On November 14, 2013, the United States Court of Appeals for the Second Circuit clarified the standard of review for mixed questions of law and fact in a case on review from the Tax Court. The case, Diebold Foundation, Inc. v. Commissioner of Internal Revenue, involved a group of shareholders who wished to dispose of the stock they owned in a corporation which in turned owned appreciated property. Further, the Second Circuit joined the First and Fourth Circuits in concluding that the two prongs of §6901, dealing with transferred assets, are independent, and that the Tax Court did not err by only addressing the second prong of that section. A copy of the decision can be found here.

BACKGROUND

Upon the disposition of appreciated property, taxpayers, including corporate entities, generally owe tax on the property’s built-in gain””that is, the difference between the amount realized from the disposition of the property and its adjusted basis. 26 U.S.C. §§ 1(h), 1001, 1221, 1222. When shareholders who own stock in a C Corp that in turn holds appreciated property wish to dispose of the C Corp, they can do so through one of two transactions: an asset sale or a stock sale. If the shareholders sell the assets, the company is liable for tax on the built-in gain of appreciated property and therefore, there is less money to distribute to the shareholders. If the shareholders sell the stock, they must sell it at a lesser value so that the buyer will be insulated from the property’s built-in gains which will trigger a tax liability when sold. For shareholders to get the benefit of selling stock at a good price and buyers to get the benefit of buying assets without built-in gains, parties engage in “Midco transactions.”

“Midco transactions” or “intermediary transactions” are structured to allow the parties to have it both ways: letting the seller engage in a stock sale and the buyer engage in an asset purchase. In such a transaction, the selling shareholders sell their C Corp stock to an intermediary entity (or “Midco”) at a purchase price that does not discount for the built-in gain tax liability, as a stock sale to the ultimate purchaser would. The Midco then sells the assets of the C Corp to the buyer, who gets a purchase price basis in the assets, as opposed to the lower basis the corporate entity formerly had. The Midco keeps the difference between the asset sale price and the stock purchase price as its fee. The Midco’s willingness to allow both buyer and seller to avoid the tax consequences inherent in holding appreciated assets in a C Corp is based on a claimed tax-exempt status or supposed tax attributes, such as losses, which allow it to absorb the built-in gain tax liability. See I.R.S. Notice 2001-16, 2001-1 C.B. 730. It is important to note that if these tax attributes of the Midco prove to be artificial, then the tax liability created by the built-in gain on the sold assets still needs to be paid. In many instances, the Midco is a newly formed entity created for the sole purpose of facilitating such a transaction, without other income or assets and thus likely judgment-proof. The IRS must then seek payment from the other parties involved in the transaction in order to satisfy the tax liability the transaction was created to avoid.

FACTS

Double D Ranch, Inc., a personal holding company taxed as a C Corp., owned assets worth approximately $319 million, all of which had substantial built-in gain, such that the sale of the assets would have triggered a tax liability of approximately $81 million. The shareholders, Dorothy R. Diebold Marital Trust and Diebold Foundation, Inc., wanted to get rid of the assets of the corporation without triggering this tax liability but also without having to sell their shares at a substantial discount. Therefore, they decided to engage in a Midco transaction.

The parties to this Midco transaction all filed tax returns. On its tax return, the Midco claimed sufficient losses to offset the gain from the sale of assets, resulting in no net tax liability. The IRS issued a notice of deficiency against Double D Ranch, determining a deficiency of income tax, penalties, and interest of approximately $100 million. The deficiency resulted from the IRS’s determination that the Shareholders sale of Double D Ranch stock was, in substance, actually an asset sale followed by a liquidating distribution to the Shareholders. Double D Ranch did not contest this assessment, but the IRS was unable to find any Double D Ranch assets from which to collect the liability, as they had all been sold as part of the “Midco” transaction.

Deciding that any additional efforts to collect from Double D Ranch would be futile, the Commissioner attempted to collect from the Shareholders as transferees of Double D Ranch. Section 6901 of the Internal Revenue Code authorizes the assessment of liability against both (a) transferees of a taxpayer who owes income tax and (b) transferees of transferees. 26 U.S.C. § 6901(a)(1)(A)(I), (c)(2). The IRS issued a notice of transferee liability against Mrs. Diebold, trustee of the Marital Trust and director of Diebold Foundation, as a transferee of Double D Ranch. The Tax Court determined that she was not liable because the Marital Trust was the actual Double D Ranch shareholder, and the court saw no reason to ignore its separate existence. The Tax Court’s decision is available here.

