Widow Wins Refund of Lien Proceeds Due to Innocent Spouse Relief

(Parker Tax Publishing October 2023)

The Tax Court held that a widow to whom the IRS granted partial relief from joint liability under Code Sec. 6015(f) was entitled to a refund under Code Sec. 6015(g)(1) of most of the proceeds from the sale of the home she owned with her late husband that were paid to the IRS in satisfaction of a lien. As a result of the partial Code Sec. 6015(f) relief, the court determined the widow's liability for that year as if she had filed a married-filing-separately return for that year. O'Nan v. Comm'r, T.C. Memo. 2023-117.

Background

Sarah O'Nan was married to Jonathan O'Nan until his unexpected death in November 2014, at the age of 43. In May 2012 the O'Nans bought a home in Franklin County, Ohio (family home). They owned the house as joint tenants with right of survivorship, referred to in Ohio law as a "survivorship tenancy."

The family home was eventually encumbered by two mortgages, each securing a different loan evidenced by a promissory note. Wells Fargo Bank held the primary mortgage and First Bexley Bank held the secondary mortgage. While both Sarah and Jonathan signed the two mortgage deeds, only Jonathan signed the promissory note secured by the primary mortgage.

The O'Nans jointly and timely filed their federal income tax returns for 2012 and 2013, but they did not pay their reported tax liabilities upon filing. The IRS assessed the liabilities for those two years in November 2013 and November 2014, respectively, while Jonathan was still living. Jonathan passed away on November 25, 2014. After issuing a notice and demand for each tax year, the IRS filed a notice of federal tax lien (NFTL) against the O'Nans in April 2015, and sent them a notice of NFTL filing that same day. The notice of NFTL filing stated that the O'Nans owed $24,683 and $90,108 for 2012 and 2013, respectively.

In March 2015 Sarah filed a survivorship affidavit with the recorder's office, confirming her sole legal title to the family home pursuant to the survivorship tenancy. However, Sarah stopped making payments on the home loans, leading Wells Fargo to initiate a foreclosure action in the Court of Common Pleas of Franklin County (court of common pleas). In June 2015, while the foreclosure action was pending, Sarah sold the family home for $895,000.

The title company presiding over the sale remitted the following pertinent amounts from the sale proceeds: (1) $423,020 to Wells Fargo in full satisfaction of its primary loan; (2) $257,955 to First Bexley in full satisfaction of its secondary loan; and (3) $123,200 to the IRS in full satisfaction of its tax lien, i.e., the outstanding tax liabilities for 2012 and 2013 plus interest and penalties (IRS lien payment). After payment of these amounts and of closing costs of $14,290, Sarah received $76,535. The IRS soon thereafter filed Form 668(Z), Certificate of Release of Federal Tax Lien, with the recorder's office, and the court of common pleas dismissed Wells Fargo's foreclosure action.

Before those payments, in May 2015, the IRS had received from Sarah Form 8857, Request for Innocent Spouse Relief, in which she requested relief from joint liability for the years at issue. The IRS, acting pursuant to Code Sec. 6015(f), granted Sarah partial relief from joint and several liability for 2012 and full relief for 2013. For 2012 the IRS determined that Sarah remained liable for $3,340. The determination letter also fully denied Sarah's claim for refund of the $123,200 IRS lien payment. In response Sarah filed a petition with the Tax Court, contesting the IRS's determination that she was not entitled to a refund of $123,200.

When a taxpayer is granted relief from joint and several liability under Code Sec. 6015(f), the taxpayer's liability for the relevant year(s) is recalculated as if the spouses had properly filed married-filing-separately returns. Code Sec. 6015(g)(1) provides that, absent certain exceptions, "credit or refund shall be allowed or made to the extent attributable to the application of this section." However, before any taxpayer is granted a credit or refund, there must be a determination that the taxpayer made an overpayment. If a tax payment is made from jointly owned property, the innocent spouse may qualify for a refund if she can trace some or all of the payment to her separate portion of the property. For instance, in Minihan v. Comm'r, 138 T.C. 1 (2012), the Tax Court held that an innocent spouse was entitled to a refund of the amount levied by the IRS from her and her former husband's joint bank account to the extent the levied funds were traceable to her portion of the account. State law determines who owns what property and, therefore, whether a requesting spouse made any tax payments from her separate funds.

