Blog

Updated Guidance from the IRS on Innocent Spouse Relief

When married taxpayers file a return, they may elect to file that return jointly with their spouse.  Sometimes that is a mistake – a big one!  When filing a joint return, the Internal Revenue Code provides that both spouses will be jointly and severally liable for the tax, penalties and interest.  This blog has reviewed the various options available to spouses requesting that they be relieved from liability on the return. Just click on “Innocent Spouse Relief” under “Posts by Category” for a general  review.  Lately, we are seeing the IRS take action to update their analysis of Innocent Spouse Applications.

General guidelines provide that understatements of tax may qualify for relief under so-called “innocent spouse” or “separation of liability” provisions, while underpayments may only qualify under “equitable relief” provisions.  All three of these are under the umbrella of “innocent spouse relief” provided by the Internal Revenue Code.

Of note, earlier this year, the IRS updated internal guidance. One change made to internal guidelines earlier this year was to clarify provisions relating to actual or constructive knowledge of the understatement of tax.  Basically, in order to qualify under this particular type of Innocent Spouse relief, it is necessary to show that the requesting taxpayer did not know about the understatement and had no reason to know of the understatement.  If this requirement isn’t met, then the requesting spouse doesn’t qualify.  However, if the requesting spouse can establish that he or she was the victim of domestic abuse prior to the time that the return was signed, but did not sign the return under duress, and as a result of the prior abuse, did not challenge any of the items on the return for fear of retaliation, then the IRS will not review the requirement of showing that the requesting spouse did not know or did not have reason to know of the understatement.

Normally, the IRS will review the following factors to determine if the requesting spouse knew or had reason to know of the understatement, absent a showing of abuse: 1) the nature of the erroneous item and the amount of the erroneous item relative to the other items, 2) the couple’s financial situation, 3) the requesting spouse’s educational background and business experience, 4) the extent of the requesting spouse’s participation in the activity that resulted in the erroneous item, 5) whether the requesting spouse failed to inquire, at or before the time the return was filed, about items on the return or omitted from the return that a reasonable person would questions, and 6) whether the erroneous item represented a departure from a recurring pattern reflected in prior year’s returns.

The IRS has pending the finalization of procedures that weigh abuse in a spousal relationship more heavily in the analysis of relief under Innocent Spouse provisions.  Some of the changes mentioned here are based in internal guidelines associated with working applications for relief and acknowledge the proposed official guidance.  Should you have questions about Innocent Spouse relief, don’t hesitate to contact our office.

Fraudulent Transfers, Alter Ego, Nominee and Successor Liability

I.R.C. Section 6321

The United States Bankruptcy Court for the District of Arizona explores the extent to which the federal tax lien remains attached to assets transferred to others through alleged fraudulent transfers in Bullseye Holdings, LLC v. Internal Revenue Service, Case Number 4:16-ap-00449-BMW dated October 15, 2018. This action was essentially one for Declaratory relief filed by Bullseye Holdings, LLC asking the Court to determine that assets owned by the related entity Bullseye Feeders, LLC, were not encumbered by the federal tax lien. The entities at issue are owned by a variety of individuals in the same immediate family. At the time of trial, those members did not exactly know who held precise interests in the various LLC’s. The United States may impose a lien on property or rights to property belonging to a taxpayer in order to satisfy a taxpayer’s tax deficiency. Property that is fraudulently transferred remains subject to the federal tax lien against it. Additionally, where property is placed in the name of another as the taxpayer’s alter ego, nominee, or successor, federal tax liens remain attached to the property. The Court ruled that the IRS failed to prove by a preponderance of the evidence that the property was fraudulently transferred. The court went through numerous factors relating to required provisions of substantiating fraudulent transfers. It seemed the IRS simply did not do their job in Court. They did a better job relating to the Alter Ego Theory – possibly because it is easier to prove. The IRS had to prove that there was a unity of control and observing the corporate form would sanction fraud or promote injustice. Some of the factors causing the alter ego theory to be upheld were: 1) close family membership of all entities, 2) One person essentially in charge of both, 3) neither entity held formal meetings, 4) no corporate records, 5) one entity did not have a bank account, 6) no payments made on obligations from one entity to the other, 7) no consideration paid on the transfer of a few promissory notes, 8) operating agreements stated the purpose was exactly the same, 9) at the time of the transfer, one entity could not pay its debts as they become due and the property transferred was the only remaining asset of the entity. Unity of control was clearly met. As for whether or not justice requires recognizing substance over corporate form, the Court found that to invalidate the IRS lien against the Property would promote injustice. Ultimately, the lien stood against the property.

