Equitable Relief Granted to Innocent Spouses
| Equitable Relief Granted to Innocent Spouses |
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The Tax Court in two recent cases granted innocent spouse relief to taxpayers. In Brown, TC Summary Opinion 2008-121 , the court held that the taxpayer was entitled to equitable relief from liability for self-employment taxes attributed to her on a joint return because her abusive spouse kept her in the dark about the family's finances, and she would suffer economic hardship if she were forced to pay the taxes. The court also granted equitable relief to the taxpayer in Schwind, TC Summary Opinion 2008-119 , but only for taxes that had not already been paid. Brown. During the 1990s the taxpayer and her husband, Stephen, worked in real estate in Florida, California, and Hawaii. They had two children, but Stephen was unstable and abusive. He had alcohol problems, and at times would hit the taxpayer and threaten to take the children away from her. In 1999, the couple moved to Nevada for new opportunities in real estate. In 2000, the year at issue, Stephen and the taxpayer worked in Las Vegas for two time share companies for which Stephen was the sales manager, and the taxpayer was a salesperson working under him. As manager, Stephen would receive the taxpayer's occasional commission checks for distribution to her, but would not give them to her, except to obtain her endorsement. He would then take the checks and cash or deposit them as he saw fit. Throughout her marriage, the taxpayer had no access to the family's financial accounts, and Stephen paid all the bills. He was in total control of the finances related to the marriage and the family, including the income the taxpayer earned at work. Stephen and the taxpayer had a major altercation at their home in September 2000, and the police were called. Stephen kept the taxpayer from entering the office when she arrived at work the next morning. They separated, and Stephen prevented the taxpayer from working the remainder of 2000. She later went to work for the same real estate company, but in a separate department and building from Stephen. In 2001, Stephen prepared a 2000 joint federal income tax return that reported a $20,918 net income, zero income tax liability (after a $656 child tax credit), and a $2,956 self-employment tax liability. The reported net income was allocated between Stephen and the taxpayer equally, and accordingly a self-employment tax liability was reported for Stephen and the taxpayer of $1,478 each. The taxpayer signed the return, but she did not participate in any other way in its preparation, and she was not allowed to review the return before signing it. She was not aware of the equal allocation on the net income, nor was she aware of the self-employment tax liability reported for her In January 2002, the taxpayer and Stephen divorced. Pursuant to the divorce decree, Stephen was obligated to pay the taxpayer $40,000, but he made only one $700 payment to her. As a result of the abuse she experienced, the divorce, and several serious accidents, the taxpayer's physical condition was poor, and she was unable to work. In connection with preparing and filing her 2003 federal tax return, the taxpayer learned of a significant amount of joint federal taxes that Stephen had never paid. She filed a request for innocent spouse relief with the IRS for the outstanding federal income taxes for the years in question. Under Section 6015, the Service granted in full her request for relief from the 1991, 1997, and 1998 joint federal income tax liability. However, the IRS granted the taxpayer relief from only one-half of the $2,956 reported self-employment taxes shown on the 2000 return. It said that although half was attributable to Stephen, the other half was attributable to her taxable income, and relief was not warranted. The Tax Court said that section 4.01 of Rev. Proc. 2003-61, 2003-2 CB 296, sets forth seven threshold conditions that a taxpayer seeking equitable relief from joint liability under Section 6015(f) is required to satisfy. The IRS argued that the taxpayer failed to satisfy section 4.01(7) because half the reported net income in the 2000 return was “attributable to” her. The taxpayer asserted that the amount in question was actually earned by her former husband, not by her, and so the amount was not attributable to her. She also claimed that she qualified for the abuse exception to the seventh threshold condition (section 4.01(7)(d)). The court agreed that the taxpayer satisfied the abuse exception. It said that Stephen's control and abuse of the taxpayer was “extensive” and established that her fear of retaliation and further abuse was the reason she did not challenge his preparation of the 2000 federal income tax return, and his equal allocation of the reported income and taxes. Once these threshold conditions under section 4.01 are satisfied, the taxpayer must next satisfy three further conditions under section 4.02. The taxpayer satisfied the first condition because she was no longer married to Stephen. The IRS disputed whether the taxpayer satisfied the other two. The IRS claimed that the taxpayer knew or had reason to know that Stephen would not pay the self-employment taxes shown due on the 2000 return (Rev. Proc. 2003-61, section 4.02(1)(b)). It argued that because of the couple's difficult relationship and because when she signed the return she knew of their financial troubles, the taxpayer should have anticipated that Stephen would fail to pay the self-employment taxes. The court disagreed, pointing out