The Tax Law Report

Disproportionate Distributions in an S-Corp; Innocent Spouse Relief

Jones v. Commissioner, T.C. Memo. 2010-112 (2010).

The issues for decision are: (1) Whether petitioner’s former husband’s distributive share of the income of two pass-through entities is includable in their joint income for the year at issue . . . .

 

Mr. Jones is a 45-percent shareholder of Hadley & Pech, Inc. (Hadley & Pech), an aviation management company that is an S corporation, and a 50-percent owner of Archipelago Aviation, LLC (Archipelago), a limited liability company that charters aircraft and is taxed as a partnership. Roger Sutton (Mr. Sutton), who was a friend of Mr. Jones’, owns the remaining 55 percent of Hadley & Pech and 50 percent of Archipelago.  (3).

 

For 2005 Hadley & Pech and Archipelago had $101,927 and $212,298 of ordinary net business income, respectively. Mr. Jones’ shares of that income, as Mr. Sutton eventually reported to the Internal Revenue Service (IRS) on the Schedules K-1, were $45,867 and $106,149, respectively. Hadley & Pech’s cash distributions for 2005 consisted of $115,000 to Mr. Sutton and $10,000 to Mr. Jones, while Archipelago did not make any distributions for 2005.  (4).

 

Although Mr. Jones received only a $10,000 cash distribution from Hadley & Pech in 2005, as a shareholder he was required to recognize his 45-percent share of the S corporation’s income even though it was not distributed. (7).

 

Archipelago reported ordinary net business income of $212,298 on its partnership return but did not make distribution to Mr. Sutton or Mr. Jones during 2005.  As a 50-percent partner, Mr. Jones is required to recognize and report $106,149, his share of the partnership income even though it was not distributed to the partners. (9).

This is an unfortunate, but correct, outcome for Mr. & Mrs. Jones.  Pass-through entities, such as partnerships and S-corporations, are double-edge swords for the unwary.  On the one hand, distributions of cash from the entity are generally not taxed.  But on the other hand, the partner's/shareholder's share of net income is taxable, EVEN IF NO DISTRIBUTIONS WERE MADE.

There were two more decisions for the court to decide: innocent spouse relief, and accuracy-related penalty.  Ms. Jones won the first and lost the second.

Divorce Decree not Controlling for Innocent Spouse Relief

Acoba v. Commissioner, T.C. Summ. Op. 2010-64 (2010)

The Tax Court held that a divorce decree allocating existing tax liabilities equally between spouses is not controlling for innocent spouse relief claims.

Petitioner and Mr. Acoba divorced on June 13, 2002. As part of the judgment of divorce, petitioner and Mr. Acoba each agreed to pay “50% of Internal Revenue Service debt for back taxes, interest, and penalties”. (3).

Petitioner argues that she should be liable for only 50 percent of the liabilities for the years at issue as provided in the divorce decree. (7).

Section 6013(d)(3) provides that if a joint return is filed, the tax is computed on the taxpayers’ aggregate income and liability for the resulting tax is joint and several. See also sec. 1.6013-4(b), Income Tax Regs. But the Internal Revenue Service (IRS) may relieve a taxpayer from joint and several liability under section 6015 in certain circumstances.  (5).

To obtain relief from joint and several liability, a spouse must qualify under section 6015(b), or, if eligible, may allocate liability under section 6015(c). In addition, if relief is not available under section 6015(b) or (c), a spouse may seek equitable relief under section 6015(f). (5).

This case does not involve a deficiency or an understatement of tax and, therefore, relief under section 6015(b) and (c) is not available to petitioner. (5).

Rev. Proc. 2003-61, sec. 4.01, 2003-2 C.B. at 297, sets forth seven threshold conditions that must be satisfied before the Commissioner will consider a request for equitable relief under section 6015(f). (7).

[A]fter weighing all the factors, the Court concludes that petitioner’s intimate involvement in the financial matters of the marriage and her knowledge of the protracted financial decline of the marriage should have put her on notice that filing a joint Federal income tax return was, for her, a poor choice. (13-14).

Unfortunately for Ms. Acoba, as the tax court points out, her divorce agreement does not defeat her "joint and several" liability for unpaid taxes.  This means the IRS can pursue either of them for 100% of the tax liability, regardless of their private agreement to share the burden equally.  If Ms. Acoba pays the entire amount, either voluntarily or involuntarily via IRS levy, the divorce decree will serve as her means for getting reimbursed by her husband.  Of course, if he has no money, she is going to have a hard time collecting.  She effectively becomes an unsecured creditor of her ex-husband, not a good place to be.

Spousal Relief Under Section 6015

Sykes v. Commissioner, T.C. Memo. 2009-197

This opinion (and post) is quite long, but it's worth reading if you really want to understand spousal relief.

Questions for the Tax Court

Is Ms. Sykes [petitioner] entitled to relief under section 6015(b), (c), or (f). (10).

Spousal Relief From Joint and Several Tax Liability

Under section 6013(d)(3), a husband and wife filing a joint return are jointly and severally liable for all tax for the taxable year, including interest and penalties. (14).

Section 6015 relieves a spouse of joint and several liability in three situations:  (1) if the spouse did not know or have reason to know of the deficiency when the return was signed, and satisfies other conditions; (2) if a divorced or separated spouse seeks to limit individual liability to the portion of the deficiency attributable to him or her; and (3) in the case of a deficiency or of a tax shown on a return but not paid, if it is inequitable to hold the spouse liable for the tax.  See sec. 6015(b), (c), and (f), respectively.  The last provision, found in section 6015(f), only applies if relief is not available to the taxpayer under the other two provisions. (14-15).

