By Terri Gutierrez

Are the courts following congressional intent?

One of the requirements for innocent spouse relief is that the innocent spouse must not have known or had no reason to know there was a substantial understatement. But what is meant by "reason to know?" The Tax Court has a very strict view that doesn't appear to agree with congressional intent. The various Circuit Courts are more liberal.

A married couple may file a joint return and generally benefit from lower marginal tax rates. The cost of this privilege is joint and several liability of each spouse for the tax. IRC Sec. 6013(e) provides relief from joint tax liability to spouses who had no reason to know of substantial understatements of tax attributable to grossly erroneous items of the other spouse. Grossly erroneous items may be either omitted income or deductions, credits, or bases for which there is no basis in fact or law. While the courts have little trouble granting innocent spouse relief to individuals who have no knowledge of omitted income items, some disagreement exists in granting relief to spouses who sign returns that contain erroneous deductions, credits, or basis. The issue is whether the listing of an erroneous item on a return is, in itself, enough evidence for a spouse to have reason to know a substantial understatement of tax may exist.

The Law

IRC Sec. 6013(e) was added in 1971 to provide relief from joint tax liability for spouses who had no reason to know of substantial understatements of tax attributable to omitted income of the other spouse. The omission must have exceeded 25% of the gross income reported on the return and the spouse seeking relief had to establish that he or she had no knowledge or reason to know of the omission. It also had to be inequitable to hold the spouse liable for the tax. One statutory factor considered was whether the innocent spouse significantly benefitted from the omission of income.

The Deficit Reduction Act of 1984 (DRA) liberalized the circumstances under which innocent spouse relief can be granted and made the changes retroactive to all open years. DRA extends innocent spouse relief to situations in which a substantial understatement is attributable to claims of deductions, credits, and bases for which there is no basis in fact or law. Although the revised statute no longer requires the innocent spouse to not have benefitted from the effects of the grossly erroneous items, the committee reports suggest that factor should continue to be taken
into account.

DRA also changed the amount of substantial understatement required before relief can be granted. The understatement of tax must exceed $500, and for understatements attributable to deductions, credits, or bases for which there is no basis in fact or law, the understatement must exceed a specified percentage of the innocent spouse's income. For AGI of $20,000 or less in the most recent year before the notice of deficiency is mailed, the substantial understatement must exceed 10% of AGI. If AGI is more than $20,000, the understatement must exceed 25% of AGI. The committee reports are silent as to the reason for the seemingly arbitrary thresholds of AGI to which different percentages apply in determining innocent spouse relief eligibility.

Four requirements must be met before innocent spouse relief will be granted:

• A joint return must be filed;
• There must be a substantial understatement of tax on the return due to grossly erroneous items of one spouse;
• The innocent spouse must not have known or had reason to know that there was a substantial understatement; and
• Based on the facts and circumstances, it must be inequitable to hold that spouse liable for the understatement.

If any one of the four requirements is not met, innocent spouse relief will not apply. The first requirement has not been subject to much consideration by the courts. The last three are not as easy to establish and have been the issues for determination in many cases. It is the third requirement, the reason to know requirement, that has caused the most controversy in the courts.

When an understatement results from omitted income, it is fairly easy to establish that a spouse did not know or had no reason to know of the understatement. If the spouse did not benefit from the income, he or she could easily have no reason to know about it since it would not be listed on the return anywhere. The same is not true for deductions, credits, or basis for which there is no basis in fact or law. Such items are visible to a spouse who reviews and signs a return. Is this enough to disqualify that spouse from relief even if he or she had no other knowledge of the item and no idea about the tax consequences? The courts do not agree on this issue. Some light can be shed by an exploration of congressional intent and the decisions of the Tax Court and circuit courts of appeal.

Congressional Intent

The innocent spouse provisions were liberalized in 1984 to encompass many situations in which innocent spouses deserve relief. The congressional committee reports specify one such situation "where one spouse claims phony business deductions in order to avoid paying tax and the other spouse has no reason to know that the deductions are phony and may be unaware that there are untaxed profits from the business which the other spouse has squandered." This example clearly suggests relief when a phony deduction is reported on a return. Just listing the deduction on the return is not enough for a spouse to have reason to know that the deduction leads to a substantial understatement. In spite of the example in the committee reports, the Tax Court expresses general disagreement with five circuit courts of appeal who have followed congressional intent in ruling on the issue.

