Despite Finding Taxpayer Had Constructive Knowledge of Income, Innocent Spouse Relief Under Section 6015(c) Granted

A taxpayer was granted innocent spouse relief in the case of Bishop v. Commissioner, TC Summary Opinion 2018-1, despite the fact that the Tax Court found that he should have been aware of the distribution that gave rise to the liability. 

The taxpayer’s spouse had inherited an IRA account from her father in 2009.  From 2009 to 2013 various distributions had been taken from the account, ranging from $4,000 to $48,000, and reported on the couple’s joint income tax return.

In 2014 the spouse took a distribution from the inherited IRA of $15,068.  The custodian withheld $2,712 for federal taxes, $6,000 was deposited into the couple’s joint checking account with the remainder being used for the benefit of the spouse’s daughter.

The couple filed a joint return for 2014.  The couple provided information to a paid preparer to prepare the 2014 return, but the IRA distribution did not end up being reported on that return.  In 2015 the couple separated and they were divorced in 2016.

The IRS issued a notice regarding the 2014 distribution based on the 1099 received from the custodian.  The taxpayer filed a Form 8857, Request for Innocent Spouse Relief, with the IRS.

Innocent spouse relief is governed by a set of provisions in IRC §6015 that provide several circumstances under which relief can be granted to a requesting spouse.  The IRS first analyzed the taxpayer’s request by looking at IRC §6015(b).  That provides:

(b) Procedures for relief from liability applicable to all joint filers

(1) In general

Under procedures prescribed by the Secretary, if—

(A) a joint return has been made for a taxable year;

(B) on such return there is an understatement of tax attributable to erroneous items of one individual filing the joint return;

(C) the other individual filing the joint return establishes that in signing the return he or she did not know, and had no reason to know, that there was such understatement;

(D) taking into account all the facts and circumstances, it is inequitable to hold the other individual liable for the deficiency in tax for such taxable year attributable to such understatement; and

(E) the other individual elects (in such form as the Secretary may prescribe) the benefits of this subsection not later than the date which is 2 years after the date the Secretary has begun collection activities with respect to the individual making the election,

then the other individual shall be relieved of liability for tax (including interest, penalties, and other amounts) for such taxable year to the extent such liability is attributable to such understatement.

In this situation the IRS found that the taxpayer should have known about the deposit into the joint checking account.  The Tax Court, agreeing with this conclusion of the IRS, noted:

The history of withdrawals from the retirement account used by the parties over a period of years and the transactions by petitioner with reference to the joint bank account support a conclusion that petitioner should have known about the distribution. The amount was very large in relation to the average balances and other transactions in the account.

But that is not the provision under which relief can be granted.  The taxpayer, having separated from his spouse and then gone through with a divorce, also potentially qualified for relief under IRC §6015(c).  That provision provides:

(c) Procedures to limit liability for taxpayers no longer married or taxpayers legally separated or not living together

(1) In general

Except as provided in this subsection, if an individual who has made a joint return for any taxable year elects the application of this subsection, the individual’s liability for any deficiency which is assessed with respect to the return shall not exceed the portion of such deficiency properly allocable to the individual under subsection (d).

(2) Burden of proof

Except as provided in subparagraph (A)(ii) or (C) of paragraph (3), each individual who elects the application of this subsection shall have the burden of proof with respect to establishing the portion of any deficiency allocable to such individual.

(3) Election

(A) Individuals eligible to make election

(i) In generalAn individual shall only be eligible to elect the application of this subsection if—

(I) at the time such election is filed, such individual is no longer married to, or is legally separated from, the individual with whom such individual filed the joint return to which the election relates; or

(II) such individual was not a member of the same household as the individual with whom such joint return was filed at any time during the 12-month period ending on the date such election is filed.

(ii) Certain taxpayers ineligible to elect

If the Secretary demonstrates that assets were transferred between individuals filing a joint return as part of a fraudulent scheme by such individuals, an election under this subsection by either individual shall be invalid (and section 6013(d)(3) shall apply to the joint return).

(B) Time for election

An election under this subsection for any taxable year may be made at any time after a deficiency for such year is asserted but not later than 2 years after the date on which the Secretary has begun collection activities with respect to the individual making the election.

(C) Election not valid with respect to certain deficiencies

If the Secretary demonstrates that an individual making an election under this subsection had actual knowledge, at the time such individual signed the return, of any item giving rise to a deficiency (or portion thereof) which is not allocable to such individual under subsection (d), such election shall not apply to such deficiency (or portion). This subparagraph shall not apply where the individual with actual knowledge establishes that such individual signed the return under duress.

A key difference in this case is the test for knowledge of the understatement.  Unlike §6015(b) where the fact the taxpayer should have known of the income is fatal to a grant of relief, IRC §6015(c)(3)(C) only denies relief if there was actual knowledge of the income by the requesting spouse—that is, in this case ignorance is truly bliss.

The IRS found that there was no evidence that the taxpayer was aware of the distribution despite the fact he should have been.  Obviously, the taxpayer’s ex-spouse wasn’t happy with that decision, as now she would be liable for the entire deficiency personally with her ex-husband off the hook.  So, she intervened and took the matter to Tax Court.

The Tax Court first notes that the traditional methods for determining burden of proof in Tax Court proceedings don’t work here—the real dispute is not between the IRS and the taxpayers, but between the taxpayers themselves.  So the Court noted:

A question exists as to where the burden of proof lies in cases when, as here, the IRS favors granting relief and the nonrequesting spouse intervenes to oppose it. The Court has resolved such cases by determining whether actual knowledge has been established by a preponderance of the evidence as presented by all parties. See Pounds v. Commissioner, T.C. Memo. 2011-202; Knight v. Commissioner, T.C. Memo. 2010-242; McDaniel v. Commissioner, T.C. Memo. 2009-137; Stergios v. Commissioner, T.C. Memo. 2009-15.

The Court then looks at the ex-wife’s arguments and evidence, since she is the one asserting that her ex-husband had actual knowledge of the distribution.  The Court notes:

Intervenor disputes petitioner's credibility. She argues that he had actual knowledge of the 2014 distribution because it was deposited in their joint bank account about seven months before the return was prepared and petitioner continued to write checks from the account and use debit cards accessing funds in the account. Intervenor does not claim that she specifically told petitioner about the distribution when it was received or at the time that the return was prepared or point to any evidence that petitioner had “an actual and clear awareness (as opposed to reason to know)” of the items giving rise to the deficiency. Intervenor testified that they both forgot about the distribution at the time the return was prepared.

The inability of the ex-wife to point to actual knowledge of the distribution was fatal to her attempt to get the IRS decision to grant relief overturned.  As the Court concluded:

There is no evidence, however, that petitioner saw the bank records before the joint return for 2014 was filed. His denials are not incredible, implausible or contradicted by direct evidence. See Culver v. Commissioner, 116 T.C. 189; Richard v. Commissioner, T.C. Memo. 2011-144. Regardless of the strong indications of constructive knowledge, the evidence falls short of establishing actual knowledge of any specific amount of the distribution in 2014.