SECOND CIRCUIT OPINION

1. Standard of Review

The Second Circuit started its discussion by setting forth that its previous standard of review for mixed questions of law and fact was clear error. See Wright v. Comm’r, 571 F.3d 215, 219 (2d Cir. 2009). However, the Court noted that, according to statutory mandate, all Courts of Appeals are to “review the decisions of the Tax Court ”¦ in the same manner and to the same extent as decisions of the district courts in civil actions tried without a jury.” 26 U.S.C. §7482(a)(1). That is, all Courts of Appeal are to review decisions of the Tax Court de novo to the extent that the alleged error is in the misunderstanding of a legal standard and for clear error to the extent the alleged error is in a factual determination. Consequently, the Second Circuit acknowledged that its case law enunciating the standard of review for mixed questions of law and fact in an appeal from the Tax Court was in direct tension with this statutory mandate. Thus, because all Article III courts, with the exception of the Supreme Court, are solely creatures of statute, see U.S. Const. art. III; 28 U.S.C. §§ 1-463, the Second Circuit found that the statute must be determinative. Moreover, the Second Circuit Court held that there is no reason to review the Tax Court under a different standard than a district court, as “its relationship to us [is] that of a district court to a court of appeals.” Scheidelman v. Comm’r, 682 F.3d 189, 193 (2d Cir. 2012) (internal quotation marks omitted). Therefore, the Court held that “the Tax Court’s findings of fact are reviewed for clear error, but that mixed questions of law and fact are reviewed de novo, to the extent that the alleged error is in the misunderstanding of a legal standard.” See 26 U.S.C. § 7482(a)(1).

1. The Merits of the Tax Controversy

In its discussion of the merits of the case, the Second Circuit Court studied IRC Section 6901, which provides that the IRS may assess tax against the transferee of assets of a taxpayer who owes income tax. The section provides that the tax liability will “be assessed, paid, and collected in the same manner and subject to the same provisions and limitations as in the case of the taxes with respect to which the liabilities were incurred” and allows for the collection of “[t]he liability, at law or in equity, of a transferee of property…of a taxpayer.” A “transferee” includes a “donee, heir, legatee, devisee, [or] distributee.”

Furthermore, the Second Circuit stated that although the provision with respect to transferees is not expansive in its terms, the IRS may assess transferee liability under § 6901 against a party if two distinct prongs are met: (1) the party must be a transferee under § 6901; and (2) the party must be subject to liability at law or in equity. Rowen v. Comm’r, 215 F.2d 641, 643 (2d Cir. 1954) (discussing predecessor statute, 26 U.S.C. § 311). Under the first prong of § 6901, courts look to federal tax law to determine whether the party in question is a transferee. The second prong, whether the party is liable at law or in equity, is determined by the applicable state law, in this case, the New York Uniform Fraudulent Conveyance Act (“NYUFCA”), N.Y. Debt. & Cred. Law §§ 270-281.

The Second Circuit joined the First and Fourth Circuits in concluding that the two prongs of § 6901 are independent and that the Tax Court did not err by only addressing the liability prong. See Frank Sawyer Trust of May 1992 v. Comm’r, 712 F.3d 597, 605 (1st Cir. 2013);Starnes v. Comm’r, 680 F.3d 417, 428 (4th Cir. 2012). The Court cited Commissioner v. Stern, 357 U.S. 39 (1958) where the Supreme Court recognized that the predecessor statute to § 6901 “neither creates nor defines a substantive liability but provides merely a new procedure by which the Government may collect taxes.” The statute was enacted in order to do away with the procedural differences between collecting taxes from one who was originally liable and from someone who received property from the original tax owner.

As for the second prong, the Second Circuit Court stated that the NYUFCA defines a “conveyance” as “every payment of money, assignment, release, transfer, lease, mortgage or pledge of tangible or intangible property, and also the creation of any lien or encumbrance.” N.Y. Debt. & Cred. Law § 270. Further, the NYUFCA establishes liability for a transferee if the transferor, without regard to his actual intent, (1) makes a conveyance, (2) without fair consideration, (3) that renders the transferor insolvent. See N.Y. Debt. & Cred. Law § 273; McCombs, 30 F.3d at 323. If Double D had sold its assets and liquidated the proceeds to its shareholders without retaining sufficient funds to pay the tax liability on the assets’ built-in gains, this would be a clear case of a fraudulent conveyance under § 273. However, due to the Midco form of this transaction, Double D did not actually make a conveyance to the Shareholders. If the form of the transaction is respected, § 273 is inapplicable.

