GOOD NEWS FOR INNOCENT SPOUSES: OVERSTATED COST OF GOODS SOLD IS
AUTOMATICALLY GROSSLY ERRONEOUS

Every year a married couple decides to file a joint tax return, each taxpayer agrees to be held jointly and severally liable for the taxes. The tax law, nonetheless, lets a spouse off the hook if he or she can meet the requirements for innocent spouse relief contained in I.R.C. Sec. 6013.

A thorny prerequisite for innocent spouse relief is that the joint tax return contain "a substantial understatement of tax attributable to grossly erroneous items of one spouse." A substantial understatement of tax is one that exceeds $500. And a grossly erroneous item is--

* any omitted item of gross income and

* a claim of deduction, credit, or basis that has no basis in fact or law.

Therefore an omission from gross income will automatically meet the innocent spouse requirements but overstated deductions, credits, or claims of basis must also be accompanied by proof of an absence of basis in fact or law.

Mrs. Lilly's problem involved a husband that overstated cost of goods sold (COGS) on the Schedule C of his construction business. Is overstated COGS an omitted item of gross income or an overstated deduction?

The Fourth Circuit Court of Appeals held that overstated COGS is not a deduction because deductions are reductions of gross income. COGS, on the other hand, is used to determine gross income, so overstated COGS is an omission of gross income.

The Fourth Circuit is not alone in this opinion. While no other Circuit Court has addressed the issue, the Tax Court has on three occasions faced it and come to the same conclusion. *