Tax Attorney: The US Supreme Court has granted a Petition for Certiorari in Deductibility of Trust Fees in William L. Rudkin Testamentary Trust v. Commissioner, CA-2, 467 F3d 149, 2006-2 USTC ¶50,569. Investment-advice fees incurred by a testamentary trust were not fully deductible in calculating its adjusted gross income. Because Code Sec. 67(e)(1) unambiguously exempted from the 2-percent floor of Code Sec. 67(a) only those costs incurred by the trust that could not have been incurred if the property were held by an individual, the fees were deductible only to the extent that they exceeded two percent of the trust's adjusted gross income. This case is interesting because it applies rules of construction to interpret IRC 67(e)(1). Section 67(e)(1) unambiguously exempts from the two-percent floor of §67(a) only those costs incurred by a trust that could not have been incurred if the property were held by an individual, we conclude that the Trust's investment-advice fees are deductible only to the extent that they exceed two percent of the Trust's adjusted gross income. The Second Circuit concluded that individual property owners can incur investment-advice fees and from the regulation explicitly including investment-advice fees among an individual's miscellaneous itemized deductions subject to §67(a)'s two-percent floor. See Temp. Treas. Reg. §1.67-1T(a)(1)(ii). Accordingly, the Court concluded that investment-advice fees the Trust paid t do not meet the requirements of §67(e)(1) and therefore are not fully deductible.



DISCUSSION



This appeal, which we have jurisdiction to consider under 26 U.S.C. §7482(a)(1) (2000), presents a question of statutory interpretation. In interpreting a statute, "[w]e start, as always, with the language of the statute." Williams v. Taylor, 529 U.S. 420, 431 (2000). "We give the words of a statute their ordinary, contemporary, common meaning, absent an indication Congress intended them to bear some different import." Id. (internal quotation marks omitted). "Our inquiry must cease if the statutory language is unambiguous and the statutory scheme is coherent and consistent." Robinson v. Shell Oil Co., 519 U.S. 337, 340 (1997) (internal quotation marks omitted). "The plainness or ambiguity of statutory language is determined by reference to the language itself, the specific context in which that language is used, and the broader context of the statute as a whole." Id. at 341. "[A]lthough a court appropriately may refer to a statute's legislative history to resolve statutory ambiguity, there is no need to do so" if the statutory language is clear. Toibb v. Radloff, 501 U.S. 157, 162 (1991).

In considering the question of statutory interpretation presented on this appeal, we review the legal conclusions of the tax court de novo. Reimels v. Comm'r [ 2006-1 USTC ¶50,147], 436 F.3d 344, 346 (2d Cir. 2006); 26 U.S.C. §7482(a)(1) (providing that the courts of appeals "shall have exclusive jurisdiction to review the decisions of the Tax Court...in the same manner and to the same extent as decisions of the district courts in civil actions tried without a jury"). "In particular, `[w]e owe no deference to the Tax Court's statutory interpretations, its relationship to us being that of a district court to a court of appeals, not that of an administrative agency to a court of appeals.' " Callaway v. Comm'r [ 2000-2 USTC ¶50,744], 231 F.3d 106, 115 (2d Cir. 2000) (quoting Exacto Spring Corp. v. Comm'r [ 99-2 USTC ¶50,964], 196 F.3d 833, 838 (7th Cir. 1999) (Posner, C.J.)).



I. Statutory Framework

Under the IRC, "the adjusted gross income of an estate or trust shall be computed in the same manner as in the case of an individual," subject to one exception relevant to this appeal. 26 U.S.C. §67(e). The exception provides that "the deductions for costs which are paid or incurred in connection with the administration of the estate or trust and which would not have been incurred if the property were not held in such trust or estate" shall be fully deductible from gross income in calculating adjusted gross income. Id. §67(e)(1). In order to understand this provision's operation, it is necessary first to comprehend the manner in which adjusted gross income is calculated for individuals.

Section 1 of the IRC imposes a tax on all "taxable income" of individuals and trusts. 26 U.S.C. §1. In calculating taxable income, a taxpayer must first determine the amount of "gross income," which is defined as "all income from whatever source derived." Id. §61(a). The taxpayer then arrives at "adjusted gross income" by subtracting from gross income certain "above-the-line" deductions, such as trade and business expenses and losses from the sale of property. Id. §62(a). Finally, "taxable income" is calculated by subtracting from adjusted gross income any "itemized" (or "below-the-line") deductions. Id. §63. In the case of an individual, "below-the-line" deductions include, inter alia, "all the ordinary and necessary expenses paid or incurred during the taxable year...for the management, conservation, or maintenance of property held for the production of income." Id. §212.

Again in the case of an individual, "the miscellaneous itemized deductions [ i.e., "below-the-line" deductions] for any taxable year shall be allowed only to the extent that the aggregate of such deductions exceeds 2 percent of adjusted gross income." Id. §67(a). Stated differently, the rule creates a "two-percent floor" for an individual's itemized deductions of the sort at issue here. Section 67(b) exempts from the two-percent floor certain specifically enumerated itemized deductions. Id. §67(b). Investment-advice fees are generally treated as itemized deductions under §212. 26 C.F.R. §1.212-1(g) (specifying the circumstances in which "[f]ees for services of investment counsel...are deductible under section 212"). They are not listed in §67(b), so are therefore not exempt from the two-percent floor established by §67(a). Temp. Treas. Reg. §1.67-1T(a)(1)(ii) (1988) (stating that "investment advisory fees" are subject to the two-percent floor of §67(a)).

As noted, under §67(e), trusts are generally subject to the same rules for calculating adjusted gross income that apply to individuals, with one exception that is relevant to this appeal. A trust's costs are fully deductible, rather than subject to the two-percent floor, if they satisfy both of the following two requirements: (1) they are "paid or incurred in connection with the administration of the...trust"; and (2) they "would not have been incurred if the property were not held in such trust." 26 U.S.C. §67(e)(1). There is no dispute here that the investment-advice fees at issue meet the requirement of the first clause, that is, that the fees Knight paid to Warfield were incurred in connection with the administration of the Trust. Instead, the issue presented here, on which our some of our sister circuits have disagreed, is whether the investment-advice fees also satisfy the requirement of the second clause of §67(e)(1) and therefore are fully deductible without regard to the two-percent floor of §67(a).



II. The Circuit Split

The Sixth Circuit was the first federal court of appeals to consider the question presented here. It held that "the investment advisor fees paid by the Trust were costs incurred because the property was held in trust, thereby making them eligible for the §67(e) exception and not subject to the base of two percent of adjusted gross income." O'Neill v. Comm'r [ 93-1 USTC ¶50,332], 994 F.2d 302, 304 (6th Cir. 1993). The Sixth Circuit reasoned that because a trustee has a fiduciary duty to manage trust assets as a "prudent investor," investment-advisory fees are "necessary to" the trust's administration and "caused by" the fiduciary duty of the trustee. Id. The court reasoned further that although individual investors often incur costs for investment advice, "they are not required to consult advisors and suffer no penalties or potential liability if they act negligently for themselves." Id. In short, O'Neill established the rule that a trust's costs attributable to the trustee's fiduciary duty, and not required outside the administration of trusts, fall within the §67(e)(1) exception and are therefore fully deductible. 1

The Federal Circuit rejected this reasoning in Mellon Bank, N.A. v. United States [ 2001-2 USTC ¶50,621], 265 F.3d 1275 (Fed. Cir. 2001). In Mellon Bank, the court held that the second clause of §67(e)(1) "serves as a filter" with respect to the first clause and "treats as fully deductible only those trust-related administrative expenses that are unique to the administration of a trust and not customarily incurred outside of trusts." Id. at 1280-81. Because "[i]nvestment advice and management fees are commonly incurred outside of trusts," the court reasoned, "these costs are not exempt under section 67(e)(1) and are required to meet the two percent floor of section 67(a)." Id. at 1281. The Federal Circuit also found its construction to be consistent with the statute's legislative history. Id. It concluded by noting that the trust's reading of the statute, which would find all costs arising out of the trustee's fiduciary duties to fall within the second clause of §67(e)(1), rendered that clause superfluous "because any costs associated with a trust will always be deductible." Id.

The Fourth Circuit subsequently joined the Federal Circuit in holding that investment-advice fees incurred by a trust are subject to the two-percent floor of §67(a). Scott v. United States [ 2003-1 USTC ¶50,428], 328 F.3d 132, 140 (4th Cir. 2003). Noting that the "text is clear and unambiguous," the Fourth Circuit stated that "trust-related administrative expenses are subject to the 2% floor if they constitute expenses commonly incurred by individual taxpayers." Id. at 139-40. Applying this rule, the court concluded that because investment-advice fees are commonly incurred outside the context of trust administration, they are subject to the two-percent floor. Id. The court noted, however, that "[o]ther costs ordinarily incurred by trusts, such as fees paid to trustees, expenses associated with judicial accountings, and the costs of preparing and filing fiduciary income tax returns, are not ordinarily incurred by individual taxpayers, and they would be fully deductible under the exception created by §67(e)." Id. These costs, the court explained, are "solely attributable to a trustee's fiduciary duties, and as such are fully deductible under §67(e)." Id. Stating a rationale similar to the Federal Circuit's in Mellon Bank, the court said that to find a trust's investment-advice fees to be fully deductible would lead to the conclusion that "[a]ll trust-related administrative expenses could be attributed to a trustee's fiduciary duties," rendering the second clause of §67(e)(1) meaningless. Id.



III. Analysis

The Trust contends that the Sixth Circuit construed §67(e)(1) correctly and that the Federal and Fourth Circuits interpreted the provision inconsistently with both its plain language and legislative history. The Trust's principal textual argument is that the second clause of §67(e)(1) creates a "but for" causation test, excluding from full deduction only those costs which would have been incurred even in the absence of the trust's ownership of the property, i.e., without the trustee. The Trust also relies on the drafting history of §67(e)(1) to make the somewhat different argument that by enacting that particular section, Congress intended only to prevent trusts from fully deducting those administrative expenses incurred by pass-through entities in which they had invested. For the reasons that follow, we reject both arguments.




A. A. Statutory Language



The Trust reads §67(e)(1) to reflect Congress's intent to allow a full deduction for the administrative costs of a trust that are attributable to the fiduciary duty of the trustee. The Trust argues that the statute sets forth a "but for" causal test: if the cost would not have been incurred without the trustee, then it is attributable to the trustee's performance of its fiduciary duty and is thus fully deductible under §67(e)(1). According to the Trust, therefore, the second prong of §67(e)(1) requires no consideration of whether a generic individual owner of the same assets may have incurred the cost at issue. Rather, the Trust contends that the causation test "plainly" entails "a simple exercise of removing the trustee from the property and seeing which costs remain and which ones disappear without him." The Trust points to specific statutory language in advancing this view. It reads the statute's use of the language "such trust" to refer to the specific trust under consideration, its trustee and that trustee's duties, rather than to the generic trust of §67(e)'s introductory language, that is, a trust of the type to which §67(e) is applicable. 2 Under the Trust's construction, the statute requires consideration of whether a particular cost would have been incurred if the trustee had never existed. It would ignore, however, how an individual property owner managing the same assets would have acted. For the following reasons, we find the Trust's interpretation unreasonable.

