Knowledge of Items Giving Rise to Understatement Precludes "Innocent Spouse" Relief

I and C were married. In 1992, C took early retirement. As a result, C received a distribution, a portion of which was rolled over into a qualified account and the rest of which was put into a joint account at the AT Credit Union. K was aware of C's receipt of the retirement distributions and the amount thereof, as well as the interest earned on the AT account.

K and C made several large disbursements from the AT account in 1992, paying off the mortgage on the family residence and purchasing a car. They also used the retirement distributions to pay family expenses and provide startup capital for a new business for C and for investments. In addition, K and C used the retirement distributions to satisfy loans taken out to acquire a family truck and for a car for one of their children, as well as to open a college bank account for their daughter.

In 1995, K and C divorced. Pursuant to a divorce decree, C transferred to K his interest in the family residence and title to the car. At the time of transfer, the family residence and the car were unencumbered.

C prepared and filed his and K's joint income tax returns, including their 1992 return. Before signing the return, K questioned her husband about the potential tax ramifications of the retirement distributions. C falsely told her he had consulted with a CPA (M), and had been advised that proceeds used to pay off the mortgage on their home would reduce the taxable amount of the retirement distributions. Accepting her husband's answer, K did not inquire further and signed the 1992 return. K assumed that the 1992 return would be timely filed. On the 1992 return, C and K reported that they had received a retirement distribution of approximately $200,000 and that $56,150 of that amount constituted taxable income. In addition, they reported $477 in interest income, as well as a $12,349 loss on Schedule C.

In August 1994, K received a letter from the IRS stating that it had not received their 1992 return. In searching for a copy of the 1992 return, K discovered in a desk drawer the original 1992 return, as well as a check for the amount of tax shown as owed. K immediately contacted M, who advised her to file the 1992 return and enclose payment for the tax liability reflected on the return as soon as possible. K filed the 1992 return along with the remittance on Aug. 15, 1994. In October 1994, K received notification from the Service that $8,502 in estimated tax payments claimed on their 1992 return had not been paid. Despite C's reassurance that he had made the estimated tax payments, K discovered that the payments in fact had not been made. K then paid the estimated tax, using borrowed funds.

The IRS determined that the entire retirement distribution (less the rollover) was taxable income, and thus C and K had understated the taxable amount of the retirement distributions; in addition, the Service disallowed their Schedule C expenses. K filed a claim for "innocent spouse" relief. Even though she had actual knowledge of the omitted retirement proceeds when she signed the return, she argued that, because she relied on C's false statements, she had reason to believe that the omitted proceeds were not taxable. In a reviewed decision, the Tax Court (opinion Jacobs, J.) holds that K is not entitled to innocent spouse relief.

As a general proposition, if a joint return is filed by a husband and wife, liability with respect to any tax shown on the return or found to be owing is joint and several. In 1971, Congress enacted Sec. 6013(e) to correct perceived grave injustices often resulting from the imposition of joint and several liability. For many taxpayers, relief under Sec. 6013(e) was difficult to obtain. To make innocent spouse relief more accessible, Congress repealed Sec. 6013(e) and enacted Sec. 6015 in 1998. Sec. 6015 provided three avenues of relief from joint and several liability:

1. Sec. 6015(b)(1) (similar to former Sec. 6013(e)) allows a spouse to escape completely joint and several liability;

2. Sec. 6015(b)(2) and (c) allow a spouse to elect limited liability through relief from a portion of the understatement or deficiency; and

3. Sec. 6015(f) confers on the Secretary discretion to grant equitable relief when relief is unavailable under Sec. 6015(b) or (c).

4. Sec. 6015 generally applies to any liability for tax arising after July 22, 1998, and any liability for tax arising on or before July 22, 1998, that remains unpaid as of such date.

