TAX CASE

ndividuals who file a joint tax return accept joint and several liability for any underpayments. IRC section 6015(a) provides an innocent spouse protection from an assessed deficiency due to an understatement of taxes because his or her spouse incorrectly reported items. A person who is no longer married to, is legally separated from, or lives apart from the spouse with whom he or she filed a joint return can choose a separate liability election under IRC section 6015(a)(2).

Lois Ordlock and her husband resided in California, a community property state. After they paid the initial reported tax liabilities for the years 1982–1984, the IRS assessed additional liabilities because Mr. Ordlock had understated various items. The couple used both community funds and Mrs. Ordlock’s separate funds to pay these additional taxes. After the IRS granted innocent spouse relief, Mrs. Ordlock requested a refund of the total amount paid using her separate funds and half of the amount paid using community funds.

The IRS refunded the payments made using Mrs. Ordlock’s separate funds, but refused to refund any payments made from community funds. She petitioned the Tax Court.

Result . For the IRS. The dispute centered on two phrases in IRC section 6015 relating to community property law in California. IRC section 6015(a) allows the innocent spouse relief from joint and several liability, stating that any determination of such relief shall be made “without regard to community property laws.” IRC section 6015(g)(1) goes on to say “notwithstanding any other law or rule of law a credit or refund shall be allowed or made to the extent attributable to the application of this section.”

Mrs. Ordlock had relied on this language when she requested a refund of her share of payments made from community funds. She asked the court to reallocate the 1982, 1983 and 1984 tax liability payments even though they actually were made during the period from 1984 through 2002. Despite the continued existence of the marital community, she contended that based on the source of these payments, IRC section 6015 required the court to reallocate them.

Judge Goeke noted that this position implied that IRC section 6015 was a “statutory exception to the well-established law that state law defines ownership interest in property for purposes of federal tax.” The judge wondered whether Congress clearly and unequivocally intended to supplant community property law regarding the type of payments in this case. He determined that a “clear and unequivocal” intent was not apparent in the tax law.

The “any determination” phrase in 6015(a) referred to a taxpayer’s eligibility for joint and several tax liability relief. The judge concluded that the phrase “not-withstanding any other law or rule of law” in IRC section 6015(g) did not mean Congress intended taxpayers to ignore community property laws in innocent spouse situations. Thus, the court limited Mrs. Ordlock’s refund to the payments she had made using her separate funds.

When a case involves unusual, important or novel issues, more than one of the 19 Tax Court judges hears or reviews it. Eighteen of the 19 judges either heard or reviewed this case. The majority of them (10, including Judge Goeke) agreed that Mrs. Ordlock did not merit a refund of the community funds. But eight judges either wrote an opinion dissenting with Judge Goeke or agreed with the dissents. The necessity for a full court review, and the lack of consensus, makes an appeal to the circuit court likely.

For the time being, it is difficult to advise clients of a strategy to protect themselves from this type of situation. For the years in question, Mrs. Ordlock apparently had no reason to suspect she needed to make payments out of separate funds. If she had taken steps to protect herself, she might not have been granted innocent spouse relief. Tax professionals must continue advising clients to protect themselves by keeping adequate records.

Lois E. Ordlock v. Commissioner, 126 TC no. 4.

Prepared by Sharon Burnett, CPA, PhD, associate professor of accounting and Darlene Pulliam, CPA, PhD, professor of accounting, both of the College of Business, West Texas A&M University, Canyon.

TAX CASE

he Ninth Circuit Court of Appeals recently considered the effects of the changes in the innocent spouse provision contained in the IRS Restructuring Act of 1998.

In 1966 Isaac Baranowicz and Lora Baran married. On their 1979–1982 tax returns, they claimed depreciation deductions from several equipment-leasing tax shelters. The IRS issued a deficiency notice denying these deductions. Following the couple’s divorce, Lora Baran filed for innocent spouse relief under IRC sections 6015 (b) and (c), which contain part of the rules for such protection. The Tax Court granted her such relief under section 6015(c). Isaac Baranowicz appealed, but the IRS argued he lacked the standing to do so.

