Taxpayer Entitled to Innocent Spouse Relief for Tax on Former Spouse's Income, but Not for Tax on Early 401(k) Withdrawal

(Parker Tax Publishing February 2018)

The Tax Court held that a taxpayer was entitled to innocent spouse relief from the taxes on her ex-husband's business income because she reasonably believed they would be paid out of the proceeds of a business contract that never materialized. However, the taxpayer was not eligible for relief with respect to an early withdrawal of her retirement savings that that her husband used to invest in an ultimately worthless venture because, although her husband misled her about the quality of the investment, she freely withdrew the funds and should have known they could be lost. Minton v. Comm'r, T.C. Memo. 2018-15.

Connie Minton moved from Ohio to Florida in 2008. She sold her house in Ohio after the sudden death of her first husband and used the proceeds to buy a house in Florida. There she met John Keeney and married him in 2009. Keeney operated an air conditioning business. Minton was listed as an agent of the business because Keeney claimed to have been a victim of identity theft, but her involvement in the business was minimal and Keeney did not want her working outside the home. Minton tried to pay bills for the business and the household and, therefore, was aware of Keeney's financial difficulties, which included insufficient funds to pay bills. However, Keeney repeatedly told Minton that a big contract was coming for his business. The contract never materialized.

In 2009, Keeney convinced Minton to withdraw $30,000 from her Code Sec. 401(k) account so he could invest it in a moneymaking venture that later turned out to be worthless. In 2010, the couple filed a joint tax return reporting the 401(k) withdrawal and other items of income, including business income, for a total of approximately $35,000 of taxable income. The tax liability came to approximately $5,300, which included $1,100 in self-employment tax and an early withdrawal tax of $3,000. The couple paid $480, leaving a balance due of around $4,800.

Minton knew that she and her husband could not pay their tax liability. However, she trusted Keeney's representations about the imminent contract his business would get and believed the proceeds would take care of their outstanding tax bill. The couple eventually declared bankruptcy but, after separating from Keeney, Minton could not afford to continue the process.

Keeney verbally abused Minton beginning early in the marriage and the abuse grew worse as time went on. Minton discovered that Keeney had lied about his prior employment and hid cash payments from his business from her. When the couple divorced in 2013, Keeney withdrew all the funds from their joint bank account and made threats which lead to Minton filing for a restraining order. Minton found a job and moved in with her mother in a house she bought after paying off a $20,000 lien on her old home so that she could sell it.

In 2014, Minton filed for relief from her and Keeney's unpaid taxes by filing a Form 8857, Request for Innocent Spouse Relief. The IRS denied her request. Minton sold her house in 2016 and paid the tax liability in full. She then sued for a refund in the Tax Court.

Under Code Sec. 6015(f), a spouse can obtain relief from liability for taxes owed on a joint return if imposing liability would be inequitable under the circumstances. Rev. Proc. 2013-34 provides guidance on when such relief will be granted. It sets forth seven threshold conditions that the taxpayer must establish before the IRS will consider the request. One is that at least part of the tax liability must be attributable to the nonrequesting spouse (the attribution rule). Certain exceptions apply to the attribution rule. For example, if the nonrequesting spouse misappropriated funds, then the requesting spouse need not show attribution. Likewise, the rule does not apply if abuse affected the requesting spouse's ability to challenge or question an item or balance due, or if the nonrequesting spouse's fraud is the reason for the erroneous item. Once the threshold conditions are met, Rev. Proc. 2013-34 further provides a list of nonexclusive factors that determine equitable relief is warranted. The Tax Court pointed out that, in this case, the only factor in question was whether Minton knew or had reason to know that Keeney would not pay the couple's tax liability.

The Tax Court held that Minton was entitled to relief with respect to the taxes on Keeney's business income but not the early withdrawal tax on her 401(k) distribution. First, the Tax Court found that not all of the threshold conditions were met because the tax on Minton's early 401(k) withdrawal could not be attributed to Keeney. The court also found that none of the relevant exceptions to the attribution rule applied. Although Minton claimed that Keeney withheld cash from household accounts, the court found that he did not misappropriate money intended to pay the taxes. Rather, Keeney convinced Minton that he had business prospects that would enable them to pay their taxes. The Tax Court noted that Keeney had made misleading statements and manipulated and verbally abused Minton throughout the marriage but found that these actions did not restrict Minton's ability to challenge how items were reported on their return. Minton freely withdrew funds from her retirement account knowing that Keeney intended to invest them, the court found, and Keeney's deceitfulness was not the type of abuse that warranted excusing Minton from the responsibility for tax on income from her own retirement account. The Tax Court further found that the fraud exception did not apply because, while Keeney misled Minton about business prospects, Minton freely withdrew the funds and should have known they could be lost.

The Tax Court found that the attribution rule applied to the liability attributable to Keeney's business because Minton's involvement in the business was nominal. The court went on to find that the equitable factors weighed in favor of granting relief with respect to Keeney's business income. Minton had a reasonable expectation that the tax on the business and self-employment income would be paid out of the proceeds from the big contract that Keeney promised was coming. The Tax Court also noted Minton's lack of sophistication and her position in the marriage as well as Keeney's duplicity and abuse and determined that under these circumstances, Minton's belief was reasonable. The Tax Court therefore concluded that it would be inequitable to require Minton to pay Keeney's tax liability and held that she was entitled to a refund for taxes paid on that amount.

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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