Relief Under Sec. 6015(b)

Sec. 6015(b)(1)(C) contains a "no knowledge of the understatement" requirement. K maintains that the standard of inquiry to be used in determining whether the putative innocent spouse knew, or had reason to know, of an understatement of tax is whether, at the time the return was signed, a reasonably prudent taxpayer in the spouse's position could be expected to know that the stated tax liability was erroneous or that further investigation was warranted. Based on this standard, K argues that, even though she knew of the retirement distributions and the interest income, she did not know that there was an understatement of tax on the 1992 return.

The "no knowledge of the understatement" requirement of Sec. 6015(b)(1)(C) is similar to that found in former Sec. 6013(e)(1)(C). When relief was requested for omission of income (the situation involved herein), innocent spouse relief has been denied for a spouse with actual knowledge of the underlying transaction that produced the omitted income. We believe this standard applies for Sec. 6015(b)(1) relief as well.

Here, K possessed actual knowledge of the underlying transactions (the distribution of retirement proceeds and the interest earned on the AT account) that gave rise to the C and K tax understatement. Thus, K does not satisfy the "no knowledge of the understatement" requirement of Sec. 6015(b)(1)(C). Moreover, because she knew, or had reason to know, of the entire amount of the retirement distributions and the interest earned on the AT account, K is not entitled to proportionate relief under Sec. 6015(b)(2).

Relief Under Sec. 6015(c)

In general, Sec. 6015(c) allows proportionate tax relief (if a timely election is made) through allocation of the deficiency between individuals who filed a joint return and are no longer married, are legally separated or do not reside together for a 12-month period. Such allocation, however, is not permitted if the Secretary demonstrates that the individual electing relief had actual knowledge, at the time the return was signed, of any item giving rise to a deficiency (or portion thereof) that is not allocable to such individual. For purposes of Sec. 6015(c), equitable considerations in holding the putative innocent spouse liable for unpaid tax or any deficiency are of no import.

K posits that, because she did not know that the taxable amount of the retirement distribution was misstated on the 1992 joint return, she is entitled to Sec. 6015(c) relief. The IRS, on the other hand, maintains that ignorance of the tax law is of no import—if K knew of the event or transaction giving rise to the deficiency (which she admits she did), she cannot obtain relief under Sec. 6015(c).

The knowledge requirement of Sec. 6015(c)(3)(C) does not require the electing spouse to possess knowledge of the tax consequences arising from the item giving rise to the deficiency or that the item reported on the return is incorrect. Rather, the statute mandates only a showing that the electing spouse actually knew of the item on the return that gave rise to the deficiency (or portion thereof). Here, when K signed the joint return, she was aware of the amount, the source and the date of receipt of the retirement distribution and interest. She was, however, under a misapprehension as to the taxable amount of the retirement distribution.

The knowledge standard for purposes of Sec. 6015(c)(3)(C) is an actual and clear awareness (as opposed to reason to know) of the existence of an item that gives rise to the deficiency (or portion thereof). In the case of omitted income (such as the situation involved here), the electing spouse must have an actual and clear awareness of the omitted income. Sec. 6015(c)(3)(C) does not require actual knowledge on the part of the electing spouse as to whether the entry on the return is or is not correct.

Generally, ignorance of the tax law is not a defense to a deficiency. Were we to accept the knowledge standard K advocates (i.e., the putative innocent spouse is entitled to relief if he misunderstood or lacked knowledge of the Code), potentially any spouse who is not a certified public accountant or tax attorney would be allowed to escape paying income tax. We do not believe Congress intended such a result.

K had actual knowledge of the disputed item of income (the retirement distribution proceeds), as well as the amount thereof, that gave rise to the deficiency at the time she signed the joint 1992 return. The fact that K did not know that the amount of the retirement distribution was misstated on the return is of no import. Consequently, the benefits of Sec. 6015(c) are unavailable to her.

Kathryn Cheshire, 115 TC No. 15

REFLECTIONS. Compare Charlton, 114 TC 333 (2000), in which the Tax Court held that an ex-spouse who did not have actual knowledge of omitted income (even though he should have known), and thus did not have actual knowledge of the item causing the deficiency, qualified for relief under Sec. 6015(c).