court admission exam for non-attorneys.