Tax Court allows hearsay evidence that was part of administrative record

The Tax Court held that it could consider hearsay included in the administrative record in its review of the IRS’s denial of a taxpayer’s request for Sec. 6015(f) equitable innocent-spouse relief. However, after reviewing the administrative record and considering the taxpayer’s testimony at trial, the court denied her request for equitable relief.

Background

Sydney Ann Chaney Thomas and her husband, Tracy, were married in 1994. For many years, Thomas’s husband had a successful career in the construction industry, and the couple prospered, living an affluent lifestyle and acquiring a home in the San Francisco suburb of Moraga, Calif., and a vacation home near Lake Tahoe.

However, around the time of the 2008 global financial crisis, Thomas’s husband’s income declined, and the couple began experiencing significant financial difficulties. Reflective of these difficulties, the Thomases filed joint returns 2012 through 2014 but did not pay the full amount of tax due that was reported on them. Thomas knew about the underpayments at the time the couple filed those returns.

Thomas’s husband died in 2016, leaving her as his sole heir. His estate consisted primarily of the Moraga and Tahoe houses, which were both subject to large mortgages. Thomas was also left owing the full amount of the unpaid taxes from 2012 through 2014, most of which remained outstanding in 2023.

Although Thomas was in severe financial straits after her husband’s death, she spent money as if she were not. She traveled extensively, including to Rome, Paris, and Florence, paying for her daughters to accompany her on some of these trips. She also borrowed money to pay for her daughters’ college education and paid for their cellphones, car insurance, and certain other expenses, such as $3,500 tuition for an advanced math class for one of the daughters. In her blog, Thomas wrote of purchasing expensive handbags and paying for an expensive business coach, as well as, in one post, stating that although her friends had advised her to sell the Tahoe vacation home (presumably because she needed the money), she would never do so.

In 2018, Thomas attempted to get out from under her creditors by filing for bankruptcy. Notably, in the bankruptcy proceedings, she claimed she had monthly income of $9,515 and monthly expenses of $7,650 and that the values of the Moraga home and Tahoe vacation home were approximately $1.5 million and $700,000, respectively. The bankruptcy case was dismissed in January 2019.

In July 2019, Thomas filed a request for innocent-spouse relief from her unpaid tax liabilities for 2012, 2013, and 2014. In a call in March 2020 with the IRS examiner who was reviewing her request, she claimed her income was $6,800 a month and her expenses were $4,320 a month. The IRS denied her request for relief in September 2020, and she subsequently petitioned the Tax Court for review of the IRS’s determination. As of March 2022, Thomas owed total tax liabilities for the three years at issue of $60,633, not including accrued interest.

In Tax Court, in addition to arguing that Thomas was not entitled to innocent-spouse relief, the IRS also argued that letters from third parties that Thomas gave the Service during her administrative hearing were inadmissible hearsay.

The Tax Court’s decision

The Tax Court held that the third-party letters that were part of the administrative record were admissible. It further held that Thomas was not entitled to Sec. 6015(f) equitable innocent-spouse relief under the rules for streamlined determinations of Sec. 6015(f) relief in Section 4.02 of Rev. Proc. 2013-34 or under the equitable factors for Sec. 6015(f) relief found in Section 4.03(2) of that revenue procedure.

Third-party letters as hearsay: The IRS argued that, applying Rule 802 of the Federal Rules of Evidence, the third-party letters in the administrative record that Thomas wished the Tax Court to consider in its review were not admissible. Rule 802 provides that hearsay is not admissible, but only where, as the Tax Court explained, the rule “is not supplanted by federal statute, other rules of the Federal Rules of Evidence, or any rules prescribed by the Supreme Court.”

The Tax Court found that in innocent-spouse relief cases, Sec. 6015(e)(7) supplants Rule 802. Sec. 6015(e)(7) provides that the Tax Court’s review of an IRS determination of innocent-spouse relief must be based on “the administrative record established at the time of the [IRS’s] determination” and “any additional newly discovered or previously unavailable evidence.” Accordingly, in the Tax Court’s view, Sec. 6015(e)(7) does not contain “any limitations on our consideration of the administrative record.” As there was no dispute that the administrative record included the letters Thomas wanted the Tax Court to consider, the court concluded that applying “the rule against hearsay to exclude these documents from our consideration would undermine Congress’s clear direction as articulated in section 6015(e)(7).”