As an initial matter, had Congress intended to create a causation test of the type the Trust advances, which disregards what an individual asset owner may have done if the assets were not held in trust, it could have done so in language clearly expressing that intent. Such a "but for" causation test, however, is not apparent from the text's "ordinary, common meaning." See Luyando v. Grinker, 8 F.3d 948, 950 (2d Cir. 1993) (noting we interpret a statute according to the "ordinary, common meaning" of the statute's "plain language"). On the contrary, the phrase "if the property were not held in such trust" more logically directs the inquiry away from the trust and back toward the hypothetical ownership of the property by an individual. That is, the introductory language of §67(e) takes as its point of reference the rules that apply to individual taxpayers, and by using the phrase, "if the property were not held in such trust," Congress has aimed the inquiry at the costs that a hypothetical individual property owner could incur with respect to that property. We therefore agree with the Fourth Circuit's statement in Scott that the second prong of §67(e)(1) does not ask whether the costs at issue are commonly incurred in the administration of trusts or are incurred as a result of a particular trustee's fiduciary duty. It focuses the inquiry, instead, on the hypothetical situation where the assets are in the hands of an individual. See [ 2003-1 USTC ¶50,428] 328 F.3d at 140.

Although the statutory language directs the inquiry toward the counterfactual condition of assets held individually instead of in trust, the statute does not require a subjective and hypothetical inquiry into whether a particular, individual asset owner would have incurred the particular cost at issue. Nothing in the statute indicates that Congress intended the test for the exception to the two-percent floor to give rise to factual disputes about whether an individual asset owner (or owners) is insufficiently financially savvy or the assets sufficiently large such that he or she unquestionably would have sought investment advice. Instead, the plain meaning of §67(e)(1)'s second clause excludes from full deduction those costs of a type that could be incurred if the property were held individually rather than in trust. In other words, for the trust to avoid the two-percent floor and have advantage of the full deduction, the plain language of the statute requires certainty that a particular cost "would not have been incurred" if the property were not held in trust.

For that reason, the statute demands not a subjective and hypothetical inquiry, but rather an objective determination of whether the particular cost is one that is peculiar to trusts and one that individuals are incapable of incurring. In other words, the statute sets an objective limit on the availability of a full deduction and, as the source of that limit, looks to those costs that individual property holders are capable of incurring and permitted to deduct from adjusted gross income. For example, the fact that investment-advice fees are subject to the two-percent floor under regulations applicable to individual taxpayers proves the fees to be a cost that individual taxpayers are capable of incurring. Investment-advice fees and other costs that individual taxpayers are capable of incurring are, therefore, not fully deductible pursuant to §67(e)(1) when incurred by a trust. By contrast, costs that individuals are incapable of incurring, like "fees paid to trustees, expenses associated with judicial accountings, and the costs of preparing and filing fiduciary income tax returns," Scott [ 2003-1 USTC ¶50,428], 328 F.3d at 140, are fully deductible.

We thus join the Federal and Fourth Circuits in holding that §67(e)(1) does not exempt from §67(a)'s two-percent floor investment-advice fees incurred by trusts. We disagree, however, with their statement that costs "not customarily incurred outside of trusts" are the ones not subject to the floor, Mellon Bank [ 2001-2 USTC ¶50,621], 265 F.3d at 1281 (emphasis added); Scott [ 2003-1 USTC ¶50,428], 328 F.3d at 139-40 (citing Mellon Bank and stating that §67(e)(1) subjects "expenses commonly incurred by individual taxpayers" to the two-percent floor (emphasis added)), because, as explained above, we believe §67(e)(1) is more restrictive than that. While the Federal and Fourth Circuits' approach properly focuses the inquiry on the hypothetical situation of costs incurred by individuals as opposed to trusts, that inquiry into whether a given cost is "customarily" or "commonly" incurred by individuals is unnecessary and less consistent with the statutory language. We believe the plain text of §67(e) requires that we determine with certainty that costs could not have been incurred if the property were held by an individual. We therefore hold that the plain meaning of the statute permits a trust to take a full deduction only for those costs that could not have been incurred by an individual property owner.

In so doing, we reject the Trust's argument that, in construing §67(e)(1) to refer to costs incurred by a generic trust rather than the particular trust under consideration, we must ignore the word "such" in the second clause of §67(e)(1). The statute's introductory language references a generic "estate or trust" by stating that, "[f]or the purposes of this section, the adjusted gross income of an estate or trust shall be computed in the same manner as in the case of an individual," subject to the exception under consideration on this appeal. 26 U.S.C. §67(e) (emphasis added). The first clause of §67(e)(1) next uses the different phrase "the estate or trust" in setting forth the condition that, to qualify for a full deduction, a cost must be "paid or incurred in connection with the administration of the estate or trust." Id. §67(e)(1) (emphasis added). The second clause of §67(e)(1) refers to "such estate or trust" in establishing that an administrative cost is fully deductible only if it "would not have been incurred if the property were not held in such trust or estate." Id. (emphasis added). For the following reason, we agree with the Commissioner that, as used here, "such trust" is best understood as referring to the generic trust of §67(e)'s introductory language and not to any actual, particular trust that incurred a cost subject to scrutiny. In the first clause of §67(e)(1), the language "the estate or trust" plainly refers not to a particular trust under consideration, but to the generic estate or trust mentioned in the provision's introductory language. The phrase "such trust or estate" of §67(e)(1)'s second clause also refers, therefore, to the generic estate or trust mentioned in both the introductory language of §67(e) and in the first clause of §67(e)(1). Moreover, as explained, nothing in the statute indicates that Congress intended to make applicability of the deduction dependent on what costs are peculiarly incurred by a specific trust.

Even if the statute's meaning were not plain and the Trust's alternative interpretation were not unreasonable, canons of statutory interpretation favor the Commissioner's interpretation of the statute. See Natural Res. Def. Council, Inc. v. Muszynski, 268 F.3d 91, 98 (2d Cir. 2001) ("If the plain meaning of a statute is susceptible to two or more reasonable meanings, i.e., if it is ambiguous, then a court may resort to the canons of statutory construction."). Specifically, our conclusion accords with the canon of statutory interpretation requiring that when the statute is ambiguous, we resolve interpretive disputes as to the availability of a tax deduction in favor of the government. "It is a common principle of taxation that where doubt exists, courts should resolve deductions in favor of the government: `Whether and to what extent deductions shall be allowed depends upon legislative grace; and only as there is clear provision therefor can any particular deduction be allowed.' " Holmes v. United States [ 96-1 USTC ¶50,299], 85 F.3d 956, 961 n.3 (2d Cir. 1966) (quoting New Colonial Ice Co. v. Helvering [ 4 USTC ¶1292], 292 U.S. 435, 440 (1934)).




B. Legislative History



The Trust also invokes the statute's legislative history to support a construction that is somewhat different from, and not obviously consistent with, its textual argument. 3 It contends that the drafting history indicates that Congress added the second clause of §67(e)(1) in order to restrict a trust's use of pass-through entities to avoid the two-percent floor of §67(a) and not to limit the deductibility of any other administrative costs of a trust. Because we find the statute's text "clear and unambiguous," we need not address the Trust's legislative history arguments. See Scott [ 2003-1 USTC ¶50,428], 328 F.3d at 139. Even if it were not, however, we disagree that this history supports the Trust's proposed interpretation of the statute discussed above or provides any reason to depart from our reading of the statute's meaning. 4

Pass-through entities, such as partnerships, S corporations, common trust funds, and nonpublic mutual funds, generally do not pay income taxes at the entity level, but instead pass their tax liabilities on to ultimate taxpayers - generally individuals. See Temp. Treas. Reg. 1.67-2T (1988). In the Tax Reform Act of 1986, Congress sought to eliminate the ability of wealthy taxpayers to avoid the two-percent floor of §67(a) by funneling income through pass-through entities. See Issues Relating to Passthrough Entities: Hearings Before the Subcomm. on Select Revenue Measures of the H. Comm. on Ways and Means on H.R. 1658, H.R. 2571, H.R. 3397, H.R. 4448, 99th Cong. 1 (1986) (stating the Subcommittee's intent to scrutinize the role of pass-through entities in "facilitating and encouraging tax avoidance techniques"). If there were no restrictions on such entities, an individual could deduct the full cost of investment advice, for example, by placing his or her investments in a pass-through entity, deducting the cost of the advice at the entity level and reporting only the net investment income on his or her individual tax return. Congress addressed this problem by enacting §67(c), which provides, inter alia, that regulations shall be issued "which prohibit the indirect deduction through pass-thru entities of amounts which are not allowable as a deduction if paid or incurred directly by an individual." 26 U.S.C. §67(c)(1). Congress also provided, however, that this rule, except as provided in regulations, shall not apply to trusts. Id. §67(c)(3)(B).

At the time Congress added §67(c), the bill provided that all costs incurred in connection with the administration of a trust were exempted from the two-percent floor of §67(a) and thus permitted trusts to deduct fully all of their administrative costs. Section 67(e)(1)'s second clause was not included in the versions of the bill that emerged initially from the House and Senate, but was added only in the joint conference draft. 5 Accordingly, under the draft language of §67(e) at the time Congress added §67(c), a trust, unlike an individual, could fully deduct the cost of investment advice and other administrative expenses incurred by pass-through entities in which the trust had invested. To correct this problem, the Trust argues, Congress added the second clause of §67(e)(1): trusts and estates could fully deduct only those administrative costs that "would not have been incurred if the property were not held in such trust or estate." According to the Trust, this language was intended to create a limited exception within an exception. Although trust income is to be calculated in the same way as individual income, administrative costs incurred by a trust are not subject to the two-percent floor of §67(a), except for those administrative costs incurred by a pass-through entity in which the trust has invested (which are subject to the floor). 6

If Congress's only purpose had been to restrict the ability of trusts as ultimate taxpayers to deduct fully their share of the administrative costs of pass-through entities in which they had invested, however, it could have drafted the second clause of §67(e)(1) more narrowly. It could have, for example, permitted full deductibility for those administrative costs "which are not pass-through costs restricted under section 67(c)." Instead, Congress chose the broader language of §67(e)(1). Thus, notwithstanding the narrow purpose the Trust attributes to Congress in enacting the second clause of §67(e)(1), the broad statutory language is the best indication that Congress intended to treat those administrative costs that would be subject to the two-percent floor when incurred by an individual as similarly subject to that floor when incurred by a trust. Nothing in the legislative history suggests a clearly expressed congressional intent contrary to the plain meaning of the statute itself. 7 See Toibb, 501 U.S. at 162.




