In the case of Wheeler v. Commissioner,[1] the Tax Court did not find persuasive a taxpayer’s argument that she should be granted innocent spouse relief for taxes related to income from an S corporation she held an interest in during the year before the Court, which also was the year her divorce was finalized late in the year.

The taxpayer and her ex-spouse resided in Texas, one of the nine community property states in the U.S.  The spouses had filed for divorce on September 21, 2015 and the divorce was finalized by decree on December 9, 2015.  The decree that was signed by the taxpayer and her ex-spouse contained the following provision related to tax issues, entitled “Treatment/Allocation of Community Income for Year of Divorce.”

IT IS ORDERED AND DECREED that, for the calendar year 2015, each party shall file an individual income tax return in accordance with the Internal Revenue Code.

IT IS ORDERED AND DECREED 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.

IT IS ORDERED AND DECREED that each party shall furnish such information to the other party as is requested to prepare federal income tax returns for 2015 within thirty days of receipt of a written request for the information, and in no event shall the available information be exchanged later than March 1, 2016. As requested information becomes available after that date, it shall be provided within ten days of receipt.[2]

One of the assets owned by the couple while married were shares in Turner Investments & Consulting, Inc., an S corporation.  The opinion notes:

In October 2006 Turner Investments & Consulting, Inc. (Turner Investments), was organized as an S corporation; petitioner and Mr. Turner were each designated 50% shareholders. 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.[3]

The final decree provided that the taxpayer “shall execute any and all documents necessary to remove her name from the corporation and/or business within 5 days of receipt of same.”[4]

The Court then describes the items reported and not reported on the taxpayer’s tax return for 2015 related to the corporation:

For 2015 Turner Investments issued to petitioner a Form W-2; she reported this wage income on her 2015 Form 1040. For 2015 Turner Investments also reported for petitioner, as a 37.44856% shareholder for that year, on Schedule K-1, ordinary business income of $63,083 and a net rental real estate loss of $1,681; she did not report this net Schedule K-1 income.[5]

The IRS noticed the omission of the S corporation income from Ms. Wheeler’s 2015 return and issued a notice of deficiency for taxes related to that omitted income.

Ms. Wheeler, after filing her petition with the Tax Court in this case, filed for innocent spouse relief from liabilities related to the S corporation income.  She argued that she is entitled to relief under IRC §66(c).  IRC §66(c) reads as follows:

(c) Spouse relieved of liability in certain other cases

Under regulations prescribed by the Secretary, if—

(1) an individual does not file a joint return for any taxable year,

(2) such individual does not include in gross income for such taxable year an item of community income properly includible therein which, in accordance with the rules contained in section 879(a), would be treated as the income of the other spouse,

(3) the individual establishes that he or she did not know of, and had no reason to know of, such item of community income, and

(4) taking into account all facts and circumstances, it is inequitable to include such item of community income in such individual’s gross income,

then, for purposes of this title, such item of community income shall be included in the gross income of the other spouse (and not in the gross income of the individual).

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.

Note that this provision provides for two separate methods for the taxpayer to be able to avoid reporting community income.  The first method, which is explained in all but the last paragraph, outlines what the court refers to as the “traditional relief” under this section, which provides four requirements a taxpayer must meet to be granted relief.

But the final paragraph offers a second offer of “equitable relief” if a taxpayer did not qualify for the traditional relief, so long as it would be inequitable to require the requesting former spouse to take the income into account.

Traditional Relief – S Corporation Flow-Through Income Not Covered by IRC §879(a)

The court noted that the S corporation income would have been treated as Ms. Wheeler’s under the rules of IRC §879(a), making it her income.  The rules of IRC §879(a), which apply to dividing income of nonresident alien spouses, are used to determine how to divide otherwise community income when the §66(c) traditional relief is sought and provides:

(a) General rule

In the case of a married couple 1 or both of whom are nonresident alien individuals and who have community income for the taxable year, such community income shall be treated as follows:

(1) Earned income (within the meaning of section 911(d)(2)), other than trade or business income and a partner’s distributive share of partnership income, shall be treated as the income of the spouse who rendered the personal services,

(2) Trade or business income, and a partner’s distributive share of partnership income, shall be treated as provided in section 1402(a)(5), (emphasis added)

(3) Community income not described in paragraph (1) or (2) which is derived from the separate property (as determined under the applicable community property law) of one spouse shall be treated as the income of such spouse, and

(4) All other such community income shall be treated as provided in the applicable community property law.