Result . For the IRS. To initiate an appeal, taxpayers must meet three conditions: They must allege a concrete injury, the injury must be traceable to the defendant’s actions and a favorable decision must provide redress. Prior to the 1998 Restructuring Act, the courts would have held that granting Lora innocent spouse relief could not have affected Isaac’s tax liability since he still would be liable for the entire deficiency under the joint and several liability rule.

Baranowicz argued that under the act a nonrequesting spouse could participate in the initial litigation and, therefore, would be entitled to appeal the decision.

The Ninth Circuit found that Baranowicz’s participation in the initial litigation would not have changed his liability; he would have remained fully liable for the deficiency both before and after the lawsuit. The potential for reimbursement in any state court litigation is not relevant for federal purposes. Thus, because the federal liability was unchanged, the taxpayer did not meet the third requirement for an appeal (redress).

Baranowicz also argued that the 1998 act gave a nonrequesting taxpayer a stake in the outcome. According to the court, such a stake, even if it existed, did not grant the taxpayer a new right of appeal. The act simply provided for adequate notice of, and the ability to participate in, a proceeding in the Tax Court.

Nonrequesting spouses must be aware of and use their right to participate in an innocent spouse relief request at the IRS and Tax Court level. If the nonrequesting spouse chooses not to participate or loses at the Tax Court level, he or she then cannot appeal the decision.

Isaac Baranowicz v. Commissioner, CA-9, 432 F3d 972.

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

TAX CASE

RC section 911(a) permits any U.S. citizen who resides and works in a foreign country to exclude up to $80,000 of earned income. To qualify for the exclusion, citizens must perform the services while their tax home is in a foreign country and must reside in that country for an uninterrupted period of 12 months or be physically present in that country for at least 330 days during a consecutive 12-month period.

In 2001 Dave Arnett, a U.S. citizen and resident of Wisconsin, worked for Raytheon Support Services Co. at a scientific station on Ross Island, Antarctica. Arnett excluded roughly $49,000 of earnings from his tax return that year because he had earned the money while working and residing in a foreign country. His was the lead case for 150 taxpayers who believed income earned in Antarctica was exempt from tax. The IRS disagreed, maintaining that Antarctica was not a foreign country, and assessed Arnett an $8,066 deficiency. Arnett petitioned the Tax Court for relief.

Result . For the IRS. Treasury regulations section 1.911-2(h) defines a foreign country as “any territory under the sovereignty of a government other than that of the United States.” In 1968, after examining an international treaty and noting that the U.S. State Department “did not consider Antarctica to be under the sovereignty of any government,” the Tax Court, in Martin v. Commissioner (50 TC 59), held Antarctica was not a foreign country.

Arnett challenged the validity of this holding, citing two later court decisions. In Smith v. United States, 507 US 197, the Supreme Court held the claimant could not bring a wrongful death action against the United States under the Federal Tort Claims Act (FTCA) as the claim had arisen in a foreign country, Antarctica. The Court used the specific language contained in the FTCA to support its finding. Arnett also cited Smith v. Raytheon , 297 FSupp2d 399, where after examining the language of the Fair Labor Standards Act, the Court held that an employer was not required to pay a higher overtime rate for work performed in Antarctica because the act did not apply to services performed in a foreign country.

The Tax Court said those cases referred to the way other laws defined a foreign country, but those definitions did not apply to the tax code. The Tax Court noted that Congress, in IRC section 911(d)(9), gave the Treasury secretary the authority to issue regulations to implement section 911. Those regulations, specifically Treasury regulations section 1.911-2(h), defined a foreign country for purposes of the foreign income exclusion. The Tax Court held that in this case the IRS must apply the definition in that section. Since Antarctica is not a foreign country for tax purposes, the foreign earned income exclusion was denied for the wages Arnett earned while working and residing there.

This case illustrates the importance of legislative regulations. The tax courts are required to follow these regulations unless the taxpayer is able to demonstrate that they are unreasonable or clearly inconsistent with the law.

Dave Arnett v. Commissioner, 126 TC no. 5.

Prepared by Charles J. Reichert, CPA, professor of accounting, University of Wisconsin, Superior.