The Second Circuit Court relied on HBE Leasing Corp. v. Frank, 48 F.3d 623, 635 (2d Cir. 1995), where it had previously stated: “[i]t is well established that multilateral transactions may under appropriate circumstances be ”˜collapsed’ and treated as phases of a single transaction for analysis under the UFCA.” HBE Leasing described a “paradigmatic scheme” under this collapsing doctrine as one in which one transferee gives fair value to the debtor in exchange for the debtor’s property, and the debtor then gratuitously transfers the proceeds of the first exchange to a second transferee. The first transferee thereby receives the debtor’s property, and the second transferee receives the consideration, while the debtor retains nothing. Such a transaction can be collapsed if two elements are met. “First, in accordance with the foregoing paradigm, the consideration received from the first transferee must be reconveyed by the [party owing the liability] for less than fair consideration or with an actual intent to defraud creditors ”¦ Second, . . . the transferee in the leg of the transaction sought to be voided must have actual or constructive knowledge of the entire scheme that renders her exchange with the debtor fraudulent.”

The Second Circuit stated that in this case, it was clear that the first element was met. Although the transaction had an additional wrinkle””namely, an additional party serving as the conduit for the transfers””it is still the case that one transferee received Double D’s property, another transferee (the Shareholders) received the consideration for these assets, and Double D was left with neither its assets nor the value of them. Therefore, in order for there to be liability against the selling Shareholders (and their successor entities), the Shareholders “must have actual or constructive knowledge of the entire scheme that renders [the] exchange with [Double D] fraudulent.”

When applying § 273 to a single transaction, the intent of the parties is typically irrelevant; the knowledge and intent of the parties becomes relevant when, as here, a court is urged to treat multiple business deals as a single transaction. Therefore, the Court proceeded to assess whether the Shareholders had actual or constructive knowledge of the entire scheme. The facts in this case demonstrated both a failure of ordinary diligence and active avoidance of the truth. Specifically the Court noted that the Shareholders recognized the “problem” of the tax liability arising from the built-in gains on the assets held by Double D, and sought out parties to help them avoid the tax liability inherent in a C Corp holding appreciated assets. They viewed slideshow and other presentations from three different firms that purported to deal with such problems.

The Court also noted that the Shareholder representatives had a sophisticated understanding of the structure of the entire transaction, a fact that courts frequently consider when determining whether to collapse a transaction and impose liability on an entity. See HBE Leasing, 48 F.3d at 635- 36 (“The case law has been aptly summarized in the following terms: “In deciding whether to collapse the transaction and impose liability on particular defendants, the courts have looked frequently to the knowledge of the defendants of the structure of the entire transaction and to whether its components were part of a single scheme.”) quoting In re Best Products Co., 168 B.R. 35, 57-58 (Bankr. S.D.N.Y. 1994 (emphasis added).

The fact that there had been a delay of the original closing date by one day, and the Shareholders’ representatives’ corresponding intervention between Shap Acquisition Corporation II (“Shap II”), an entity created specifically to carry out the transaction  and Morgan Stanley, the ultimate buyer of Double D securities, made the conclusion of their “active avoidance of the truth” inescapable. By asking Morgan Stanley to “back off” and give Shap II extra time to provide the Double D securities so that the transactions would not be upended, the Shareholders demonstrated not only their knowledge of the structure of the entire transaction, but their understanding that Shap II did not have the assets to meet its obligation to buy equivalent shares on the open market for delivery to Morgan Stanley or pay Morgan Stanley an equivalent sum in cash. This understanding, combined with the Shareholders’ knowledge that Shap II had just come into existence for the purposes of the transaction, was more than sufficient to demonstrate an awareness that Shap II was a shell that did not have legitimate offsetting losses or deductions to cancel out the huge built-in gain it would incur upon the sale of the Double D securities.

The Second Circuit Court concluded that the Shareholders’ conduct evinced constructive knowledge, and therefore collapsed the series of transactions and found that there was a conveyance under the NYUFCA. In collapsing the transactions, the Court stated that, in substance, Double D sold its assets and made a liquidating distribution to its Shareholders, which left Double D insolvent””that is, “the present fair salable value of [its] assets [wa]s less than the amount . . . required to pay [its] probable liability on [its] existing debts as they bec[a]me absolute and matured.” N.Y. Debt. & Cred. Law § 271. With the liquidating distribution, Double D did not receive anything from the Shareholders in exchange, and thus Double D certainly did not receive fair consideration. Consequently, all three prongs of § 273 were met: Double D (1) made a conveyance, (2) without fair consideration, (3) that rendered Double D insolvent. See N.Y. Debt. & Cred. Law § 273; McCombs, 30 F.3d at 323. Because the Court determined that there was state law liability, an issue arose regarding whether Diebold New York was a transferee under I.R.C. § 6901, and subsequently, whether Diebold was a transferee of a transferee under the same statute. To answer these questions, the Second Circuit Court remanded the case to the Tax Court.