The Tax Court further observed that there might be questions about whether the evidence in the administrative record is “probative and reliable,” and, when deciding if the evidence in question is probative and reliable, the court may consider factors such as “whether a document is or contains hearsay.” However, according to the court, under Sec. 6015(e)(7), the IRS is not entitled to exclude portions of the administrative record on hearsay grounds and that “based on the congressional command” in the statute, “Ms. Thomas is allowed to rely on the administrative record for whatever it can bear.”

Sec. 6015(f) equitable innocent-spouse relief

Spouses are generally jointly and severally liable for amounts shown on a joint tax return or found to be owed. However, under Sec. 6015, a spouse who has made a joint return may seek relief from joint and several liability in some circumstances. A requesting spouse may request full or partial relief under Sec. 6015(b); proportionate relief under Sec. 6015(c); or, if relief is not available under these two subsections, equitable relief under Sec. 6015(f).

Relief under Sec. 6015(b) requires that the taxpayer have an understatement of tax, and relief under Sec. 6015(c) requires a deficiency. Thomas had an underpayment of tax, not an understatement of tax or a deficiency, so she and the IRS agreed that the only relief she could be entitled to was equitable relief under Sec. 6015(f).

The factors the IRS considers in determining whether a spouse requesting equitable relief is entitled to it are set out in Rev. Proc. 2013-34. Section 4.01 of that revenue procedure lists seven threshold conditions that the taxpayer must meet. Thomas and the IRS agreed that she met the threshold conditions, so the Tax Court did not discuss them in its opinion.

Under Section 4.02 of Rev. Proc. 2013-34, if the threshold conditions are met, the IRS will make a streamlined determination to grant innocent-spouse relief if the requesting spouse establishes that they (1) are no longer married to the nonrequesting spouse; (2) would suffer economic hardship if relief were not granted; and (3) did not know or have reason to know that the nonrequesting spouse would not or could not pay the underpayment of tax reported on the joint income tax return.

Where the requesting spouse meets the threshold conditions for equitable relief but does not meet the requirements for a streamlined determination, Section 4.03 of Rev. Proc. 2013-34 provides seven factors that the IRS will consider in determining whether the requesting spouse is entitled to relief. The factors are: (1) the taxpayer’s marital status; (2) whether the requesting spouse will suffer economic hardship absent relief; (3) whether the requesting spouse had knowledge or reason to know that the nonrequesting spouse would not or could not pay the income tax liabilities; (4) whether either spouse had a legal obligation to pay the liabilities; (5) whether the requesting spouse significantly benefited from the underpayments; (6) whether the requesting spouse has complied with income tax laws in the years following those to which the request for relief relates; and (7) the mental or physical health of the requesting spouse. The IRS must give appropriate weight to each factor, and no one factor is determinative.

Streamlined determination for relief

The Tax Court found that Thomas met the first factor for granting streamlined relief: She was no longer married to her husband. On the other hand, it found that she had not established the second factor — that she would suffer an economic hardship if equitable relief was not granted — so she was not entitled to a grant of streamlined relief. Since she did not meet the economic hardship requirement, the court did not address, in the context of streamlined relief, the third factor regarding knowledge or reason to know the tax liability would not be paid.

Economic hardship exists “if satisfaction of the tax liability in whole or in part will cause the requesting spouse to be unable to pay reasonable basic living expenses” (Rev. Proc. 2013-34, §4.03(2)(b)). A requesting spouse can demonstrate economic hardship by showing that (1) their annual income is below 250% of the federal poverty guidelines or (2) their monthly income exceeds their reasonable basic monthly living expenses by $300 or less. In addition, the spouse must also prove that they do not have assets from which payments could be made toward the liability and still meet reasonable basic living expenses (id.).