CONCLUSION



Because §67(e)(1) unambiguously exempts from the two-percent floor of §67(a) only those costs incurred by a trust that could not have been incurred if the property were held by an individual, we conclude that the Trust's investment-advice fees are deductible only to the extent that they exceed two percent of the Trust's adjusted gross income. This conclusion follows from the fact that individual property owners obviously can incur investment-advice fees and from the regulation explicitly including investment-advice fees among an individual's miscellaneous itemized deductions subject to §67(a)'s two-percent floor. See Temp. Treas. Reg. §1.67-1T(a)(1)(ii). Accordingly, the investment-advice fees the Trust paid to Warfield do not meet the requirements of §67(e)(1) and therefore are not fully deductible. For the foregoing reasons, we AFFIRM the judgment of the tax court.

* Judge Wilfred Feinberg, originally a member of the panel, recused himself subsequent to oral argument. Because the remaining members of the Panel are in agreement, we decide this case in accordance with §0.14(b) of the rules of this Court.

1 The American Bankers Association and the New York Bankers Association, appearing in this case as amici curiae, advocate the position adopted by the Sixth Circuit. They contend that investment-advice fees incurred by a trustee are fully deductible under the statute "because the prudent execution of the duties imposed upon a trustee rendered it necessary to obtain investment advisory services."

2 The Trust thus contends that the word "such" in the statute, emphasized below, refers to "the" estate or trust mentioned in the first clause of §67(e)(1), also emphasized below, which it understands to refer not to the generic estate or trust mentioned in the introductory text of §67(e)(1), but to the particular trust at issue.

For purposes of this section, the adjusted gross income of an estate or trust shall be computed in the same manner as is the case of an individual, except that -(1) the deductions for costs which are paid or incurred in connection with the administration of the estate or trust and which would not have been incurred if the property were not held in such trust or estate....

26 U.S.C. §67(e)(1) (emphasis added).

3 While the Trust's textual argument is essentially that fiduciary administrative costs are exempt from the two-percent floor, its argument based on the drafting history, as explained below, is that the second clause of §67(e)(1) makes only the indirect administrative costs of a pass-through entity in which a trust has invested subject to the two-percent floor. If the second clause were so limited, one might think that the statute exempts from the two-percent floor more than simply fiduciary administrative costs. On this view, the statute would appear to exempt from the two-percent floor all costs incurred in connection with the administration of a trust except a trust's share of the administrative costs of a pass-through entity owned, at least in part, by the trust.

4 We note that the legislative history upon which the Federal Circuit relied in Mellon Bank [ 2001-2 USTC ¶50,621], 265 F.3d at 1281, chiefly H.R. Rep. No. 99-426 (1985) and S. Rep. No. 99-313 (1986), predates the introduction of §67(e)(1)'s second clause, and this history relates to a bill that treated all costs incurred in the administration of a trust or an estate as fully deductible. Thus, unlike the Federal Circuit, we do not view this history as persuasive evidence of the meaning of §67(e)(1).

5 The House bill included the following language:

(c) DETERMINATION OF ADJUSTED GROSS INCOME IN CASE OF ESTATES AND TRUSTS. --For purposes of this section, the adjusted gross income of an estate or trust shall be computed in the same manner as in the case of an individual, except that the deductions for costs which are paid or incurred in connection with the administration of the estate or trust shall be treated as allowable in arriving at adjusted gross income.

H.R. 3838, 99th Cong. §67(c) (1985). The Senate Committee on Finance did not amend this provision, but expressed the view that "the bill attempts to reduce the benefits arising from the use of trusts...by revising the rate schedule applicable to trusts." S. Rep. No. 99-313, 99th Cong. 868 (1986). The second clause of §67(e)(1) appeared for the first time in the final version of the bill that emerged in the Joint Conference Agreement. See H.R. Rep. No. 99-841, vol. II, at 34 (1986) (Conf. Rep.), reprinted at 1986 U.S.C.C.A.N. 4075, 4122.

6 The Trust relies most heavily in making this argument on the House Conference Report, which provides some indication that the second clause of §67(e)(1) was drafted to address indirect deductions through pass-through entities. The Trust relies on the following passage from the Report:

Pursuant to Treasury regulations, the [two-percent] floor is to apply with respect to indirect deductions through pass-through entities (including mutual funds) other than estates, nongrantor trusts, cooperatives, and REITs. The floor also applies with respect to indirect deductions through grantor trusts, partnerships, and S corporations by virtue of present-law grantor trust and pass-through rules. In the case of an estate or trust, the conference agreement provides that the adjusted gross income is to be computed in the same manner as in the case of an individual, except that the deductions for costs that are paid or incurred in connection with the administration of the estate or trust and that would not have been incurred if the property were not held in such trust or estate are treated as allowable in arriving at adjusted gross income and hence are not subject to the floor. The regulations to be prescribed by the Treasury relating to application of the floor with respect to indirect deductions through certain pass-through entities are to include such reporting requirements as may be necessary to effectuate this provision.

H.R. Rep. No. 99-841, at 34, reprinted at 1986 U.S.C.C.A.N. 4075, 4122 (emphasis added).

7 The Trust also argues that its reading of the statute in light of the legislative history eliminates the superfluity problem that the Federal and Fourth Circuits, as well as the Commissioner in this case, identified. The Federal and Fourth Circuits both concluded that to interpret §67(e)(1)'s second clause similarly to the "but for" causation test the Trust advances here renders that clause superfluous because "[a]ll trust-related administrative expenses could be attributed to a trustee's fiduciary duties." Scott [ 2003-1 USTC ¶50,428], 328 F.3d at 140; Mellon Bank [ 2001-2 USTC ¶50,621], 265 F.3d at 1281 ( "Under Mellon's construction, the second prerequisite of section 67(e)(1) would be rendered superfluous because any costs associated with a trust will always be deductible."). We do not adopt the Federal and Fourth Circuits' view. The Trust contends that the second clause is necessary to filter out a specific subset of the administrative costs described in the first clause -those incurred by pass-through entities in which a trust has invested. Assuming arguendo that such costs are "incurred in connection with the administration" of a trust for purposes of the statute (and satisfy the first clause), they are not caused by the trustee's fiduciary duty (and so fall outside the Trust's reading of the second clause). We find it difficult to conceive that a trustee's fiduciary duty could require that trust assets be invested in a particular vehicle.

Back Taxes: Note especially the flaws identified in the IRS Determination Letter



Blog – IRS abused its discretion in an innocent spouse case



The IRS abused its discretion in denying an individual Innocent Spouse equitable relief from joint and several liability under IRS Code Sec. 6015(f). Most of the factors in section 4.03 of Rev. Proc. 2003-61, 2003-2 CB 296, either favored granting her relief or were of neutral impact. Although the taxpayer had constructive knowledge of the taxes due because she signed the returns, the liabilities reported on those returns were solely attributable to her husband's businesses. Further, she derived no significant benefit from the failure to pay the tax liabilities for the years at issue and she would suffer even greater economic hardship than already existed if forced to pay the outstanding tax liability. See Cynthia K. Beatty v. Commissioner. Dkt. No. 22047-04 , TC Memo. 2007-167, June 27, 2007. Although the taxpayer had constructive knowledge of the taxes due because she signed the returns, the liabilities reported on those returns were solely attributable to her husband, who exercised absolute control over all the couple's financial matters. Further, the taxpayer derived no significant benefit from the failure to pay the tax liabilities for the years at issue and she would suffer ever greater economic hardship than already existed if forced to pay the outstanding tax liability. The wife stated thatt she did not review the returns and had no idea of the amount of taxes due, if any. Since she signed the returns without looking at any of the figures, she had no information to make the determination as to whether the taxes could be paid or not. The wife and her attorney mentioned on numerous occasions that she just signed without questioning because she believed her husband would go to jail if she didn't sign. Although the Tax Court did not emphasize this intimidation, it likely that this fact was given more weight than other factors. The following is text of the Tax Court opinion:


*******

Revenue Procedure 2000-15 as amplified by the provisions of Revenue Procedure 2003-61 provides a list of elements to be developed to determine the extent, if any of relief to be granted under these innocent spouse provisions. * * * The merits and circumstances of each case will dictate the weight assigned to each factor in reaching a decision to grant or reject innocent spouse relief.



Divorced, separated or living apart for at least 12 months when claim is filed



This condition is not met. Mr. & Mrs. Beatty are not divorced or separated. They lived together during the years under consideration and are still living together. Mrs. Beatty filed delinquent returns with her husband in November of 2001.



Payment of the tax liabilities would cause hardship



Economic hardship is defined as: the payment of the tax would make it impossible to meet your basic living expenses for housing, clothing, food, transportation medical etc. Reasonable belief that tax would be paid. Mr. Beatty is self-employed, yearly household income fluctuates to some extent. Current expense information was gathered from an interview as well as from a check spread performed using 2000 bank records. Income information was derived from tax returns filed for 2001. (The most recent return filed) Comparison of monthly household income to monthly basic living expenses indicates that the Beattys are having financial difficulties. This is also evident from the bankruptcies that have been filed. The question is not whether hardship exists, but whether a hardship will be created if innocent spouse relief is not granted. In this case, hardship already exists and will continue to exist whether or not relief is granted to Mrs. Beatty. The two still live in the same household so even if [she] is relieved, Mr. Beatty's liability will impact on the family's ability to pay personal living expenses. This condition is not met.



Attribution



Mrs. Beatty's attorney states that having heard the stern warning from the court that if returns were not filed her husband would go to jail, Mrs. Beatty signed whatever was placed in front of her. She contends that this caused Mrs. Beatty to do something she wouldn't ordinarily have done. The liability is solely attributable to Mr. Beatty's income and Mrs. Beatty did not receive a significant benefit from the unpaid taxes beyond that of minimal living expenses. The underpayments of tax are attributed to Mr. Beatty. The taxpayer alone did not have sufficient income to require her to file a return. The tax liabilities rest solely with Mr. Beatty for failure to file timely returns and to pay his income tax annually.



Marital Abuse



If abuse does not rise to the level duress, then the electing spouse's level of influence with respect to the unpaid tax must be evaluated.



There have not been any claims of marital abuse.