The attorneys at Fuerst Ittleman David & Joseph, PL have extensive experience in the areas of tax litigation. They will continue to monitor developments in this and similar cases. If you have any questions, an attorney can be reached by emailing us atcontact@fidjlaw.com or by calling 305.350.5690.

 

INTRODUCTION AND BACKGROUND

It is a bedrock principle of tax litigation that the US Tax Court is bound to following the precedent of the Circuit Court of Appeals to which its decisions are subject to appeal.  See Golsen v. Comm’r, 54 T.C. 742 (1970).  Generally, this determination is based on the residence of the taxpayer at the time the Tax Court petition is filed.  For instance, if a taxpayer residing in Miami petitions the Tax Court for review of a Statutory Notice of Deficiency, appeal of the Tax Court’s decision will be to the 11th Circuit Court of Appeals, which covers Alabama, Florida, and Georgia.  Logically, and more importantly, in adjudicating the taxpayer’s case, the Tax Court is bound by the precedents of the 11th Circuit.

However, in recent years the jurisdiction of the Tax Court has expanded from its traditional role of serving as a prepayment forum in tax deficiency cases.  For example, the Tax Court has recently been granted jurisdiction over requests for innocent spouse relief, collection due process appeals, review of IRS denials of interest abatement requests, and the review of IRS whistleblower awards, among other varieties of actions.

With the expansion of the Tax Court’s jurisdiction, an exception to the “geographic” determination of the applicable Circuit Court of Appeals precedent appears to have developed.  The source of this exception is Internal Revenue Code (hereinafter “IRC”) § 7482(b)(1).  That statute sets forth six types of Tax Court cases that are subject to the general rule, outlined above, that the taxpayer’s residence (or principal place of business for taxpayer entities) will determine which Court of Appeals is the appropriate forum for review of the Tax Court’s decision.  The cases subject to this general rule include review of determinations by the IRS of tax deficiencies alleged to be owed by individuals or entities, certain declaratory judgment actions, and partnership cases implicating TEFRA.

However, when expanding the Tax Court’s jurisdiction by statute (for example, by extending the Tax Court’s jurisdiction to collection due process appeals) Congress has not correspondingly amended IRC § 7482(b)(1) to include each new type of case the Tax Court can hear.  In other words, while the variety of cases the Tax Court has power to decide has expanded, the six varieties of cases subject to the general geographic-determinative rule of IRC § 7482(b)(1) has remained the same.

This lack of correlation appears to implicate the catchall of IRC § 7482(b)(1), which states: “If for any reason no subparagraph (listing the six type of cases subject to the general, geographic-determinative venue provision) of the preceding sentence applies, then such decisions may be reviewed by the Court of Appeals for the District of Columbia.”

A plain reading of the appellate venue statute leads to the conclusion that regardless of the taxpayer’s residence at the time the Tax Court petition is filed, if the action is of a type not expressly set forth in IRC § 7482(b)(1), the D.C. Circuit Court of Appeals is the appropriate appellate venue.  Consequently, under the Golsen rule, the D.C. Circuit’s precedents will govern these actions at the Tax Court level.

Recently, this interpretation of § 7482(b)(1) has been gaining more traction.  For instance, in Whistleblower 14106-10W v. Comm’r, 137 T.C. 183 (2011), the Tax Court indicated that an appeal of that whistleblower action would lie with the D.C. Circuit under the § 7482(b)(1) catchall.  Further, in Cohen v. Comm’r, 139 T.C. No. 12 (2012), another whistleblower case, the government sought to transfer appellate venue from the Third Circuit to the D.C. Circuit using the § 7482(b)(1) catchall (the motion was unopposed and the case is currently pending before the D.C. Circuit).  Finally, in a case pending before the D.C. Circuit, Byers v. Comm’r, the taxpayer has argued that appeal of his collection due process case should lie in the D.C. Circuit, rather than the Eighth Circuit, which would be the geographically applicable Circuit Court of Appeal, based on the § 7482(b)(1) catchall provision.

THE EFFECT OF D.C. CIRCUIT APPELLATE REVIEW OF COLLECTION DUE PROCESS CASES

The impact of this interpretation of the statute could be wide-ranging.  First, it is important to note that the under IRC § 7482(b)(2), the parties (i.e. the taxpayer and the IRS) can stipulate to review by a Circuit Court of Appeals of their choosing.  However, in situations where the parties do not stipulate, review by the D.C. Circuit could be advantageous to a taxpayer.

