Epstein v. Commissioner

(A) a joint return has been made under this section for a taxable year,

(B) on such return there is a substantial understatement of tax attributable to grossly erroneous items of one spouse,

(C) the other spouse establishes*252 that in signing the return he or she did not know, and had no reason to know, that there was such substantial understatement, and

(D) taking into account all the facts and circumstances, it is inequitable to hold the other spouse liable for the deficiency in tax for such taxable year attributable to such substantial understatement,

then the other spouse shall be relieved of liability for tax (including interest, penalties, and other amounts) for such taxable year to the extent such liability is attributable to such substantial understatement.

(In 1984, section 424(a) of Pub. L. 98-369, 98 Stat. 801, 803, amended the Code to provide that current section 6013(e) is applicable to all taxable years to which the Internal Revenue Code of 1954 applies, which includes 1976, 1977, and 1978.)

Respondent concedes that petitioner satisfies the section 6013(e)(1)(A) and (B) and 6013(e)(4) elements of the innocent spouse requirements for the relevant years. (Section 6013(e)(4) relates to understatements exceeding a specified percentage of the putative innocent spouse's income.) Therefore, the two elements of the innocent spouse requirements remaining in dispute are whether petitioner*253 had the kind of knowledge referred to in subparagraph (C), and whether under the facts of this case there would be the type of inequity referred to in subparagraph (D). In reaching our conclusions as to Arlene's liability we are substantially aided by guidelines provided by the recent decisions of the U.S. Court of Appeals for the Second Circuit (the court to which this case would ordinarily be appealed) in Friedman v. Commissioner, 53 F.3d 523 (2d Cir. 1995), affg. in part, revg. in part and remanding in part T.C. Memo. 1993-549; and Hayman v. Commissioner, 992 F.2d 1256 (2d Cir. 1993), affg. T.C. Memo. 1992-228.

In Friedman v. Commissioner, 53 F.3d at 525, the Court of Appeals stated the issue in that case in a way that also succinctly states the issue in this case, to wit: whether an individual is entitled to assert the innocent spouse defense to avoid joint tax liability for tax transactions of which he or she was aware but did not thoroughly understand. We take the liberty of quoting at some length from the Friedman case because*254 we believe it appropriately points the way to a resolution of our case:

The "innocent spouse" exemption was not designed to protect willful blindness or to encourage the deliberate cultivation of ignorance. Extravagant tax savings may alert even a financially unsophisticated spouse to the possible improprieties of a tax scheme.

Nevertheless, we recognize that in the bewildering world of tax shelter deductions, few experts, let alone laypersons, easily discern the difference between a fraudulent scheme and an exceptionally advantageous legal loophole in the tax code. There is a common sense limit we think to a spouse's duty of investigation in those circumstances where the more financially sophisticated spouse invokes the support of tax experts and accountants in asserting an improper deduction. The wife claiming status as an innocent spouse under such circumstances must persuade the factfinder that she had no reason to suspect that what her more financially sophisticated husband did was wrong. In short, an innocent spouse is one who despite having made reasonable efforts to investigate the accuracy of the joint return remains ignorant of its illegitimacy. [Id.]

In *255 Friedman v. Commissioner, supra, the husband was a financially successful mortgage broker, and the wife was a widowed mother of two who, prior to the couple's marriage, had been the future husband's secretary. The Court of Appeals considered the couple's lifestyle as one which could be characterized as "lavish", made possible by the husband's business success. The substantial understatements of tax on the returns in question resulted from the husband's participation in a computer-leasing transaction that the Court described as a "complex international tax shelter". Friedman v. Commissioner, supra at 530. The wife was aware of the transaction, but did not understand it and because of her husband's business acumen assumed it to be legitimate.

The Court of Appeals in the Friedman case applied the test enunciated in Hayman v. Commissioner, supra, that required a taxpayer to establish that she or he did not know and did not have reason to know that the deduction would give rise to a substantial understatement. Friedman v. Commissioner, supra at 530.

The Court of Appeals*256 in Hayman listed four factors to consider in deciding whether a reasonably prudent person in the "innocent" spouse's position at the time she signed a return should have known that the return contained a substantial understatement. Hayman v. Commissioner, 992 F.2d at 1261. According to Hayman, a court should look at (1) The level of education and (2) the knowledge and experience in the family's business and financial affairs attained by the spouse claiming to be innocent; (3) whether the family's current standard of living was lavish compared to past levels of income and expenditures; and (4) the conduct of the culpable spouse in concealing the true state of the family's finances from the "innocent" spouse. Friedman v. Commissioner, supra at 531-532.

We have made detailed findings of fact, many of which encompass the Hayman case factors, and no useful purpose is served by rehashing these facts in detail. But in our view, when the Hayman four factors are applied in our case, petitioner satisfies the requirement of subparagraph (C) that in signing the return she did not know, and had no reason to know, *257 that there were substantial understatements.

(1) Petitioner, while well educated, devoted most of her time to her interest in the arts--graphic arts and the theater--and her work experience as a space salesman for a small, local newspaper did nothing to fit her for an understanding of business matters on anything like a sophisticated level.