Tax Court

The Tax Court has taken a firm position in interpreting the third requirement of IRC Sec. 6013(e)(1). The court applies the pre-1984 act income omission legal standard to post-1984 act deduction cases by holding that mere knowledge of the transaction underlying a grossly erroneous deduction is enough to deny innocent spouse relief. In Bokum, [93-2 USTC 50,374 (11th Cir., 10-18-89) aff'g 94 TC 126] the Tax Court met en banc to hear an innocent spouse case involving grossly erroneous deductions and the reason- to-know requirement. The court decided not to follow the Ninth Circuit's liberal decision in Price (See Exhibit), but rather to adhere to its own position that an innocent spouse must establish that he or she was unaware of the circumstances giving rise to the error on the tax return and not merely unaware of the tax consequences. It is important to note the decision was not unanimous. Nine judges agreed with the majority opinion, one concurred in result only, five dissented, and two did not participate in the opinion.

In Bokum, the husband (TPH) formed an S corporation in which his wife (TPW) was an officer-director, never a shareholder, nor took part in corporate affairs. The corporation sold part of its assets at a significant gain. TPW knew of the sale but did not participate in the decision to sell, and did not know the selling price or what TPH did with the proceeds. On their joint tax return the Bokums reported the dividend distribution from the S corporation as a long-term capital gain against which they offset the basis in TPH's stock. A CPA determined the treatment of the gain and basis offset. Both TPH and TPW signed the return without reviewing it and neither knew their tax liability was understated due to the incorrect basis offset.

The Tax Court ruled that offsetting a basis in S corporation stock against an S corporation capital gain dividend distribution was a grossly erroneous item with no basis in fact or law. The final two issues for determination of innocent spouse status for TPW were whether she knew or had reason to know of the substantial understatement and whether it would be inequitable to hold her liable for the joint tax liability attributable to the item. The Tax Court ruled that to qualify for innocent spouse relief, TPW could not know of the underlying circumstances giving rise to the disallowance of stock basis offset. If the sale of S corporation property was the underlying transaction, TPW's knowledge of the sale would disqualify her from innocent spouse relief. The court did not stop at this literal interpretation of the
reason-to-know requirement but went on to apply the reason-to -know standard of Stevens (See Exhibit) and subsequently used by various circuit courts of appeal. This standard asks whether "a reasonably prudent taxpayer under the circumstances of the spouse at the time of signing the return could be expected to know that the tax liability stated was erroneous or that further investigation was warranted." The Tax Court held that TPW either knew or should have known the tax liability was erroneous or that further investigation was warranted. A cursory glance at the return would have brought the S corporation distribution and basis deduction to TPW's attention, and if TPW had examined the return, the large items would have put her on notice that further inquiry was necessary. She could not expect to be granted innocent spouse relief simply by turning a blind eye to items that were disclosed on the return.

The Tax Court believed the Eleventh Circuit would hold that TPW in Bokum had reason to know of the erroneous basis deduction if that court applied the same standard as it had in Stevens. The facts of each case do not tend to support this conclusion of the Tax Court. The Tax Court itself acknowledged that the case against the innocent spouse was stronger in Stevens than in Bokum.

TPW appealed to the Eleventh Circuit, the same circuit that affirmed the Tax Court in Stevens some four years earlier. The appeals court affirmed the lower court's decision without addressing the reason-to-know requirement. Rather, the court looked to the fourth requirement of IRC Sec. 6013(e)(1) and ruled that it would not be inequitable to hold TPW liable. TPH did not act to deceive TPW. Both spouses misunderstood the applicable tax law and this should not release either of them from tax liability. The appeals court found no inequity in holding both spouses jointly liable for the tax and upheld the Tax Court in denying innocent spouse relief to TPW.

In a subsequent case, Park (See Exhibit), a taxpayer asked the Tax Court to adopt the more liberal approach of the Ninth, Eighth, and Second Circuits. The Tax Court cited Price in defining the liberal approach as requiring "a spouse seeking relief to establish that she did not know that the deduction would give rise to a substantial understatement." This is in contrast to the Tax Court requirement that a spouse not know of the transaction giving rise to the understatement. The Tax Court refused to reconsider its position because the court believed the petitioner had reason to know under either approach. The Fifth Circuit agreed that the reason-to-know standard was met under either approach. In a sample of nine deduction cases citing Bokum in the past two years, the Tax Court has followed the circuit courts of appeal as required in six cases and applied its own literal approach in the remaining three. In two of the three, the Tax Court applied the reason-to-know standard only after determining that the innocent spouses had no knowledge of the transactions underlying the substantial understatements.