A primary example of when review in the D.C. Circuit can be advantageous is a collection due process case.  In a collection due process case, the IRS serves a notice of intent to begin collection activity or to lien or levy against the taxpayer’s property.  Upon receipt of that notice, the taxpayer may invoke the review of the IRS Office of Appeals to determine whether the IRS’s proposed collection action is proper in light of the taxpayer’s financial circumstances.  The taxpayer may also request a collection alternative (such as an offer in compromise or a payment plan) and assert other rights.

If the Appeals Office upholds the IRS’s proposed collection action, the taxpayer has the right to seek review of the Appeals Office’s determination in the Tax Court.  In reviewing the determination, an issue arises as to the scope of the Tax Court’s review.  The Tax Court has held that its review of the evidence presented at trial is de novo, which means it can accept new evidence not presented at the Appeals Office level.  See Robinette v. Comm’r, 123 T.C. 85 (2004).  However, three Circuit Courts of Appeal have  held that the Tax Court is limited to review of the administrative record (so that if the taxpayer fails to present evidence at the Appeals Office level, the taxpayer will be precluded from introducing the evidence at the Tax Court level).

The D.C. Circuit Court of Appeals has not proscribed the scope of Tax Court review of a collection due process case (the three Circuit Courts that have done so are the First, Eighth, and Ninth).  For that reason, a taxpayer residing in the First, Eighth, or Ninth Circuits seeking de novo review of the evidence in a collection due process case would be wise to assert and attempt to establish appeals venue in the D.C. Circuit under the IRC § 7482(b)(1) catchall (thereby establishing de novo review of evidence at the Tax Court level under Golsen), rather than the geographically applicable Circuit Court.

However, this is a two way street and can be disadvantageous to the taxpayer.  If the DC Circuit establishes precedent that is contrary to the taxpayer’s interests, the government would be in position to ensure that the case is appealed to the D.C. Circuit, under the IRC § 7482(b)(1) catchall, thereby ensuring application of the negative precedent at the Tax Court level.

IMPLICATIONS FOR TAX COURT LITIGATION STRATEGY

The combination of the Golsen rule and the flexible nature of appeals court venue for Tax Court cases raises another interesting issue bearing on litigation strategy: at what point does a party (and the Tax Court) become bound by a particular Circuit Court’s jurisprudence?  As stated above, the parties in a Tax Court case can stipulate to appeals venue in a particular Circuit Court of Appeals of their choosing.  By so doing, the parties presumably bind themselves to the precedents of that Circuit Court under the Golsen rule.  This indicates that the Appeals Court venue provision is not jurisdictional in nature, and the right to assert a particular appeals venue can be waived.  That, in turn, raises the issue of whether a party can bind another party to a particular Circuit Court at the pleadings stage or some other stage of the litigation.  Doing so would have the effect of cutting off the right to subsequently file a motion to transfer appeals venue.

Under Tax Court Rule 36(c), if a material allegation set forth in a petition is not expressly admitted or denied in the Respondent’s answer, the allegation is deemed admitted.  Further, Tax Court precedent generally indicates that failure by a party in Tax Court litigation to respond to an argument on a specific point results in concession of that point.  See Straight v. Comm’r,1999 WL 33587419 (U.S. Tax Court May 6, 1999).

This authority indicates that it may be beneficial in some circumstances for a litigant to assert its position regarding the proper appeals venue early in the case.  Failure by other party to directly address the issue may result in waiver of the right to assert venue in an alternative appeals court.  At the very least, raising the appeals venue issue early forces the parties to commit to a position and clarifies which Circuit’s law will govern the proceedings.

FUTURE CONGRESSIONAL ACTION

The issue of Appeals Court venue in collection due process cases is currently included in potential tax reforms being considered by Congress, a good compilation of which can be found here.  Current draft legislation would apply the general geography-based appeals venue provision to both innocent spouse cases and collection due process cases.  This legislation could have the effect of applying, on a nationwide basis, the more restrictive scope of Tax Court review currently in place in the First, Eighth, and Ninth Circuits.  This important issue will undoubtedly continue to develop, both in Congress and with the resolution of the Byers case, over the next year.

The attorneys at Fuerst, Ittleman, David & Joseph have extensive experience in tax litigation and working with taxpayers facing tax deficiencies and IRS collection efforts.  We will continue to monitor the development of these issues, and we will update this blog with relevant information as often as possible. You can reach an attorney by calling us at 305-350-5690 or emailing us at contact@fidjlaw.com.