The representative explained that duress is the most compelling reason for requesting equitable relief. Mrs. Beatty would not have signed joint tax returns with her husband if she had not heard the judge order returns to be filed. She feared that her husband would go to jail if she did not sign the returns presented to her. Mrs. Beatty did not have a filing obligation of her own because she had withholdings from her paycheck to more than cover any taxes due on her own income. She certainly would not have filed jointly if she had understood the ramifications.



Mrs. Beatty signed the tax returns under duress. The returns may be invalid joint return.



Joint Returns: Joint and Several Liability: Duress, fraud or misrepresentation



A wife was liable for tax on a joint return where the evidence failed to show that she was unwilling to sign the return or that her husband made her sign the return under threat of force. Fear alone is insufficient to prove duress.



Although it is unfortunate that Mrs. Beatty was not aware of and was not informed of her options, ignorance of the law is no excuse. Mrs. Beatty cannot be relieved of her joint liability simply because she didn't know the tax laws. In order for duress to be a factor, Mrs. Beatty would have to show that she had no choice and that she was reluctant to sign a joint return. In this case, Mrs. Beatty did have a choice. She could have filed separately whether or not she realized it at the time. Further, she was not reluctant to sign the joint returns. In fact, she was eager to do whatever was asked of her at the time. No one forced Mrs. Beatty to sign joint tax returns against her will. Duress did not occur and is not a factor to consider in this case.



Reasonable belief that the tax would be paid:





Non-requesting spouse's legal obligation to pay A stipulation in the property settlement or a decree of divorce must be evidenced that requires the non electing spouse to assume responsibility for the unpaid income taxes for the periods at issue. Since the parties are still married and living together a marital agreement such as this does not exist.



Knowledge



She signed the joint tax returns because her husband was under court order to file returns with both the State of Maryland and the federal government. He was charged with willful failure to file tax returns by the State. In order to receive a reduced sentence, he was required to file all returns or face a substantial jail sentence. Mrs. Beatty was not involved in the tax preparation process. Returns were prepared using extrapolations and estimates computed by the State of Maryland. Mr. Beatty had some documentation for business expenses but was not very good at keeping the documentation. When the returns were completed, Mr. and Mrs. Beatty went to the CPA's office. She did not review or question the returns and signed them.



Significant Benefit



Other than usual and customary living expenses there is no evidence to indicate that you derived a significant benefit from the failure to report these sources of income. The Beatty's did not live extravagantly or take trips, they didn't have any investments, life insurance, savings, or anything else of value to show for the money earned. When Mrs. Beatty became aware of the amount of money her husband earned, she couldn't understand where the funds went. She then found out that her husband had a problem with Keno gambling. He lost their money and then became involved with loan sharks to fund his addiction. Other than customary basic living expenses the taxpayer did not derive a significant benefit from the unpaid federal income taxes.





DETERMINATION



We look to the court case of Alice Berger, et al. v. Commissioner T.C. Memo. 1996-76, 71 TCM 2160. Alice Berger asserts that the Chancery Court ordered her to sign the 1988 return and that she signed it because she believed she had no choice and was afraid of the "consequences" of defying a court order. Although she signed the return at the courthouse, she does not appear to have been signed it before a judge who was threatening improper or oppressive "consequences against her. Alice Berger did not testify that the Chancery Court had threatened "consequences" directly to her. This court case demonstrates that signing a return at the order of a Court because one is afraid of the "consequences" of defying a court order does not equal a showing of abuse of discretion or theat of improper sanction sufficient to invalidate the return. In Mrs. Beatty's case, the court didn't even ask her to sign returns. The court didn't abuse its authority and did not force Mrs. Beatty to sign joint tax returns.



Another court case of interest is Hazel Stanley v. Comm. 45 TC 555. Mrs. Stanley's husband was very domineering and sometimes violent. She would go along with her husband in many situations simply to avoid conflict. Mrs. Stanley signed joint returns as directed by her husband. However, she failed to demonstrate that she did so unwillingly and was found to be jointly liable. Mrs. Beatty does not claim any undue influence from her husband; however the important point to note in this case is the "willingness" to file jointly. Like Mrs. Stanley, Mrs. Beatty has not demonstrated that she filed unwillingly.



Although it is unfortunate that Mrs. Beatty was not aware of and was not informed of her options, ignorance of the law is no excuse. Mrs. Beatty cannot be relieved of her joint liability simply because she didn't know the tax laws and their impact on her.



The taxpayer had complete awareness of the balances due when the returns were filed. She was well aware that the family did not have the funds to pay the tax. She did not have a reasonable belief that the taxes would be paid. It has been established that the taxpayer's do not qualify for economic hardship. The representative had made reference to a substantial gambling debt that she insists causes economic hardship. However she has failed to submit documentation of such an expense.



The taxpayers still reside together as a married couple. Abuse is not a factor. The taxpayer claims that the level of duress caused by this situation merits innocent spouse relief. This is a misnomer as explained. The cumulative effect of the development of these equitable relief elements clearly demonstrates that the taxpayer does not qualify for innocent spouse relief under the provisions of IRC Section 6015(f).





CONCLUSION



Since the taxpayer will not execute a form 870-IS and has expressed her intention to litigate this matter there remains no alternative but to recommend that a statutory notice of claim disallowance be issued. [Reproduced literally.]



On December 29, 2004, petitioner and Mr. Beatty refinanced the mortgage loan on the house in which they resided. Around January 4, 2005, petitioner and Mr. Beatty used funds that they received from that refinancing to make a $151,423.56 payment to the IRS with respect to the unpaid liabilities for the taxable years 1998 and 1999. After the refinancing of the mortgage loan on their house, petitioner and Mr. Beatty had no equity in that house and were required to make a monthly mortgage loan payment of $3,400.



During 2004, petitioner received $12,906 as an employee of RIG, Inc., as well as $1,274 in unemployment compensation. On January 6, 2006, petitioner filed late a Federal return for her taxable year 2004 (2004 return) that showed a $2 refund due.



On January 6, 2006, petitioner submitted to respondent Form 433-A, Collection Information Statement for Wage Earners and Self-Employed Individuals (Form 433-A). That form contained several sections identified as section 1 through 9. In section 2 of Form 433-A that petitioner submitted to respondent (petitioner's Form 433-A), petitioner did not respond to a question relating to whether she or Mr. Beatty was self-employed or operated a business, although she indicated in section 3 of that form that she was unemployed. In section 3 of petitioner's Form 433-A, petitioner did not indicate whether Mr. Beatty was employed.



In section 5 of petitioner's Form 433-A, petitioner indicated that she (1) maintained a checking account with a $200 account balance, (2) had $50 cash on hand, (3) had a credit card balance of $400, (4) owed $4,700 with respect to an equity line of credit, and (5) had $400 of credit available to her.



In sections 5 and 6 of petitioner's Form 433-A, petitioner provided the responses indicated to the following questions:



16. LIFE INSURANCE. Do you have life insurance with a cash value? : [x] No [] Yes



* * * * * * *



17a. Are there any garnishments against your wages? [x] No [] Yes



* * * * * * *



17b. Are there any judgments against you? [x] No [] Yes



* * * * * * *



17d. Did you ever file bankruptcy? [] No [x] Yes



If yes, date filed 9/14/2000 Date discharged 12/27/2000



17e. In the past 10 years did you transfer any assets out of your name for less than their actual value? [x] No [] Yes



* * * * * * *



17f. Do you anticipate any increase in household income in the next two years? [] No [x] Yes



If yes, why will the income increase? I hope to find seasonal employment * * *



How much will it increase? $??? In 2004, I earned $12,906



17g. Are you a beneficiary of a trust or estate? [x] No [] Yes



* * * * * * *



17h. Are you a participant in a profit sharing plan? [x] No [] Yes



In section 7 of petitioner's Form 433-A, petitioner indicated that she owned (1) a 2005 Jeep Liberty valued at $18,785 with respect to which there was a $23,000 outstanding loan balance and (2) two vehicles, neither of which had any value. In section 7 of petitioner's Form 433-A, petitioner also indicated that in 1991 she purchased real estate in Ocean City for $130,000, that the current value of that real estate was $500,000, and that there was a $450,000 outstanding mortgage loan with respect to that real estate, which was required to be paid in full in 2035.



In section 7 of petitioner's Form 433-A, petitioner indicated that she had personal assets valued at $6,000.



Section 9 of Form 433-A listed various income items and various living expense items. With respect to the income items listed in that section, petitioner stated that she was unemployed. With respect to the expense items listed in section 9 of Form 433-A, petitioner indicated that she had total monthly living expenses of $4,003, consisting of $3,600 of monthly expenses for housing and utilities and $403 of monthly expenses for food, clothing, housekeeping supplies, and personal care products.





OPINION



We review respondent's denial of relief under section 6015(f) for abuse of discretion. Butler v. Commissioner, 114 T.C. 276, 292 (2000). Respondent's denial of such relief constitutes an abuse of discretion if such denial was arbitrary, capricious, or without sound basis in fact or law. Woodral v. Commissioner, 112 T.C. 19, 23 (1999). The question whether respondent's denial of relief under section 6015(f) was arbitrary, capricious, or without sound basis in fact is a question of fact. Cheshire v. Commissioner, 115 T.C. 183, 197-198 (2000), affd. 282 F.3d 326 (5th Cir. 2002).



Petitioner bears the burden of proving that respondent abused respondent's discretion in denying her relief under section 6015(f). See Jonson v. Commissioner, 118 T.C. 106, 125 (2002), affd. 353 F.3d 1181 (10th Cir. 2003). That this case was submitted under Rule 122 does not change that burden or the effect of a failure of proof. See Rule 122(b); Borchers v. Commissioner, 95 T.C. 82, 91 (1990), affd. 943 F.2d 22 (8th Cir. 1991).



Section 6015(f) grants respondent discretion to relieve an individual who files a joint return from joint and several liability with respect to that return. That section provides:



SEC. 6015. RELIEF FROM JOINT AND SEVERAL LIABILITY ON JOINT RETURN.



* * * * * * *



(f) Equitable Relief. --Under procedures prescribed by the Secretary, if --



(1) taking into account all the facts and circumstances, it is inequitable to hold the individual liable for any unpaid tax or any deficiency (or any portion of either); and



(2) relief is not available to such individual under subsection (b) or (c),



the Secretary may relieve such individual of such liability.



In the instant case, the parties agree that relief is not available to petitioner under section 6015(b) or (c), thereby satisfying section 6015(f)(2). They disagree over whether petitioner is entitled to relief under section 6015(f).