The Court, applying the rules for trade or business income, found:

Under section 879(a), community income that is trade or business income is treated as provided in section 1402(a)(5). 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.[6]

Based on this factor alone, the Tax Court found that Ms. Wheeler could not qualify for traditional relief.  But the Court also noted that Ms. Wheeler also should have been aware of this income (another condition for traditional relief is to be unaware of the income).  While Ms. Wheeler argued that the fact that she was not provided with a Schedule K-1 proves she was not aware of the income, the court found that Ms. Wheeler reasonably should have been aware of the existence of the income:

..[A] taxpayer’s knowledge of an item of community income must be determined by considering her knowledge of the particular income-producing activity. See McGee v. Commissioner, 979 F.2d 66, 70 (5th Cir. 1992), aff’g T.C. Memo. 1991-510; sec. 1.66-4(a)(2), Income Tax Regs. Petitioner was a shareholder in Turner Investments and reported Schedule K-1 income for the three years before 2015 on her Form 1040 jointly filed with Mr. Turner, received and reported Form W-2 income from Turner Investments for 2015 (and prior years), signed several checks for Turner Investments in 2013, and signed a divorce decree that referenced Turner Investments and required her to execute documents to remove her name from it. See Felt v. Commissioner, T.C. Memo. 2009-245 (finding that a requesting spouse knew the source of the income because she knew the name of and had deposited checks from a nonrequesting spouse’s business that generated family income), aff’d, 433 F. App’x 293 (5th Cir. 2011). Crediting her testimony that she did not receive a Schedule K-1 for 2015 thus would not defeat a finding that she knew of or had reason to know of Turner Investments as an income-producing activity.

Moreover, the divorce decree gave petitioner the right to request information “to prepare federal income tax returns for 2015” from Mr. Turner and required Mr. Turner “to furnish such information to * * * [petitioner]” within a specified period. Petitioner introduced no evidence that she requested such information or that Mr. Turner blocked her from doing so; rather, she claims that he failed to provide the Schedule K-1 for 2015. Her right to request information under the divorce decree also was a means by which petitioner could have correctly reported her portion of Turner Investments’ estimated tax payments.[7]

The opinion adds a final reason why the taxpayer should have known that there was a K-1 with income that should be reported.

Petitioner also hired a tax return preparer to assist her, mitigating her lack of tax knowledge.[8]

Tax professionals may be troubled by this statement, since it implies that having hired a tax professional was a negative factor in determining if she had acted reasonably in remaining unaware of the existence of this income. The ruling implies (likely correctly) that a competent tax professional should have noticed the K-1 income reported in prior years and made inquiries to determine if such a K-1 had been issued to Ms. Wheeler for the current year. 

As the Court notes, if such inquiries had been made (which the taxpayer conceded had not been made), her former spouse would have been required under the agreement to provide her with such information.

Equitable Relief Not Available Due to the Income Being Hers

The opinion also looks at the option made available for general equitable relief under IRC §66(c) in cases where the taxpayer cannot meet the conditions for traditional relief.

