Sometimes it's the Devil You Know... Innocent Spouse Relief.

Jacobsen v. Comm’r, T.C. Memo. 2018‑115, 2018 WL 3598803 (2018)

(a) Facts: The husband worked 12-hour shifts 14 days per month as a machine operator at a factory. He also operated a home inspection business. The wife was employed as an accountant and also managed the finances of both the home inspection business and the family. The husband never reviewed bank or credit statements or otherwise examined the parties’ finances. “Petitioner relied on Ms. Lemmens to handle the family finances because of her training as an accountant.” 2018 WL 3598803, at *1.

In 2010, the husband gave the wife his tax information. She combined that with her own information and gave both to a paid preparer, who drafted a joint tax return.

The wife was arrested in 2011 and charged with embezzling $485,681 from her employer. She was convicted and imprisoned, and the parties were divorced. After the wife was arrested, the husband provided both parties’ 2011 tax information to the same preparer who had drafted the 2010 return, and that preparer drafted a joint return for 2011. The husband did not tell the preparer about the wife’s embezzlement.

“Petitioner [husband] is a disabled veteran who continues to suffer from posttraumatic stress disorder (PTSD). As a result of Ms. Lemmens’ arrest and conviction, the divorce, and his financial problems, petitioner suffered a mental breakdown. As of the time of trial, petitioner was recovering from his mental health problems through medication and participation in a PTSD treatment program at a veterans hospital.” Id. at *8. The IRS assessed deficiencies on the 2010 and 2011 returns. The husband filed a petition for innocent spouse relief from that portion of the deficiencies that were attributable to the wife’s failure to pay taxes on her embezzlement income. This was 85% of the total deficiency for 2010; the court did not provide a percentage for 2011. The IRS granted the petition, but the wife appealed, and the IRS then agreed with the wife that the husband was not entitled to relief. The husband sought relief in the Tax Court.

(b) Issue: Was the husband entitled to innocent spouse relief?

(d) Summary of Rationale: A spouse is entitled to mandatory innocent spouse relief under I.R.C. § 6015(b) if “the other individual filing the joint return establishes that in signing the return he or she did not know and had no reason to know, that there was [a tax] understatement,” id. § 6015(b)(1)(C), and “it is inequitable to hold the other individual liable for the deficiency,” id. § 6015(b)(1)(D).

The husband testified that he did not know of the wife’s embezzlement until she was arrested. The court found this testimony credible with regard to the 2010 return, which was filed before the wife’s arrest. Thus, the husband had no actual knowledge of the wife’s embezzlement. The husband lacked financial knowledge generally, was not involved in the parties’ finances, and did not engage in lavish spending. The court held that he lacked any reason to know of the embezzlement income omitted from the 2010 return.

But the husband did know of the wife’s embezzlement when the 2011 return was filed.

The court considered a series of factors in determining whether it would be inequitable to hold the husband liable for the 2010 deficiency. The husband had not engaged in lavish spending with funds not used to pay taxes. He had divorced the wife. Paying the tax liability would challenge, though perhaps not overcome, his ability to pay. The parties’ divorce decree required them to share the 2010 and 2011 tax liability equally, but this factor was only neutral; the state court decree was not controlling under federal law. The husband had complied with tax law in future years, and, as noted above, he had significant mental health problems. Because all of the factors were favorable or neutral, the court awarded the husband mandatory innocent spouse relief under § 6015(b) for the 2010 taxes.

The husband also sought discretionary innocent spouse relief. The court considered this request only for the 2011 taxes, as relief from the 2010 taxes had already been granted. The 2011 taxes were generally similar to the 2010 taxes, the only difference being that the husband was aware of the wife’s embezzlement when the 2011 return was filed.

But this was a major difference. The wife was convicted in November of 2011 and sentenced in January of 2012, so the amount of her embezzlement was known in April of 2012 when the 2011 return was first due. Despite this fact, the husband “chose not to inform the paid preparer of the embezzlement income for 2011.” Jacobsen, 2018 WL 3598803, at *11. “[P]etitioner’s knowledge of the embezzlement income and his involvement in preparing the 2011 return weigh too heavily against him to allow relief.” Id. The court, therefore, refused to grant discretionary innocent spouse relief from the 2011 taxes.

Lessons:

When your spouse embezzles hundreds of thousands of dollars from her employer, and she is an accountant, and you are not, and you have no reasonable way to know of her misconduct, your argument for innocent spouse relief is probably strong.

When you have actual knowledge that your spouse has embezzled hundreds of thousands of dollars from her employer (because she has been convicted of embezzlement and sent to prison), and you still do not tell your tax preparer about the embezzlement income, your argument for innocent spouse relief is probably weak.

Observations:

It is not entirely clear why the IRS reversed its initial determination and refused to grant the husband any innocent spouse relief. The court stated that the wife told the IRS that the husband was aware of her embezzlement. But she provided no supporting evidence, and the testimony of a convicted embezzler would not normally be entitled to significant weight. The wife initially intervened in the Tax Court proceedings, but then withdrew. It appears that the IRS may have initially given the wife’s testimony more weight than the court did. The IRS may also not have distinguished as carefully as the court between the husband’s strong argument regarding the 2010 taxes and his weak argument regarding the 2011 taxes.

“Petitioner and Ms. Lemmens’ divorce agreement stated that petitioner and Ms. Lemmens each agreed to pay one-half of the 2010 and 2011 tax liabilities, including the liabilities arising from the embezzlement income. Petitioner claims he agreed to pay one-half of the outstanding liabilities that did not include any portion of the liabilities arising from the embezzlement income.” Id. at *7-8. If the husband did indeed agree to pay one-half of the tax liability arising from the embezzlement income, he would still be liable under state law for one-half of what the wife ultimately pays. A grant of innocent spouse relief is not a defense to liability in state court under a divorce settlement agreement. But there seems to be a dispute between the parties as to the construction of the agreement, a dispute that was obviously outside the Tax Court’s jurisdiction to resolve.