O’Neil v. Commissioner T.C. Memo 2012-339 is a good innocent spouse case to read.  Without going into all of the dreary details, the bottom line is that the parties were married and then divorced.  While they were estranged and still separated, the Former Wife Allison signed a 2005 joint tax return even though she didn’t trust her former husband Michael (who intervened in her case) and the joint return reported a balance of tax due of $70,000.  Michael had told her that the tax owed was due to a mistake on a Schedule K-1 from one of his failed business deals; and, that he would get the K-1 corrected and no additional tax would have to be paid.  That promise turned out to be a ruse.

IRS collected the tax due from some of Allison’s separate assets, an overpayment which it applied to the joint return and the sale of real estate still owned jointly with Michael.   Alison requested innocent spouse relief which IRS denied.  She petitioned the Tax Court seeking a refund of the taxes collected from her assets.  IRS stipulated that the tax due was entirely due to Michael’s income.

Since this case involved an unpaid tax shown on the 2005 return and not a deficiency or understatement, Allison’s request for innocent spouse relief was made under Section 6015(f).  To prevail she had to establish that it would be “inequitable” to hold her liable.  The court examined the factors stated in Rev. Proc. 2003-61, 2003-2 C.B. 296.  There was no dispute that Allison qualified under the initial threshold requirements contained in section 4.01 of the Rev. Proc. to be considered for equitable relief; thus, like the court, I shall not discuss those requirements.

Having met the threshold tests, the Rev. Proc. then lists in section 4.02 three requirements which, if satisfied, will result in IRS granting equitable relief (Safe Harbor test).  These are:

• Allison must have been divorced from Michael on the date she requested relief.  IRS conceded that she passed this test.
• When she signed the 2005 tax return, she didn’t know, or have reason to know, that Michael wouldn’t pay the tax liability.  .
• She will suffer economic hardship if the IRS doesn’t grant her relief.

Knowledge or reason to know

Allison’s “Knowledge or reason to know” that Michael would not pay the tax is tested on the date she signed the joint return.  Most significantly, the court stated:

“… IB)y October 2006, when they filed their 2005 tax return, Allison didn’t trust her estranged and soon-to-be-ex-husband (emphasis added) She recounted frustration with his growing detachment and evasiveness as early as 2002, frustration so great the she sought medical help. This was not surprising, for by that time Michael was spending less and less time at home, and Allison was tired of dealing with the resulting stress and isolation.  When Michael gave her the …return in October 2006, Allison consulted her attorney and spoke with both Michael land his accountant before signing. She questioned them specifically about the increased income, and she knew that Michael couldn’t pay the tax. She knew that she couldn’t pay the tax.  And she knew that her husband had just lost very large lawsuit… We therefore do not find credible her claim that she trusted Michael to make the liability “all go away.”  Such a belief could not possibly have been reasonable under the circumstances. “

Economic hardship

To establish “economic hardship” one must show that “… satisfaction of the levy in whole or in part will cause an individual taxpayer to be unable to pay his or her reasonable basic living expenses.” Treas. Reg. 301.6343-1(b) (4).   The court found that Allison did not establish that she would suffer economic hardship because:

• The tax debt had already been paid.
• She still had $55,000 in liquid assets after payment of the joint tax debt.
• She had been experiencing economic problems long before the tax levies were made so the collection action of IRS could not have been the source of her economic hardship.
• The levies were paid from assets and not from her monthly income so as to prevent her from paying her living expenses.
• The bulk of the tax liability was paid from the sales proceeds of a home she was not using to pay her living expenses.
• Hardship she may suffer in the future is not “economic hardship” under the regulation.

Thus, the court found that Allison was not entitled to automatic equitable relief under the safe harbor tests because she flunked two of the three tests.

Facts and circumstances: balancing of factors

The court went on to employ the balancing of factors analysis contained in Section 4.03 of Rev. Proc. 2003-61 to determine if Allison would still be entitled to equitable relief.  These factors include:

• Separated or divorced (also safe harbor test)?
• Economic hardship (also safe harbor test)?
• Know or Reason to know (also safe harbor test)?
• Legally obligated to pay the tax under state law decree?
• No significant benefit?
• Tax compliant?
• Abuse present?
• Poor mental or physical health?
• Other unstated factors?

The court applied this testing and found that Allison did not qualify for equitable relief. Under this facts and circumstances testing Allison also argued that to deny her relief would allow her ex-husband an un-deserved financial windfall.  That, she argued, would be unfair and inequitable.  The court’s response:

“As we noted, the Code makes jointly filing spouses jointly liable for the tax.  Congress itself balanced the equities of this policy choice when it enacted section 6013(d) (the predecessor to section 6015).  The zero-sum problem that Allison highlights here applies to any ex-spouse who is held liable for the debts of the other ex-spouse.  This is a restatement of the general problem of how to disentangle the joint tax debt leftover from a marriage – the very problem that Congress addressed in section 6015.  When Congress has balanced the equities, it’s not our place to rebalance.  This factor neither helps nor hurts Allison.”

What to lessons take from this case?

1. Don’t sign a joint return if you don’t trust your spouse or former spouse.
2. Seek innocent spouse relief before the tax is paid.
3. If there is a tax due shown on the return, do not sign unless you are presented with sufficient evidence that funds are on hand to pay the tax due and that those funds will be remitted to IRS. I suggest having the funds deposited into your attorney’s trust account for remittance to IRS.
4. If you don’t follow these admonitions, don’t cry to the Tax Court that the result is unfair.

© 2013 by Robert S. Steinberg, Esquire
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