The revised innocent spouse equitable relief rules: renewed controversy over the knowledge factor.
To redress the potential unfairness of joint tax returns, Congress implemented the innocent spouse relief provisions under IRC section 6015. Three types of innocent spouse relief are provided. IRC section 6015(b) prescribes the traditional relief, where an innocent spouse who did not know or had no reason to know about the understatement of tax may be relieved from the tax deficiency. IRC section 6015(c) offers a separate liability election that allows the requesting spouse to limit individual liability to the portion allocated to her. If an innocent spouse does not qualify for relief under IRC sections 6015(b) or (c), section 6015(f) equitable relief may be granted by the IRS; this occurs when, taking into account all the facts and circumstances, it is inequitable to hold the individual liable for any unpaid tax or any deficiency. Most of the cases decided by the Tax Court entail innocent spouse equitable relief under IRC section 6015(f). Accordingly, issues related to this type of relief attract more taxpayers' attention and are the focus on this analysis.
To establish guidelines for granting innocent spouse equitable relief, the IRS originally issued Revenue Procedure 2000-15, which later was superseded by Revenue Procedure 2003-61. Revenue Procedure 2013-34 now replaces the latter guidance. Generally, to be considered for equitable relief, a requesting spouse should meet seven threshold conditions. Furthermore, the IRS will make streamlined determinations granting equitable relief in cases where the requesting spouse is no longer married to the nonrequesting spouse, would suffer economic hardship if relief were not granted, and did not know or had no reason to know about the understatement or deficiency on the joint tax return. When the requesting spouse does not qualify for the streamlined equitable relief, the IRS will make the relief decision on the basis of several important factors, including marital status, economic hardship, knowledge or reason to know, legal obligation, whether a significant benefit was received, compliance with tax laws, and mental or physical health. In addition, abuse or financial control by the non-requesting spouse are two important factors that may result in certain factors (e.g., the knowledge factor and the significant factor) weighing in favor of equitable relief when they might otherwise weigh against relief. Nevertheless, no single factor is decisive, and the IRS will weigh all relevant elements, regardless of whether they are listed in Revenue Procedure 2013-34.
The Knowledge Factor
The knowledge factor has been included in the equitable relief rules since the IRS issued Revenue Procedure 2000-15. There are two types of knowledge: actual knowledge and constructive knowledge. Actual knowledge means that the requesting spouse in fact had knowledge of an erroneous item or unpaid tax liability; constructive knowledge means that, even where the requesting spouse did not actually know about the erroneous item or unpaid tax liability, she had reason to have known about it.
As shown in Exhibit 1, the weighting of die knowledge factor has changed along with different versions of the equitable relief rules. Under Revenue Procedure 2000-15, when a requesting spouse knew or had reason to know of the item giving rise to a deficiency or an underpayment, the knowledge factor was treated a strong factor weighing against relief. However, this weighting was revised under Revenue Procedure 2003-61 to become more lenient to taxpayers regarding constructive knowledge. That is, reason to know of an item giving rise to the deficiency would not be weighed more heavily than other factors, while actual knowledge would still weigh heavily against relief. Revenue Procedure 2013-34 further revised the weighing method regarding the actual knowledge. Namely, actual knowledge of an item giving rise to the deficiency is not weighed more heavily than any other factor under Revenue Procedure 2013-34. Consequently, neither the constructive knowledge nor the actual knowledge should be weighed more heavily than any other factor.
The IRS includes the knowledge factor when considering whether to grant equitable relief. This inclusion, however, may give rise to certain practical issues.
First, consideration of the knowledge factor in equitable relief decision-making has been much debated. Some have argued that it is counterintuitive to include the knowledge factor in the equitable relief requirements (G. Fleischman and J. Bryant, "A Critique of the Innocent Spouse Equitable Relief Provisions," Tax Notes, Mar. 19, 2001, pp. 1716-1720). Congress intended equitable relief to be a safety net for spouses unable to receive relief under IRC sections 6015(b) and (c). Many of these failures were caused by spouses' actual knowledge or constructive knowledge. Therefore, inclusion of the knowledge factor in the equitable relief rules could contradict Congress's intent and be inappropriate and unhelpful (G. Fleischman and S. Valentine, "Professionals' Tax Liability Assessments and Ethical Evaluations in an Equitable Relief Innocent Spouse Case," Journal of Business Ethics, vol. 42, pp. 27-44, 2003).
