(a) Facts: A woman married a man who ran a struggling air conditioner business. The wife was aware that the business was struggling, as the parties had difficulty paying their bills, but the husband convinced her that a big contract was coming and success was just around the corner. He even convinced her to make a tax-penalized early withdrawal from her 401(k) plan and invest the funds in his business. The wife was abused verbally during the marriage, but not physically.
The parties separated, and the wife learned the truth about the husband’s finances. She also learned that his statement that he had worked as a police officer before the marriage was untrue and that he had received cash payments during the marriage he had not told her about.
The parties filed a joint return for the year in which the wife made the withdrawal from her 401(k) plan. The wife filed a request for innocent spouse relief. The IRS denied the request, the wife paid the taxes in full and then sought a refund in the Tax Court.
(b) Issue: Was the wife entitled to innocent spouse relief?
(c) Answer to Issue: No as to the 401(k) withdrawal; yes as to tax due on the husband’s income.
(d) Summary of Rationale: The IRS denied relief as to tax on the 401(k) withdrawal because the final threshold condition was not met; the tax was attributable in part to the wife’s income. There is an exception to the final condition when the petitioning spouse was a victim of abuse, but only where the abuse prevents the petitioning spouse from challenging the tax return. The husband abused the wife verbally, “[b]ut the actions he took did not restrict her ability to challenge how items were reported on their joint return.” 2018 WL 718520, at *9. The husband’s “duplicity as to the future success of this investment or his business does not constitute the type of abuse that warrants excusing her from the responsibility for tax on income from her retirement account.” Id.
There is also a fraud exception to the final condition, which applies “if the requesting spouse establishes that the non-requesting spouse’s fraud is the reason for the erroneous item.” Rev. Proc. 2013-34, § 4.01(7)(e). This language is followed by a hypothetical example, in which the wife fraudulently sells the husband’s stock without his knowledge. The court construed this language to require that fraud related to the incurring of the income itself:
While we believe petitioner’s testimony that Mr. Keeney misled her about business prospects, she was the one who withdrew the funds and knew that they would be invested and therefore should have known that they could be lost. We, therefore, conclude that petitioner does not satisfy the threshold conditions as to her 401(k) withdrawal, and therefore she is not entitled to relief from joint and several liability as to the liability attributable to that withdrawal. While we recognize the duplicity of Mr. Keeney and the difficulties of the marriage, they are insufficient to overcome the fact that the liability relates to a withdrawal petitioner made freely (even if she was misled about the quality of the investment). Unfortunately, the tax laws cannot right that wrong.
Minton, 2018 WL 718520, at *9-10. In other words, even though the husband misled the wife about the prospects for her investment, the investment itself was made knowingly by the wife.
Because the wife did not meet the final threshold condition, she was not entitled to innocent spouse relief from tax on the early withdrawal from her 401(k) plan.
The wife also sought innocent spouse relief from tax liability on income from the husband’s business. That income was not attributable to the wife, so the final threshold condition was met.
The safe harbor conditions were not met because paying the debt would not create economic hardship. Indeed, the wife had paid the debt at question.
The issue, therefore, turned upon the discretionary relief factors. Only one factor potentially opposed relief: the wife’s awareness that the tax would not be paid. But “[w]e have held consistently that a requesting spouse carries her burden of proof to establish that she reasonably believed her spouse would pay an outstanding liability where the requesting spouse is not involved in the family finances or sophisticated about them and the non-requesting spouse had the income to make the payments.” Id. at *13. “We are convinced by petitioner’s testimony that she believed the Federal tax liability would be paid out of the proceeds from the ‘big contract’ that Mr. Keeney promised was coming. Given petitioner’s lack of sophistication and her position in the marriage, and taking into account Mr. Keeney’s duplicity and abuse, we also conclude that her belief was reasonable.” Id. at 14.
Because none of the factors opposed relief, the court granted innocent spouse relief as to tax items coming from the husband’s income.
Question: Did the court read the regulation correctly? The regulation provides, again, that the final threshold condition is met “if the requesting spouse establishes that the non-requesting spouse’s fraud is the reason for the erroneous item.” Rev. Proc. 2013-34, § 4.01(7)(e).
In any realistic sense, the husband’s fraud was the reason for the wife’s 401(k) plan withdrawal. If the husband had truthfully told the wife the actual financial condition of his business, the wife would never have made the withdrawal. “[T]he erroneous item” was the 401(k) plan withdrawal; without the husband’s fraud, the withdrawal would never have been made; the fraud was, therefore “the reason” for the item.
The court’s reasoning was that the hypothetical example that followed the above language limited its scope to situations in which the income at issue was incurred without the knowledge of the petitioning spouse. That is certainly one particularly clear fact situation in which fraud is present. But nothing in the text of the regulation suggests that the example is the only situation in which fraud would be present or that the example was intended to restrict the meaning of the language that immediately preceded it. The court gave too much weight to the example, and not enough weight to the text, in construing the regulation.
The wife in Minton was obviously a victim of fraud; the court expressly so found. One of the key messages of the 2013 reform in the innocent spouse factors was that the IRS should be more sensitive to situations involving fraud and abuse. If the court’s reading of Revenue Procedure 2013-34, § 4.01(7)(e) is broadly accepted, innocent spouse relief will be denied in any fraud situation when the tax at issue is incurred knowingly, even if the incurring spouse has been substantially misled. These cases could potentially be a significant majority of the total cases in which fraud is present on the facts, so the net effect will be to greatly restrict the fraud exception. It will be interesting to see if future cases continue to read the regulation so narrowly and whether Congress accepts the narrow reading.