Knowledge of Husband's Tax Scheme Dooms Wife's Innocent Spouse Relief Claim

(Parker Tax Publishing September 2021)

The Seventh Circuit affirmed a Tax Court ruling that a taxpayer was not eligible for innocent spouse relief under Code Sec. 6015(b) or (f) with respect to taxes owed as a result of her husband's abusive tax shelter schemes. The court found that the taxpayer had reason to know of the understatement on the couple's joint tax returns because she had a law degree, reviewed the tax returns each year, and partnered with her husband in a real estate development project, the funds from which her husband used to invest and participate in the tax shelter schemes. Rogers v. Comm'r, 2021 PTC 262 (7th Cir. 2021).

Background

Married in 1967, John and Frances Rogers filed joint federal income tax returns for many years. John is a Harvard-trained tax attorney who developed and marketed abusive tax shelters. A part of John's tax schemes involved a partnership called Sugarloaf Fund, LLC, which acquired and subsequently transferred highly distressed or uncollectible accounts receivable from retailers located in Brazil. The point of the transfers was to convey interests in the receivables - assets with meaningful face value but no economic value in the hands of the Brazilian retailers - to U.S. taxpayers, who then deemed them uncollectible and used the concocted loss to reduce their tax liability. As the architect of this scheme, John used the tax shelters to underreport his personal income tax obligations. But the IRS eventually caught on to his underpayments and in time litigation ensued. In several cases involving multiple tax years, the Tax Court concluded that John perpetuated fraudulent tax avoidance, and it thus imposed significant liability on the Rogerses. The Tax Court's decisions were affirmed by the Seventh Circuit.

Frances sought relief for the couple's joint tax liabilities under the innocent spouse relief rules in Code Sec. 6015(b) and (f). Under Code Sec. 6015(b), relief from joint and several tax liability is available when the taxpayer establishes that: (1) a joint return was made, (2) there is an understatement of tax attributable to the errors of one individual filing the return, (3) the other individual who filed the return did not know, and had no reason to know, of the understatement at the time of signing the return, and (4) it would be inequitable to hold the other individual liable for the tax deficiency resulting from the understatement. Under Code Sec. 6015(f), the Tax Court may provide relief from joint liability if, taking into account all the facts and circumstances, it would be inequitable to hold the individual liable for any unpaid tax or any deficiency and relief is not otherwise available.

In Resser v. Comm'r, 74 F.3d 1528 (7th Cir. 1996), the Seventh Circuit established a "reasonably prudent person" test, under which a spouse has "reason to know" if a reasonably prudent person under the circumstances could be expected to know at the time of signing the return that the tax return contained a substantial understatement. Under Resser, four factors determine whether the spouse has reason to know of the understatement: (1) the spouse's level of education, (2) the spouse's involvement in the family's financial and business activities, (3) the presence of unusual or lavish expenses beyond the family's norm, and (4) the culpable spouse's evasiveness or deceitfulness about the family's finances.

Frances sought innocent spouse relief for the following tax years: 2003, 2005-2007, and 2009-2012. The Tax Court denied her relief for all years. For 2003, the Tax Court held that principles of res judicata codified in Code Sec. 6015(g)(2) barred relief after finding that Frances meaningfully participated in a Tax Court trial regarding her and John's 2010 tax. For the remaining years, the Tax Court applied Code Sec. 6015(b) and (f), along with the factors outlined in Resser, and determined that Frances knew or had reason to know of the tax understatements in the joint returns she filed with John and that Frances was not entitled to equitable relief. Frances appealed to the Seventh Circuit.

Analysis

The Seventh Circuit affirmed the Tax Court's rulings. For 2003, the Seventh Circuit agreed that Frances meaningfully participated in the tax deficiency trial for the 2003 tax year, in part because she was represented by counsel (her husband John), attended the entire trial, and sat at the table reserved for petitioners and their counsel. The court also found that Frances - the holder of a law degree and an M.B.A. - is highly educated, a fact that supported the finding that she understood the proceedings and the implications of the Tax Court's decision. The court also saw no clear error in the Tax Court's discrediting of Frances's claim that she had no knowledge of her husband's business activities or the tax shelter he promoted.

Regarding the 2005-2007 and 2009-2012 years, the Seventh Circuit found that the Tax Court applied the correct standard, with the possible exception of one factual error in its 2018 opinion regarding the couple's lavish lifestyle. But the court was certain that any error was harmless and the rest of the Tax Court's analysis remained sound. The Seventh Circuit agreed with the Tax Court that Frances's higher education, especially the tax courses she took in law school, undercut the credibility of her argument that she was not capable of understanding complex financial, accounting, and tax concepts.

The Seventh Circuit also agreed with the Tax Court's discrediting of Frances's claims that she had no knowledge or involvement in her husband's businesses or law practice. The court noted that Frances reviewed the couple's joint tax returns each year with John and asked him follow-up questions. For a time, she also assisted in managing her husband's law firm while he sought treatment for alcoholism in 2009. During that time, Frances fired the office manager, maintained accounting records, endorsed and deposited checks, and paid expenses. In addition, in 2004 Frances partnered with her husband to develop a residential subdivision in Orland Park, Illinois, called Sterling Ridge. The court noted that Frances was actively involved in the subdivision's development and had participated in its design and layout and assisted with setting sale terms and prices for the lots. To facilitate the project, Frances formed Sterling Ridge, Inc., an S corporation, and the court found that Frances knew John was using the new enterprise to invest and participate in the Sugarloaf Fund tax shelter schemes. What is more, Frances traveled to Brazil with John and attended Sugarloaf Fund-related meetings, and she testified to having understood the basics of the Brazilian receivables transactions at the heart of the tax scheme. The Seventh Circuit found that Frances knew, or had every reason to know, that Sterling Ridge sold at meaningful profits plots of land worth millions but reported losses of over $3.2 million and claimed a $4 million deduction from the Sugarloaf Fund tax shelter. The Tax Court determined that these facts, too, weighed against Frances's claim for innocent spouse relief, and the Seventh Circuit could not call the findings clearly erroneous.

The Seventh Circuit said that the Tax Court's finding that Frances maintained a high standard of living may have been clearly erroneous since, under Resser, the test is whether the taxpayer's expenses reflect a substantial unexplained increase in her lifestyle. The Seventh Circuit observed that the Rogerses' standard of living remaining consistent during the relevant years, so this factor did not cut against relief. However, the court found the error to be harmless since the other factors, supported a finding that Frances knew or had reason to know of the tax understatements. On the last factor, the Seventh Circuit agreed with the Tax Court that nothing in the record showed that John tried to deceive or hide anything from Frances. Frances had access to the family's financial information and reviewed the tax returns before their being filed, and there was no evidence that John concealed any financial dealings or bank accounts from her.

The Seventh Circuit went on to analyze the fourth element under Code Sec. 6015(b) - whether it would be inequitable to hold Frances liable for the tax understatements - and found that no unfairness would result considering that Frances knew that the couple had earned $13 million from the Sterling Ridge sales, and that John had a salary of $500,000, yet the couple paid little to no income tax and enjoyed a comfortable lifestyle. For the same reason, the Seventh Circuit also upheld the Tax Court's finding that Frances was not entitled to equitable relief under Code Sec. 6015(f).

For a discussion of innocent spouse relief, see Parker Tax ¶260,560.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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