The Limits of Community Property Relief When Spouses Split a Joint Business

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We have not covered IRC 66(c) relief from community property taxation in detail on PT before.  Keith wrote about the 2018 case of U.S. v. Kraus, where the grant of personal relief under IRC 66 failed to lift the federal tax lien or prevent foreclosure of the lien. (Similar hurdles exist with IRC 6015.) We have also noted, in another post by Keith, that contesting the validity of a joint return is much more fraught in community property states, as it does not relieve the spouses of liability for each other’s income as it does in common law states. A December 2021 summary opinion by Judge Pugh, Wheeler v. Comm’r, provides an opportunity to further explore the limits of relief from community property taxation under IRC 66(c).

The Wheeler case caught my eye as I (with guest blogger Audrey Patten) finalized the updates to Robert Nadler’s classic book, A Practitioner’s Guide to Innocent Spouse Relief. In addition to updating the book generally, for the third edition we added new material including a chapter on community property states, with an overview of relief from community property taxation. For those wanting more detail, the Saltzman & Book treatise IRS Practice and Procedure has an excellent and thorough explanation at ¶ 7C.07.

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Marriage and Divorce and a Jointly Owned Business

Ms. Wheeler and Mr. Turner resided in Texas during their marriage, during which they formed an S Corporation naming each spouse as a 50% shareholder. The opinion does not include many details about Ms. Wheeler’s involvement in the operation of the business, but she apparently performed work for the business including in 2015, the year at issue. The court finds that “Income reported on Schedule K-1, Shareholder’s Share of Income, Deductions, Credits, etc., from Turner Investments was included on petitioner’s joint return with Mr. Turner for the three years (2012-14) before the year in issue. She was also issued Forms W-2, Wage and Tax Statement, reporting income from Turner Investments in years before 2015 and during that year, and she signed several checks for Turner Investments in 2013.”

When the couple divorced in 2015, Mr. Turner was awarded the business, and by the end of September 2015, Ms. Wheeler was no longer a shareholder.

The divorce decree provided that each spouse would file an individual income tax return for 2015, and “that for calendar year 2015, each party shall indemnify and hold the other party and his or her property harmless from any tax liability associated with the reporting party’s individual tax return for that year unless the parties have agreed to allocate their tax liability in a manner different from that reflected on their returns.”

Tax Troubles

Ms. Wheeler reported her W-2 income from Turner Investments on her 2015 tax return, but she did not report any pass-through income from Schedule K-1, which listed her as a 37.44856% shareholder for that year. The IRS subsequently issued a Notice of Deficiency and Ms. Wheeler timely petitioned the Tax Court, where she raised spousal relief as an affirmative defense.

Ms. Wheeler apparently viewed the 2015 net income from Turner Investments as equitably belonging to Mr. Turner, and therefore she sought relief under section 66(c) from the operation of community property taxation. (Because no joint return was filed for 2015, section 6015 was not applicable.)

The Court notes that

Texas is a community property State, and under section 66, married couples who do not file joint tax returns “generally must report half of the total community income earned by the spouses during the taxable year” unless an exception applies. Sec. 1.66-1(a), Income Tax Regs.

This general rule can lead to harsh results, as it does not depend on how income is actually received and spent. For example, in Hiramanek v. Comm’r, T.C. Memo. 2011-280, a preschool teacher who suffered years of abuse at the hands of her spouse would have been responsible for taxes on half of his much higher income as a corporate finance director, absent relief from community property laws. The Wheeler Court explains that

Section 66 provides that under certain circumstances a taxpayer may be relieved of Federal income tax liability on community property income earned by a spouse. Section 66(c) offers two types of relief to a requesting spouse — “traditional” and “equitable”. Sec. 1.66-4, Income Tax Regs.

Traditional Relief under IRC 66(c)

Traditional relief from community property taxation under IRC 66(c) is similar in many ways to “traditional” innocent spouse relief under IRC 6015(b), but in some ways it is more limited. The Court in Wheeler summarizes the four requirements:

(i) The requesting spouse did not file a joint Federal income tax return for the taxable year for which he or she seeks relief;

(ii) The requesting spouse did not include in gross income for the taxable year an item of community income properly includible therein, which, under the rules contained in section 879(a), would be treated as the income of the nonrequesting spouse;

(iii) The requesting spouse establishes that he or she did not know of, and had no reason to know of, the item of community income; and

(iv) Taking into account all of the facts and circumstances, it is inequitable to include the item of community income in the requesting spouse’s individual gross income.

As with 6015(b), many traditional relief cases under section 66(c) hinge on knowledge. For example, in the Hiramanek case linked above, the requesting spouse was not entitled to traditional relief under section 66(c) because she knew that her husband had been employed during the tax year.

The Wheeler case is different, and it highlights one big distinction between section 6015(b) and traditional 66(c) relief. Here, the Court stops at the second condition, finding that the business income included in the SNOD would not be treated as income of Mr. Turner under the rules of IRC 879(a) (which in turn reference section 1402):

Under section 1402(a)(5)(A), gross income and deductions attributable to a jointly operated trade or business are treated as the gross income and deductions of each spouse on the basis of their respective distributive shares of the gross income and deductions. Therefore, the rules contained in section 879(a) treat income from Turner Investments, a jointly operated trade or business, as the income of petitioner and Mr. Turner on the basis of their respective distributive shares. The income from petitioner’s 37.44856% ownership of Turner Investments and reported on her 2015 Schedule K-1 would not be treated as income of a nonrequesting spouse, and she therefore does not satisfy section 1.66-4(a)(1)(ii), Income Tax Regs. We therefore hold that petitioner is not entitled to traditional relief under section 66(c).