Moreover, the innocent spouse equitable relief rules stipulate that when the factors in favor of equitable relief are unusually strong or compelling, it may be appropriate to grant equitable relief even with the existence of actual knowledge or constructive knowledge [see Revenue Procedure 2000-15 section 4.03(2)(b) and Revenue Procedure 2003-61 section 4.03(2)(a)(iii)(B)]. In practice, this exception applies rarely. One study found that only 5 of 78 Tax Court cases in which the knowledge factor was weighed against relief (Englebrecht, Pierce, and Chiang 2007). Therefore, it is likely that if a requesting spouse had actual knowledge or constructive knowledge, she would probably be denied for equitable relief.
Second, the presence of abuse outweighing the knowledge factor is a practical concern. The revenue procedures indicate that the presence of abuse by the non-requesting spouse may result in the knowledge factor weighing in favor of relief when otherwise it may have weighed against [Revenue Procedure 2003-61 section 4.03(2)(b)(i); Revenue Procedure 2013-34 section 4.03(2)(c)(iv)]. In one survey, business professionals, including accounting managers, human resource managers, and sales and marketing managers were asked to decide whether to grant equitable relief in a scenario where constructive knowledge exists (G. Fleischman, S. Valentine, and D. Finn, "Ethical Reasoning and Equitable Relief," Behavioral Research in Accounting, vol. 19, pp. 107-132, 2007). Using the presence of abuse as a control, the researchers found that although the abuse factor was positively related to relief judgment, it was not compelling enough to overcome the knowledge factor.
A third issue is how to weigh the knowledge factor against other factors. Revenue Procedure 2013-34 states that actual knowledge of an item giving rise to the understatement or deficiency will not be weighted more heavily than any other factor. But researchers found that three equitable relief factors (economic hardship, knowledge, and sole attribution) were found to be more influential by Tax Court judges (G. Whittenburg, I. Horowitz, and W. Raabe, "Determining Innocence in Innocent-Spouse Court Cases Using Logit/Probit Analysis," Advances in Taxation, vol. 17, pp. 143-165, 2006). Among the three, the knowledge factor was found to be the most influential. Now that Revenue Procedure 2013-34 has set new rules for the knowledge factor, it remains to be seen whether the judicial system.
The weighting methods of the knowledge factor under Revenue Procedure 2013-34 are more favorable to equitable relief claimants. But because actual knowledge used to weigh heavily against equitable relief, it is worthwhile to inquire how the new knowledge rules have been applied in court so far. As of June 24, 2015, there have been 21 Tax Court rulings under Revenue Procedure 2013-34. A selection of six cases provides useful examples to explore the practice of the knowledge factor. Exhibit 2 provides the details of these cases.
The knowledge factor weighed against equitable relief in all six of these cases but taxpayers were granted equitable relief in three cases [Demeter (T.C. Memo 2014-238), Howerter (T.C. Summary Opinion 2014-15), and Raschke (T.C. Summary Opinion 2014-32)]. In the past, when the knowledge factor weighed against relief, the relief request was generally denied. Therefore, it seems that the new rules would increase the probability that a taxpayer will be granted equitable relief. On the other hand, the knowledge factor is still very determinative. In the three other cases [Barrera (T.C. Summary Opinion 2014-30), Zelasko (T.C. Summary Opinion 2014-52), Ehrmann (T.C. Summary Opinion 2014-96)], the knowledge factor was the only factor weighing against relief while other factors were either neutral or favored relief; nonetheless, the requesting spouses were denied equitable relief. As such, further inquiry into these decisions and an analysis of why the court denied equitable relief is warranted:
* In Barrera, the Tax Court noted that the requesting spouse acted as the non-requesting spouse's attorney-in-fact on the joint return and possessed the bank records which documented most of the unreported wages. In addition, the requesting spouse would not have suffered economic hardship and the requesting spouse and the non-requesting spouse agreed in the divorce decree to pay equal shares of the tax deficiency.
* The Tax Court in Zelasko noted that the requesting spouse, who had obtained significant relief under IRC section 6015(c), was aware of a portion of the omitted income and would suffer no economic hardship.
* In Ehrmann, the Tax Court's decision was rendered because the requesting spouse knew of the non-requesting spouse's long history of tax noncompliance, was actively involved with the non-requesting spouse's business activities that had generated the unpaid tax liability, knew that the non-requesting spouse failed to make estimated tax payments, exercised considerable control over the household finances and decision-making, and would not suffer economic hardship if relief were denied.