Failed Installment Agreement Proposal

Collection Due Process Hearing

In Richard H. Levin and Linda D. Levin v. Comm’r, T.C. Memo 2018-172, Filed October 15, 2018, the Tax Court ruled that IRS Appeals had acted appropriately in denying taxpayers’ proposal for an installment agreement and sustaining IRS Collections proposed levy action. Taxpayers created a liability for tax year 2010 of $468,696, prior to assessment of penalties and interest. Taxpayers’ representative proposed a payment agreement to the IRS wherein taxpayers would pay their liability within four months. During that time, taxpayers made a $50,000 payment. The IRS issued a final notice of intent to levy, at which point the taxpayers requested a Collection Due Process hearing with IRS Appeals. There is a lengthy narrative in this case regarding the details of financial information. During this time, the Appeals office indicated that the taxpayers must remain compliant with their current tax liabilities in order to qualify for a payment agreement. Taxpayers also requested a face to face meeting with IRS Appeals. IRS ultimately agreed to the face to face meeting – which caused a lengthy delay of over a year. Rather than take advantage of the time to liquidate assets and pay down the tax debt, taxpayers liquidated one of their four homes and paid off other creditors in an amount in excess of the IRS debt – approximately $575,000. These creditors included State taxing authorities and credit cards. They additionally capitalized taxpayer husband’s new law firm in the amount of $281,000. Persistently during negotiations with the IRS, the taxpayers’ representative argued that the filing of a tax lien would have a detrimental effect on taxpayer husband’s ability to earn income in his law firm. The Court ruled that the taxpayers “have repeatedly chosen not to prioritize payment of their 2010 outstanding Federal income tax liability. Indeed their failure to use net proceeds of $843,293 from the sale of their Los Angeles, California home to pay their 2010 liability was particularly brazen.” The Tax Court confirmed the reasonableness of the Appeals’ Settlement Officer to file a notice of Federal Tax Lien and to reject the taxpayers’ proposed installment agreement.

Failure to File Returns

I.R.C. section 6651

The United States Court of Federal Claims granted summary judgment in favor of the IRS to sustain penalties in the case of Shih-Fu Peng and Roisin Heneghan v. The United States, No 16-1263T, Filed October 24, 2018. The plaintiffs were assessed late filing penalties in relation to their 2012 tax return. They allege that their return was filed late due to four reasons: 1) The father of one of the taxpayers died in July 2012, 2) their child was born in January 2013, 3) The grandmother of one of the taxpayers died in October 2013, and 4) their accountant was at times unresponsive while trying to prepare their 2012 return. Of course the Court applied the standard of I.R.C . 6651(a)(1)-(2) in determining if relief was appropriate – was the failure to file due to reasonable cause and not due to willful neglect? Their argument relating to the accountant failed as they only argued that he was the reason they did not file their extension. Ultimately, their return was filed after the extension due date. As such, even if they were correct, their return was still filed late. As for the other events that delayed the taxpayers’ filing, the Court indicated that it has recognized personal hardship as reasonable cause for failure to timely fund under some circumstances – such as an illness or debilitation that, because of its severity or timing, make it virtually impossible for the taxpayer to comply. The Court also explained that a taxpayer could supply evidence of incapacity caused by mental or emotional circumstances. Unfortunately for these taxpayers, it was not clear that their life events made it “virtually impossible,” for them to comply with the filing deadline. As such, no relief was granted.

