Expanded innocent spouse relief.

In Ferrarese, TC Memo 2002-249, the Tax Court found that the IRS abused its discretion when it denied a taxpayer equitable relief from joint and several tax liability. The taxpayer filed Form 8857, Request for Innocent Spouse Relief (And Separation of Liability and Equitable Relief), asking for equitable relief from such liability for 1983, which the IRS denied.

Facts

Ruth Ferrarese and her husband Albert filed joint tax returns for 1981, 1982 and 1983. Albert had embezzled money from his company from 1975-1983. In 1983, he embezzled $392,468. Albert told Ruth about the embezzlement in January 1984, when he was fired after the embezzlement was discovered. In April 1984, Ruth agreed to allow Albert to sign their 1983 return for her. The facts do not indicate whether she saw the return before it was filed, or what happened to the embezzled money. The IRS determined a deficiency in the joint returns for 1981-1983 based on the couple's failure to report the embezzlement income.

Ruth and Albert (ages 68 and 77, respectively, at time of trial) receive a total of $1,540 per month from Social Security. Their bank account balance averaged less than $1,000 in the four months prior to the trial. Ruth owns their residence, which has a $50,000 fair market value, purchased with funds from a sale of a previous (separately owned) property. The couple's children help them make ends meet each month.

In 1993, the Tax Court granted Ruth relief from joint liability under Sec. 6013(e) for 1981 and 1982 (Ferrarese, TC Memo 1993-404, aff'd, 43 F3d 679 (11th Cir. 1994)). It decided that (1) although Ruth filed joint returns for those years, she did not know or have reason to know of the embezzled funds for those years, (2) she did not significantly benefit from those funds and (3) holding her liable for the deficiencies would have been inequitable.

Ruth's standard of living was the same in 1983 as in the two prior years, and she never received significant benefit from the embezzlement. However, the court held that Ruth was not entitled to joint relief for 1983, because she had reason to know of the 1983 understatement, before her husband (with her permission) signed her name to their 1983 return.

Law Changes

Sec. 6015 was enacted in 1998, repealing Sec. 6013(e). It is effective for any tax liability arising after July 22, 1998 and any liability arising before and remaining unpaid on that date. Under Sec. 6015(f), the IRS will grant relief if "... taking into account all the facts and circumstances, it is inequitable to hold the individual liable for any unpaid tax or any deficiency (or any portion ..." (Emphasis added.) Subsequently, Rev. Proc. 2000-15 listed eight factors to consider when deciding whether to grant Sec. 6015 (f) relief.

Rev. Proc. 2000-15

According to Rev. Proc. 2000-15, the Service will consider only the following two factors in granting relief: whether the taxpayer (1) is separated or divorced from the other spouse and (2) was abused by the spouse. It will consider, against granting relief, whether the taxpayer (1) received significant benefit from the item giving rise to the deficiency and (2) made a good-faith effort to comply with the tax laws in the years following the year to which the relief request relates. The IRS may consider the following factors in allowing or denying relief: whether (1) the taxpayer would suffer economic hardship if the request were denied, (2) the taxpayer knew or had reason to know of the item giving rise to the deficiency, (3) the deficiency is attributable to a nonrequesting spouse and (4) either spouse has a legal obligation under a divorce decree or agreement to pay the outstanding liability.

Court's Decision

In 2000, Ruth, who still owed 1983 taxes, filed Form 8857. In October, in denying the request, the IRS cited the 1993 ruling that Ruth had knowledge and reason to know of the items that gave rise to the tax deficiency. Ruth argued that the Service failed to follow Rev. Proc. 2000-15. The court found that the IRS abused its discretion in denying the request.

Essentially, according to the court, the IRS relied only on one factor (i.e., that Ruth had reason to know of the items that gave the rise to the deficiency), and ignored its responsibility to evaluate all of the facts and circumstances, including those outlined in Rev. Proc. 2000-15.

Most of the factors described in the procedure favored granting relief to Ruth, the mere fact that one or more negative factors existed was not enough to deny relief. The four favorable factors were: Ruth would suffer economic hardship, the embezzlement income was solely attributable to Albert, Ruth received no significant benefit and she was in compliance with the tax laws in subsequent years.

Conclusion

This case confirms the expanded scope of the innocent spouse relief provisions. It is hard to imagine why the Service even pursued the case, given the couple's economic circumstances. In addition, the court ruled twice on the matter--taxpayers do not often get two shots at the same issue.

The Sec. 6015 innocent spouse rules are retroactive and, in effect, supersede the previous regime. The IRS's reliance on the 1993 case failed to recognize the expanded law and the Service's own interpretation of that law.

FROM JOE SCHNEID, CPA, ALDRICH, KILBRIDE, & TATONE LLP, LAKE OSWEGO, OR