Prior Closing Agreement Subject to Innocent Spouse Provisions

In a case of first impression, the Tax Court ruled, in Marianne Hopkins, 120 TC No. 17 (2003), that a closing agreement executed before July 22, 1998, did not bar a later claim for Sec. 6015 innocent spouse relief when the tax liability resulting from the closing agreement remained unpaid on that date. The taxpayers signed the closing agreement 15 years ago; presumably, after Hopkins, many closing agreements could qualify for the same treatment. The Tax Courts rationale indicates that it will probably interpret other provisions of Sec. 6015 broadly. Sec. 6015 is a pro-taxpayer statute and includes retroactive provisions.

Background

Sec. 6013(d)(3) provides for joint and several liability for spouses filing jointly (i.e., each spouse is liable for all of the tax). Enacted in 1971, Sec. 6013(e) provided relief from such liability if there was a substantial understatement of tax due to grossly erroneous items of one spouse, the innocent spouse proved he or she did not know (nor have reason to know) of the substantial understatement when signing the return, and it would be inequitable to hold the innocent spouse liable for the resulting tax. Congress thought Sec. 6013(e) relief was inadequate because it was limited to only the most egregious cases.

Law and Regulations

The Internal Revenue Service Restructuring and Reform Act of 1998 repealed Sec. 6013(e) and enacted Sec. 6015, effective for any tax liability arising after July 22, 1998, and any prior tax liability remaining unpaid on that date. It applies to all understatements; partial relief is also available, under Sec. 6015(b)(2), if the innocent spouse knew (or had reason to know) of the understatement, but not its extent. Under Sec. 6015(c) and Regs. Sec. 1.6015-3(a), if spouses are widowed, divorced, legally separated or living apart, the innocent spouse can elect separate liability, unless the Service proves that spouse had actual knowledge of the item when signing the return. The innocent spouse also must prove the item is properly allocable to the other spouse. Sec. 6015(f) allows spouses not qualifying under the above rules to request equitable relief. According to Sec. 6015(a), community property laws are ignored. Finally, Sec. 6015 relief is available even if previously denied under Sec. 6013(e).

Under Regs. Sec. 1.6015-5, innocent spouses elect or request relief on Form 8857, Request for Innocent Spouse Relief, no earlier than after receiving notice of an audit or possible liability for the year in question, and no later than two years after the first collection activity occurring after July 22, 1998. Under Sec. 6015(e), the Tax Court has jurisdiction to review denials of Sec. 6015(b) and (c) elections.

Under Sec. 7121(b), closing agreements are final in the absence of fraud, malfeasance or misrepresentation; in fact, courts have enforced closing agreements even if the tax at issue is later declared unconstitutional. Sec. 6015(g)(1) allows credits or refunds under Sec. 6015(b) and (f), unless a Sec. 7121 closing agreement has been executed. Regs. Sec. 1.6015-1(c)(1) denies Sec. 6015 relief for any tax year in which the spouse had previously executed a Sec. 7121 closing agreement or a Sec. 7122 offer-in-compromise, but the effective date of the Sec. 6015 final regulations was not until July 18, 2002.

A final court decision is similar to a closing agreement. Sec. 6015(g)(2) specifies that a final court decision on the spouses tax liability bars subsequent relief under Sec. 6015(b) and (c) for the same tax year, unless Sec. 6015 was not an issue in the court proceeding and the innocent spouse did not meaningfully participate in such proceeding. Under Regs. Sec. 1.6015-1(e), a spouse has not meaningfully participated if Sec. 6015 was effective after the court proceeding.

Facts

On Marianne and Donald Hopkinss joint returns for 1982 and 1983, they claimed loss deductions averaging over $85,000 per year from a drilling partnership. In 1988, the Service audited the partnership and executed a Sec. 7121 closing agreement with the taxpayers as to their partnership losses. In 1989, the taxpayers separated and later divorced.

In 1995, Ms. Hopkins filed for bankruptcy and requested innocent spouse relief from the 1982 and 1983 tax liabilities under former Sec. 6013(e). The bankruptcy court ruled that she waived her right to an innocent spouse defense by signing the closing agreement, and the district court agreed. The Ninth Circuit (146 F3d 729 (1998)) also affirmed, ruling that she did not preserve the innocent spouse defense in the closing agreement. The 1982 and 1983 tax liabilities stemming from the closing agreement remained unpaid. In 1999, Ms. Hopkins filed Form 8857, requesting Sec. 6015 relief. The Service had not acted on this request by 2001, when she filed in Tax Court.

Tax Courts Decision

The Tax Court ruled that Ms. Hopkins could claim Sec. 6015 relief even though a closing agreement would ordinarily bar any defense to a liability covered by the agreement. The Tax Court based its ruling on the following:

1. Because Congress enacted Sec. 6015 to expand access to innocent spouse relief, the statute should be construed liberally to effectuate its remedial purpose.

2. Congress provided for retroactive Sec. 6015 relief for unpaid taxes arising from pre-July 22, 1998, tax liabilities.

3. Sec. 6015 relief was unavailable when Ms. Hopkins executed the closing agreement.

4. Sec. 6015(g)(2) and Regs. Sec. 1.6015-1(e) would allow Sec. 6015 relief subsequent to a final court decision, and final court decisions are similar to closing agreements.

5. Sec. 6015(g)(1) denies credits or refunds if a prior closing agreement was executed, but Ms. Hopkins did not request a credit or refund.

The Tax Court will decide whether to grant Ms. Hopkins Sec. 6015 relief in a separate opinion.

Conclusion

Tax advisers should become familiar with Sec. 6015 because of its sweeping approach to innocent spouse relief and Hopkins expansive interpretation of Sec. 6015. Although the Tax Court did not decide whether Sec. 6015 relief could also apply to closing agreements executed before July 18, 2002 (the Sec. 6015 regulations effective date), it is unlikely to permit innocent spouse relief for closing agreements executed after July 22, 1998. In the future, tax advisers should carefully consider Sec. 6015 before clients sign a closing agreement.

From Peter C. Barton, MBA, CPA, J.D., Professor of Accounting, and Clayton R. Sager, Ph.D., Associate Professor of Accounting, University of WisconsinWhitewater, Whitewater, WI (Neither Affiliated with DFK International)