Originally Published on forbes.com on July 22nd, 2011
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The case of Timothy Lee Richard is unusual for two reasons. The first is that it is a case of a man claiming innocent spouse status. They are not that rare, but if you’ll excuse the antediluvian attitude, claiming innocent spouse status doesn’t seem to be the manly thing to do. I did an unscientific sample once and came up with about 25% of the innocent spouse cases going to tax court coming from men. The other unusual thing is that he won. My overall impression is that taxpayers usually lose these cases. The case of Robert McGhee, an airline pilot and Air Force reservist, who spent his spare time serving his country while his wife spent her spare time embezelling, exhausted my gender equity theorizing on this topic, so I won’t get into that. I’ll just note that a guy winning an innocent spouse case is unusual. Frankly a woman winning one isn’t all that common either.
Before I get into the case a brief discussion of “innocent spouse” might be in order. Innocent spouse cases come from the dark side of the joint return privelege afforded to legally married heterosexual couples. Many practitioners fail to realize that there are two distinct areas of tax practice. (There is actually is a third area, well covered by Jack Townsend’s blog Federal Tax Crimes, but that is an area I stay away from.) First there is planning to minimize legally required tax and preparing the appropriate returns (Some practitioners would divide that into two distinct fields, but I think that is a mistake. If compliance and planning are not integrated, neither will be done well). The other area is collection. In collection matters the correct amount of tax is rarely of more than academic interest. Collections is about how much blood can be squeezed from the turnip. It is a pretty much a given that the amount will be less than the “correct tax”.
The area where I see the two fields most commonly overlapping is in the decision of married couples to elect to file a joint return. Of course, it is rarely an actual decision and I think some people fail to realize that it is an election. Although a married couple, particularly one with roughly equal incomes, will sometimes pay more filing jointly then if they were single, as I observed in my post on marriage equality, they will almost always come to a higher total using married filing separately, which is the only other alternative if they are of different genders. So from a planning and compliance view point joint filing seems like a no brainer. From a collections perspective, though, if you are married to a dead beat loser or even someone who is somewhat casual about their financial obligations filing a joint return with them can be a no brains maneuver particularly in the final year of the marriage.
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Often in divorce negotiations there is an assumption that a joint return will be filed for the final year of the marriage. Possibly the lower earning spouse will get a share of the savings as an inducement. Suppose Robin and Terry aregetting divorced. Robin has significant taxable income and Terry has none. If Robin files separately there will be a balance due of $20,000 whereas a joint return would have a balance due of $12,000. The divorce agreement provides that the balance due is Robin’s obligation. If Terry refuses to sign a joint return, does it mean that Terry is being mean and vindictive? Most likely it does, but it is possible that Terry has a reasonable basis for the decision. Terry could not file at all, or, as I would advise, file a 0 liability married filing separate return to forestall Robin from arguing that Terry consented to a joint return without signing it. So why should Terry not, with a stroke of the pen, convert Robin’s $20,000 tax obligation to $12,000 ? Because, notwhithstanding the divorce agreement, if Robin does not pay the $12,000, the IRS can collect all of it from Terry. If that is the way things play out Terry’s recourse is to file aRequest for Innocent Spouse Relief. The recourse is far from a sure thing. If the IRS does not agree with Terry, Terry can go to Tax Court where Terry will be called the petitioner. Robin can get back into the act to argue that Terry really should be paying some of the tax in which case Robin will be called the intervenor. (Terry will be calling Robin something else, but it would be unwise for me to repeat that.) On to the case, where I can start using third person pronouns.
Timothy Lee Richard seems to have encountered the middle class American nightmare. Health problems create work problems which create financial problems:
In the years leading up to 2004 petitioner encountered a series of unfortunate medical events. He suffered a heart attack and had open heart surgery and was later diagnosed with prostate cancer. He was then forced to discontinue his work as an investment broker because of his persistent health concerns. The series of medical events caused a downward financial spiral for both petitioner and intervenor. They began to experience considerable financial difficulty because of credit card debt and an overrun of home construction costs.
