Failure to Notice Obvious Issues with Returns Fatal to Innocent Spouse Relief

At first glance Sletta Arobo appeared to be a perfect “innocent spouse” candidate.  But, as we’ll discover in her case (Arobo v. Commissioner, TC Memo 2016-66) even the “perfect” candidate has certain minimum duties with regard to the tax return and when she ignored these duties she lost the possibility of gaining innocent spouse relief.

The tax in this case arose from her husband’s business, as well as a failure to file returns for a number of years. 

As the Court explained:

Petitioners’ Federal income tax return for each year involved was filed late. Petitioners’ income tax return for 2004 was filed on January 19, 2010. The IRS commenced an audit of that return in October 2010. Petitioners filed their 2005 income tax return on February 25, 2011, and their 2006 and 2007 income tax returns on March 2, 2011, while the 2004 return was under audit, through the IRS examining agent. Mr. Arobo was responsible for the preparation and filing of petitioners’ income tax returns. Mrs. Arobo did not review the returns; rather, she “entrusted her husband and just signed them”. She testified that she learned that Mr. Arobo had failed to file their 2004, 2005, 2006, and 2007 tax returns only when they were contacted by the IRS.

The 2004 and 2005 income tax returns each reported on the first page, on line 12, a business loss and negative adjusted gross income. The 2006 and 2007 income tax returns reported adjusted gross income of $52,163 and $32,049, respectively; no business income or loss was reported on, and no Schedule C, Profit or Loss From Business, was attached to, either the 2006 return or the 2007 tax return.1 Each year’s tax return reflected a tax overpayment.

Although the business had generated substantial income prior to 2004, the returns were now showing a substantial loss for two years, followed by no reported activity for the next two years. While Ms. Arobo did not question this when signing the returns, the IRS agent examining the returns was not so accepting.  The agent noted that the Arobo’s standard of living had not changed during the time period, something that did not make sense if, in fact, the business had collapsed entirely during that period.

It turns out the agent’s suspicions were confirmed and the Arobo admitted to having significantly underreported gross receipts for the years in question. 

But at trial the taxpayers argued that Ms. Arobo should be granted innocent spouse relief since it was Mr. Arobo’s income, he had prepared the returns and Ms. Arobo had always relied upon him to do so.

However, the Court didn’t accept this view. 

First, the Court noted that the fact that the returns had only been prepared after the IRS examination commenced should have put Ms. Arobo on notice of the need to carefully review these returns.

The returns for 2005, 2006, and 2007 were filed only after the 2004 return was under IRS examination. Under the facts and circumstances present in this case, we would expect a reasonably prudent person in the position of Mrs. Arobo to be diligent, vigilant, and circumspect and that he/she would carefully review the 2005, 2006, and 2007 tax returns for accuracy.

Mrs. Arobo was a college-educated individual. She knew, or should have known, of her responsibility to file an accurate tax return, especially in view of the fact that she taught at-risk students to be responsible. She knew that the returns had been filed because petitioners had been contacted by the IRS. That knowledge should have put her on notice that petitioners’ 2005, 2006, and 2007 tax returns would likely be subject to scrutiny. Even a cursory review of each year’s tax return would have revealed that Mr. Arobo’s mortgage origination business had reported (on line 12 of the first page of each return) substantial losses for 2004 and 2005 and that no business income or loss was reported for 2006 and 2007.

Even though she did not prepare the returns, she did have intimate knowledge of the couple’s finances as the Court noted:

Mrs. Arobo was responsible for paying the family’s bills. Had she reviewed the tax returns she would have seen that the returns reported no net business income for four years and yet the family’s standard of living was not diminished. See Reser v. Commissioner, 112 F.3d 1258, 1267-1268 (5th Cir. 1997) (“Tax returns setting forth ‘dramatic deductions’ will generally put a reasonable taxpayer on notice that further investigation is warranted.”), aff’g in part, rev’g in part T.C. Memo. 1995-572; Levin v. Commissioner, T.C. Memo. 1987-67 (spouse requesting relief had a duty to inquire about large deductions reported on the face of the joint tax return and could not escape her responsibilities by ignoring the contents of the return when signing). As there was no indication that Mr. Arobo was deceitful or evasive with respect to the family’s finances, Mrs. Arobo cannot escape her responsibility to be informed of the contents of the joint tax return.

Thus, the Court found she did not qualify for innocent spouse relief, as she reasonably should have known about the understatement in question.  She had disregarded her duty to insure a proper return had been filed and, as such, did not qualify for innocent spouse relief, either under §6015(b)’s general innocent spouse relief or the equitable relief under §6015(f).