Circuit Courts of Appeal

Six circuits have heard appeals of innocent spouse cases involving grossly erroneous deductions and the reason to know requirement. The first to hear such a case was the Sixth Circuit in Purcell [87-2 USTC 9479 (6th Cir., 8-18-87) aff'g 86 TC 228]. The appeals court avoided the issue by focusing on the fourth requirement of IRC Sec. 6013(e)(1) and ruled that it would not be inequitable to hold Mrs. Purcell liable for the joint tax liability. The five other circuits to hear similar appeals and the rationale for their decision are shown in the Exhibit.

Circuit Courts vs. Tax Court

The circuits generally agree that the Tax Court is interpreting the reason-to-know requirement too literally, thus too narrowly. By applying the pre-1984 Act income omission legal standard to post-1984 Act deduction cases, the Tax Court appears to be acting contrary to congressional intent. Congress intended to liberalize the innocent spouse provisions by broadening the statute and extending relief to situations where substantial understatements are attributable to claims of deductions, credits, and basis that have no basis in fact or law. IRC Sec. 6013(e)(1)(C) requires that the innocent spouse in signing the return "did not know, and had no reason to know, that there was such substantial understatement." The disagreement between the Tax Court and the circuit courts of appeal lies in the interpretation of "reason to know." The Tax Court literally interprets this requirement to mean if an innocent spouse was aware of the transaction underlying the grossly erroneous item, he or she knew or had reason to know of the understatement. The appeals courts believe that merely knowing a transaction has occurred does not always mean a spouse has reason to know of a substantial understatement. All courts agree that ignorance of the tax consequences of an erroneous item is not a defensible position. But if a spouse's ignorance of a transaction extends beyond the tax consequences, just seeing a deduction listed on a return might not be enough reason to know. Rather, the appeals courts look at all the facts of the situation including the level of education, involvement in the family's business and financial affairs, lavish lifestyle, and culpable spouse's evasiveness.

The statute refers to a spouse not knowing of a substantial understatement not to a spouse not knowing of a grossly erroneous item. Even if a spouse reviews and signs a joint return with an erroneous deduction on it, is it fair to require that spouse to be able to identify that a deduction is erroneous and leads to a substantial understatement? The courts of appeal do not believe it is fair and agree that applying the Tax Court's test in deduction cases would effectively preclude innocent spouse protection in such cases. This is contrary to congressional intent in liberalizing the statute.

A dissenting opinion in Bokum agrees with the circuit courts' more liberal interpretation of the reason to know requirement. The dissenting judge believes the majority opinion of the Tax Court defeats the protection of the statute when a spouse has general knowledge of a transaction but does not know or have reason to know that some element of the transaction as reported gives rise to a substantial understatement. Having knowledge of a transaction is relevant but standing by itself should not preclude relief. The judge said the Tax Court should follow the Ninth Circuit in Price and "give the statute the more liberal reading which Congress intended." Otherwise, according to another dissenting judge, one spouse would be required to hire an independent tax advisor to review the joint return prepared by the other spouse's accountant. This would defeat the
purpose of hiring a professional return preparer in the first place.

A Close Call

The Tax Court's interpretation of the reason-to-know requirement of IRC Sec. 6013(e)(1)(C) places an unfair burden on taxpayers whose spouses cheat by overstating deductions rather than by omitting income. The Supreme Court refused to hear an appeal by Parks. Perhaps its refusal stems from the fact the Appeals Courts have so far adopted more liberal interpretations of the reason-to-know requirement. The Tax Court must follow a particular court of appeals decision in cases where appeals lie in that circuit. Since all circuits have concurred so far, the Supreme Court probably will not agree to hear an appeal until such time as one circuit disagrees with the rest.

Although five circuits have adopted the reason-to-know standard of Stevens, only two of the five have overturned Tax Court decisions (See Exhibit). In both Price and Erdahl, petitioners had knowledge of the transactions underlying the grossly erroneous deductions of their spouses. But both had much less knowledge about the transactions and other financial affairs of their families than petitioners in the other three cases. It appears the Tax Court and Appeals Courts will generally reach the same conclusions except in those cases in which spouses know a transaction has occurred but know little else about it. In such situations, the less education, involvement in family financial affairs, and lavish lifestyle, and the more deceitful the culpable spouse, the more chance the other spouse has of winning innocent spouse relief on appeal.