He and his wife, Susan Lynn Ellis, weren’t excactly scraping the bottom. In 2004 their total income was about $305,000. Of that about $276,000 was attributable solely to her and $14,000 solely to him. Maybe this is more of the upper middle class American nightmare. What does one do ? Well, if there are no wealthy parents to turn to, no kids college fund to raid and no home equity to borrow against, you’ve got to tap your 401(k), which is what Ms. Ellis decided to do:
Petitioner and intervenor discussed possible solutions to address their financial situation. One possible solution they discussed was borrowing from intervenor’s section 401(k) retirement account (retirement account). Following their discussion, intervenor made an Internet request for a distribution of $50,000 from her retirement account. On March 24, 2004, the distribution was deposited into petitioner and intervenor’s joint account and the bank statement labeled the deposit “Fidelity Investm Pension; Susan L. Ellis-Richard”. Intervenor intended to withdraw the portion as a loan; however, she never received the paperwork or otherwise satisfied the statutory requirements to process the distribution as a loan.
Petitioner and intervenor did not report the distribution on their 2004 joint Federal income tax return.
Here we have an example of how many tax plans go astray. It’s in the execution. She planned to borrow the money, but didn’t do the loan paperwork. Then she took the money and acted as if she had borrowed it. Now I don’t give advice based on the audit lottery, but I will tell you that if you are hoping something is just going to slide by and not be noticed, a distribution from a 401(k) is not your best bet:
Petitioner and intervenor divorced on July 14, 2006. In late 2006 petitioner and intervenor received a notice of deficiency for their failure to report as income the $50,000 7 distribution. On June 18, 2007, petitioner filed Form 8857, Request for Innocent Spouse Relief, requesting relief pursuant to section 6015(b), (c), and (f). Respondent sent to petitioner a final Appeals determination denying his request for innocent spouse relief.
In this particular case it was clear that the income was that of Ms. Ellis. The question is whether Mr. Richard was aware of it. She said:
Intervenor testified that petitioner was aware of the distribution; they had discussed it before she requested the funds, he was present when she initiated the request for the distribution, and after the distribution she told him that they had received the funds. Intervenor further alleged that in early 2004 petitioner and intervenor fell several months behind on the mortgage and began receiving phone calls from their mortgage company requesting payment. After the distribution intervenor testified that they were able to make their mortgage payments, an expense of almost $15,000. She further testified that after making their mortgage payments they no longer received phone calls from their mortgage company.
The IRS found that pretty convincing but the Court did not:
Although petitioner may have had “reason to know” of the distribution as a result of his status as a joint signatory on the joint account, the Court is not convinced that this fact alone indicates that petitioner had “actual knowledge” of the distribution. Petitioner testified that he did not review the joint bank account statements and that intervenor primarily handled the finances and balanced the joint checking account, an assertion uncontested by intervenor. Furthermore, petitioner’s expenditures following the distribution were not so extraordinary as to signal that he was aware of the availability of additional funds beyond intervenor’s usual earnings.
Although petitioner may have had “reason to know” of the distribution as a result of his status as a joint signatory on the joint account, the Court is not convinced that this fact alone indicates that petitioner had “actual knowledge” of the distribution. Petitioner testified that he did not review the joint bank account statements and that intervenor primarily handled the finances and balanced the joint checking account, an assertion uncontested by intervenor. Furthermore, petitioner’s expenditures following the distribution were not so extraordinary as to signal that he was aware of the availability of additional funds beyond intervenor’s usual earnings.
The Court was convinced of what he said:
Petitioner credibly testified that he was unaware of intervenor’s request for and receipt of the $50,000 distribution. Petitioner admits that he and intervenor discussed the possibility of obtaining a loan from her retirement account but states that he was unaware that she had actually obtained a distribution from her retirement account. He alleges that although he maintained a joint checking account with intervenor, she primarily wrote the checks drawn on the joint account and that he wrote checks drawn on the joint account only when he was instructed to do so by intervenor. He also admitted that he opened the mail sent to their home but would put the bank statements aside for intervenor to “deal with”.
So if the IRS wants the tax on the $50,000 they have to get all of it from Ms. Ellis. I leave it to the reader to ponder whether this would have gone to Tax Court if the genders were reversed.