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Wife granted innocent spouse relief from husband's disallowed deductions.

Rebecca Reser was married to Don Reser from 1974 until their divorce in 1991. Both were personal injury defense lawyers. In 1984, Don created a professional corporation, Donald Reser, P.C. (DRPC), which was involved in the sale o a large shopping center in San Antonio, Texas. DRPC obtained a line of credit from a bank, evidenced by 14 promissory notes executed jointly by Don and the corporation. When DRPC needed to draw on the line of credit, the bank would deposit funds directly into DRPC's account. Don also drew on the DRPC account for his personal use. In 1986, he signed an agreement with a friend who guaranteed payment on the bank line of credit; Don agreed to pay the friend a fee for each period the guaranty was outstanding.

In 1987 and 1988, DRPC reported losses of $257,354 and $333,581, respectively; the Resers filed joint income tax returns and claimed these losses. The IRS audited the returns, questioning the deductibility of the DRPC losses. They determined that because the bank loan was made to DRPC, Don could not increase his basis in DRPC by the amount of the loan proceeds. Therefore, he did not have enough basis in DRPC to deduct the losses. Don claimed the bank had made the loan to him personally and that he had loaned the money to DRPC. He did not provide any evidence to back his claim.

In 1991, the IRS issued a notice of deficiency, disallowing all of the DRPC deductions the Resers had claimed for 1987 and 1988. Rebecca filed for relief under the "innocent spouse" rule. Generally, married persons who file jointly are jointly and severally liable for the tax due, unless under the innocent spouse rule a spouse can show that (1) on the tax return there is a substantial understatement of tax attributable to grossly erroneous items of the other spouse, (2) in signing the return, the spouse seeking relief had not known and had had no reason to know of such substantial understatement and (3) taking into account all the acts and circumstances, it would be inequitable to hold the spouse liable for the deficiency.

The Tax Court upheld the IRS determination that the loan was made to DRPC and that Don Reser did not have enough basis to claim the deductions, assessing penalties on both Resers for negligent, substantial understatements of tax and or failure to file on time. The court denied Rebecca innocent spouse relief, because she failed to pass the "knowledge of the transaction test" -- the taxpayer could not show that she did not know and had no reason to know that the stated liability on the tax returns was erroneous. Furthermore, the Tax Court found that Rebecca Reser had had a duty to inquire as to the propriety of the deductions and had failed to do so.

Result: On appeal, the Fifth Circuit Court of Appeals upheld the Tax Court decision that Don did not have enough basis in DRPC to claim the deductions but found Rebecca was eligible for innocent spouse relief. The court outlined the conflict between several appeals courts and the Tax Court regarding the test for innocent spouse relief: The Tax Court applies the knowledge of transaction test in cases involving both erroneous deductions and omission of income. However, some appeals courts have found that the test for erroneous deductions should be whether the spouse seeking the relief knew or had reason to know the deduction would give rise to a substantial understatement (Price v. Commissioner, 887 .2d 959 [9th Cir. 1989]).

The Fifth Circuit found the Tax Court approach made it virtually impossible or a spouse to obtain relief in erroneous deduction cases, because deductions are conspicuously recorded on the face of a tax return; therefore, any spouse who reads the return would be put on notice that some transaction had given rise to the deduction. The court found such a result would "undermine the objective of the innocent spouse defense."

The court decided to follow Price and outlined four factors it would consider in the substantial understatement standard.

1. The spouse's level of education.

2. The spouse's involvement in the family's business and financial affairs.

3. The presence of expenditures that appear lavish or unusual when compared with the family's past levels of income, standard of living and spending patterns.

4. The culpable spouse's evasiveness and deceit concerning details of the couple's finances.

The court said, however, that "dramatic deductions" generally would put a reasonable taxpayer on notice that further investigation was needed. A spouse who has a duty to inquire, but fails to do so, may be charged with constructive knowledge of the substantial understatement and denied innocent spouse relief.

Applying the substantial understatement standard and four factors to Rebecca, the court found the Tax Court clearly had erred.

1. Although Rebecca's education was advanced, it provided her with no special knowledge of complex tax issues, such as basis computation.

2. Rebecca was not personally involved with DRPC's business and financial affairs to any significant degree; instead, she was occupied full-time in her law practice and was the family's sole financial support.

3. The record did not show any lavish or unusual expenditures for the years in question compared with the Resers' normal standard of living or spending patterns.

4. While the Resers were married, Rebecca advanced significant amounts of her personal funds for DRPC's operating expenses and knew her husband had obtained a line of credit from the bank. She thought they had invested sufficient funds to cover the losses. However, she did not know that Don had signed a guaranty agreement until after they were divorced.

The court also considered whether Rebecca Reser had the duty to inquire about the deductions. Although the deduction amounts were large in relation to the personal funds the Resers had invested and DRPC did not generate any income, they were not dramatic enough to alert Rebecca to inquire further. In addition, the court noted the return was prepared by a CPA who had concluded the Resers were entitled to deduct the losses, and even two of the IRS's own agents arrived at different calculations of Don's basis in DRPC. Given that determining basis is an extremely technical process, the court found Rebecca had had no duty to make further inquiries as to whether the deductions were legitimate and granted her innocent spouse relief.


Who's Filing What

* The average tax rate for 1994 individual income tax returns increased to 14.3% because more taxpayers reported incomes of at least $50,000. This and other interesting historical information can be found in the IRS's Spring 1997 Statistics of Income Bulletin. For example, according to the bulletin, tax-exempt charities filed 165,599 returns and reported total revenue of $566 billion. An annual subscription for the Statistics of Income Bulletin is available for $33 from the Superintendent of Documents, U.S. Government Printing Office, P.O. Box 37194, Pittsburgh, Pennsylvania 15250-7954.

Understanding Payback Time

* On July 1 the IRS issued proposed regulations designed to provide further relief for employers amending their pension plans so they no longer have to make in-service distributions to participants turning age 70 1/2. The IRS also released announcement 97-70 to provide transition relief to qualified plans that failed to make distributions to employees who became 70 1/2 in 1996. The announcement appeared in Internal Revenue Bulletin 1997-29 on July 21. A public hearing on the proposed regulations is scheduled for October 28 at the IRS building in Washington, D.C.
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Publication:Journal of Accountancy
Date:Sep 1, 1997
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