The court found that Thomas had not established that she was entitled to a finding of economic hardship. Thomas claimed in Tax Court that her annual income was at most $37,800, which, if true, would meet the standard of income below 250% of the federal poverty line (which the court stated, assuming her daughters were part of her household, would have been $57,575). However, the court found that “significant holes in the record” precluded it from determining that her income was less than this amount.

Income: The court first noted that Thomas had not provided it with sufficient documentary evidence to satisfy her burden of proof for her income claim and that what evidence she did provide (e.g., lease agreements and Airbnb reservations for the Tahoe property and bank deposit records) suggested her income was greater than what she claimed. Her testimony in court was similarly unhelpful to her, as specific amounts of income she testified to receiving totaled more than $37,800 a year, and she testified that she also had unspecified amounts of income from other side jobs.

Thomas also testified that a sailing apparel business she ran lost money, but the only evidence she provided was a tax return from more than a year before the Tax Court trial. Finally, the court observed that the amounts of income she was claiming were “generally inconsistent” with amounts she had previously reported to the IRS and during her bankruptcy proceedings.

Assets: The Tax Court considered whether Thomas had equity in her Moraga and Tahoe homes that would allow her to pay her tax liability while still paying reasonable basic living expenses. Thomas claimed the value of the Moraga home was $1.25 million and the value of the Tahoe home was $670,000, which was less than the combined outstanding mortgages on them of $2.03 million, leaving her with no equity in the houses with which to pay her tax bill or reasonable basic living expenses. The court, however, found that Thomas had failed to prove that the values she claimed for the homes were accurate. Thus, it held she had not established that she did not have enough equity in either of the houses to pay her tax liabilities or that selling either of the properties to do so would leave her unable to pay reasonable basic living expenses.

For the Moraga home, Thomas based her valuation on the amount from a 2018 property listing, with a $200,000 downward adjustment to the price based on a letter from her real estate agent from 2019 that advised her that prospective buyers had indicated the house was overpriced by that amount. The court found this evidence to be unpersuasive, as the documents she relied on were several years old, and Thomas admitted in her testimony that the value of the house had “popped up” since 2018. The court also noted that Thomas’s claimed value for the house was belied by the higher value she claimed for it in her bankruptcy proceedings.

For the Tahoe home, Thomas based her claimed value on its assessed value for property tax purposes reported in a letter from the county tax assessor. Again, the court found fault with using that amount because the letter was several years old. Also, there was no indication in the record that the assessed value of the home was its fair market value. In addition, the court noted that, in her testimony, Thomas stated that a similar home on the same street had sold for $1.1 million three months before trial.

Equitable factors

Because Thomas was not eligible for a streamlined grant of equitable relief, the Tax Court considered whether she was entitled to relief based on the equitable factors in Rev. Proc. 2013-34, Section 4.03(2). Thomas and the IRS agreed that these factors were neutral in her case except for three: whether she would suffer economic hardship absent relief, whether she had known or had reason to know that her husband would not or could not pay the income tax liabilities, and whether she significantly benefited from the underpayment of tax.

The court first found, for the same reasons it discussed in its analysis of the economic hardship factor for streamlined relief, that Thomas had not proved for purposes of weighing the equitable factors that she would suffer economic hardship. Therefore, it concluded the factor was neutral. It then substantively analyzed the other two factors. While it determined that there was some doubt as to whether she knew or had reason to know that her husband would not or could not pay the income tax liabilities, even if this factor favored relief, it was “outweighed by the significant benefit to [Thomas] from the unpaid income tax liabilities.” Therefore, it held that Thomas was not entitled to relief under a weighing of the equitable relief factors.

Knowledge or reason to know: Under Section 4.03 of Rev. Proc. 2013-34, in the case of an underpayment, this factor weighs in favor of relief for the requesting spouse if the spouse reasonably expected the non-requesting spouse to pay the liability within a reasonable period after filing the return. It weighs against the requesting spouse if, based on all the facts and circumstances, the belief that the nonrequesting spouse would pay was unreasonable.