Fraudulent Transfers, Alter Ego, Nominee and Successor Liability

I.R.C. Section 6321

The United States Bankruptcy Court for the District of Arizona explores the extent to which the federal tax lien remains attached to assets transferred to others through alleged fraudulent transfers in Bullseye Holdings, LLC v. Internal Revenue Service, Case Number 4:16-ap-00449-BMW dated October 15, 2018. This action was essentially one for Declaratory relief filed by Bullseye Holdings, LLC asking the Court to determine that assets owned by the related entity Bullseye Feeders, LLC, were not encumbered by the federal tax lien. The entities at issue are owned by a variety of individuals in the same immediate family. At the time of trial, those members did not exactly know who held precise interests in the various LLC’s. The United States may impose a lien on property or rights to property belonging to a taxpayer in order to satisfy a taxpayer’s tax deficiency. Property that is fraudulently transferred remains subject to the federal tax lien against it. Additionally, where property is placed in the name of another as the taxpayer’s alter ego, nominee, or successor, federal tax liens remain attached to the property. The Court ruled that the IRS failed to prove by a preponderance of the evidence that the property was fraudulently transferred. The court went through numerous factors relating to required provisions of substantiating fraudulent transfers. It seemed the IRS simply did not do their job in Court. They did a better job relating to the Alter Ego Theory – possibly because it is easier to prove. The IRS had to prove that there was a unity of control and observing the corporate form would sanction fraud or promote injustice. Some of the factors causing the alter ego theory to be upheld were: 1) close family membership of all entities, 2) One person essentially in charge of both, 3) neither entity held formal meetings, 4) no corporate records, 5) one entity did not have a bank account, 6) no payments made on obligations from one entity to the other, 7) no consideration paid on the transfer of a few promissory notes, 8) operating agreements stated the purpose was exactly the same, 9) at the time of the transfer, one entity could not pay its debts as they become due and the property transferred was the only remaining asset of the entity. Unity of control was clearly met. As for whether or not justice requires recognizing substance over corporate form, the Court found that to invalidate the IRS lien against the Property would promote injustice. Ultimately, the lien stood against the property.

Notice of Deficiency

I.R.C. section 6213

The United States Tax Court in Jeffrey D. Gregory v. Comm’r, Docket No. 1090-16L, filed November 20, 2018, held that a “reprint” of a notice of deficiency is evidence of the creation of the notice before assessment, even though the reprint was prepared more than two years after the alleged mailing of the original notice and omitted or misstated information that would have appeared on any notice actually mailed. Further, the Court ruled, that the omission from a notice of deficiency of the last day to timely file a petition for re-determination does not invalidate the notice. This case was before the Tax Court for review of a determination by IRS Appeals Office to sustain the filing of a notice of Federal Tax Lien for unpaid income tax liabilities. The Petitioner conceded all aspects of the case except the validity of the notice of deficiency issued by the IRS. The IRS asserted that they issued the petitioner a notice of deficiency for the relevant tax period but admitted there was no copy of the original notice that could be reproduced. The Court ultimately ruled that it did not see why the reprints couldn’t serve as evidence that the IRS prepared the notice of deficiency, even if they were not deemed duplicates. The Court inferred from the inclusion in the IRS database of the information about the taxpayer on the reprint that it had created the notice of deficiency in accordance with its “customary practice.” As for the lack of a date to file the Petition in Tax Court, the reprint would not reflect that information as the IRS had explained this information is entered by hand when the original is issued.

Taxation of Discharge of Indebtedness

I.R.C. Section 108(a)(1)(B), insolvency exception

In Vincent C. Hamilton and Stephanie Hamilton v. Comm’r, T.C. Memo 2018-62, filed May 8, 2018, the Tax Court explores a common exception to inclusion of discharge of indebtedness in gross income. Gross income generally includes discharge of indebtedness – I.R.C. section 61(a)(12). Section 108(a)(1)(B) excludes income from the discharge of indebtedness from gross income if the discharge occurs when the taxpayer is insolvent. Insolvency is measured by comparing the excess of the taxpayer’s liabilities over the fair market value of the taxpayer’s assets immediately before discharge. Taxpayers borrowed money in order to finance their son’s education. The husband ultimately injured his back and became permanently disabled. The student loan provider discharged over $158,000 in student loan debt. Husband then exhibited poor money management skills and his wife took over their finances. To protect their assets, she transferred $323,000 into their son’s savings account. She had the password and permission from her son to transfer money. She did this regularly during the year at issue to pay bills from her joint account with her husband. When filing the return, their accountant advised they were insolvent and claimed as much on the return. He had not included the value of the savings account in the son’s name. In this case, the sole issue is whether or not a bank account of taxpayers’ son should be included in their asset calculation. In this case, the taxpayers failed to prove that their son was not their nominee because they continued to enjoy the benefits of the funds they transferred to their son’s savings account. There was no evidence that the son paid any consideration for the funds transferred to his savings account by the taxpayers. As such, the funds were included as assets of the taxpayers, and the taxpayers were no longer insolvent.

