The case of Chico v. Commissioner, T.C. Memo. 2019-123 points out the benefits to the “good” spouse when the other spouse files a fraudulent tax return. The case follows earlier Tax Court precedent established in the non-precedential case of Said v. Commissioner, T.C. Memo. 2003-148. Because of the interplay of the fraud penalty and the accuracy related penalties, the “good” spouse gets a pass on penalties on the return. While this outcome has nothing to do with the innocent spouse provisions, it has the effect of leaving the “good” spouse free of penalties when the fraud on the return relates only to the other spouse. Thanks to our fellow blogger Jack Townsend for bringing this case to my attention.
Mr. Chico ran several businesses including a return preparation business. He filed returns that failed to report income from several sources and otherwise contained errors that caused the IRS to assert the fraud penalty. When the IRS asserts the fraud penalty on a joint return, it must prove fraud of each spouse in order to have the fraud penalty apply to both spouses. Here, Mr. Chico’s knowledge of the businesses and of return preparation made him the obvious target of the penalty while the IRS could not overcome the showing that Mrs. Chico had little knowledge of the matters on the return. So, the court found the fraud penalty with respect to Mr. Chico but not his wife.
The finding of the fraud penalty against Mr. Chico did not end the pursuit of penalties by the IRS. As it normally does, the IRS had asserted the lesser penalties in the accuracy penalty provisions of IRC 6662 against both husband and wife. Here, the issue of penalty stacking comes into play. The IRS cannot hit someone with the fraud penalty and the accuracy related penalty. It can either obtain the fraud penalty or the accuracy related penalty but not both. Because of the anti-stacking provision found in IRC 6662(b), the Tax Court found that it could not impose an accuracy related penalty against Ms. Chico since doing so would create a stacking of penalties.
IRC § 6662(b) states the following as it pertains to the imposition of accuracy-related penalties on underpayments. The IRS may not stack penalties when any of the following apply:
- When a penalty is imposed under IRC § 6663 (fraud penalties)
- When a penalty is determined as being a “gross valuation misstatement” as defined under IRC § 6662(h)(2), the portion of the underpayment shall be penalized 40 percent in total (and not an additional 40 percent to the standard 20 percent penalty)
- When a penalty is determined from a nondisclosed noneconomic substance transaction as defined under IRC § 6662(i), the portion of the underpayment shall be penalized 40 percent in total (and not an additional 40 percent to the standard 20 percent penalty)
Treas. Reg. 1.6662-2(c) is the anti-stacking provision in the CFR as it pertains to accuracy related penalties:
A. If a portion of the underpayment of tax shown on a return is attributable to both negligence and a substantial understatement, the accuracy-related penalty would apply only once at the 20 percent rate to this portion of the underpayment. The examiner should assert the penalty that is most strongly supported by the facts and circumstances and write up the other as an alternative penalty position.
B. The penalty is applied at the 40 percent rate on any portion of the underpayment attributable to a gross valuation misstatement. Any penalty at the 20 percent rate that could have applied to this portion is not asserted except as an alternative penalty position.
C. A penalty is applied at the 75 percent rate on any portion of the underpayment attributable to civil fraud. Any penalty that could have applied to this portion at the 20 or 40 percent rate is not asserted except as an alternative penalty position.
IRM 126.96.36.199.3.1 No Stacking Provision (12-13-2016) sets out the anti-stacking rules for IRS employees to follow.
The application of the anti-stacking penalties allows Mrs. Chico to avoid having any penalty for filing an improper return assessed against her. Although the IRS sought the accuracy related penalty against her it does not seem inclined to pursue the issue into the circuit courts to overturn the position stated by the Tax Court that imposing the lesser penalty on the spouse not liable for fraud creates impermissible stacking. In the absence of a court challenge, the IRS must go to Congress and seek a change in the stacking rules to allow assessment against the spouse who did not commit fraud or forgo any lesser penalty against that spouse in these circumstances.
The spouse who did not commit fraud may still suffer because of the fraud. Unless that spouse obtains innocent spouse relief, that spouse will owe all of the additional tax assessed as a result of the audit. Unless the spouse who did not commit the fraud has no withholding and makes no estimated tax payments during the year, that spouse may have to repeatedly apply for injured spouse relief in subsequent years if the couple receives a refund of taxes since the IRS will likely take the whole refund to satisfy the penalty liability of the fraudulent spouse.
Here, the Chico’s filed a joint petition. Two attorneys are listed in the opinion as representing the taxpayers. It is not clear if one was representing Mr. Chico and the other Mrs. Chico or if they were both representing both parties. This is a situation in which the attorneys must be careful because the interests of Mr. and Mrs. Chico do not align.
This is also a situation in which Mrs. Chico was fortunate to have representation. Without representation she has little chance of catching the mistake made by the IRS in seeking to impose a lesser included penalty on her. Perhaps the Tax Court Judge would always or almost always catch this mistake and protect the unrepresented party but that puts a great deal of pressure on the judge which does not belong there. Just because Tax Court judges do a good job of catching these issues and protecting unrepresented taxpayers does not mean that this is a perfect system. An unrepresented taxpayer could end up owing a penalty which the IRS should not have imposed. Even the accuracy related penalty would have been almost $40,000 for the three years at issue in this case. That would have been a steep price for the unrepresented spouse to pay.
The court stated:
Respondent has not asserted fraud penalties against Ms. Chico but alleges that she is liable for the section 6662(a) accuracy-related penalty for each year at issue.
I interpret the court’s statement to mean that no penalty was asserted against Ms. Chico in the notice of deficiency but the attorney in Chief Counsel’s office decided to pursue the penalty after the filing of the petition. If I have interpreted the situation correctly, it looks like the notice writers at the IRS read the IRM but the Chief Counsel attorney and supervisor did not or maybe Chief Counsel’s office does not agree with the decision in Said. If I interpreted the situation correctly, maybe it’s time for a new Chief Counsel notice assuming that Chief Counsel’s office now agrees with this outcome.