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Tax Court Inconsistent on Economic Hardship

Posted on June 15, 2022

Before I embark on a discussion of this innocent spouse case, I want to pause for a brief commercial interlude.  My fellow blogger, Christine Speidel, and my colleague at Harvard, Audrey Patten, have just published, through the ABA Tax Section, the third edition of “A Practitioner’s Guide to Innocent Spouse Relief.”  I read the book and it is excellent.  Here is a link to the ABA announcement about the book which contains a link you could use to purchase it if desired.  Keith

The case of Pocock v. Commissioner, T.C. Memo 2022-55 holds that payment of the tax liability at issue would create an economic hardship for Ms. Pocock.  I agree with the decision in the Pocock case but find it at odds with an earlier TC Memo decision, Sleeth v. Commissioner, my clinic appealed to the 11th Circuit where the Tax Court found in similar circumstances that equity in property precluded a determination of economic hardship. For a discussion of the Sleeth case look here.

The situation in Pocock and Sleeth arises when a spouse with limited income owns property in which equity exists.  This fact pattern arises with some regularity and a consistent position from the Court would assist in resolving these cases at the administrative stage.  In the typical case, the requesting spouse could sell the property with equity, their home, and satisfy a portion of the outstanding liability; however, selling the house would generally create hardship for the requesting spouse who would then need to move, probably to a rental unit of lesser quality with little or no future prospect of purchasing a home.  The requesting spouse in these cases generally has no ability to extract the equity through borrowing because of low income stream to support loan repayment.  Is it economic hardship to require sale of the home to partially satisfy the outstanding joint liability or should the requesting spouse eliminate their equity in assets before basing their economic hardship request on available income?

Fascinating Facts

The facts in Pocock interest me and should greatly concern the IRS and the public in general. Mr. Pocock tried his hand at several income producing activities without success until he settled on an annual scheme of obtaining a six figure income by grossly inflating his withholding credits. The Court describes in some detail his efforts to produce income the honest way before embarking on a “money brokering business.” For reasons described in the opinion, the requesting spouse could not get her husband to discuss his business ventures without fear of physical and verbal reprisal. She learned to avoid the topic. He also controlled the mailbox cutting off another avenue of information that might have been available to her.

Here’s the Court’s description of his money brokering scheme:

For taxable years 1995 through 2005, Mr. Pocock fraudulently claimed large refunds on his and petitioner’s joint returns by overstating his income and federal income tax withholdings. Because the IRS did not examine or otherwise correct those returns, respondent’s account transcripts for those years show balances of zero.


On the joint returns for 1995 through 2005, Mr. Pocock reported federal income tax and withholding as follows:

Tax year        Filing date    Total tax       Withholding  Overpayment
1995              9/4/1997      $26,593        $80,674        $54,081
1996              9/8/1997      58,768           98,523           39,755
1997              2/3/1999     61,475           172,406         110,931
1998              12/10/1999 56,158           169,968         113,810
1999              5/4/2001      58,745           174,898         116,153
2000              8/29/2002    51,244           194,170         142,926
2001              12/30/2002 55,060           208,836         153,776
2002              1/11/2005    52,803           219,628         166,825
2003              1/14/2005    47,488           184,828         137,340
2004              10/21/2005 35,253           193,627         158,104
2005              1/17/2008    53,435           149,012         95,577











After receiving the above-described joint returns, the IRS issued Mr. Pocock and petitioner the following refund checks comprising the reported overpayments and, for some years, interest:


Tax year        Issue date     Amount
1997              4/30/1999    $112,621
1998              2/13/2000    115,137
2000              9/27/2002    142,926
2001              3/21/2003    153,776
2002              4/8/2005      168,594
2003              4/1/2005      138,243
2004              7/14/2006    166,077
2005              2/15/2008    95,577









Petitioner, who believed that Mr. Pocock was earning periodic commissions from his “money brokering” business, endorsed the refund checks for 1997 and 2004. Occasionally she asked about the status of their tax filings, but he never gave her a clear answer. When he showed petitioner the 2004 refund check, Mr. Pocock explained that it was part of his compensation for the closing of a deal.

I would like to believe that the fraud filters at the IRS work better than Mr. Pocock’s case suggests. His scheme succeeded for a long time. Eventually, the IRS caught on but not for three more years. He essentially got the same amounts of refunds based on overclaiming withholding for 2006 and 2007 before his 2008 return finally caused the IRS computer or someone at the IRS to wake up.

Mr. Pocock then had the chutzpah to file a CDP request regarding the liability triggered as the IRS refused to give him credit for his bogus overpayment claim. Only 16 years after his scheme started, criminal investigators appeared on his doorstep. They eventually recommended prosecution of Mr. Pocock but not of petitioner. The U.S. Attorney’s office declined to prosecute. A footnote in the opinion suggests the declination resulted from concerns about the statute of limitations. I wonder if extreme embarrassment over the IRS’s inability to detect the scheme also played a part in the decision.