(2) Petitioner had no role whatever in the family's financial affairs beyond, at most, making cash payments for household expenses. Harvey simply refused to discuss finances with petitioner, and systematically excluded her from his business affairs, at least the business affairs which he conducted after he left Dreyfus in 1971, well before the relevant years. Whatever petitioner spent to indulge her own taste for art and afford herself a few small luxuries, she paid for out of her own meager earnings. She in fact gave Harvey money to pay "IRS taxes" out of money she received from her father, and used additional funds from that source to rehab the smaller house into which petitioners were forced to move after tax deficiencies required them to sell their larger, more comfortable house in Hewlett Park.

(3) Nothing in the record would lead one to*258 believe that petitioners' lifestyle was lavish either before, during, or after the relevant years. While petitioner conceded that Hewlett Bay Park is considered to be a wealthy area, she also testified that the couples' house on Piermont Avenue was at the "low end". We perceive no reason to question the truthfulness of her testimony on this point, and respondent's counsel did not challenge it.

(4) Harvey and his friend, Kreindler, repeatedly kept from Arlene the truth about the tax shelter deductions that were being claimed on the couple's returns for the relevant years, and systematically refused to explain the returns to Arlene or give any meaningful answers to any questions she from time to time asked.

As stated in Friedman, the fact that the innocent spouse-taxpayer knows of the existence of a tax shelter, and the deductions it hopefully gives rise to, does not itself establish that she cannot meet the lack of knowledge requirement of section 6013(e)(1)(C). Friedman v. Commissioner, supra at 530. In the case before us, petitioner testified that she knew that Harvey was in the business of selling tax shelters, but was unaware that he was*259 investing in them himself. While this profession of lack of knowledge is of course self-serving, petitioner's additional testimony rings true, namely, that she was led to believe, at least during the relevant years, that tax shelters were on the up and up and were, like IRAs, a legitimate way to save taxes. In the era that encompassed the years 1976-1978, individuals far more financially sophisticated than petitioner let themselves believe that the tooth fairy in the guise of a tax shelter would bring them substantial wealth, at little or no cost to themselves, which would be entirely paid for out of the National fisc as tax savings. We, therefore, hold that petitioner had no reason to know that the returns for the relevant years contained substantial understatements of tax.

To meet the fourth requirement imposed by section 6013(e) to validate an innocent spouse claim, the taxpayer must establish that it would be inequitable to hold her liable for the substantial understatement-related deficiency. Sec. 6013(e)(1)(D). One of the factors to be considered is whether the "innocent" spouse received significant benefits as a result of the understatements. Friedman v. Commissioner, 53 F.3d at 532;*260 sec. 1.6013-5(b), Income Tax Regs. Normal support, measured by the circumstances of the parties, is not considered a significant benefit for purposes of this determination. Id., Flynn v. Commissioner, 93 T.C. 355, 367 (1989).

There is no evidence that petitioner received any unusual benefit from the tax shelter deduction. Harvey controlled the family finances, and did not allow petitioner to have access to the couple's money beyond that which he, Harvey, chose to give her. Even if part of the understatements did inure to petitioner's benefit, such benefit did not exceed normal support.

At the trial respondent attempted to attach significance to the fact that in 1986 petitioners sold their Hewlett Bay Park house for $ 725,000, which they had purchased in 1973 for approximately $ 118,000. Since the record contains no indication that the house was in any way enhanced by the money generated by tax savings in the relevant years, we cannot attribute a tax generated benefit to Arlene in connection with the increased value of the house. Increases in values merely through inflation, which in this case would also include not only the house but also the house*261 furnishings and the art collection, have no apparent significance in the determination of whether petitioner received any benefit from the understatement.

Another factor to be considered is whether the spouses have been divorced. Flynn v. Commissioner, supra at 367; sec. 1.6013-5(b), Income Tax Regs. Given the couple's uneasy relationship throughout their marriage, we do not attach particular significance to the fact that they have remained together. Petitioner characterized her marriage as not one "made in heaven", and testified that because of her chronic health problem, which appears to have persisted throughout most of her adult life, she "couldn't think of leaving, because how was I going to take care of myself?" Petitioner first discovered in 1984 that Harvey had been "sheltering" his income in the relevant years. Other recent cases have considered the impact and reliability of a spouse's promise to pay any tax deficiencies resulting from grossly erroneous items. See, e.g., Friedman v. Commissioner, T.C. Memo. 1995-576 (on remand from 53 F.3d 523); Stiteler v. Commissioner, T.C. Memo. 1995-279;*262 Foley v. Commissioner, T.C. Memo. 1995-16. But in the instant case the record only reveals a struggle by both spouses to pay unidentified Federal tax bills, with Arlene contributing $ 34,000 at one point from money received from her father, and the couple selling their comfortable home to raise cash with which to pay other income tax bills. Thus, the fact that the couple was not divorced or separated appears at best to be a neutral factor in determining the inequity question, and we afford it no negative significance.

Taking into account all the facts and circumstances, we conclude and hold that it would be inequitable to hold petitioner liable for the substantial understatements in the relevant years.

For the foregoing reasons, we hold that petitioner Arlene Epstein is an innocent spouse within the meaning of section 6013(e) as to that part of the deficiencies in income tax for the relevant years attributable to the grossly erroneous items of her spouse, petitioner Harvey Epstein.

Decision will be entered under Rule 155.