Under Internal Revenue Code (hereinafter “IRC” or “Code”) § 6013(d)(3), spouses who file joint tax returns are jointly and severally liable for all tax due and owing for the tax year, as well as any penalties or interest that accrue on the tax liability.  Because the debt is joint and several, the IRS can choose to collect the outstanding tax in its entirety from a single spouse.  Further, a divorce settlement or other state court document directing a spouse to pay the tax liability is not binding on the IRS.

In certain circumstances, imposing joint and several liability on both spouses can create inequitable results.  For instance, a spouse that is completely unaware of an item of income attributable to the other spouse, and did not benefit from the income, is still held liable for payment of tax on the income under the provisions of § 6013(d)(3).  Recognizing the potential for inequity, Congress added provisions to the Internal Revenue Code which set forth grounds upon which so-called “innocent spouses” can obtain relief from the general imposition of joint and several liability.

Recently, changes have been made to the innocent spouse provisions that make their scope and applicability more available for taxpayers.  This blog entry will first provide a general overview of the Internal Revenue Code’s innocent spouse provisions, and will then highlight the key recent modifications to those provisions.

Overview of Innocent Spouse Provisions

Innocent spouse relief is set forth in § 6015 of the Code.  Generally, three types of relief are potentially available, depending on the individual spouse’s circumstances.  Each of the three bases for relief has unique characteristics, but there are some universal conditions which must be met before any of the three types of relief can be utilized.  First, there must a valid joint return (i.e. the taxpayers’ marriage must be valid, the signature of a spouse cannot be forged or coerced).  Without a valid joint return, there is no joint and several liability.  Second, the request for relief, form 8857, must be timely filed.  In most circumstances, the deadline to file is two years from when the IRS first begins collection action.  However, as explained below, the time limit may be different depending on which basis for relief the spouse invokes in his or her request.  Third, the liability must arise out of income taxes.  Most taxes required to be included on a joint return are income taxes, so this requirement is usually not a significant obstacle.  One example of a tax that is required to be reported on a joint return but is not considered income tax is the tax imposed on domestic employment service (i.e. working in the employer’s private home) by § 3510 of the Code.  Fourth, a court cannot have rendered a judgment as to the liability of the spouse requesting relief (hereinafter “requesting spouse”).  If the requesting spouse participated in a proceeding regarding the liability and had a chance to request relief but failed to do so, relief is also precluded. 

Once these threshold requirements are met, it is necessary to determine which specific type of relief under IRC § 6015 is potentially available to the requesting spouse.

        i. Innocent Spouse Relief: IRC § 6015(b)

The first type of relief, set forth under IRC § 6015(b), is called “Innocent Spouse Relief.”  This relief is potentially available to all joint filers.  To qualify for this relief, in addition to the universal requirements set forth above, the following requirements must be met:

1. There must be an understatement of tax, i.e. the amount stated on the return is less than the amount actually due.  This is distinguished from anunderpayment of tax, where the correct amount is stated on the return, but not enough money was paid toward the liability;

2. The understatement must be based on an erroneous item (either unreported income or an incorrect deduction, credit, or determination of basis) attributable to the other spouse;

3. The requesting spouse must be without knowledge of the understatement, and without a reason to know of its existence;

4. Taking into account all facts and circumstances it would be unfair to hold the innocent spouse liable for the tax.

A determination of whether a spouse had reason to know of the understated tax, thus precluding that spouse from taking advantage of § 6015’s equitable relief, is based on factors such as the educational background of the requesting spouse, the business experience of the requesting spouse, and whether the erroneous item represents a departure from a recurring pattern in previous tax years.  This is not an all or nothing proposition””a spouse can be aware of some erroneous items (and thus remain jointly and severally liable for those items) but still gain equitable relief for other items of which he or she was not aware.

In determining whether it is unfair to hold a spouse jointly and severally liable, the IRS will look to several factors, including whether the claiming spouse benefitted from the understated tax (for instance, by living a lavish lifestyle while tax liabilities went unpaid), whether the parties were divorced, and whether one spouse deserted the other. 

It is also important to note that relief under § 6015(b) does not provide relief for underpayments of tax.  For example, if the return states a tax due of $5,000.00 and only $3,000.00 is paid, § 6015(b) would be unavailable to a spouse seeking relief from the balance of $2,000.00, regardless of any of the innocent spouse factors.

        ii. Separation of Liability Relief: IRC § 6015(c)

A distinct form of equitable relief is available to innocent spouses under IRC § 6015(c) if the spouses are divorced, legally separated or living apart.  The understated tax can be allocated based on amounts for which each spouse is responsible.  In addition to meeting the universal requirements set forth above, there are a few key points regarding relief under § 6015(c) that should be highlighted.