As directed by section 6015(f), respondent has prescribed procedures in Rev. Proc. 2003-61, 2003-2 C.B. 296 (Revenue Procedure 2003-61)2 that are to be used in determining whether it would be inequitable to find the requesting spouse liable for part or all of the liability in question. Section 4.01 of Revenue Procedure 2003-61 lists seven conditions (threshold conditions) which must be satisfied before the IRS will consider a request for relief under section 6015(f). In the instant case, respondent concedes that those conditions are satisfied. Where, as here, the requesting spouse satisfies the threshold conditions, section 4.01 of Revenue Procedure 2003-61 provides that a requesting spouse may be relieved under section 6015(f) of all or part of the liability in question if, taking into account all the facts and circumstances, respondent determines that it would be inequitable to hold the requesting spouse liable for such liability.



Where, as here, the requesting spouse satisfies the threshold conditions, section 4.02(1) of Revenue Procedure 2003-61 sets forth the circumstances under which respondent ordinarily will grant relief to that spouse under section 6015(f) in a case, like the instant case, where a liability is reported in a joint return but not paid. Petitioner concedes that she does not qualify for relief under section 4.02(1) of Revenue Procedure 2003-61. Instead, she relies on section 4.03 of that revenue procedure in support of her claim for relief under section 6015(f). Section 4.03 of Revenue Procedure 2003-61 provides a list of factors which respondent is to take into account in considering whether to grant an individual relief under section 6015(f). No single factor is to be determinative in any particular case; all factors are to be considered and weighed appropriately; and the list of factors is not intended to be exhaustive. Rev. Proc. 2003-61, sec. 4.03, 2003-2 C.B. at 298.



As pertinent here, section 4.03(2)(a) of Revenue Procedure 2003-61 sets forth the following factors which are to be considered and weighed appropriately:



(i) Marital status. Whether the requesting spouse is separated (whether legally separated or living apart) or divorced from the nonrequesting spouse. * * *



(ii) Economic hardship. Whether the requesting spouse would suffer economic hardship (within the meaning of section 4.02(1)(c) of this revenue procedure) if the Service does not grant relief from the income tax liability.



(iii) Knowledge or reason to know.



(A) Underpayment cases. In the case of an income tax liability that was properly reported but not paid, whether the requesting spouse did not know and had no reason to know that the nonrequesting spouse would not pay the income tax liability.



* * * * * * *



(C) Reason to know. For purposes of (A) * * * above, in determining whether the requesting spouse had reason to know, the Service will consider the requesting spouse's level of education, any deceit or evasiveness of the nonrequesting spouse, the requesting spouse's degree of involvement in the activity generating the income tax liability, the requesting spouse's involvement in business and household financial matters, the requesting spouse's business or financial expertise, and any lavish or unusual expenditures compared with past spending levels.



(iv) Nonrequesting spouse's legal obligation. Whether the nonrequesting spouse has a legal obligation to pay the outstanding income tax liability pursuant to a divorce decree or agreement. * * *



(v) Significant Benefit. Whether the requesting spouse received significant benefit (beyond normal support) from the unpaid income tax liability or item giving rise to the deficiency. See Treas. Reg. §1.6015-2(d).



(vi) Compliance with income tax laws. Whether the requesting spouse has made a good faith effort to comply with income tax laws in the taxable years following the taxable year or years to which the request for relief relates.



(We shall hereinafter refer to the factors set forth in section 4.03(2)(a)(i), (ii), (iii), (iv), (v), and (vi) of Revenue Procedure 2003-61 as the marital status factor, the economic hardship factor, the knowledge or reason to know factor, the legal obligation factor, the significant benefit factor, and the tax law compliance factor, respectively.)



Section 4.03(2)(b) of Revenue Procedure 2003-61 sets forth the following factors which, if present in a case, will weigh in favor of granting an individual relief under section 6015(f), but will not weigh against granting such relief if not present:



(i) Abuse. Whether the nonrequesting spouse abused the requesting spouse. * * *



(ii) Mental or physical health. Whether the requesting spouse was in poor mental or physical health on the date the requesting spouse signed the return or at the time the requesting spouse requested relief. The Service will consider the nature, extent, and duration of illness when weighing this factor.



(We shall hereinafter refer to the factors set forth in section 4.03(2)(b)(i) and (ii) as the abuse factor and the mental or physical health factor, respectively.)



Before turning to the factors set forth in section 4.03(2)(a) and (b) of Revenue Procedure 2003-61, we address respondent's position that, in determining whether petitioner is entitled to relief under section 6015(f), we should consider only respondent's administrative record with respect to petitioner's taxable years at issue. We stated our position on that issue in Ewing v. Commissioner, 122 T.C. 32 (2004). In Ewing, we held that our determination of whether a taxpayer is entitled to relief under section 6015(f) "is made in a trial de novo and is not limited to matter contained in respondent's administrative record". Id. at 44. Respondent urges us to reconsider that position since the United States Court of Appeals for the Ninth Circuit vacated our decision in Ewing on jurisdictional grounds.3 See Commissioner v. Ewing, 439 F.3d 1009 (9th Cir. 2006), revg. 118 T.C. 494 (2002), vacating 122 T.C. 32 (2004).



Assuming arguendo that we were to accept respondent's position that, in determining whether petitioner is entitled to relief under section 6015(f), we should consider only respondent's administrative record with respect to petitioner's taxable years at issue, on the record before us, we find that petitioner has carried her burden of showing that respondent abused respondent's discretion in denying her such relief with respect to the unpaid liabilities for the years at issue.4 We turn now to the factors set forth in section 4.03(2)(a) of Revenue Procedure 2003-61 that support our finding.



With respect to the marital status factor set forth in section 4.03(2)(a)(i) of that revenue procedure, the parties agree on brief that that factor is neutral.



However, the notice of determination stated in pertinent part:



Divorced, separated or living apart for at least 12 months when claim is filed



This condition is not met. Mr. & Mrs. Beatty are not divorced or separated. They lived together during the years under consideration and are still living together. * * *



As we understand it, the Appeals Office concluded in the notice of determination that the marital status factor weighed against granting petitioner relief under section 6015(f). We reject that conclusion as unfounded. We agree with the parties' position on brief, and we find, that the marital status factor is neutral.



With respect to the economic hardship factor set forth in section 4.03(2)(a)(ii) of Revenue Procedure 2003-61,5 petitioner argues that that factor weighs in favor of granting her relief under section 6015(f). On brief, respondent contends that not granting such relief will have no effect on petitioner's economic situation.6



However, the notice of determination stated in pertinent part:



Mr. Beatty is self-employed, yearly household income fluctuates to some extent. Current expense information was gathered from an interview as well as from a check spread performed using 2000 bank records. Income information was derived from tax returns filed for 2001. (The most recent return filed) Comparison of monthly household income to monthly basic living expenses indicates that the Beattys are having financial difficulties. This is also evident from the bankruptcies that have been filed. The question is not whether hardship exists, but whether a hardship will be created if innocent spouse relief is not granted. In this case, hardship already exists and will continue to exist whether or not relief is granted to Mrs. Beatty. The two still live in the same household so even if [she] is relieved, Mr. Beatty's liability will impact on the family's ability to pay personal living expenses. This condition is not met. [Reproduced literally.]



As we understand it, the Appeals Office concluded in the notice of determination that the economic hardship factor weighed against granting petitioner relief under section 6015(f) because the Appeals Office's failure to grant such relief would not "create" economic hardship, since economic "hardship already exists and will continue to exist whether or not relief is granted to Mrs. Beatty." We reject as unfounded the rationale stated by the Appeals Office for its conclusion that the economic hardship factor weighed against granting petitioner relief under section 6015(f). The Appeals Office implicitly acknowledged in the notice of determination that payment of the unpaid liabilities for the years at issue would cause even greater economic hardship than already existed.7 We find that the economic hardship factor weighs in favor of granting petitioner relief under section 6015(f).



With respect to the knowledge or reason to know factor set forth in section 4.03(2)(a)(iii) of Revenue Procedure 2003-61, petitioner argues that she did not know and had no reason to know that Mr. Beatty would not pay the tax shown due in each of the respective joint returns for the years at issue and that therefore that factor weighs in favor of granting her relief under section 6015(f). Respondent disagrees.



The notice of determination stated in pertinent part:



Mrs. Beatty states that she did not review the returns and had no idea of the amount of taxes due, if any. Since Mrs. Beatty signed the returns without looking at any of the figures, she had no information to make the determination as to whether the taxes could be paid or not. Mrs. Beatty and her attorney mentioned on numerous occasions that she just signed without questioning because she believed her husband would go to jail if she didn't sign. There was no thought given at that point in time as to whether or not the taxes would be paid. Therefore, there was no belief that the taxes would be paid.



In support of her argument that the knowledge or reason to know factor set forth in section 4.03(2)(a)(iii) of Revenue Procedure 2003-61 weighs in favor of granting her relief under section 6015(f), petitioner asserts:



Petitioner acknowledged in her responses set forth on the Innocent Spouse Questionnaire * * * that she did not review the returns prior to signing and therefore, had no actual knowledge of the tax reported on the returns, or actual knowledge that the tax reported would not be paid. Petitioner further believed that, based on the Beattys standard of living, they had very little income and thus, had no reason to know that Mr. Beatty would not pay, or be able to pay, the tax due. * * * Petitioner did not know that Mr. Beatty had a long-time Keno gambling problem or that he was spending significant sums betting on Keno and repaying high interest rate advances to loansharks. * * * Since Mr. Beatty had been ordered by the court in his criminal proceedings to file his missing returns, it was certainly reasonable for Petitioner to believe that Mr. Beatty would ultimately pay the tax due.



In addition, Petitioner did not understand that she was not required to file a return for most of the years at issue, or that she had the option of filing separately for those years she was required to file (1998, 1999 and 2000). Petitioner also did not understand that she would be liable for any tax owed on Mr. Beatty's self-employment income. * * * Mr. Beatty's accountant, Mr. Vinson, told Agent Renshaw that "he didn't think about any impact on Mrs. Beatty when returns were prepared and filed. He didn't explain the implications of filing jointly or notify them [the Beattys] that they had a choice. He figured they didn't have any assets anyway so he didn't give it any thought." In this regard, Petitioner is similar to the taxpayer in Washington v. Commissioner, 120 T.C. 137 (2003).8 [Reproduced literally.]



We turn first to petitioner's reliance on Washington v. Commissioner, 120 T.C. 137 (2003).9 In Washington, the taxpayer took the position that she relied on her spouse to pay the tax shown due in the return in question and that she believed that her spouse would pay such tax. In contrast, in the instant case, petitioner took the position before the IRS, and takes the position before the Court, that at the time she signed each of the respective joint returns for the years at issue (1) she did not know that each such return showed tax due, and (2) therefore she did not know at that time that Mr. Beatty would not pay such tax. On the record before us, we find Washington v. Commissioner, supra, to be materially distinguishable from the instant case and petitioner's reliance on that case to be misplaced.