Although that finding is enough to prevent traditional relief, the Court also addresses Ms. Wheeler’s arguments that she did not know about the income. As with 6015 cases, the knowledge factor does not require knowledge of the tax law, only knowledge of the activity that produced the income. Given the history of joint returns reporting Schedule K-1 income, the Court finds that Ms. Wheeler had ample reason to know of the income. Nails in the coffin are (a) a provision in the divorce decree giving each spouse the duty to furnish to the other any information requested to prepare the 2015 tax return, and (2) the fact that Ms. Wheeler hired a tax preparer.

Equitable Relief Also Fails

In addition to the traditional relief outlined above, Section 66(c) contains flush language providing for equitable relief:

Under procedures prescribed by the Secretary, if, taking into account all the facts and circumstances, it is inequitable to hold the individual liable for any unpaid tax or any deficiency (or any portion of either) attributable to any item for which relief is not available under the preceding sentence, the Secretary may relieve such individual of such liability.

The procedures governing equitable relief under section 66(c) are the same familiar procedures and factors that govern equitable relief under section 6015(f), set out in Rev. Proc. 2013-34. (Hooray for tax simplification!)

The Court starts and ends its equitable relief analysis with the threshold requirement that the liability be attributable to the nonrequesting spouse. The attribution rule is not absolute, however. The Court notes that the Rev. Proc. provides for five exceptions, “(a) attribution solely due to operation of community property law, (b) nominal ownership, (c) misappropriation of funds, (d) abuse, and (e) fraud committed by the nonrequesting spouse.” Also, as the revenue procedure is not binding on the Court, in some cases judges have found that relief is warranted under slightly different fact patterns not captured by the five enumerated exceptions. This occurred for example in the Boyle case, which Les discussed here.

The Court finds that Ms. Wheeler does not meet any of the exceptions, and as she seeks relief from her own income items, she does not qualify for equitable relief. The Court also addressed other facts that Ms. Wheeler raised.

Petitioner does not meet any of these exceptions because: (a) the Schedule K-1 income from Turner Investments is attributable to her under section 1366, not solely by the operation of community property law; (b) the Schedule K-1 is in her name, and she did not rebut the consequent presumption that the income is attributable to her; (c) her failure to claim estimated tax payments (and the IRS’ subsequent refund of those excess payments to Mr. Turner pursuant to section 6402 and section 1.6654-2(e)(5)(ii), Income Tax Regs.) does not constitute misappropriation of funds; (d) she filed an individual return and did not establish how any prior abuse by Mr. Turner would result in her inability to challenge the treatment of items on a return that she filed individually after her divorce was finalized and with the help of her own return preparer; and (e) she did not argue or establish that fraud is the reason for an erroneous item. Nor are we persuaded that her failure to claim the estimated tax payments and the subsequent refund to Mr. Turner provided sufficient ground for equitable relief independent of these factors. While the facts here are unfortunate, they were not unavoidable. We therefore hold that petitioner is not entitled to equitable relief under section 66(c).

Conclusion

The Wheeler case is not really about community property taxation, despite the petitioner’s attempt at framing it that way. It appears that the SNOD did not rely on the law of community property taxation to charge Ms. Wheeler with income that was received by her ex-husband during their marriage. Rather, the SNOD relied on the Schedule K-1 issued separately to Ms. Wheeler, and the deficiency would have been the same if the parties had lived in a common law state.

If Mr. Turner had been the sole shareholder of Turner Investments for all of 2015, and the IRS had attempted to charge Ms. Wheeler with half of his net business income under community property principles, the analysis (and potentially the result) would have been very different.

It seems likely that Ms. Wheeler misunderstood the tax implications of her divorce agreement. As the business had been awarded to Mr. Turner and transferred to him by the end of September, it seems quite realistic to me that an unsophisticated taxpayer would believe the net business income for 2015 should fall entirely to Mr. Turner. In his blog about the case, CPA Ed Zollars observes that such misunderstandings are common in his experience, and he notes the difficulties that tax preparers often have in convincing their clients of the need to report community income.

As is unfortunately the usual case, the parties failed to coordinate when filing their 2015 returns. This is understandable given the opinion’s mention of abuse, but it left Ms. Wheeler at a disadvantage. Mr. Turner initially only claimed half of the estimated payments made by the business for the first three quarters of 2015. If the parties had coordinated, Ms. Wheeler could have claimed the rest of the estimated payments. As Ms. Wheeler did not claim any of them, the IRS later refunded them to Mr. Turner prior to this case. Now she is stuck with the liability but gets no benefit from the estimated payments. Mr. Turner seems to have acted in accordance with the tax laws and the divorce decree; the problem was likely Ms. Wheeler’s (or her preparer’s) misunderstanding of the full impact of the divorce decree on her 2015 taxes. It is unfortunate that responsibility for taxes on the net business income was not explicitly addressed in the decree.

About Christine Speidel

Christine Speidel is Associate Professor and Director of the Federal Tax Clinic at Villanova University Charles Widger School of Law. Prior to her appointment at Villanova she practiced law at Vermont Legal Aid, Inc. At Vermont Legal Aid Christine directed the Vermont Low-Income Taxpayer Clinic and was a staff attorney for Vermont Legal Aid's Office of the Health Care Advocate.

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