Tax Court's Section 6015(b) Analysis

Under section 6015(b), the first situation above, A spouse has reason to know of the understatement if a "reasonably prudent taxpayer in her position at the time she signed the return could be expected to know that the return contained the . . . understatement." Price v. Commissioner, 887 F.2d 959, 965 (9th Cir. 1989). (16).

Factors to consider in analyzing whether a spouse had reason to know of the understatement include: (1) the spouse's level of education; (2) the spouse's involvement in the family's business and financial affairs; (3) the presence of expenditures that appear lavish or unusual when compared to the family's past levels of income, standard of living, and spending patterns; and (4) the culpable spouse's evasiveness and deceit concerning the couple's finances. Price v. Commissioner, 965. (17).

[Here], Ms. Sykes held two bachelor degrees, kept all the records for her husband's law practice in 2003, was the sole party responsible for reviewing the documents to be presented to the tax return preparer for the tax year 2003. (17).  Her husband was not deceptive about financial matters, and in fact frequently discussed with her . . . business and family financial matters. (17).  She either knew or should have known, as the manager of the law practice that business expenses were being twice deducted and that excessive deductions for advance client costs were being claimed. (18).  Thus, because she knew or should have known of the understatement of tax, she does not qualify for relief under section 6015(b).

Tax Court's Section 6015(c) Analysis

[U]nder section 6015(c)(3)(C), apportionment of liability does not apply if the Commissioner "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 . . . ".  This Court has defined actual knowledge as "an actual and clear awareness (as oppose to a reason to know) of the existence of an item which gives rise to the deficiency (or portion thereof)".  Cheshire v. Commissioner, 115 T.C. 183, 195 (2000). (20).

And, consistent with Cheshire, such actual knowledge does not include knowledge of the tax laws or knowledge of the legal consequences of the operative facts. (21).

It is clear to the Court that Ms. Sykes had actual knowledge of all items giving rise to the deficiency in joint tax.  She was solely responsible for keeping the finances of the law practice; had actual knowledge of the year the Cadillac Escalade was purchased and placed in service; helped prepare the 2003 income tax return by reviewing items with the preparer and reviewing and gathering all financial documents . . . . (22).

Tax Court's Section 6015(f) Analysis

Section 6015(f) relief is available if, taking into account all of the facts and circumstances, it is inequitable to hold the individual liable for any unpaid tax or deficiency, and if relief is not available under section 6015(b) or (c). (22).

Rev. Proc. 2003-61 states the requesting spouse must satisfy all of the following threshold conditions to be eligible for relief under section 6015(f) . . . Ms. Sykes satisfies these threshold requirement for equitable relief. (24.)  However, the I.R.S. argues that as described under the revenue procedure, she is not entitled to relief under section 6015(f) because petitioner had knowledge of the items giving rise to the deficiency; had knowledge or reason to know that intervenor would not or could not pay the tax liability shown on the return; and if held liable for the payment of the tax she would not suffer an economic hardship. (24).

[T]he Court determines that petitioner is not entitled to relief under section 6015(f). (26).  [Ms. Sykes] knew at the time she signed the 2003 tax return that [her husband] owed a separate in come tax liability for tax year 2001 in excess of $50,000. (25).  This liability was not satisfied until after the 2003 return was filed, and the money used to [pay] the debt was provided by [her husband's] family.  This information supports the conclusion that Ms. Sykes knew that . . . [her husband] could not pay the tax liabilities shown on the return. (25).

Comments

Three strikes and your out.  Ms. Sykes failed the test for relief under (b), (c), and (f).  It goes to show that spousal relief is not a "get out of tax owed" free card.  It is truly for those occasions where it would be inequitable to hold the truly 'unknowing' spouse 'jointly and severally' liable for the tax of his or her deadbeat spouse.

Spousal Relief & "Reason to Know"

The IRS denied Mrs. Villela-Wilcox relief under section 6015 because she "knew", or had "reason to know" of significant loss deductions taken on her and her husband's 1997 and 2000 joint tax returns. Mrs. Villela-Wilcox filed a petition in 2007 challenging the IRS's determination. At the time of this decision, the IRS had conceded Mrs. Villela-Wilcox was entitled to relief under 6015(c).

This case is interesting because Mr. Wilcox, petitioner's ex-husband, challenged the agreement between the IRS and Mrs. Villala-Wilcox (he can join the issue as an intervenor under rule 325 of the Tax Court Rules of Practice and Procedure). Mr. Wilcox re-asserts the IRS's original point; that she "knew" or had "reason to know" of the loss deductions taken on their 1997 and 2000 joint return. As such, Mr. Wilcox disputes Mrs.'s entitlement to any relief under section 6015.

The Tax Court agreed with Mr. Wilcox that the "evidence overwhelmingly would support a finding that Mrs. Villela-Wilcox had 'reason to know'." The Tax Court points out, however, that section 6015(c) requires "actual knowledge." Mr. Wilcox's evidence on balance, per the Tax Court, was not strong enough to overcome the agreement between the IRS and his ex-wife. Thus, the agreement stands.

It seems to me this case could have gone either way. This couple was separated in 2002 and were divorced in 2006. It means three years after their divorce they are still fighting! What is more, now that Mrs. Villela-Wilcox is entitled to relief, there needs to be an allocation under 6015(d). So, it is not over. Divorce is the gift that keeps on giving.

Download VillelaWilcox.SUM.WPD