Last night I taught my last income tax class of the semester in the Villanova Graduate Tax Program. Jim Fee, one of my longtime colleagues, suggested a few years ago that the course should end with a review of the tax consequences of divorce. Jim’s suggestion has worked well, as it allows us to discuss income and deduction issues associated with alimony, tease out a complex statutory recapture provision for excess alimony payments, consider and compare property transfers under Section 1041 with other transactions like part-gift/part-sales, and review the deductibility of legal fees associated with the divorce. It is a nice way to review concepts while at the same time introducing a topic that is essential for practitioners.
How does this relate to procedure? In class we only touch briefly on issues of filing status and mention though do not discuss in detail issues relating to relief from joint and several liability. That is left for our Tax Procedure class. And of course for Procedurally Taxing, which takes us to an early December Tax Court summary opinion, McDonald v Commissioner.
McDonald involves Section 6015(c), which for qualifying spouses results in an allocation of liability between the nonrequesting spouse and the spouse requesting relief. It provides a nice platform for discussing the difficult issues that arise when ex spouses do not agree on whether one is eligible for relief and the challenges associated with determining what constitutes disqualifying actual knowledge of an erroneous position on a return.
Section 6015(c) relief is more mechanical than the statutory basis for relief under either Section 6015(b) or the equitable relief rules in Section 6015(f). To get (c) relief the requesting spouse must be divorced, legally separated or widowed, or not part of the same household for 12 months prior to the request. In addition, there must be a valid joint return, the deficiency must be allocable (at least in part) to items pertaining to the nonrequesting spouse, and the request must be made within two years of the first collection activity.
While the test is somewhat mechanical, the statute provides that no relief is eligible if the IRS demonstrates that at the time that the individual signed the return the requesting spouse had “actual knowledge” that that “any item giving rise to a deficiency (or a portion thereof)” is erroneous. (Note that relief under Section 6015(b) is denied if the requesting spouse does not have actual knowledge but has “reason to know” of an understatement). Regulations expand a bit on the actual knowledge rule, providing that if “the requesting spouse had actual knowledge of an erroneous item that is allocable to the nonrequesting spouse, the election to allocate the deficiency attributable to that item is invalid, and the requesting spouse remains liable for the portion of the deficiency attributable to that item.” The regulations place the burden of proving knowledge on the IRS, which must establish by a “preponderance of the evidence” that the requesting spouse had actual knowledge of the erroneous item.
An interesting feature of spousal relief cases is that the statute allows a nonrequesting ex spouse to participate in a Tax Court proceeding; it is possible for the IRS to agree with the requesting spouse on the request for relief only to have the nonrequesting spouse intervene and become a party. Not surprisingly, ex-spouses do not always see eye to eye on eligibility for relief, and at times IRS may take a back seat and let the Tax Court judge decide issues like credibility and apply the law to the facts at hand.
That takes us to the McDonald case. I will simplify for purposes of highlighting the procedural issues. There were three years in issue. In the years in question the husband was a full-time employee of IBM working as an IT specialist. The wife operated a travel agency and was attending nursing school as a part time student. After graduating nursing school the wife worked part-time as a nurse. While the husband did use a management company for day-to-day management of the properties he did actively participate in its operations; the wife was a co-owner of some of the rental properties but otherwise according to the opinion only occasionally answered phone calls and took messages if the management company called the husband.
At trial the wife testified that she had no access to the business records because her ex kept all financial records relating to the real estate business in a locked storage room. In addition, she testified that she relied on her ex and a CPA to prepare the tax returns. The marital settlement agreement stated that the ex owned the real estate rental business and he received all the rental properties pursuant to that agreement.
The McDonalds filed the first of the returns for the years 2009-2011 in June of 2011. A CPA prepared the returns, and Mrs. McDonald testified that while she went to the CPA’s office to sign the returns the preparer did not review the return with her. She did testify, however, that a couple of years earlier that the CPA told her that “one or both of them qualified as real estate professionals by virtue of the substantial time and effort devoted to the rental real estate activity.”
The IRS examined the returns and made adjustments, including disallowing losses in excess of $25,000 on the real estate activity due to its conclusion that Mr. McDonald was not a real estate professional because he did not “materially participate” in a “real property trade or business.” (To put some context on this during the years in question the returns reflected about $119,000, $78,000 and $58,000 in real estate losses). In addition, one of the returns failed to include approximately $10,000 in wages attributable to Mrs. McDonald’s part-time work as a nurse.
The McDonalds conceded the adjustments in the notice of deficiency but Mrs. McDonald raised as an affirmative defense the issue of relief under Section 6015(c) with respect to the disallowed real estate losses. IRS agreed with Mrs. McDonald that she was entitled to relief; Mr. McDonald opposed her request for relief because he claimed that she had actual knowledge of the losses.
Before getting to what actual knowledge means in this context the Tax Court had to resolve the preliminary issue of burden of proof. The statute is silent on who has the burden when the ex spouse (and not the IRS) opposes the request for relief; the opinion notes that the Tax Court has held that the inquiry is “whether actual knowledge has been established by a preponderance of the evidence presented by all three parties.”
How did the Tax Court resolve this pickle of determining whether Mrs. McDonald had actual knowledge? There have been a number of cases teasing out the concept of actual knowledge both on the income and deduction side. Citing to the Cheshire case, the opinion notes that “[a]ctual knowledge” means “an actual and clear awareness (as opposed to reason to know) about the item giving rise to the deficiency.” In the context of deductions, the opinion discussed how the Tax Court considers whether “the requesting spouse has knowledge of the factual circumstances which made the item unallowable as a deduction.”
The term factual circumstances is not clear on its face, and the key in this case was whether the circumstances related to an awareness of the losses and expenses in the business itself or the actual tax treatment of the losses that were disallowed. Here the opinion considered circumstances in relation to the specific treatment of the losses:
The factual circumstance which made the balance of those losses unallowable as a deduction was that Mr. McDonald was not a real estate professional, i.e., that he did not “materially participate” in a “real property trade or business.”… We accordingly must decide whether Mrs. McDonald had “actual knowledge” that Mr. McDonald did not qualify as a real estate professional under the governing statutory standards.
The opinion goes on to discuss those standards and how given Mrs. McDonald’s lack of sophistication and the advice she received from the CPA she did not have “actual and clear awareness” of the disallowed losses:
She had no knowledge of Federal tax law and was advised by their C.P.A. in 2009 that she or Mr. McDonald (or both of them) did qualify as a real estate professional. She had no reason to question the C.P.A.’s advice: Although she did not know the exact scope of Mr. McDonald’s rental real estate activity, she was aware that his participation in the activity was significant. She knew that he devoted substantial time to the recordkeeping and financial aspects of the real estate business; that he kept volumes of financial records in a locked room to which she had no access; and that the management companies routinely called him when decisions about the rental properties needed to be made.
While McDonald is a non-precedential opinion, it is a helpful case for practitioners. It resolved the question of actual knowledge in a way that takes into account the sophistication of the taxpayer, the technical reasons for disallowance, and the taxpayer’s lack of awareness as to how the item should be treated for tax purposes. Knowledge of the mere existence of the expenses and even some engagement with the business that generated the deductions were insufficient to defeat relief.