The IRS pointed out that the federal tax lien attached, in the first instance, to both Jonathan's and Sarah's one-half interests in the family home and that it was unaffected by Jonathan's death. Therefore, the IRS concluded, Sarah had a right to only that portion of the net proceeds of the family home that remained after deducting the full value of the federal tax lien along with the other liabilities. In consequence, the IRS asserted, none of the IRS lien payment was made from Sarah's separate funds. Sarah, on the other hand, argued that her refund should consist of the entire $123,300 IRS lien payment.

Analysis

The Tax Court held that Sarah was entitled to a refund under Code Sec. 6015(g)(1) of $123,200 less the $3,340 plus interest, for which she remained liable. The court reasoned that, if Sarah and Jonathan had filed married-filing-separately returns for 2012 and 2013, then for 2012 Sarah would have had a liability of $3,340 (the amount for which she was denied Code Sec. 6015(f) relief) and for 2013 she would have had no liability (as she was granted full relief for that year). Therefore, although the IRS retained a lien on the family home in the full amount of the liabilities for the years at issue, the court found that the IRS lien did not encumber Sarah's original one-half interest except to the extent of $3,340 plus interest.

Having determined Sarah's tax liabilities for the years at issue, the court next had to decide whether any of the IRS lien payment was attributable to Jonathan's former one-half interest in the family home. If so, that portion was not an overpayment by Sarah because such funds already belonged to the IRS on the basis of its persisting lien on Jonathan's former one-half interest. However, if any portion of the payment was attributable to Sarah's original one-half interest and exceeded the $3,340 plus interest for which she remained liable, that portion would have to be refunded to Sarah under Code Sec. 6015(g)(1).

The court determined that under Ohio law, the $895,000 of gross proceeds from the family home sale were attributed one-half to Sarah's original interest and one-half to Jonathan's interest - that is, $447,500 apiece. Accordingly, there was a total of $447,500 of proceeds attributable to Jonathan's former one-half interest out of which to satisfy the liabilities encumbering it. Likewise, there was a total of $447,500 of proceeds attributable to Sarah's original one-half interest out of which to satisfy the liabilities encumbering it.

The court went to find that of the $447,500 proceeds attributable to Jonathan's former interest, the first $7,145 belonged to the closing cost lienors. The next $423,020 belong to Wells Fargo. The court noted that, although both Sarah and Jonathan signed the mortgage deed for the Wells Fargo loan, Jonathan alone signed the promissory note. In addition, the Wells Fargo mortgage deed stated that Sarah was "not personally obligated to pay the sums security by this Security Instrument." Thus, under Ohio law Sarah was merely a surety, rather than a principal obligor, for Jonathan's obligation. Wells Fargo therefore had a lien on Jonathan's former one-half interest, while its lien on Sarah's original one-half interest was residual (i.e., effective only to the extent that Jonathan's interest yielded insufficient funds).

This left $17,335 for both First Bexley and the IRS. The court determined that, whether the $247,955 First Bexley debt fell proportionately or only residually on Sarah's original interest (that is, whether Sarah cosigned the First Bexley promissory note or did not sign it at all), the First Bexley loan absorbed the full remaining portion of the proceeds attributable to Jonathan's former interest. The court therefore concluded that the $123,200 IRS lien payment (less the $3,340 plus interest for which Sarah remained liable) could have come only from Sarah's unencumbered separate funds. Thus, under Code Sec. 6015(g)(1), she had to be refunded all but $3,340, plus interest, of the IRS lien payment.

For a discussion of innocent spouse relief, see Parker Tax ¶260,560. For a discussion of IRS tax liens, see Parker Tax ¶260,530.

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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