Court Adopts “Reason to Know” Test for Innocent Spouse Cases

By James Beavers, J.D., LL.M., CPA

The Sixth Circuit adopted the “reason to know” test for determining whether a taxpayer was eligible for innocent spouse relief from tax liability for an understatement arising out of an erroneous deduction on a tax return.

Background

Winnie Greer married Daniel Greer in 1967 while in college and remains married to Mr. Greer. Mrs. Greer continued her education after marriage and eventually earned a master’s degree in music education; however, she had no financial or accounting training. During their entire marriage, Mr. Greer managed the couple’s financial affairs. He did not conceal any financial activities from the petitioner or mislead her about those activities, but he was the primary decision maker, and she relied upon him to direct their investments and make decisions regarding their finances and taxes.

Mr. Greer and his father-in-law started a cable television business in 1979. In an effort to offset anticipated taxable income from this business, he invested in Madison Recycling Associates, Inc. (Madison) in 1982. Mr. Greer claimed significant investment tax credits related to Madison on the couple’s joint return for 1982 and carried back some of the credits on amended returns for 1979–1981. The IRS disallowed all the tax benefits arising from the Madison investment in a final partnership administrative adjustment issued in 1987.

After prolonged litigation, the Tax Court and the Sixth Circuit upheld the IRS’s position, and the IRS issued the Greers a notice of deficiency in 2003 for the tax ($87,627) and interest ($544,125) due related to the disallowed credits. The Greers challenged the amount, but the courts again rebuffed them. In 2006, Mrs. Greer requested innocent spouse relief from the IRS under Secs. 6015(b) and (f) for the deficiency. The IRS denied her request, finding that she knew of the Madison investment, that the money for the investment was drawn from the Greers’ joint bank account, that she signed Form 1045, Application for Tentative Refund, requesting refunds, and that she received the benefit of those refunds. Undaunted, Mrs. Greer filed an administrative appeal, but the appeals officer denied her request based on her failure to inquire into the claimed deductions. The appeals officer also rejected her claims that she qualified for equitable relief because she would face economic hardship if she were forced to pay the deficiency.

Mrs. Greer next petitioned the Tax Court to review the IRS’s determination. The Tax Court held that she did not qualify for innocent spouse relief, emphasizing that under the circumstances she should have inquired further into the extraordinary tax benefits claimed on the couple’s 1982 return and that she thus had reason to know of the tax understatements. Mrs. Greer appealed the Tax Court’s decision to the Sixth Circuit.

Sec. 6015(b)

The innocent spouse relief provisions of Sec. 6015(b) state that a taxpayer will be relieved of liability for an understatement of tax if (1) a joint return was filed for the tax year in question; (2) there is an understatement of tax attributable to one of the taxpayers; (3) the taxpayer requesting relief “did not know, and had no reason to know, that there was such understatement” when he or she signed the return; (4) taking into account all the facts and circumstances, it would be inequitable to hold the taxpayer liable for the deficiency attributable to such understatement; and (5) the taxpayer elects to have Sec. 6015(b) apply within two years of the initial collection action.

The Sixth Circuit’s Decision

Two tests have been used by courts to determine whether a spouse did not know or had no reason to know of the understatement as required by Sec. 6015(b): the knowledge of the transaction test and the reason to know test. The Sixth Circuit announced that it was adopting the reason to know test. Although it was critical of the Tax Court’s application of the test in the case, the Sixth Circuit held that the Tax Court did not clearly err in holding that Mrs. Greer had reason to know of the understatement on the returns in question and did not qualify for innocent spouse relief.

Under the knowledge of the transaction test, a taxpayer is considered to have had reason to know of an understatement if he or she had knowledge of the transaction giving rise to the claimed tax benefits. The Sixth Circuit criticized this standard for erroneous deduction cases because it would effectively make it impossible for a spouse to qualify for innocent spouse relief in these cases. Because an erroneous deduction will always be included on a return, a taxpayer who has read a return will be deemed to have known or have had reason to know of a transaction that gives rise to the erroneous deduction. The court found that this result was contrary to Congress’s intent for the innocent spouse provisions.

The court instead chose to apply the reason to know test that the Ninth Circuit set out in Price, 887 F.2d 959 (9th Cir. 1989), under which a spouse is deemed to know or have reason to know of an understatement if a reasonably prudent taxpayer in his or her position at the time he or she signed the return would be deemed to know that the return contained the understatement. To make this determination, the Ninth Circuit stated that four factors should be analyzed: (1) the taxpayer’s level of education; (2) the taxpayer’s involvement in the family’s business and financial affairs; (3) the presence of expenditures that appear lavish or unusual when compared with the family’s past levels of income, standard of living, and spending patterns; and (4) the culpable spouse’s evasiveness and deceit concerning the couple’s finances.

The Sixth Circuit found that these same factors could be used to determine whether a taxpayer had a duty to inquire about the legitimacy of a deduction in cases where the information available to the taxpayer was sufficient to put the taxpayer on notice that an underpayment might exist. In these cases, the court held that in addition to the four Price factors, it was appropriate to consider whether the tax returns in question “set forth deductions or credits large enough, relative to the size of the underlying investment or of reported income, to prod a reasonable taxpayer into further investigation.”

Anticipating that the Sixth Circuit would choose the reason to know test, the Tax Court had analyzed the four Price factors in Mrs. Greer’s case. It found that all but the third factor weighed against Mrs. Greer. It also found that she was aware of the large tax benefits generated by the Madison investment and the refunds attributable to them. Therefore, it held she had a duty to inquire about the investment and a reason to know about the understatements on the 1982 return. Accordingly, the Tax Court held that she did not qualify for innocent spouse relief.

The Sixth Circuit was critical of the tax court’s application of the test, specifically finding that the four-factor analysis did not indicate that Mrs. Greer had a duty to inquire about the understatements on the Greers’ 1982 return. However, it further found that the low level of tax reported on the 1982 return and the refunds generated by the carryback of the investment credits from the Madison investment to the earlier tax years should have led Mrs. Greer to inquire into the propriety of claiming the credits for the transactions. Therefore, it held that the Tax Court had not clearly erred in holding that Mrs. Greer had a duty to inquire about the Madison investment and thus had reason to know of the understatement on the couple’s 1982 return and that she did not qualify for innocent spouse relief.

Reflections

In adopting the “reason to know” test in an erroneous refund case, the Sixth Circuit joins the Second, Fifth, Seventh, Eighth, and Eleventh Circuits. Generally, this should be good news for taxpayers: As the court points out, applying the knowledge of the transaction standard in erroneous refund cases would effectively bar innocent spouse relief for any spouse who read and signed the tax return. The Sixth Circuit described this as “a close case” and deferred to the Tax Court’s findings of fact to deny Mrs. Greer innocent spouse relief.

Greer, No. 09-1420 (6th Cir. 2010)

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