Innocent Spouse Relief: Income attribution

Income attribution rule addressed by Tax Court

In Connie L. Minton a.k.a. Connie L. Keeney v. Comm’r, T.C. Memo 2018-15, filed February 5, 2018, the Tax Court was asked to review an IRS Appeals’ decision denying innocent spouse relief based on equitable relief. In this case, taxpayer made application for relief after divorce. The return in question reflected income from a 401(k) withdrawal taxpayer instituted at the request of her former spouse – for the purpose of investing in a business venture that failed. Additionally, the spouse’s income from his business, along with a small amount of interest income was reported on the return. The Appeals officer indicated that the taxpayer’s request for relief failed because the tax was attributed to her income. Thus, it did not meet the threshold condition for relief. The Tax Court reviewed this decision and discussed the exceptions to the attribution rule. Those exceptions include: a) attribution due solely to the operation of community property law, b) nominal ownership, c) misappropriation of funds, d) abuse before the return was filed that affects the requesting spouse’s ability to challenge the treatment of items on the return or question payment of any balance due, and e) fraud committed by the nonrequesting spouse that is the reason for the erroneous item. Ultimately, the Court indicated that the taxpayer did not meet any of the exceptions and failed the threshold conditions as to her 401(k) withdrawal. The Tax Court, however, disagreed with Appeals in that they concluded the liability attributed to the nonrequesting spouse’s business income should not be attributed to the taxpayer because her involvement in the business was nominal only. This is a good discussion of some exceptions to the income attribution rule, not regularly reviewed by the Court.

Passports: Revocation or denial due to tax debt

I.R.C. Section 7345

If a taxpayer has “seriously delinquent tax debt,” the IRS will certify that debt to the State Department for action. The State Department will generally not issue a passport to a taxpayer after receiving certification from the IRS. Further, the State Department may revoke a taxpayer’s passport on certification from the IRS. “Seriously delinquent tax debt” is defined as a tax debt currently in excess of $51,000 (this is inflation adjusted), for which a notice of federal tax lien has been issued and all administrative remedies under I.R.C. section 6320 have lapsed or been exhausted, or a levy has been issued. Some tax debts are not included, even if they meet the above criteria. This includes tax debt that is being paid timely on an IRS approved installment agreement, is being paid timely with an accepted Offer in Compromise, is pending a timely requested Collection Due Process hearing regarding a levy, or for which collection is suspended because of an application for innocent spouse relief. Additionally, a passport won’t be at risk under the program if the taxpayer is in bankruptcy, identified by the IRS as a victim of identity theft, if the taxpayer’s account is in currently not collectible, if the taxpayer resides in a federally declared disaster area, if the taxpayer has a pending request for an installment agreement, if the taxpayer has a pending Offer in Compromise, or if the taxpayer has an IRS accepted adjustment that will satisfy the debt in full. Before denying a passport, the State Department will hold the application for 90 days to allow the taxpayer to resolve any erroneous certification issues, make a full payment of the tax debt, or enter a payment arrangement with the IRS.

Trust Fund Recover Penalty

I.R.C. section 6672

This is a hard fought case on a narrow issue that ultimately went in favor of the IRS. The Tax Court in Scott T. Blackburn v. Comm’r, 150 T.C. No. 9, filed April 9, 2018, was asked to review the verification of compliance rule of I.R.C. section 6751(b), as required by sections 6330(c)(1) and (3)(A). The Appeals officer must “obtain verification from the Secretary that the requirements of any applicable law or administrative procedure have been met.” Sec. 6330(c)(1). The Petitioner did not argue or contest the liability issue relating to assessment of the Trust Fund Recovery Penalty against him. The Revenue Officer in this instance has recommended assessment and said assessment was approved by the Revenue Officer’s manager using Form 4183. The name of the manager was listed on the form, but no signature was present. The taxpayer argued that in creating section 6751(b), Congress could not have meant to require a meaningless, supervisory “rubber stamped” signature. Petitioner asked the IRS many times to provide some evidence that the supervisor’s review was meaningful. Petitioner relies on the Internal Revenue Manual to suggest an argument that the signature of a supervisor in support of a penalty is not in itself a sufficient showing to comply with section 6751(b). The Court indicated that caselaw review applying these code sections has only required the officer to review the administrative steps taken before assessment of the underlying liability. To impose the requirement of a substantive review on the officer would allow the taxpayer to avoid the limitations of pursuing the underlying liability in a review under section 6330 and apply a level of detail in the verification process that has never been previously required, the Court explained.