Burden of proof shifts to IRS.

Generally, if the IRS determines a taxpayer owes additional tax, it should send the taxpayer a deficiency notice describing the basis for the additional tax and any penalty due. A deficiency notice serves three purposes: (1) it notifies a taxpayer of proposed tax adjustments, (2) it gives the taxpayer an opportunity to contest the proposed adjustments in Tax Court and (3) it gives the Tax Court jurisdiction to redetermine the amount of the proposed deficiency.

In Tax Court, the taxpayer has the burden of proving that the Service's deficiency determination is incorrect. In Shea, 112 TC No. 14, the Tax Court held that, when a deficiency notice fails to describe the basis on which the Service relies to support its deficiency determination, and a new basis relied on by the IRS requires the presentation of evidence different from that necessary to resolve the issue contained in the notice, the IRS bears the burden of proof for the new basis.

In Shea, the taxpayer contested the Service's determination, based on bank deposits, that he underreported his income for 1990-1992. Shea asserted he had business deductions and was entitled to the benefit of California's community property law in calculating his 1992 income. In the deficiency notice, the IRS determined Shea's unreported income without making an adjustment for the community property law. Moreover, the notice did not refer to the community property law, any exceptions to that law or any facts that might support exceptions to it.

The Service eventually conceded that all of the disputed income was community income, but asserted that Sec. 66(b) permitted it to disallow the application of the community property law to assets the taxpayer treated as his sole property. The taxpayer contended that, because the IRS made no mention of the community property issue in its deficiency notice, its reliance on Sec. 66(b) raised a "new matter" within the meaning of Tax Court Rule 142 (a), shifting the burden to the IRS to prove the existence of a deficiency.

The IRS asserted that the invocation of Sec. 66(b) was not a new matter, because it was implicitly raised in the deficiency notice. The Tax Court rejected this assertion, stating that "the objective language in the deficiency notice remains the controlling factor."

The court concluded that the factual basis required to establish whether business income was understated is quite different from that necessary to establish whether community property law applied. Finding that the facts established only that Shea's spouse had little involvement in his business affairs and that he underreported the business's income, the court held that the Service failed to establish a factual basis to justify its invocation of Sec. 66(b).

FROM JOHN KEENAN, J.D., WASHINGTON, DC