Tax Court in Brief | Reynolds v. Comm’r | Spousal Relief, Substantial Benefit, Constructive Knowledge, and No Divorce

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The Tax Court in Brief – November 28th – December 2nd, 2022

Freeman Law’s “The Tax Court in Brief” covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.

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Tax Litigation:  The Week of November 28th, 2022, through December 2nd, 2022

Reynolds v. Comm’r, T.C. Memo. 2022-115 | November 30, 2022 |Wells, J. |Docket No. 14433-16

Short Summary: This case involves the IRS’s denial of a taxpayer’s request for innocent spouse relief following findings of deficiencies and assessment of penalties and interest for tax years 2004 through 2007. Most of the deficiencies resulted from the husband’s embezzlement of funds his employer, a church where he served as the director of finance. However, deficiencies also arose from the couple’s failure to report income earned by the wife including unemployment compensation, legal fees, and interest. The couple also failed to account for the wife’s self-employment taxes and erroneously claimed deductions for her legal practice and certain child tax credits. The husband was incarcerated for the embezzlement in 2013. In 2014, the wife received a discharge of her debts in Chapter 7 bankruptcy and timely filed Form 8857, Request Innocent Spouse Relief. The coupled did not divorce or legally separate during the incarceration. During the bankruptcy, the family lost their home to foreclosure. The wife moved in with her parents until she was able to purchase a new home in 2016. Upon release from prison in 2018, the husband moved back in with the wife and their 5 children.

Key Issue: The Tax court evaluated whether the IRS appropriately denied the petitioner wife’s request for innocent spouse relief on June 1, 2017.

Primary Holding: The petitioner wife was not entitled to full or partial relief under 6015(b), proportional relief under 6015(c), or equitable relief under 6015(f) and remained jointly and severally liable. The Tax Court evaluated the five conditions for relief under section 6015(b)(1). First, the Court found that innocent spouse relief could not apply to portions of the understatement that were attributable to her. For portions of the understatement that were attributable to the petitioner husband, the court found that the petitioner wife did not qualify for relief because (1) she had reason to know of the understatement at the time the return was signed and (2) holding her liable would not be inequitable.

The wife apparently did not have direct knowledge of the husband’s embezzlement, but the Tax Court found that the petitioner spouse had a duty of inquiry into the couple’s returns. The husband did the taxes and primarily handled their finances, but the court found that the wife should have known about the understatements for the following reasons:

  1. She used jointly held accounts to cover household expenses in which the embezzled payments were deposited in addition to the husband’s biweekly payments from the church.
  2. She reviewed the returns before signing them.
  3. She was responsible for many household purchases and should have known the family’s income far exceeded what they reported.
  4. Her legal training should have alerted her to a likely understatement.
  5. She derived a significant benefited from the understatements. The couple sent their kids to private school and the husband purchased the wife gifts such as a vintage coat, a diamond anniversary ring, and a designer handbag.

The court held that the wife could not elect under section 6015(c) to limit liability consistent with section 6015(d) and could not elect proportionate relief. Those options apply, respectively, when the requesting spouse is (i) divorced or legally separate from the other spouse or (ii) not a member of the same household during 12-month period ending on the date section 6015 relief is requested. Despite the petitioners’ argument to the contrary, the Tax Court found the petitioners were never legally separated under Maryland law during the husband’s incarceration and that they remained part of the same household.

Finally, the court applied the analysis stipulated by Revenue Procedure 2013-34 and found that the petitioner wife was not entitled to equitable relief under section 6015(f). The respondent conceded that the petitioner wife met the seven threshold conditions for equitable relief, but the court agreed she failed to qualify for a “streamlined determination” because the couple was still married. Therefore, the finding as to equitable relief was appropriately based on the facts and circumstances for the same reasons that she did not qualify under section 6015(b).

Key Points of Law: