Spouse Had “Reason to Know” of Disallowed Deductions
The Sixth Circuit joined the Second, Fifth, Seventh, Eighth, Ninth and Eleventh circuits in adopting the “knowledge of the transaction” test of Price v. Commissioner (887 F.2d 959 (9th Cir., 1989)) in innocent spouse cases, upholding a Tax Court finding of ineligibility for relief.
IRC § 6015(b)(1)(C) requires taxpayers seeking relief from joint and several liability for a deficiency to show that in signing the return they did not know, and had no reason to know, of an understatement of tax stemming from an erroneous item attributable to the other spouse on a jointly filed return. In Price, the Ninth Circuit set forth four factors to be considered in assessing “reason to know”: (1) the spouse’s education; (2) his or her involvement in the family’s financial affairs; (3) unusual or lavish expenditures compared with past income and spending; and (4) the other spouse’s evasiveness or deceitfulness concerning financial matters.
Taxpayer Winnie L. Greer’s husband invested in a plastics recycling business, Madison Recycling Associates Inc., to shelter dividend income received in 1982. This pass-through investment yielded losses and investment credits that were carried back to years 1979–1981 and was itself subject to audit by the IRS and eventual adjudication in Greer I (TC Memo 2007-119, aff’d, 6th Cir., 2009) and Madison Recycling Associates (295 F.3d 280 (2nd Cir. 2002), aff’g, TC Memo 2001-85 and TC Memo 1992-605). The IRS argued, and the courts agreed, that Madison operated primarily as a tax shelter. Thus, the courts upheld an assessment against the Greers of a total joint deficiency of $87,627 in tax and $544,125 in interest, from which Greer sought innocent spouse relief.
Greer, a homemaker employed variously as a music education teacher and photographer, had no actual knowledge of the tax deficiency, but the Tax Court denied relief on the “reason to know” basis, in keeping with its position in Richard D. Bokum II v. Commissioner (94 TC 126) that knowledge of the underlying transaction giving rise to tax benefits supports a finding that the taxpayer had reason to know of an understatement. The Tax Court weighed three of the four Price factors against Greer in its determination that she had a duty to inquire into the legitimacy of the tax benefits claimed on the basis of the Madison investment: (1) While not specifically educated in accounting, economics or finance, she was generally well educated; (2) she was aware of a large cash distribution from the couple’s sale of stock in her husband’s cable television business in the same tax year for which she signed forms for tax refunds; and (3) while she relied upon her husband to handle finances, he was not evasive or misleading concerning them. However, the Greers did not extravagantly increase their expenditures, the Tax Court found.
The Sixth Circuit concluded that the Tax Court had not clearly erred in its finding and concurred that Greer’s duty to inquire as a reasonably prudent taxpayer should have led her to question the legitimacy of the tax benefits claimed. Although it did not weigh the Price factors of education and involvement in family finances as heavily as did the Tax Court against Greer, the Sixth Circuit found that the relative levels of taxes to income reported on the return and the elimination of taxes in two carryback years created a duty for Greer to have inquired about the benefits of the Madison investment.
By Nell Adkins, CPA, Ph.D., and Richard A. Turpen, CPA, Ph.D., CFE, both of the University of Alabama–Birmingham.
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