Allocating Tax Deficiencies

BY EDWARD J. SCHNEE

TAX CASE

n specific instances, IRC section 6015 provides relief from joint and several liability imposed on joint tax returns. When a taxpayer qualifies for this relief, it is necessary to allocate the tax deficiency between the taxpayers who filed the joint return. The Tax Court recently examined the methodology for making this allocation.

Ingrid Capehart and Robert J. Capehart filed a joint return for 1994 on which they incorrectly claimed a $37,239 loss on the sale of business property and a $4,183 theft loss. The IRS did not allow these deductions; instead, it determined an $8,225 tax deficiency and levied a $507 accuracy penalty. Ingrid computed her share of the deficiency and penalty and filed for relief under IRC section 6015(c).

Result . For the IRS. Section 6015(c) allows a divorced or separated spouse who previously filed a joint return to calculate his or her deficiency based on the portion of incorrect items the spouse had generated, rather than holding each spouse liable for the entire deficiency under the joint and several liability rule. Both sides agreed that Ingrid qualified for this relief; they disagreed on the actual computation of the tax due from each person.

Ingrid’s share of the deficiency was the total deficiency multiplied by the ratio of her share of the erroneous items to the total amount of such items. To correctly determine her share, she should have allocated the erroneous items—that is, the actual erroneous items plus any recalculated deductions that resulted from them—as if she and Robert were filing separate returns. The inclusion of the erroneous items would have increased the Capeharts’ adjusted gross income and reduced the allowable medical expense deduction. This recalculated deduction was also an erroneous item that should have been allocated equally unless the taxpayer could prove a different allocation is appropriate.

There is an exception to this proportional allocation method that requires reallocating the erroneous item to the taxpayer who received a tax benefit from it. Using the proportional allocation method, Ingrid would have determined her share of the erroneous items was $21,282. If she had filed a separate tax return reporting only her items of income and deduction, her taxable income would have been $14,204. Under the tax-benefit exception, she would have been allocated only $14,204 of the erroneous items (an amount equal to her separate taxable income). The remaining $7,078 of erroneous items ($21,282 – $14,204) would have been allocated to Robert.

The Treasury Department allows taxpayers to use yet another alternative method of allocation but only when there are differing tax rates for the erroneous items. For example, a taxpayer who understates both capital gains and interest income qualifies for a special allocation because a different tax rate applies to each item. The court rejected Ingrid’s alternative method because all erroneous items were subject to the same tax rate.

The accuracy-related penalty is allocated to the spouse whose item generated the penalty. This rule interacts with the tax benefit exception. To calculate the accuracy-related penalty for each party, multiply the tax due after final allocation of the erroneous items by the 20% penalty rate.

The Tax Court accepts the allocation methods prescribed by the tax code and regulations; allocations based on equity arguments fail. Taxpayers should use only the methods detailed in the case study to calculate a spouse’s tax liability under section 6015(c).

E state of Robert J. Capehart and Ingrid Capehart v. Commissioner, 125 TC no. 10.

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

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