Facts and circumstances that Rev. Proc. 2013-34 states can be considered in determining whether the requesting spouse knew or had reason to know whether the nonrequesting spouse could or would pay a reported income tax liability include, but are not limited to, the requesting spouse’s level of education, any deceit or evasiveness of the nonrequesting spouse, the degree of the requesting spouse’s involvement in the activity generating the liability, the requesting spouse’s involvement in business or household financial matters, the requesting spouse’s business or financial expertise, and any lavish or unusual expenditures compared with past spending levels.

Even if the requesting spouse has the requisite knowledge or belief, Rev. Proc. 2013-34 goes on to provide that the knowledge is negated and the factor will weigh in the requesting spouse’s favor if the requesting spouse was abused by the nonrequesting spouse or the nonrequesting spouse maintained control of the household finances by restricting the requesting spouse’s access to financial information, and because of the abuse or financial control, the requesting spouse was not able to question the payment of the taxes reported as due on the return or challenge the nonrequesting spouse’s assurance regarding payment of the taxes for fear of the nonrequesting spouse’s retaliation. However, the Tax Court has held that a generalized claim of abuse is not sufficient (Pocock, T.C. Memo. 2022-55).

The Tax Court found that Thomas knew of the unpaid tax liabilities when the returns for 2012–2014 were filed because she admitted as much in a brief filed in the case, and the court doubted that Thomas could have reasonably expected her husband would pay them, given the couple’s extensive history of financial problems. Thomas, however, argued that she was abused by her husband and therefore could not question his payment of the tax liabilities; thus, that factor should weigh in her favor.

The Tax Court acknowledged that the record contained numerous general and specific descriptions of physical abuse and financial control by her husband, allegations of financial control, and verbally abusive texts and emails, which the IRS had provided little evidence to refute. But the court found that the record also disclosed several instances in which Thomas had expressly disagreed with her husband about financial decisions, suggesting that Thomas was not afraid to question her husband about them.

Moreover, the Tax Court found that Thomas had never actually stated on the record that she disagreed with her husband’s not paying the income taxes; rather, she had only stated she had disagreed with his decision to take early distributions from his retirement account, which caused at least some of the underpayments. Thus, the court stated that it had “some doubt” about whether this factor favored Thomas.

Significant benefit: As defined by Rev. Proc. 2013-34, a significant benefit is any benefit in excess of normal support, such as owning luxury assets and taking expensive vacations. The revenue procedure provides that if a requesting spouse received a significant benefit due to taxes’ not being paid, the factor will weigh against the spouse.

The court concluded that Thomas had significantly benefited by not paying her tax liabilities, noting that the record showed that not paying the liabilities had at least partially allowed her to continue owning two homes in desirable areas; pay for expensive vacations for herself and her daughters; and, as described in the blog entries she wrote, pay for luxury items and services.

Thomas argued that some of the purchases the court pointed to were purchased when she thought the taxes were paid, but the court found that Rev. Proc. 2013-34 makes no distinction between expenses made before a requesting spouse knows about unpaid tax liabilities and those made after. Furthermore, the court stated that the record showed that many of what it called the “lavish expenses” Thomas incurred were made at a time when she was aware of her unpaid taxes.

Finally, Thomas argued that many of her expenses did not exceed normal support as measured by her particular circumstances. The court disagreed, concluding that, based on her testimony about changes in her financial circumstances that began as early as 2009, many of the expenses that had once been normal to her “likely no longer constituted normal support at the times relevant to this case.”

Reflections

Another evidentiary issue that was new to the Tax Court was decided in favor of the IRS earlier in Thomas’s case. In Thomas, 160 T.C. No. 4 (2023), the court ruled on Thomas’s motion to strike her blog posts, which the IRS sought to have included in evidence. The blog posts, unlike the third-party letters Thomas wanted considered in the Tax Court’s review, were not part of the administrative record; the IRS had discovered them after Thomas filed her petition. The court held that the posts from her blog were “newly discovered” evidence under Sec. 6015(e)(7)(B) and had properly been admitted. (See Beavers, “Blog Posts Are Admissible in Innocent-Spouse Relief Case,” 54-6 The Tax Adviser 58 (June 2023).)

Thomas, 162 T.C. No. 2 (2024)

Contributor

James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser’s tax technical content manager. For more information about this column, contact thetaxadviser@aicpa.org.