Analysis. These decisions reveal several points. First, the knowledge factor still plays an important role in denying equitable relief. Although Revenue Procedure 2013-34 does not weight actual knowledge more heavily than other factors, the Tax Court in these cases seemed to give heavy weight to the knowledge factor. Second, "no economic hardship" should be weighed as neutral under Revenue Procedure 2013-34, but the Tax Court in these cases weighted "no economic hardship" against relief. It would seem that the Tax Court was still following Revenue Procedure 2003-61 in this regard. Third, even if the number of factors in favor of relief is greater than the number of factors against relief, the Tax Court might still deny the relief request. The court has noted that the decision of whether relief is appropriate is not based on a simple tally of those factors (Hudgins, T.C. Memo 2012260). Finally, in Porter (132 T.C. 203), the Tax Court adopted a de novo scope and standard of review in determining whether equitable relief was warranted. As a result, although the Tax Court will consider the IRS's guidelines for equitable relief, the court is not bound by them (Pullins, 136 T.C. 432). That is, the Tax Court might not follow the new rules regarding actual knowledge under Revenue Procedure 2013-34.
Early Pattern of Relief
Revenue Procedure 2013-34 provides more lenient rules for innocent spouse equitable relief. Specifically, actual knowledge of an item giving rise to a tax deficiency will not be weighted more heavily than any other factor. However, the knowledge factor has raised some practical concerns in the past that may persist into the future. An analysis of cases ruled by the Tax Court under Revenue Procedure 2013-34 reveals the judicial opinions on the new rules. While the Tax Court is not bound by the new weighting methods regarding actual knowledge under Revenue Procedure 2013-34, the new rules have changed the Tax Court's decision pattern, resulting in the granting of more equitable relief when actual knowledge was present. Nevertheless, because Revenue Procedure 2013-34 is relatively new at this juncture, taxpayers should be wary as to whether these judicial practices will continue in the future.
Wei-Chih Chiang, DBA, is an assistant professor of accounting, Yingxu Kuang, DBA, is an assistant professor of accounting, and Ziyun Yang, PhD, is an assistant professor of accounting, all in the school of business administration at the University of Houston-Victoria, Sugar Land, Texas.
EXHIBIT 1 Weighting of the Knowledge Factor Weighting for Equitable Relief Revenue Procedure Actual Knowledge Constructive Knowledge Revenue When a requesting spouse When a requesting spouse had Procedure knew of the item giving rise reason to know of the item 2000-15 to a deficiency or the giving rise to a deficiency underpayment, it is an or the underpayment, it is extremely strong factor an extremely strong factor weighing against relief. weighing against relief. Revenue In a deficiency case, actual In a deficiency case, reason Procedure knowledge of the item giving to know of the item giving 2003-61 rise to the deficiency is a rise to the deficiency does strong factor weighing not weigh more heavily than against relief. other factors. Revenue In a deficiency case, actual If the requesting spouse had Procedure knowledge of the item giving reason to know of the item 2013-34 rise to the deficiency does giving rise to the not weigh more heavily than understatement, the any other factor. knowledge factor weighs against relief. EXHIBIT 2 Summary of Judicial Opinions Equitable Relief Factors Marital Economic Case Relief? Status Hardship Knowledge Demeter, T.C. Granted Favor Favor Against Memo 2014-238 Howerter, T.C. Granted Favor Neutral Against Summ. 2014-15 Raschke, T.C. Granted Favor Favor Against Summ. 2014-32 Barrera, T.C. Denied Favor Neutral Against Summ. 2014-30 Zelasko, T.C. Denied Favor Neutral Against Summ. 2014-52 Ehrmann, T.C. Denied Favor Neutral Against Summ. 2014-96 Equitable Relief Factors Mental or Legal Significant Compliance Physical Case Obligation Benefit Health Demeter, T.C. Favor Favor Favor Neutral Memo 2014-238 Howerter, T.C. Neutral Favor Favor Neutral Summ. 2014-15 Raschke, T.C. Neutral Favor Neutral Favor Summ. 2014-32 Barrera, T.C. Neutral Neutral Favor Neutral Summ. 2014-30 Zelasko, T.C. Neutral Favor Favor Neutral Summ. 2014-52 Ehrmann, T.C. Neutral Favor Favor Neutral Summ. 2014-96
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|Title Annotation:||Taxation: federal taxation|
|Author:||Chiang, Wei-Chih; Kuang, Yingxu; Yang, Ziyun|
|Publication:||The CPA Journal|
|Date:||Oct 1, 2015|
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