IRS Grants Extension for Treaty-Based Sourcing Election Under § 865(h)(2)(A)

IRS Grants Relief for Missed Treaty-Based Sourcing Election: A $5M+ Tax Savings Opportunity

The IRS granted a 120-day extension to taxpayers who missed a critical treaty-based sourcing election under Section 865(h)(2)(A), potentially saving over $5 million in U.S. tax liability by treating gains from the sale of foreign stock as foreign-source income. The relief, issued under Treas. Reg. § 301.9100-3, hinged on the taxpayers’ reasonable reliance on tax professionals who failed to advise them of the election’s availability. While the ruling is non-precedential, it establishes a narrow but significant precedent for taxpayers seeking late regulatory elections under international tax treaties.

The $5M Mistake: A Missed Election and Its Consequences

In Tax Years 1 and 2, Individual A held interests in partnerships that sold stock in foreign corporations established in Country X. The partnerships reported the resulting capital gains as U.S.-source income, subjecting them to U.S. tax despite Individual A already paying tax in Country X on the same gains.

Firm O, the taxpayers’ U.S. tax compliance provider, failed to advise them of the Section 865(h)(2)(A) election, which allows U.S. taxpayers to treat gains from the sale of personal property as foreign-source income if the property is sold outside the U.S. and attributable to a foreign office. Firm O filed the taxpayers’ returns without making the election. Individual A later discovered the election’s availability from Firm P in Year 4, but the deadline to make the election had passed.

The Legal Battle: Why the IRS Initially Resisted (And Why It Relented)

The IRS initially resisted granting relief due to strict timing rules for treaty-based sourcing elections under Treas. Reg. § 301.9100-3, which requires elections to be made on a timely filed tax return. Under Section 865(h)(2)(A), the election to treat gain from the sale of personal property as foreign-source income must meet this deadline, reinforced by Article 25(3) of the U.S.-Country X Treaty, which defers to domestic sourcing rules unless the treaty explicitly overrides them.

The IRS also cited Treas. Reg. § 301.9100-3, which allows late elections only if the taxpayer acted reasonably and in good faith and the grant of relief wouldn’t prejudice the Government. The agency interpreted "prejudice" narrowly, ensuring relief wouldn’t reduce aggregate tax liability. The IRS’s stance shifted when professional reliance became evident: the rules were clear, but the taxpayer’s delay was unintentional and correctable.

The IRS's Rationale: Why Reliance on Tax Professionals Saved the Day

The IRS reversed its hardline stance after taxpayers demonstrated reasonable reliance on Firm O, which failed to advise them of the § 865(h)(2)(A) election. Under Treas. Reg. § 301.9100-3(b)(1)(v), the IRS grants relief for late elections when the taxpayer demonstrates good faith reliance on a tax professional who provided incorrect advice. The agency determined this standard was met, as the taxpayers had no reason to suspect the omission.

The IRS found no prejudice to the Government—granting relief would not reduce aggregate tax liability, as the election would merely restore the treatment the taxpayers would have received had it been timely made. This shifted the focus from a precedent-setting rewrite of tax outcomes to a narrow correction of professional error. The IRS ultimately granted a 120-day extension to file the § 865(h)(2)(A) election, allowing the taxpayers to claim foreign-source treatment under the U.S.-Country X Treaty for gains from stock sales of Country X foreign corporations.

What This Means for Taxpayers: A Narrow but Critical Precedent for Treaty Elections

The IRS’s decision to grant relief under Treas. Reg. § 301.9100-3—allowing a 120-day extension to file a § 865(h)(2)(A) election—creates a non-precedential but instructive precedent for taxpayers who missed treaty-based sourcing elections. While Section 6110(k)(3) bars the PLR from being cited as authority, it signals the IRS’s willingness to correct professional errors when taxpayers demonstrate good faith reliance on advisors.

Taxpayers who missed similar elections should immediately assess eligibility under § 301.9100-3, particularly if they relied on tax professionals. The IRS’s shift suggests documented advisor reliance and proactive correction may outweigh strict timeliness. Relief is unlikely without clear evidence of reasonable cause (e.g., advisor missteps, administrative oversights).

Taxpayers with foreign partnerships, cross-border capital gains, or treaty-based sourcing disputes should review past elections. The ruling underscores the IRS’s focus on substance over form, meaning elections tied to real foreign offices or treaty benefits are more defensible.

Action items:

• File a PLR request with detailed documentation of reliance on advisors and the election’s tax impact.
• Timing is critical: delays beyond 120 days may face stricter scrutiny.
• Attach the PLR to filings for those with pending audits to strengthen a good-faith defense.