Expat Tax Info from Barron HarperCongress Legislates Accuracy Penalty

By Barron Harper
www.taxbarron.com

RJ has been employed as a consular agent since 2003. As a foreign resident, he should qualify for the Foreign Earned Income Exclusion (FEIE) even though he does not report or pay taxes to the foreign country wherein he resides. To be sure, he consulted with IRS agents in Paris who told him that he qualified for FEIE because his employment was non-permanent and intermittent. As a result, RJ has taken the Foreign Earned Income Exclusion each year in filing his annual income tax return.

In 2008 he was audited by Internal Revenue Service for tax years 2006 and 2007. The auditor in a letter notified RJ that he was being denied FEIE and assessed Accuracy Penalties. On Form 886-A – EXPLANATION OF ITEMS – the auditor stated: ‘Per IRC 911(b)(1)(B)(ii), amounts paid by the United States or any of its agencies to its employees are not considered foreign earned income for the purposes of the foreign earned income exclusion.’

RJ, however, was bewildered. He had relied on the advice of IRS agents only to find their advice contradicted by another agent. In denying RJ his FEIE, the auditor was assessed additional taxes of $11,000 in 2006 and $9,000 in 2007, as well as Accuracy Penalties $2,200 ($11,000 x 20%) and $1,800 ($9,000 x 20%).

Accuracy penalties include 1) negligence or disregard of rules or regulations, 2) substantial understatement of income tax, 3) substantial valuation misstatement, 4) substantial overstatement of pension liabilities, and 5) substantial valuation misstatement in connection with gift or estate tax. In the auditor’s notice, the Accuracy Penalty was for substantial tax understatement per IRC Section 6662(d). The notice further stated: ‘If we increase your tax and the increase exceeds 10% of the corrected tax and is also equal to or greater than $5,000, the law requires an accuracy-related penalty due to substantial understatement of tax. The penalty is 20% of your tax increase.’

Human performance can be affected by a variety of factors such as age, attitude, physical health, state of mind, emotional state, and stressful events. To err is simply to be human. In addition to these contributing factors, accuracy errors in preparing a tax return occur due to missing tax documents, inexact records, mathematical mistakes, misinterpreting tax code or instructions, rush to meet filing deadlines, erroneous use of tax tables, etc.

IRS states that an Accuracy Penalty may only be decreased or waived if the taxpayer can 1) provide substantial authority (Internal Revenue Code, Regulations, Revenue Rulings, Revenue Procedures, etc.) used to treat disputed income or deduction; 2) show the facts supporting the treatment of disputed income or deduction; 3) submit a signed statement that outlines the facts supporting the treatment of understated income.

While it would appear heavy-handed that Congress should have armed the Internal Revenue Service with the power to assess Accuracy-related penalties and then allow limited defenses, taxpayers must exercise diligence in preparing their tax returns if they are to avoid the nightmare of IRS tax and penalty assessments.

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