Theresa Karam was denied innocent spouse status by the Tax Court and has lost on appeal to the Sixth Circuit. There is a very interesting twist to her case. Her failure to get innocent spouse status was cushioned by the lawsuit that she won against her accountant. He did not make it clear to his client that filing a joint return is an election. A joint return will generally result in a lower tax than the total of two married filing separate returns, but there is a significant downside. It is called joint and several liability. The IRS can collect the entire tax from either of the spouses. There can be relief from this harsh result but, as Theresa Karam learned, it is not easy to get that relief.
The story is a little odd:
The Karams have used an accountant to file joint federal income tax returns since they were married. However, in 1997, following the death of their long-time accountant, James Karam retained Theodore C. Schumann, P.C., C.P.A., doing business as Dental Business Services, Inc. (the “Schumann firm”), to take over the family’s accounting and taxes. Although James provided the Schumann firm with tax documentation necessary to timely prepare their tax returns, the firm was delinquent in preparing the Karam’s tax returns for the years 1998, 1999, 2000, and 2001. The Karams later discovered that the accountant assigned to their file was ill, and the firm never had another accountant prepare their returns.
I don’t get how Dr. Karam went as long as he did providing information to timely file his returns and not think that there was some sort of problem when they never got prepared. It took pressure from the IRS to get him to look into it.
In August 2002, IRS Officer Sharon Sloan demanded that the Karams file their delinquent income tax returns or face a financial records subpoena. Thereafter, the Schumann firm finally delivered joint income tax returns for the Karams to sign. Attached to each return was a note saying “please sign.” Theresa Karam alleges that she had to sign the returns as presented and was unaware that she could decline to file a joint return and instead file as “married filing separately.” The Schumann firm never advised her with respect to the tax consequences of filing a joint return. She nevertheless signed each of the four returns, and the Schumann firm filed them with the IRS.
I don’t want to knock the accountants for the mistake that they seem to have made, because it is close to a universal mistake. There are two very distinct areas of tax practice. In one area you are determining the correct tax and coming up with legitimate ways to make the correct tax as low as possible given whatever constraints you might be working with. Call that compliance/planning. The other area is collections. When practicing in the collections area, lowering the correct tax will often be only of academic interest. Collections is all about what you can pay. Filing a joint return is almost always the right answer in compliance/planning mode. If the balance due is being paid, making it as small as possible is clearly the way to go.
If the balance due is not going to be paid, filing a joint return is quite likely the wrong answer. Ms. Karam was an employee and presumably had withholdings. It seems unlikely that she would have had a huge balance due had she filed separately. Doctor Karam would likely have owed even more on a separate return. So what ? He didn’t pay the lower balance due for the joint return and by making it a joint return the IRS ended up with two people they could chase for it.
In August 2006, Theresa Karam sued the Schumann firm in Michigan state court, alleging that the firm’s negligence and breach of contract resulted in her joint and several liability for federal income taxes. The case was ultimately settled, with a payment of $150,000 to petitioner. After paying attorney’s fees and costs, Karam offered the IRS the remaining balance of $99,186 to settle her outstanding tax liability. Pursuant to administrative procedure, Karam was required to deposit twenty percent of her offer with the IRS, which she did. However, the IRS ultimately rejected Karam’s settlement offer and kept her $19,837 deposit.
Ms. Karam was denied innocent spouse relief for a couple of reasons. The Court did not believe that she was unaware that her husband was not going to pay the balance due on the delinquent returns. There was also a finding that she had benefited from the unpaid taxes since they allowed her to devote her own earnings towards the expenses of getting a PhD and sending her children to private schools. Perhaps the unkindest cut of all:
Additionally, her admission that she is using the remaining $80,000 from the settlement with the Schumann firm to finance this litigation further undermines her claim for relief. Karam questionably asserts “economic hardship” while possessing a large litigation fund that she could use to make partial payments on her tax debt. The equities of the situation are not in her favor.
Robert Steinberg in his The Tax Wars Blog wrote about the original Tax Court decision last year. He suggested that preparers add a paragraph, which he provides, to engagement or transmittal letters warning about the implications of filing a joint return. The idea has merit, but when I think about how long some engagement letters already are, the value of adding another paragraph, beyond CYA for the preparer, is limited. What is really important is for preparers to be alert to the situations where separate filing might be the best course. A pile of delinquent returns with large balances is such a situation. Making the large balances a little less large might not be worth giving IRS collections people another person to pursue. It is also important for the preparer to recognize that the interests of the couple might not be aligned in situations like that.
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Originally published on Forbes.com Nov 24th, 2012