1. For § 6015(c) to apply, the spouses must be divorced, legally separated, or living apart.  While the status of being divorced or legally separated is clear, “living apart” is less clear.  Based on guidance published by the IRS, spouses are living apart if they are not members of the same household during the 12-month period ending on the day innocent spouse relief is requested.  Even if spouses are separated, if the home is maintained in anticipation of the spouse’s return (for example, if one spouse is in prison or away on military service), then the spouses are not considered to be living apart.

2. Equitable relief is not available under § 6015(c) to the extent that the requesting spouse had actual knowledge of the understatement.  This is a different standard than that set forth under 6015(b); simply having reason to know of the erroneous item is not a basis upon which a court can draw the inference that the spouse had actual knowledge of the understatement.  However, a spouse that deliberately avoids learning about the erroneous item, or if the erroneous item is the result of property that the spouses jointly owned, then a determination of actual knowledge is more likely.

3. Equitable relief is precluded in its entirety if the IRS can prove that the spouses transferred assets to each other as part of a fraudulent scheme.  Additionally, if property is transferred to the requesting spouse in an effort to avoid the incurrence or payment of a tax liability, then the understatement of tax attributable to the requesting spouse is increased by the value of the property transferred to the requesting spouse.  If a transfer of property is made to the requesting spouse within one year before the IRS sends its first notice of the proposed deficiency, then a presumption arises that the transfer was made to avoid the incurrence or payment of tax.

4. Like § 6015(b), this section only applies to understatements of tax.  No relief is provided under this section for underpayments of tax.

5. In allocating liability, the requesting spouse does not have to establish his or her innocence regarding the deficiency.  If the requesting spouse proves that any part of the understatement is not attributable to him or her, relief must be granted unless the IRS can prove a condition defeating relief exists.

        iii. Equitable Relief: IRC § 6015(f)

In the event a spouse does not qualify for relief under IRC §§ 6015(b) or (c), the spouse may still pursue relief under the catchall of IRC § 6015(f), generally described as “equitable relief.” 

Equitable relief under this provision is unique in that it can provide relief from both an understatement of tax and an underpayment of tax.

In addition to meeting the universal requirements set forth above, several other conditions must be met before a spouse is eligible for relief under § 6015(f):

1. Relief under either IRC § 6015(b) or (c) cannot be available to the requesting spouse;

2. Assets cannot have been transferred between the spouses as part of a fraudulent scheme or in an effort to avoid tax;

3. The requesting spouse cannot have knowingly participated in the filing of a fraudulent return;

4. The liability at issue must be attributable to the non-requesting spouse (this requirement can be disregarded in in certain circumstances, such as when the non-requesting spouse engages in fraud, or the requesting spouse is the victim of domestic violence);

5. The non-requesting spouse cannot have transferred “disqualified assets” to the requesting spouse.  A “disqualified asset” is one that was transferred to the non-requesting spouse with the principal purpose of the avoidance of tax or payment of tax.  A presumption arises that an asset is disqualified if it is transferred within a year of the IRS contacting the taxpayers about a proposed deficiency.    

Once the threshold requirements for relief under § 6015(f) are met, the next determination the IRS will make is whether the case is “streamlined” or not.  Under newly issued IRS guidelines, set forth in Rev. Proc. 2013-34, equitable relief cases under IRC § 6015(f) are divided into streamlined and non-streamlined categories.  If a case is streamlined, relief is generally granted.  A case is considered streamlined if all of the following conditions are met:

1. The spouses are either divorced, legally separated, have not been members of the same household for a year or more, or one of the spouses is deceased;

2. The requesting spouse will suffer economic hardship if the IRS does not grant the requested relief;

3. The requesting spouse did not:

1. Know of or have reason to know of the deficiency, or
2. Know of or have reason to know that the non-requesting spouse would not or could not pay the underpayment

If streamlined treatment is not available, then the IRS will weigh the particular facts and circumstances applicable to the requesting spouse to determine whether it would be inequitable to hold the requesting spouse partially or wholly responsible for the at-issue liability.  The factors the IRS looks to in making this determination include:

1. Whether the spouses are separated or divorced;

2. Whether the requesting spouse would suffer significant economic hardship if relief is not granted;

3. Whether one or both of the spouses has a legal obligation under a divorce decree to pay the tax;

4. Whether the requesting spouse received a significant benefit (beyond normal support) from the underpaid tax or the item giving rise to the understatement of tax;

5. Whether the requesting spouse has made a good faith effort to comply with the tax laws; and

6. Whether the requesting spouse knew or had reason to know about the item that caused the understatement or that the tax would not be paid.