We address now whether petitioner has carried her burden of establishing that the knowledge or reason to know factor weighs in favor of granting relief. In support of her position for relief under section 6015(f), petitioner chose to present her case to the IRS and to the Court by claiming that she did not know that there was a tax shown due in each of the respective joint returns for the years at issue. Petitioner must bear the consequences of that choice. Assuming arguendo that we were to accept petitioner's contention that she did not know that each of the joint returns for the years at issue showed tax due, on the record before us, we find that, by signing each such return, petitioner is charged with constructive knowledge of, inter alia, the tax shown due therein. See Park v. Commissioner, 25 F.3d 1289, 1299 (5th Cir. 1994), affg. T.C. Memo. 1993-252; see also Hayman v. Commissioner, 992 F.2d 1256, 1262 (2d Cir. 1993), affg. T.C. Memo. 1992-228. We further find that petitioner should have inquired about whether the tax shown due in each of the joint returns for the years at issue, as to which she had constructive knowledge, would be paid. It would be inequitable to allow petitioner to turn a blind eye to the tax shown due in each such return. The amount of such tax was large enough as to put petitioner on notice that further inquiry should be made as to whether it would be paid. She failed to do so. Petitioner thus failed to present any evidence to the IRS and to the Court with respect to whether the tax shown due in each of the respective joint returns for the years at issue would be paid. We find that the knowledge or reason to know factor weighs against granting petitioner relief under section 6015(f).



With respect to the legal obligation factor set forth in section 4.03(2)(a)(iv) of Revenue Procedure 2003-61, the parties agree on brief that that factor is neutral.



However, the notice of determination stated in pertinent part:



Non-requesting spouse's legal obligation to pay



A stipulation in the property settlement or a decree of divorce must be evidenced that requires the non electing spouse to assume responsibility for the unpaid income taxes for the periods at issue. Since the parties are still married and living together a marital agreement such as this does not exist.



As we understand it, the Appeals Office concluded in the notice of determination that the legal obligation factor weighed against granting petitioner relief under section 6015(f). We reject that conclusion as unfounded. We agree with the parties' position on brief, and we find, that the legal obligation factor is neutral.



With respect to the significant benefit factor set forth in section 4.03(2)(a)(v) of Revenue Procedure 2003-61, petitioner argues that that factor weighs in favor of granting her relief under section 6015(f). On brief, respondent argues that the significant benefit factor is neutral.



The notice of determination stated in pertinent part:



Other than usual and customary living expenses there is no evidence to indicate that you derived a significant benefit from the failure to report these sources of income. The Beatty's did not live extravagantly or take trips, they didn't have any investments, life insurance, savings, or anything else of value to show for the money earned. When Mrs. Beatty became aware of the amount of money her husband earned, she couldn't understand where the funds went. She then found out that her husband had a problem with Keno gambling. He lost their money and then became involved with loan sharks to fund his addiction. Other than customary basic living expenses the taxpayer did not derive a significant benefit from the unpaid federal income taxes. [Reproduced literally.]



As we understand it, although the Appeals Office found in the notice of determination that petitioner did not receive a significant benefit from the failure to pay the unpaid liabilities for the years at issue,10 that office did not conclude that therefore the significant benefit factor weighed in favor of granting petitioner relief under section 6015(f). We reject as unfounded the Appeals Office's failure to conclude in the notice of determination that the significant benefit factor favored granting petitioner such relief. Under cases where Revenue Procedure 2003-61 is applicable, we consider the lack of significant benefit by the taxpayer seeking relief from joint and several liability to be a factor that favors granting relief under section 6015(f).11 We find that the significant benefit factor weighs in favor of granting petitioner relief under section 6015(f).



With respect to the tax law compliance factor set forth in section 4.03(2)(a)(vi) of Revenue Procedure 2003-61, petitioner argues that that factor weighs in favor of granting her relief under section 6015(f). On brief, respondent asserts:



If the Court restricts itself to the administrative record then this factor favors petitioner. If the Court considers information outside of the administrative record then this factor weighs against relief. [Reproduced literally.]



The notice of determination failed to address whether petitioner made a good faith effort to comply with the tax laws for any of the taxable years following the taxable years at issue. However, respondent acknowledges on brief that petitioner "appears to have been compliant at the time the Notice of Determination was issued." We reject as unfounded the Appeals Office's failure to conclude in the notice of determination that the tax law compliance factor favored granting petitioner relief under section 6015(f).



After the Appeals Office issued the notice of determination, petitioner failed to file timely her 2004 return that showed a $2 refund due. We find that petitioner's failure to file timely her 2004 return weighs against granting petitioner relief under section 6015(f). However, given (1) that petitioner's noncompliance is limited to only one delinquently filed return for 2004 that showed a refund due and (2) the other facts and circumstances in the instant case, we further find that the tax law compliance factor is not a significant factor weighing against relief in this case.



We turn now to the factors set forth in section 4.03(2)(b) of Revenue Procedure 2003-61. The parties agree, and we find, that the abuse factor and the mental or physical health factor set forth in section 4.03(2)(b)(i) and (ii), respectively, of Revenue Procedure 2003-61 are neutral.



Based upon our examination of the entire record before us, we find that petitioner has carried her burden of showing that respondent abused respondent's discretion when the Appeals Office determined in the notice of determination to deny her relief under section 6015(f) with respect to the unpaid liabilities for the years at issue.12



We have considered all of the contentions and arguments of the parties that are not discussed herein, and we find them to be without merit, irrelevant, and/or moot.



To reflect the foregoing,



Decision will be entered for petitioner.


1 All section references are to the Internal Revenue Code in effect at all relevant times. All Rule references are to the Tax Court Rules of Practice and Procedure.

2 We note that Revenue Procedure 2003-61 superseded Rev. Proc. 2000-15, 2000-1 C.B. 447. Revenue Procedure 2003-61 is effective for requests for relief under sec. 6015(f) which were filed on or after Nov. 1, 2003, and for requests for such relief which were pending on, and for which no preliminary determination letter had been issued as of, that date. Rev. Proc. 2003-61, sec. 7, 2003-2 C.B. at 299. Revenue Procedure 2003-61 is applicable in the instant case. That is because as of Nov. 1, 2003, no preliminary determination letter had been issued to petitioner with respect to petitioner's request for relief under sec. 6015(f), and that request was still pending.

3 In further support of respondent's position that, in determining whether petitioner is entitled to relief under sec. 6015(f), we should consider only respondent's administrative record with respect to petitioner's taxable years at issue, respondent relies on Robinette v. Commissioner, 439 F.3d 455 (8th Cir. 2006), revg. 123 T.C. 85 (2004), a case under sec. 6330. The Court to which an appeal in this case would ordinarily lie is the United States Court of Appeals for the Fourth Circuit. We are not bound by Robinette. See Golsen v. Commissioner, 54 T.C. 742, 757 (1970), affd. 445 F.2d 985 (10th Cir. 1971).

4 If, as we held in Ewing v. Commissioner, 122 T.C. 32 (2004), we were to consider in this case respondent's administrative record with respect to petitioner's taxable years at issue as well as matters that the parties stipulated that are not part of that administrative record, our holding under sec. 6015(f) would remain the same.

5 In determining whether a requesting spouse will suffer economic hardship, sec. 4.02(1)(c) of Revenue Procedure 2003-61, to which sec. 4.03(2)(a)(ii) of that revenue procedure refers, requires reliance on rules similar to those provided in sec. 301.6343-1(b)(4), Proced. & Admin. Regs.Sec. 301.6343-1(b)(4), Proced. & Admin. Regs., generally provides that an individual suffers an economic hardship if the individual is unable to pay his or her reasonable basic living expenses. Sec. 301.6343-1(b)(4), Proced. & Admin. Regs., provides, in pertinent part:

(ii) Information from taxpayer. --In determining a reasonable amount for basic living expenses the director will consider any information provided by the taxpayer including --

(A) The taxpayer's age, employment status and history, ability to earn, number of dependents, and status as a dependent of someone else;

(B) The amount reasonably necessary for food, clothing, housing (including utilities, home-owner insurance, home-owner dues, and the like), medical expenses (including health insurance), transportation, current tax payments (including federal, state, and local), alimony, child support, or other court-ordered payments, and expenses necessary to the taxpayer's production of income (such as dues for a trade union or professional organization, or child care payments which allow the taxpayer to be gainfully employed);

(C) The cost of living in the geographic area in which the taxpayer resides;

(D) The amount of property exempt from levy which is available to pay the taxpayer's expenses;

(E) Any extraordinary circumstances such as special education expenses, a medical catastrophe, or natural disaster; and

(F) Any other factor that the taxpayer claims bears on economic hardship and brings to the attention of the director.

6 On brief, respondent contends in pertinent part with respect to the economic hardship factor that petitioner provided respondent with no evidence of this economic hardship. * * * Whether she is jointly liable for the income tax or not does not affect her economic situation: she does not have any economic responsibilities.

* * * * * * *

* * * Accordingly, petitioner will not experience economic hardship if relief is not granted. * * *

Respondent's administrative record with respect to petitioner's taxable years at issue belies respondent's position on brief about the economic hardship factor. As quoted below, the notice of determination, which was based upon that record, also belies that position.

7 Additional facts not presented to the Appeals Office but presented to the Court further support what the Appeals Office implicitly acknowledged. For example, on Dec. 29, 2004, petitioner and Mr. Beatty refinanced the mortgage loan on the house in which they resided. On or about Jan. 4, 2005, petitioner and Mr. Beatty used $151,423.56 of the funds that they received from that refinancing to pay their unpaid liabilities for 1998 and 1999. After the refinancing of the mortgage loan on their house, petitioner and Mr. Beatty had no equity in that house and were required to make a monthly mortgage payment of $3,400 on that refinanced loan.

8 Despite the above-quoted assertions of petitioner, she acknowledges on brief that

ignorance of the law does not excuse a spouse from joint and several liability for tax due on a joint return under § 6013(d)(3). Petitioner further acknowledges prior decisions of this court that charge a taxpayer with constructive knowledge of the underpayment where the taxpayer signed the returns without reviewing them, and a duty to inquire "whether such a tax shown due would be paid." Simon v. Commissioner, T.C. Memo. 2005-220 (and cases cited therein); see also Weist [sic]v. Commissioner, T.C. Memo. 2003-91.

9 In support of her argument that she did not know and had no reason to know that Mr. Beatty would not pay the tax shown due in each of the respective joint returns for the years at issue, petitioner also cites Keitz v. Commissioner, T.C. Memo. 2004-74, and Levy v. Commissioner, T.C. Memo. 2005-92. We find those cases to be materially distinguishable from the instant case and petitioner's reliance on them to be misplaced.

10 On brief, respondent agrees that petitioner did not receive a significant benefit from the failure to pay the unpaid liabilities for the taxable years at issue.

