Tax Court Rejects Taxpayer's Claim for Relief Under Section 66(c) on S Corp Income

(Parker Tax Publishing December 2021)

The Tax Court held that a taxpayer did not qualify for tax relief under Code Sec. 66(c) with respect to income from an S corporation she co-owned with her husband because the income tax liability from which she was seeking relief was attributable to her status as a shareholder. In rejecting the taxpayer's assertion that she did not receive a Schedule K-1 and was therefore unaware of the S corporation income, the court noted that she had reported such income for the three prior years, signed several checks for the S corporation, and signed a divorce decree that referenced the S corporation. Wheeler v. Comm'r, T.C. Summary 2021-42.

Background

Libia Wheeler married John Turner in 2000. In October 2006, Turner Investments & Consulting, Inc. (Turner Investments), was organized as an S corporation and Wheeler and Turner were each designated 50 percent shareholders. Income reported on Schedule K-1, Shareholder's Share of Income, Deductions, Credits, etc., from Turner Investments was included on Wheeler's joint return with Turner for years 2012-14. Wheeler also received Forms W-2, Wage and Tax Statement, reporting income from Turner Investments in years before 2015. In 2013, she signed several checks for Turner Investments.

Wheeler and Turner filed for divorce in September of 2015, and their divorce was finalized by decree in December of that year. The final divorce decree included provisions addressing federal income tax liability, information requests, and tax filings, which distinguished between years before the divorce (2000-2014) and the year of divorce (2015). The divorce decree stated that Wheeler and Turner were equally responsible for all of their federal income tax liabilities from the date of marriage through December 31, 2014. For 2015, Wheeler and Turner were each required to file an individual tax return and furnish any requested information to the other party necessary to prepare the other party's individual tax return. The divorce decree awarded Turner Investments to Turner and ordered Wheeler to execute any and all documents necessary to remove her name from the corporation.

In compliance with the divorce decree, Wheeler filed a separate 2015 Form 1040 with the help of a tax preparer. Wheeler received a Form W-2 from Turner Investments for 2015 and she reported this wage income on her 2015 Form 1040. For 2015, Turner Investments also issued Wheeler a Schedule K-1, reporting ordinary business income of $63,083 and a net rental real estate loss of $1,681. Wheeler did not report this net Schedule K-1 income. In addition, Turner Investments had made quarterly estimated tax payments for 2015. For the first three quarters, these were joint estimated tax payments by Wheeler and Turner of $5,000, $7,500, and $8,000, respectively. For the fourth quarter, after Turner Investments had been awarded to Turner by the divorce decree, it made an estimated tax payment of $8,000. On his 2015 Form 1040, Turner claimed one-half of the joint estimated tax payments ($10,250) plus the fourth quarter estimated tax payment ($8,000). This left unclaimed estimated tax payments of $10,250 for 2015, which the IRS subsequently refunded to Turner. Wheeler did not claim any estimated tax payments on her 2015 return.

The IRS issued a notice of deficiency to Wheeler for 2015 because of the omission of her Schedule K-1 income from Turner Investments. Wheeler submitted a Form 8857, Request for Innocent Spouse Relief, to the IRS. The IRS denied her request for relief under Code Sec. 66(c) and Wheeler took her case to the Tax Court.

Under Code Sec. 66, married couples who do not file joint tax returns generally must report half of the total community property income earned by the spouses during the tax year. Code Sec. 66 provides that under certain circumstances a taxpayer may be relieved of federal income tax liability on community property income earned by a spouse. Two types of relief are available under Code Sec. 66(c): traditional relief and equitable relief. To qualify for traditional relief, the requesting spouse (i.e., Wheeler) must satisfy the four conditions provided in Reg. Sec. 1.66-4(a)(1): (1) the requesting spouse did not file a joint tax return for the year for which he or she seeks relief; (2) the requesting spouse did not include in gross income for the year an item of community income which under Code Sec. 879(a) would be treated as the income of the nonrequesting spouse; (3) the requesting spouse did not know of and had no reason to know of the item of community income; and (4) it would be inequitable to include the item of community income in the requesting spouse's gross income. Under Code Sec. 879(a), community income that is trade or business income is treated as provided under Code Sec. 1402(a)(5), and under that provision, gross income and deductions allocable 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.