Recent Modifications to Equitable Relief under § 6015(f)

The determination of whether a spouse is entitled to equitable relief under IRC § 6015(f) has recently undergone significant modification.  Specifically, in Rev. Proc. 2013-34, a link to which is provided above, the IRS superseded its previous guidance (Rev. Proc. 2003-61) and modified, in a manner favorable to taxpayers, certain substantive considerations in determining whether a spouse is entitled to equitable relief.

        i. Substantive Modifications of Rev. Proc. 2013-34

Rev. Proc. 2013-34 primarily altered the substantive analysis the IRS will undertake when determining whether a requesting spouse is entitled to equitable relief.  Keep in mind that the changes set forth in Rev. Proc. 2013-34 are most relevant when a case is not “streamlined” and the IRS is therefore required to engage in a balancing test to determine whether holding the requesting spouse liable would be inequitable. 

The changes set forth in Rev. Proc. 2013-24 are almost uniformly taxpayer-friendly.  More than anything, these changes represent awareness on the IRS’s part of the severe hardship spouses in abusive or domineering relationships face.  Below is a brief summary of the significant changes:

1. Rev. Proc. 2013-34 directs the IRS to place greater emphasis on, and grant more deference to, the issue of whether the spouse suffered from domestic abuse.  The weight given to the existence of domestic abuse is significant enough that it will negate other factors that might have weighed against a finding of entitlement to equitable relief.

2. The determination of whether economic hardship would result if equitable relief were denied was modified to be based on minimum standards of income, expenses, and assets.  Further, a finding that economic hardship will not result from a denial of the requested relief does not, in and of itself, weigh against a granting equitable relief as it previously did. Instead, it is now treated as neutral factor. 

3. A finding that the requesting spouse had actual knowledge of the item causing the understatement is not weighed more heavily than other factors, as it was previously.  Additionally, if the requesting spouse did not challenge the non-requesting spouse’s treatment of any tax items out of fear of retaliation, then even actual knowledge of improper treatment of an item will not preclude equitable relief. 

4. Similarly, abused spouses, or those spouses with no control over financial decisions, will not suffer from having the “significant benefit” factor weigh against them in the determination of equitable relief.

5. A spouse’s subsequent compliance with the tax laws will weigh in favor of a request for equitable relief.  Prior to Rev. Proc. 2013-34 it was merely a neutral factor.

6. Whereas previously the liability from which the requesting spouse sought relief had to be attributable to the non-requesting spouse, relief under § 6015(f) is available even if the item is attributable to the requesting spouse if the tax deficiency is the result of the non-requesting spouse’s fraud.

7. A legal obligation of the requesting spouse to pay the liability is taken into consideration.  Previously, only whether the non-requesting spouse had a legal obligation to pay the liability was taken into account.     

ii. Procedural Modifications

Additionally, recent changes to the application of IRC 6015(f) have eased time constraints on filing relief requests.  Whereas previously claims for equitable relief had to be filed within two years of the IRS’s first attempt to collect the liability (as is still the case under IRC §§ 6015(b) and (c)), in IRS Notice 2011-70, the time period was extended to match the IRS’s general collection deadline of 10 years after the assessment of the liability.  This provision was recently adopted as part of a proposed treasury regulation, and is likely to become final regulation.  We previously blogged about this change here and here. 

Conclusion

The modifications to equitable relief set forth in Rev. Proc. 2013-34 are a clear sign that the IRS is beginning to recognize the reality that its previous standards in evaluating equitable relief claims were too stringent.  Abused spouses, or those spouses who have no control over the household’s finances and fear retaliation from their spouse if any attempt to assert control is made, should not be forced to incur joint and several liability based on the actions of their spouse.  Further, the two-year deadline on filing equitable relief claims was too strict.  Given the turmoil that divorced or separated spouses often face, resolving past tax liability may, initially, be a low priority.  The extended time limit allows spouses to focus on more immediately pressing concerns before addressing their tax debt.

Innocent spouse relief under IRC § 6015 is a crucial lifeline to many taxpayers facing severe, unexpected tax burdens due to the actions of their spouse.  Reforms liberalizing the application of section 6015, like Rev. Proc. 2013-34, should be both welcomed and taken advantage of by taxpayers.

The attorneys at Fuerst, Ittleman, David & Joseph have extensive experience working with taxpayers facing tax deficiencies and IRS collection efforts.  We will continue to monitor the development of innocent spouse relief under the Internal Revenue Code, and we will update this blog with relevant information as often as possible. You can reach an attorney by calling us at 305-350-5690 or emailing us at contact@fidjlaw.com.