11 See Magee v. Commissioner, T.C. Memo. 2005-263. We also note that, based on cases decided under former sec. 6013(e), we consider the lack of significant benefit by the taxpayer seeking relief from joint and several liability to be a factor that favors granting relief under sec. 6015(f). Ferrarese v. Commissioner, T.C. Memo. 2002-249.<

12 Our finding is the same regardless whether we limit our consideration to respondent's administrative record with respect to petitioner's taxable years at issue.

Tax Help: 75% Civil Fraud Penalty not imposed even though taxpayer made disclosures to IRS Examiner after the audit examination began. The IRS failed to meet its heavy burden of establishing by clear and convincing evidence that taxpayer had the requisite fraudulent intent for any of the years at issue. Several aspects of taxpayer’s conduct were markedly inconsistent with fraudulent intent. At her first meeting with the IRS Agent , taxpayer voluntarily disclosed the existence of her personal accounts, the very accounts in which respondent alleges that she hid her income. When Taxpayer discovered that the first set of letters she had presented were not originals, she disclosed that information to the Agent. Taxpayer also freely disclosed her unreported tip income and that she had cash expenditures for personal expenses even though she had nearly zero cash withdrawals from her bank accounts. In effect, petitioner consistently drew respondent's attention to those areas in which her explanations were less than satisfactory. Such behavior is hardly consistent with intent "to conceal, mislead, or otherwise prevent the collection of taxes". This case is very unusual because ‘willfulness” was negated by voluntary disclosures even though the disclosures may not have been made without the IRS examination. Voluntary disclosures are very important in negating either civil or criminal “willfulness.”



Elizabeth Lai v. Commissioner, Dkt. No. 142-05 , TC Memo. 2007-165, June 26, 2007.





OPINION

Generally, the Commissioner's determinations of deficiencies in a notice of deficiency are presumed correct, and the taxpayer bears the burden of showing that the Commissioner's determinations are in error. See Rule 142(a); Welch v. Helvering , 290 U.S. 111, 115 (1933).5 The U.S. Court of Appeals for the Ninth Circuit (to which an appeal of this matter would lie) has held that the Commissioner must establish "some evidentiary foundation" connecting the taxpayer with the income-producing activity, Weimerskirch v. Commissioner, 596 F.2d 358, 361-362 (9th Cir. 1979), revg. 67 T.C. 672 (1977), or demonstrate that the taxpayer actually received unreported income, see Edwards v. Commissioner, 680 F.2d 1268, 1270 (9th Cir. 1982) (the Commissioner's assertion of a deficiency is presumptively correct once some substantive evidence is introduced demonstrating that the taxpayer received unreported income), for the presumption of correctness to attach to the deficiency determination in unreported income cases. If the Commissioner introduces some evidence that the taxpayer received unreported income, the burden shifts to the taxpayer to show by a preponderance of the evidence that the deficiency was arbitrary or erroneous. See Hardy v. Commissioner, 181 F.3d 1002, 1004 (9th Cir. 1999), affg. T.C. Memo. 1997-97.

Respondent has introduced adequate evidence to show that petitioner received unreported income during 1999, 2000, and 2001. With regard to respondent's determinations that resulted from respondent's bank deposit analyses, respondent is not required to show a link between petitioner's bank deposits and a likely taxable source of income. See, e.g., Tokarski v. Commissioner, supra; Kudo v. Commissioner, T.C. Memo. 1998-404, affd. 11 Fed. Appx. 864 (9th Cir. 2001). Respondent's determinations regarding the cashier's check and petitioner's cash income are founded on statements from third parties such as banks and brokerage firms, and on petitioner's admissions that she received cash income that she failed to report on her tax returns. Moreover, petitioner's nail salon business clearly qualifies as an income-producing activity. See, e.g., Hamilton v. Commissioner, T.C. Memo. 2004-66 (ownership of interests in businesses sufficient to prove likely source of unreported income). Respondent has therefore introduced adequate substantive evidence to show that petitioner received unreported income in the amounts determined, and, as noted supra, the burden of proof falls on petitioner to demonstrate that respondent's determinations are arbitrary or erroneous.



In addition to her own testimony, petitioner offered testimony from her sisters Hong Lai and Sharon Huynh, and her daughter Victoria Lai Hutchins to support her contention that the deposits into her personal accounts represent loan proceeds and repayments from intrafamily loans. Petitioner also offered the second set of letters that she gave to Agent Cedergreen during the examination of petitioner's 1999, 2000, and 2001 income tax returns.



Petitioner, Hong Lai, Sharon Huynh, Victoria Lai Hutchins all testified that petitioner participated in several intrafamily loans during the years at issue in an effort to help family members establish financial stability as they arrived and settled in the United States. Petitioner testified that she deposited the proceeds of several loans into her personal accounts during the years at issue. Hong Lai, who had indepth knowledge of her extended family's financial affairs, corroborated that several letters from the second set were authentic and that she recognized the handwriting and signatures of her sisters in Vietnam on 31 of the letters.6 Sharon Hunyh's and petitioner's testimony regarding the letters corroborated Hong Lai's testimony.



We decide whether a witness is credible on the basis of objective facts, the reasonableness of the testimony, and the demeanor of the witness. Quock Ting v. United States, 140 U.S. 417, 420-421 (1891); Wood v. Commissioner, 338 F.2d 602, 605 (9th Cir. 1964), affg. 41 T.C. 593 (1964); Dozier v. Commissioner, T.C. Memo. 2000-255. Having had the opportunity to observe the above-mentioned witnesses at trial, we find petitioner, Hong Lai, Sharon Huynh, and Victoria Lai Hutchins to be honest, forthright, and credible. Based on this testimony and the 31 letters from the second set of letters, we find that petitioner deposited proceeds she received from intrafamily loans into her personal accounts as follows:







Penalties

A. Section 6663



Section 6663 imposes a penalty equal to 75 percent of the portion of any underpayment which is attributable to fraud. Sec. 6663(a). The penalty in the case of fraud is a civil sanction provided primarily as a safeguard for the protection of the revenue and to reimburse the Government for the heavy expense of investigation and the loss resulting from a taxpayer's fraud. Helvering v. Mitchell, 303 U.S. 391, 401 (1938). Fraud is intentional wrongdoing on the part of the taxpayer with the specific purpose to evade a tax believed to be owing. McGee v. Commissioner, 61 T.C. 249, 256 (1973), affd. 519 F.2d 1121 (5th Cir. 1975).



The Commissioner has the burden of proving fraud by clear and convincing evidence. Sec. 7454(a); Rule 142(b). To satisfy this burden, the Commissioner must show: (1) An underpayment exists; and (2) the taxpayer intended to evade taxes known to be owing by conduct intended to conceal, mislead, or otherwise prevent the collection of taxes. Parks v. Commissioner, 94 T.C. 654, 660-661 (1990). The Commissioner must meet this burden through affirmative evidence because fraud is never imputed or presumed. Petzoldt v. Commissioner, 92 T.C. at 699; Recklitis v. Commissioner, 91 T.C. 874, 909-910 (1988); Beaver v. Commissioner, 55 T.C. 85, 92 (1970).



The Commissioner must prove that a portion of the underpayment for each taxable year in issue was due to fraud. Profl. Servs. v. Commissioner, 79 T.C. 888, 930 (1982). If the Commissioner establishes that any portion of an underpayment in a particular year is attributable to fraud, the entire underpayment is treated as attributable to fraud, except with respect to any portion of the underpayment which the taxpayer establishes (by a preponderance of the evidence) is not attributable to fraud. Sec. 6663(b).



The existence of fraud is a question of fact to be resolved from the entire record. Gajewski v. Commissioner, 67 T.C. 181, 199 (1976), affd. without published opinion 578 F.2d 1383 (8th Cir. 1978).



Respondent has failed to meet his heavy burden of establishing by clear and convincing evidence that petitioner had the requisite fraudulent intent for any of the years at issue. Several aspects of petitioner's conduct are markedly inconsistent with fraudulent intent. At her first meeting with Agent Cedergreen, petitioner voluntarily disclosed the existence of her personal accounts, the very accounts in which respondent alleges that she hid her income. When petitioner discovered that the first set of letters she had presented were not originals, she disclosed that information to respondent. Petitioner also freely disclosed her unreported tip income and that she had cash expenditures for personal expenses even though she had nearly zero cash withdrawals from her bank accounts. In effect, petitioner consistently drew respondent's attention to those areas in which her explanations were less than satisfactory. Such behavior is hardly consistent with intent "to conceal, mislead, or otherwise prevent the collection of taxes". Katz v. Commissioner, 90 T.C. 1130, 1143 (1988).



Petitioner contradicted herself on a few occasions during the examination and at trial. However, having had the opportunity to observe petitioner as a witness at trial, and considering that many of her contradictions and disclosures could not have advanced her cause, we do not attribute petitioner's contradictions to fraudulent intent. Rather, we attribute them to a series of misunderstandings and to petitioner's fear of governmental attention due to negative experiences with foreign governments.



Finally, and most importantly, the evidence before us is sufficiently credible to convince us that petitioner did actually participate in the kind of intrafamily transactions which would explain the deposits in her personal accounts, though the record is not sufficiently detailed to establish that all of the deposits into petitioner's personal accounts represent proceeds from such transactions. We therefore do not sustain respondent's imposition of the section 6663 penalty.



B. Burden of Production



Section 7491(c) provides that the Commissioner will bear the burden of production with respect to the liability of any individual for additions to tax and penalties. "The Commissioner's burden of production under section 7491(c) is to produce evidence that it is appropriate to impose the relevant penalty, addition to tax, or additional amount." Swain v. Commissioner, 118 T.C. 358, 363 (2002); see also Higbee v. Commissioner, 116 T.C. 438, 446 (2001). Once the Commissioner has done so, the burden of proof is upon the taxpayer to establish reasonable cause and good faith. Higbee v. Commissioner, supra at 449.



C. Section 6662(a)



Pursuant to section 6662(a), a taxpayer may be liable for a penalty of 20 percent of the portion of an underpayment of tax (1) attributable to a substantial understatement of tax or (2) due to negligence or disregard of rules or regulations. Sec. 6662(b). The term "understatement" means the excess of the amount of tax required to be shown on a return over the amount of tax imposed which is shown on the return, reduced by any rebate (within the meaning of section 6211(b)(2)). Sec. 6662(d)(2)(A). Generally, an understatement is a "substantial understatement" when the understatement exceeds the greater of $5,000 or 10 percent of the amount of tax required to be shown on the return. Sec. 6662(d)(1)(A). The term "negligence" in section 6662(b)(1) includes any failure to make a reasonable attempt to comply with the Code. Sec. 6662(c). Negligence has also been defined as the failure to exercise due care or the failure to do what a reasonable person would do under the circumstances. See Allen v. Commissioner, 92 T.C. 1, 12 (1989), affd. 925 F.2d 348, 353 (9th Cir. 1991); Neely v. Commissioner, 85 T.C. 934, 947 (1985). The term "disregard" includes any careless, reckless, or intentional disregard. Sec. 6662(c). Failure to keep adequate records may be evidence not only of negligence, but also of intentional disregard of regulations. See sec. 1.6662-3(b)(1) and (2), Income Tax Regs.; see also Benson v. Commissioner, T.C. Memo. 2007-113.



