Tax Matters

Nonelecting Innocent Spouse Rules
In 1984 Congress expanded the protection from joint and several liability it provided to innocent spouses. Recently, an appeals court affirmed a Tax Court decision that there is a glitch in the law.

John and Judith Maier were divorced in 1995. At the time of their divorce they owed both federal and state income taxes, for which the divorce decree provided they would remain jointly liable. In spite of the decree, Judith requested and was granted relief from the federal tax liability by the IRS under the innocent spouse provisions. The IRS notified John of her request and permitted him to provide information relevant to the decision; he pointed out the terms of the divorce decree but the IRS granted the relief anyway. John petitioned the Tax Court to overrule the IRS. It rejected the petition on the grounds it lacked jurisdiction. The taxpayer appealed.

Result. For the IRS. The rules concerning innocent spouse requests are contained in IRC section 6015. Under section 6015(e)(1)(A), the Tax Court has jurisdiction to review a petition from an electing taxpayer to determine the appropriate relief in cases where the IRS had denied the request. Section 6015(e)(4) says a nonelecting spouse shall receive notice and have the opportunity to become a party to any proceeding the electing spouse brings. Section 6015(h)(2) provides that the Treasury Department issue regulations that provide notice and give the nonelecting spouse an opportunity to participate in any administrative hearing. None of these provisions or any other subsection of 6015 provides for a court petition solely by the nonelecting spouse for review of a grant of relief to an electing spouse.

The Second Circuit Court of Appeals rejected the cases John Maier cited as authority for reviewing his case. In each one the Tax Court already had jurisdiction to review a deficiency. Therefore it had jurisdiction to review the innocent spouse issue. In this instance there was no existing deficiency case. The court acknowledged that a Tax Court statement in Carson v. Commissioner could be read to imply the Tax Court felt nonelecting spouses should have the same rights as electing spouses to petition for a judicial hearing. However, this was not binding on the appeals court.

The Second Circuit noted that commentators previously had pointed out this inequality and agreed it was not fair. However, it is up to Congress to change the law. The courts do not have the authority to rewrite tax sections they think are deficient.

Nonelecting spouses must take full advantage of their right to participate in the administrative determination of an innocent spouse request. They will not be able to challenge the grant of relief in the courts unless a deficiency already is being contested. Provisions in a divorce decree that maintain continued joint liability may not be effective in preventing the IRS from imposing liability on only one spouse.

John Maier, III v. Commissioner, CA-2.

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

Shareholder Guarantee to S Corporation Creditors Doesn’t Increase Basis
According to IRC section 1366(d) the aggregate amount of losses and deductions an S corporation shareholder may take into account for any taxable year may not exceed the sum of the adjusted basis of the shareholder’s stock in the S corporation and the shareholder’s adjusted basis in any amount the corporation owes the shareholder. Taxpayers generally may not increase the basis in their S corporation stock by the amount of a loan guaranty to S corporation creditors until they make an actual “economic outlay.” In a recent case the court considered whether an S corporation shareholder could include the amount of the guaranteed debt in his stock basis.

Gary Luiz and two other shareholders formed Green Valley Sawmills Inc., an S corporation, in 1995. Luiz contributed approximately $27,000 in capital and was the corporation’s president and one-third owner. By 1997 Luiz owned 43.03% of Green Valley.

Green Valley in 1996 owed approximately $416,093 for logs it had purchased and $17,000 for transportation services provided to it in 1995 and 1996. Luiz orally guaranteed Green Valley’s creditors he would pay the debts if the company did not.

Luiz did not make any payments to Green Valley creditors during 1996 or 1997, but in 1998 he issued a promissory note to pay the corporation’s transportation debt. He paid about $19,000 under the terms of the note.

Luiz filed federal income tax returns for 1996 and 1997 deducting losses from Green Valley of $234,945 and $193,920, respectively. The IRS determined that Luiz’s basis in his Green Valley stock was $23,965 in 1996 and $7,499 in 1997 and that his deduction of the S corporation’s losses should have been limited to the amount of that basis.

Luiz’s position was that he had made an economic outlay relating to Green Valley’s debts before or during 1996 to 1997. He advanced the following arguments in support of this contention:

His basis in Green Valley stock included the amount of Green Valley’s debts he had guaranteed. Relying on Selfe v. United States, (86-1 USTC 9115), Luiz argued he could increase his basis in Green Valley by the amount of his guarantees to the S corporation’s creditors. In Selfe the court held that shareholder guarantees of S corporation indebtedness increased the shareholder’s tax basis in his or her stock where, in substance, the shareholder personally borrowed funds and advanced them to the corporation.

Relying on Bloom v. Bender, 48 Cal. 2d 793 (1957), Luiz contended a guarantor’s obligation is presumed to be unconditional and he or she is liable on the default of the primary obligor without notice or demand.

His guarantee of Green Valley debt was an economic outlay under section 3054 of the California civil code, which grants a lending institution a general lien on all property in its possession belonging to customers. Luiz argued Green Valley’s creditors could have filed a general lien on his personal property while the guarantees were in effect.

IRC section 752(a) applied because S corporations are similar to partnerships. Section 752(a) provides in part that any increase in a partner’s individual liabilities by reason of the partner’s assumption of partnership liabilities shall be considered a contribution of money to the partnership.

Result. For the IRS. The court disagreed with Luiz, finding Selfe distinguishable from this case. The court held that unlike Selfe, there was no evidence in this case that Luiz personally had borrowed funds and advanced them to Green Valley, that he had pledged personal assets as collateral or that Green Valley creditors had looked primarily to him for repayment.

The court said section 3054 of the California civil code did not apply. It applied instead to banks and savings and loan associations, which none of Green Valley’s creditors were.

The court found Bloom also did not apply. In that case the court did not discuss or decide whether the guarantor pledged collateral or whether there was an economic outlay. The court held that the obligation of the guarantor was not barred by the running of the statute of limitations against the principal debtor or the discharge of the principal debtor in bankruptcy. The court also said section 752(a) applied to partnerships, not to S corporations.

The court concluded that because Luiz had not made an economic outlay under the guarantee in 1996 or 1997, he had insufficient basis in his Green Valley stock and debt to allow him to deduct the losses he claimed in that period. An economic outlay occurs when a taxpayer/shareholder is left poorer in a material sense after the transaction. Pledging personal assets also is not an economic outlay sufficient to increase basis.

Gary and Janet Luiz v. Commissioner, TC Memo 2004-21.

Prepared by Claire Y. Nash, CPA, PhD, associate professor of accounting, Christian Brothers University, Memphis, and Tina Quinn, CPA, PhD, associate professor of accounting, Arkansas State University, Jonesboro.