The Court notes that the IRS has outlined procedures for obtaining equitable innocent spouse relief in Revenue Procedure 2013-34.  And the opinion notes that the relief can normally only be made available for income that is wholly that of the nonrequesting spouse:

The requesting spouse must satisfy five threshold conditions to be eligible to submit a request for equitable relief under section 66(c). Rev. Proc. 2013-34, sec. 4.01, 2013-43 I.R.B. at 399-400. One threshold condition is that “[t]he income tax liability from which the requesting spouse seeks relief is attributable (either in full or in part) to an item of the nonrequesting spouse or an underpayment resulting from the nonrequesting spouse’s income.” Id. sec. 4.01(7), 2013-43 I.R.B. at 399.[9]

In this case, the problem was that the income from her shares in the S corporation was her income:

The income tax liability from which petitioner seeks relief is not attributable (either in full or in part) to an item or underpayment of another individual. See id. Rather, the liability from which she seeks relief is attributable to her status as a 37.44856% shareholder in Turner Investments (distinct from Mr. Turner’s status as a 62.55144% shareholder).[10]

The opinion continues on to note why this is not one of the special cases where Ms. Wheeler could obtain relief even though the income was her own:

The exceptions for which “the Service will consider granting relief regardless of whether the * * * deficiency * * * is attributable * * * to the requesting spouse” under Rev. Proc. 2013-34, sec. 4.01(7), 2013-43 I.R.B. at 399-400, are (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.

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).[11]

Lessons from the Case

In my career as a tax professional in Arizona (a community property state), I’ve noticed that recently divorced spouses, or even those going through a divorce, do not appreciate the impact of community property rules on how income must be reported on either returns with a married filing separate status or those for a tax year during which the divorce decree was granted.  A former (or soon to be former) spouse often believes he/she just has to report his/her income based on how items were divided in the divorce or on general non-community property law views of what income belongs to each spouse.

In many cases, even after being made aware of the requirements to report income based on state law ownership of the income unless the special requirements of IRC §66(c) are met, the client will strongly resist such reporting, either finding it “unfair” or, more often, simply not wanting to interact with the other spouse as necessary to obtain the information.

Similarly, in looking over returns prepared by other preparers, it appears often preparers either are also unaware of these rules or simply decide to prepare the return ignoring community property rules when the client balks at getting the proper information.  As well, even some preparers that are generally aware of the community property rules and special rules for IRC §66(c) are unaware of the limitations on the types of income to which such relief applies under the traditional rule.

Most often such reporting does not lead to problems with the IRS, resulting in an unfortunate reinforcement for all parties that such reporting is “fine” and there’s no need to worry about proper reporting.  To be honest, if the corporation had not issued a K-1 in the ex-spouse’s name, rather erroneously preparing a K-1 showing all income as the ex-husband’s, it’s highly likely nothing would have happened here. 

But as is often the case with such “practical” decision making (“I’ve been doing it this way for decades and never had an issue with the IRS on this!”), if the IRS does become aware of the issue and starts looking to collect tax, the taxpayer has no practical defense against paying the tax.  And, as this case made clear, the fact the client sought professional help makes the situation worse, as the taxpayer’s lack of sophistication no longer is a factor that might have shown it was reasonable to conclude the taxpayer wasn’t aware of her error.

[1] Wheeler v. Commissioner, TC Summary Opinion 2021-42, December 9, 2021, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/individual-denied-relief-from-taxes-on-income-allocated-to-her/7cp60 (retrieved December 11, 2021)

[2] Wheeler v. Commissioner, TC Summary Opinion 2021-42, December 9, 2021

[3] Wheeler v. Commissioner, TC Summary Opinion 2021-42, December 9, 2021

[4] Wheeler v. Commissioner, TC Summary Opinion 2021-42, December 9, 2021

[5] Wheeler v. Commissioner, TC Summary Opinion 2021-42, December 9, 2021

[6] Wheeler v. Commissioner, TC Summary Opinion 2021-42, December 9, 2021

[7] Wheeler v. Commissioner, TC Summary Opinion 2021-42, December 9, 2021

[8] Wheeler v. Commissioner, TC Summary Opinion 2021-42, December 9, 2021

[9] Wheeler v. Commissioner, TC Summary Opinion 2021-42, December 9, 2021

[10] Wheeler v. Commissioner, TC Summary Opinion 2021-42, December 9, 2021

[11] Wheeler v. Commissioner, TC Summary Opinion 2021-42, December 9, 2021