How to remedy the situation (and get back in the good graces of the IRS!)
Most Americans living and working overseas are aware that $80,000 of foreign earned income can be exempted when certain foreign residency requirements are met. It may not be so obvious, however, that every year a federal tax return should be filed reporting that income.
Up until 1993 the rules in this area were quite harsh. If a taxpayer did not file a tax return within a certain period of time after the normal due date, he/she lost the right to claim the foreign earned income exclusion. This meant that the $80,000 (or whatever the actual income was) would be included as taxable income and, in addition, penalties and interest from the due date of the return could be assessed. These amounts, accumulating over a period of years, could have devastating financial consequences for the taxpayer.
The rules changed in 1993 with the issuance of a Treasury Decision that permits you to take the foreign earned income exclusion for any tax year no matter when you file so long as no tax is owed. A taxpayer falling into this category should file a tax return for each year in question and should put at the top of each 1040 the words "FILED PURSUANT TO SEC.1.911-7(a)(2)(i)(D)".
If it turns out the taxpayer actually owes tax, but the I.R.S. has not discovered either that fact or the fact that the return was not timely filed, the taxpayer can still take advantage of the foreign earned income exclusion by following the above procedure (i.e., file and put the words "Filed Pursuant to Sec. 1.911-7(a)(2)(i)(D)" at the top of the 1040). And, of course, pay the tax due. If interest and penalties are due, the I.R.S. will be in touch!
In cases where the I.R.S. has discovered that the taxpayer both didn’t file and owes taxes, the taxpayer can seek a Private Letter Ruling wherein he asks the I.R.S. for relief from the filing requirement on the grounds that there was a good reason for not filing.
Unfortunately, a Private Letter Ruling is costly--$500 for taxpayers with income less than $150,000 and $2500 for taxpayers with income exceeding $150,000. Those amounts are payable to the I.R.S. In addition, it is recommended that professional help be retained to submit the request for a Private Letter Ruling which, of course, would entail additional cost.
One final note. There is no Statute of Limitations when a tax return is not filed (meaning there in no time limitation on when tax can be assessed).