If traditional relief is not available to a requesting spouse under Code Sec. 66(c), equitable relief may be available if the taxpayer satisfies the five threshold conditions set forth in Rev. Proc. 2013-34. One threshold condition is that the 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. However, under Section 4.01(7) of Rev. Proc. 2013-34, the IRS will consider granting relief regardless of whether the deficiency is attributable to the requesting spouse in cases involving (1) attribution solely due to operation of community property law, (2) nominal ownership, (3) misappropriation of funds, (4) abuse, and (5) fraud committed by the nonrequesting spouse.

Wheeler did not dispute that she received the income reported by Turner Investments on her 2015 Schedule K-1. She also did not contest the refund of the estimated tax payments to Turner. Instead, she contended that she did not know about the Schedule K-1 income because Turner did not provide her with a Schedule K-1 for 2015. She argued that her failure to claim the estimated tax payments and the subsequent refund to Turner of those payments bolstered her claim for relief and demonstrated her lack of knowledge about Turner Investments.

Analysis

The Tax Court held that Wheeler did not qualify for either traditional or equitable relief under Code Sec. 66(c). According to the court, Wheeler was not entitled to traditional relief because under the rules of Code Sec. 879(a), the income from Turner Investments was treated as the income of Wheeler and Turner on the basis of their respective distributive shares. Therefore, the court found that the income from her 37.4 percent ownership of Turner Investments reported on her 2015 Schedule K-1 was not income of a nonrequesting spouse under Reg. Sec. 1.66-4(a)(1)(ii). According to the court, a taxpayer's knowledge of an item of community income must be determined by considering her knowledge of the particular income-producing activity. The court pointed out that Wheeler was a shareholder of Turner Investments and reported Schedule K-1 income for the three years before 2015 on her Form 1040 jointly filed with Turner, received and reported 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. In the court's view, even if Wheeler did not receive a Schedule K-1 for 2015, that would not defeat a finding that she knew of or had reason to know of Turner Investments as an income-producing activity.

Moreover, the court found that Wheeler had the right under the divorce decree to request information from Turner in order to prepare her 2015 return, but Wheeler provided no evidence that she requested such information or that Turner blocked her from doing so. Rather, Wheeler claimed that Turner failed to provide the Schedule K-1 for 2015. In the court's view, Wheeler's right to request information was also a means by which she could have correctly reported her portion of Turner Investments' estimated tax payments. The court noted that Wheeler also hired a tax return preparer to assist her, mitigating her lack of tax knowledge. The court said it was unfortunate that Wheeler did not exercise her right to request such information, which could have alerted her to both the Schedule K-1 and the estimated tax payments. But it did not alter the court's conclusion that Wheeler knew of, or had reason to know of, Turner Investments as an income-producing activity.

The court found that Wheeler did not qualify for equitable relief under Code Sec. 66(c) for the same reason she failed to qualify for traditional relief - she was requesting relief from tax on her own income. In addition, the court determined that Wheeler did not meet any of the exceptions in Section 4.01(7) of Rev. Proc. 2013-34 because (1) the Schedule K-1 income from Turner Investments was attributable to her under Code Sec. 1366, not solely by the operation of community property law; (2) the Schedule K-1 was in her name, and she did not rebut the consequent presumption that the income was attributable to her; (3) her failure to claim estimated tax payments (and the IRS's subsequent refund of those excess payments to Turner) did not constitute misappropriation of funds; (4) Wheeler filed an individual tax return and did not establish how any prior abuse by 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 (5) she did not argue or establish that fraud was the reason for an erroneous item. The court also was not persuaded that Wheeler's failure to claim the estimated tax payments and the subsequent refund to Turner provided sufficient ground for equitable relief independent of these factors.

For a discussion of relief from liability from community property rules, see Parker Tax ¶11,130.

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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