I apologize for taking you on a long journey through facts that really have nothing to do with the issue causing me to write this post, but I was so fascinated that Mr. Pocock could use a scheme of overclaiming withholding credits for over a decade that I could not help myself from writing about it. If you have my same voyeuristic tendencies, I recommend reading the 27 page opinion.

Innocent Spouse Claim

Not that it especially matters but it is worth noting that petitioner filed her innocent spouse request almost a decade ago in January of 2013. By that point the IRS had established liabilities against the couple of almost $500,000 and it could have been higher. She petitioned the Tax Court in November of 2016 so it only had her case for five and one half years before rendering an opinion.

At the time of the trial, petitioner was 68 years old. She had total assets of slightly over $190K almost all of which came from equity in her home. Her monthly income totaled, $1,855 resulting from social security, wages and rental income from Mr. Pocock, her ex-husband, whom she rented space to in the house. His presence in the house did continue to cause difficulty as discussed below.

She sought relief under IRC 6015(f) and the Court cited the requirements set out in Rev. Proc. 2013-34. The Court looked to see if she met the threshold requirements for streamlined relief. The IRS raised concerns about three elements of the bases for relief. First, it expressed concern about the transfer of assets from Mr. Pocock to petitioner. After he stole from the estate of his mother, he transferred his interest in their Florida home to petitioner and her mother (a joint owner of the home.) The Court finds that the transfer did not occur as part of a fraudulent transfer but rather as compensation for damages resulting from his mishandling of the estate case.

Next the IRS raised an objection concerning her knowledge of the scheme. The Court found her testimony credible that she did not know what he did each year. The returns looked proper on their face and he had told her the money resulted from his money brokering business. The Court was also impressed with the testimony regarding why petitioner would not question him about finances. As a result, the Court finds she had no knowledge of the overstated withholding and no reason to know the returns were incorrect.

Lastly, the Court found the liabilities resulted from Mr. Pocock’s actions and not hers meaning that the liabilities all met the test of resulting from items attributable to the non-requesting spouse.

The Court then turned its attention to the elements of a streamlined determination.

The requesting spouse is eligible for a streamlined determination by the Commissioner only in cases in which the requesting spouse establishes that she (1) is no longer married to the nonrequesting spouse (marital status requirement), (2) would suffer economic hardship if not granted relief (economic hardship requirement), and (3) did not know or have reason to know that the nonrequesting spouse would not or could not pay the underpayment of tax reported on the joint income tax return, or did not know or have reason to know that there was an understatement or deficiency on the joint income tax return (lack of knowledge requirement). The requesting spouse must establish that she satisfies each of the three elements to receive a streamlined determination granting relief.

The IRS challenged the marital status element because they still lived in the same house; however, the Court determined that they had become roommates. The Court did not find that the divorce served as a ruse.

The IRS challenged the economic hardship element because she had substantial equity in the house.  The Court finds:

we doubt petitioner could access the equity in the property without selling it. The record includes a statement of credit denial from a credit union, and petitioner credibly testified that her work prospects were diminishing on account of physical ailments. Given these circumstances, we do not believe petitioner could liquidate her assets to make even a partial payment of the liabilities and still meet her reasonable basic living expenses. She therefore satisfies the second prong of the economic hardship test.

Almost identical facts to Sleeth and the opposite result.  Ms. Sleeth had even less income and no real work history.  She was also in her 60s.  Maybe the Court in Pocock was influenced by a concession by the IRS and maybe the inconsistency is in the approach of the IRS and not the Court.  In footnote 20 the Court states:

Respondent does not contend that petitioner could sell the home and still meet her reasonable basic living expenses. To the contrary, respondent states on brief: “Respondent is not arguing that petitioner should have to sell the home in order to pay the tax liability.”

She did put on evidence that should could not borrow on the equity in the house because she did not have the income to support repayment of any loan.

Finally, the Court looks again at knowledge and determines that she did not have knowledge of the scheme. It states that Mr. Pocock had proved to petitioner that he was untrustworthy putting her on constructive notice warranting an inquiry by her. Because he became violent when questioned about finances, her failure to question him in this situation is excused based on the totality of the circumstances.

Conclusion

As a result, the Court determines she qualifies for streamlined relief.  As I mentioned at the outset, I agree with the opinion but find the result here with respect to economic hardship difficult to square with at least one prior opinion from the Court.  Because of the importance of that issue in innocent spouse cases, it deserves more attention at the IRS and the Court.

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