that Stephen kept the taxpayer in the dark about the family's finances, including tax payments. He did not allow her to review any financial records or tax returns, and she had essentially no knowledge of the family's finances or tax liabilities. The court concluded that the taxpayer established that it was reasonable for her to believe that Stephen would pay the taxes The Service also asserted that the taxpayer would not suffer economic hardship if she were denied relief from liability for the $1,478 of 2000 self-employment taxes. Economic hardship under Rev. Proc. 2003-61, section 4.02(1)(c), exists if satisfaction of the liability in whole or in part would result in the taxpayer's inability to pay reasonable living expenses. The court disagreed with the Service's assessment, noting that the taxpayer was living from day to day with help from family and friends and that her medical condition prevented her from working and earning income. It concluded that the denial of the taxpayer request for relief would cause her economic hardship. Schwind. The taxpayer and her husband, David, were married in 2001. David was employed as an engineer until June 2003 when his employer terminated his employment. He was able to find new employment by the end of 2003. In December 2003, David sold his stock holdings in his former employer for $99,900, but did not withhold any federal income tax. He deposited the check a few months later in the couple's joint checking account. Although the account was used to deposit their paychecks and to pay household bills, David would not allow the taxpayer to open or review the account statements. David prepared the couple's 2003 federal income tax return. The taxpayer did not participate in its preparation, beyond providing her Form W-2, but David did allow her to review the return before he filed it. On the return, David reported $66,332 in withholdings, while third-party records showed withholdings of only $36,331. The IRS determined that the couple had overstated their withholdings by $30,001, and issued a notice to the couple in May 2005 that they owed $31,656 in 2003 taxes. In the interim, both David and the taxpayer had left the marital home, and divorce proceedings were instituted in 2005, with the divorce being finalized in February 2006. In January 2006, David and the taxpayer entered into a property settlement agreement in which they agreed that they had a potential 2003 tax liability of $31,656. It also stated that David had paid that amount to the IRS and that the taxpayer had paid half that amount to David as her share of the liability. David agreed to pay any additional 2003 tax liabilities. While the divorce was pending, the taxpayer submitted a request for innocent spouse relief to the IRS, which denied relied under Sections 6015(b), (c), and (f) because it asserted that the taxpayer knew or had reason to know of the excess withholding when the return was filed. She then appealed to the Appeals Office, which denied relief because the item “leading to the understatement was not attributable” to David. In the interim, David made a $31,656 payment on behalf of himself and the taxpayer. Subsequently, the IRS determined that David and the taxpayer were liable for a $3,000 addition to tax under Section 6651(a)(2), plus interest. According to the notice of determination, the unpaid balance of income tax due from the taxpayer was $4,367. The amount of 2003 income tax relief sought by the taxpayer was $30,001. As in Brown, the Tax Court examined Rev. Proc. 2003-61 to determine if the taxpayer was entitled to relief. It said that the only section 4.01 threshold condition in contention was the attribution factor in section 4.01(7) The court agreed with the taxpayer that the overstated withholding credits should be attributed to her ex-husband because he prepared the return and wrongfully reported the overstated amounts. It did not matter, as the IRS contended, whether the overstated withholding was related to David's stock sale. Next, the court found that the taxpayer failed the section 4.02 conditions (specifically section 4.02(1)(a)) because she was not divorced or legally separated when she requested relief, and the couple resided together within the six-month period preceding her request. That left the court to weigh the nonexhaustive list of factor contained in section 4.03 to determine whether relief should be granted: (1) Marital status. The taxpayer was separated from David when she requested relief. (Factor weighs in favor of relief.) There was no evidence presented on the final three factors (compliance with federal laws, abuse, and mental or physical health), so they were neutral. After weighing the factors (three in favor, one against, four neutral, the court determined that the taxpayer was entitled to relief under Section 6015(f). While the economic hardship factor weighed against her, the court decided that it did not outweigh the other factors. Although the taxpayer was entitled to innocent spouse relief, the court pointed out that Rev. Proc. 2003-61, section 4.04(2) provides that in a case involving an underpayment of income tax, a requesting spouse is not eligible for refunds of payments made with the joint return, joint payments, or payments made by the nonrequesting spouse. Therefore, the taxpayer was not entitled to a refund of her withholdings paid on the joint return or the $31,656 payment made by her ex-husband, of which she paid half. The only bright note for the taxpayer was that she was at least off the hook for $4,367, which represented the unpaid addition to tax and interest. |