In the matter before us, respondent has met the burden of production imposed on him by section 7491(c). Respondent has shown that petitioner failed to keep adequate records for the years at issue. To avoid application of the penalty, petitioner must therefore demonstrate that the underpayments of tax for 1999, 2000, and 2001 were due to reasonable cause and good faith. See sec. 6664(c)(1); Higbee v. Commissioner, supra at 449.



The decision as to whether a taxpayer acted with reasonable cause and in good faith depends upon all the pertinent facts and circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs. Relevant factors include the taxpayer's efforts to assess his or her proper tax liability, including the taxpayer's reasonable and good faith reliance on the advice of a professional such as an accountant. See id. However, reliance on the advice of a professional tax advisor does not necessarily establish reasonable cause and good faith. Id. Particularly, reliance on the advice of a tax professional is not reasonable when a taxpayer fails to disclose a fact that he or she knows, or reasonably should know, is relevant to the proper tax treatment of an item. Sec. 1.6664-4(c)(1)(i), Income Tax Regs.



Petitioner has not demonstrated that any of her underpayments are due to reasonable cause and good faith. Petitioner did not mention her tip income to Mr. Nguyen during his preparation of petitioner's income tax returns. Although petitioner may have believed that tip income was not taxable, that belief is not reasonable. Petitioner has failed to demonstrate that she acted with reasonable cause and good faith with regard to any particular portion of the underpayments in this case. Therefore, to the extent that we uphold respondent's determination of deficiencies for the years at issue, we conclude that petitioner is liable for the section 6662(a) penalties.



To reflect the foregoing,



Decision will be entered under Rule 155.

Tax Attorney: Taxpayer wins “reasonable cause” argument and avoid the negligence penalty

Taxpayer avoids underpayment “negligence” penalty because of the complexity of the law, temporary homelessness, his health issues, and the technical nature of the law under section 104. Viewing all the facts and circumstances, including the experience, knowledge, and education of the taxpayer, the Tax Court concluded that the taxpayer demonstrated reasonable cause for failing to report the settlement proceeds as income and that he acted in good faith under section 6664(c). Accordingly, taxpayer was not liable for the accuracy-related penalty under section 6662(a). This case should be used as precedent in arguing “reasonable cause” in other cases.

Taxpayer wins on avoiding a negligence penalty by proving “reasonable cause” for an underpayment of tax. Reginald James Smith, Petitioners V. Commissioner, TC Summary Opinion 2007-106, Docket No. 8241-06S. . Filed June 25, 2007.

Reasonable cause was demonstrated by the technical nature of the law, the hardship endured by the individual as a result of his joblessness, and the experience, knowledge and education of the individual.

The IRS required the taxpayer to include in income an amount obtained as part of a settlement agreement against a former employer, but was not subject to the accuracy-related penalty for his underpayment. The individual filed a lawsuit alleging, among other claims, sexual and racial harassment. The two parties settled, and the individual failed to include the settlement amount in his income. However, the settlement was not excluded from income under Code Sec. 104 because it was not for a personal injury or sickness. The settlement did not mention a personal injury or sickness and there was no indication that the paying former employer intended to compensate the individual for a personal injury or sickness. However, an accuracy-related penalty under Code Sec. 6662 was not imposed because the individual demonstrated reasonable cause for the underpayment and good faith with respect to the underpayment.



Respondent determined a deficiency in petitioner's 2004 Federal income tax of $12,546. Respondent also determined an accuracy-related penalty in accordance with section 6662(a) in the amount of $2,509 for 2004. After concessions,1 the issues for decision are: (1) Whether a settlement payment received by petitioner is excludable from gross income under section 104(a); and (2) whether petitioner is liable under section 6662(a) for an accuracy-related penalty.





Background



Petitioner worked as a warehouse employee at Onyx Environmental Services (hereinafter Onyx) from April 15, 2002 through November 2002 when he was terminated. On December 16, 2003, petitioner and another individual filed a complaint for damages for sexual and racial harassment, failure to take reasonable steps to prevent and correct harassment, and retaliation, against Onyx and petitioner's former supervisor in the Superior Court of the State of California, County of Contra Costa. In his suit against Onyx, petitioner stated a prayer for relief for compensatory damages, mental and emotional distress damages, punitive damages, interest, attorney's fees, and costs of suit incurred.



In September 2004, petitioner reached a settlement agreement with Onyx and petitioner's former supervisor with respect to the suit he filed on December 16, 2003. Pursuant to the settlement agreement, Onyx paid petitioner $41,651.81 in 2004. Petitioner timely filed his 2004 Federal income tax return, but he did not report the amount received from the settlement on the return. Respondent determined that $41,6512 was includable in petitioner's gross income and issued a notice of deficiency to petitioner on March 13, 2006.





Discussion



In general, the Commissioner's determinations set forth in a notice of deficiency are presumed correct, and the taxpayer bears the burden of proving that these determinations are in error. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Pursuant to section 7491(a), the burden of proof as to factual matters shifts to respondent under certain circumstances. Because the facts are not in dispute, we decide this case without regard to the burden of proof.




I. Taxability of Payment Petitioner Received

A taxpayer's gross income includes all income from whatever source derived unless excluded by a specific provision of the Internal Revenue Code. Sec. 61(a). Gross income does not include "the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness". Sec. 104(a)(). To qualify for this exclusion, the taxpayer must demonstrate: (1) The underlying cause of action giving rise to the recovery is based upon tort or tort type rights; and (2) the damages were received on account of personal physical injuries or physical sickness. Commissioner v. Schleier, 515 U.S. 323, 337 (1995); Allum v. Commissioner, T.C. Memo. 2005-177, affd. 99 AFTR 2d 2007-2527, 2007-1 USTC par 50489 (9th Cir. 2007). The terms "physical injury" and "physical sickness" do not include emotional distress, except to the extent of damages not in excess of the amount paid for medical care attributable to emotional distress. Sec. 104(a); see also Prasil v. Commissioner, T.C. Memo. 2003-100.



When damages are received pursuant to a settlement agreement, the nature of the claim that was the actual basis for settlement controls whether such amounts are excludable under section 104(a)(2). United States v. Burke, 504 U.S. 229, 237 (1992); Prasil v. Commissioner, supra. The determination of the nature of the claim is a factual inquiry and is generally made by reference to the settlement agreement. Robinson v. Commissioner, 102 T.C. 116, 126 (1994), affd. in part and revd. in part 70 F.3d 34 (5th Cir. 1995). If the settlement agreement lacks express language stating what the settlement amount was paid to settle, we look to the intent of the payor, based on all the facts and circumstances of the case, including the complaint that was filed and the details surrounding the litigation. Knuckles v. Commissioner, 349 F.2d 610, 613 (10th Cir. 1965), affg. T.C. Memo. 1964-33; Allum v. Commissioner, supra.



Here, the settlement agreement provides that Onyx will pay petitioner $41,651.81 in exchange for petitioner's release and discharge of all claims against Onyx. The settlement agreement does not mention any physical injury or sickness. It refers generally to "all issues and claims" surrounding petitioner's employment at Onyx, and releases Onyx from "all claims, rights, demands, actions, obligations, and causes of action of any and every kind, known or unknown" by petitioner.



Looking beyond the settlement agreement, we likewise find no indication that Onyx intended the $41,651.81 to compensate petitioner for physical injury. As mentioned supra, the complaint that petitioner filed in State court alleges sexual and racial harassment, failure to take reasonable steps to prevent and correct harassment, and retaliation, and the prayer for relief requests compensatory damages, mental and emotional distress damages, punitive damages, interest, attorney's fees, and costs incurred. The complaint says nothing about physical injury or physical sickness sustained by petitioner. There is nothing in the record linking the settlement proceeds to any physical injury or sickness. Accordingly, respondent's determination on this issue is sustained. Based on our resolution of this issue, we do not address whether the underlying cause of the State court action was based upon tort or tort type rights. See Allum v. Commissioner, supra.




II. Accuracy-Related Penalty Under Section 6662(a)

Section 6662(a) provides that a taxpayer may be liable for a penalty of 20 percent of the portion of an underpayment of tax attributable to negligence or disregard of rules or regulations. Sec. 6662(a) and (b)(1). The term "negligence" includes any failure to make a reasonable attempt to comply with the provisions of the Internal Revenue Code. Sec. 6662(c). The term "disregard" includes any careless, reckless, or intentional disregard. Id. The Commissioner bears the burden of production with respect to the accuracy-related penalty. See sec. 7491(c); Higbee v. Commissioner, 116 T.C. 438, 446 (2001).



An exception to the section 6662 penalty applies when the taxpayer demonstrates: (1) There was reasonable cause for the underpayment, and (2) the taxpayer acted in good faith with respect to the underpayment. Sec. 6664(c). Whether the taxpayer acted with reasonable cause and in good faith is determined by the relevant facts and circumstances on a case-by-case basis. See Stubblefield v. Commissioner, T.C. Memo. 1996-537; sec. 1.6664-4(b)(1), Income Tax Regs. "Circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of all the facts and circumstances, including the experience, knowledge, and education of the taxpayer." Sec. 1.6664-4(b)(1), Income Tax Regs. The most important factor is the extent of the taxpayer's effort to assess the proper tax liability. Stubblefield v. Commissioner, supra; sec. 1.6664-4(b)(1), Income Tax Regs.



As discussed above, petitioner worked for Onyx as a warehouse employee, stocking and keeping inventory. After he was terminated in 2002, petitioner had difficulty finding a new job. Petitioner was evicted from his home and lived in his car for several months because he could not pay the rent and had no other place to stay. Petitioner also fell behind on paying bills and student loans. Although petitioner eventually found a new job, it paid close to minimum wage and provided no health benefits. Petitioner sustained at least one injury from an accident while he was uninsured, and he had to pay the related expenses out of pocket.



The record is unclear as to whether petitioner received the Form 1099-MISC, Miscellaneous Income, issued by Onyx.3 Given the circumstances described herein, it seems unlikely that petitioner would have appreciated the significance of the Form 1099-MISC even if he did receive it, even though failure to receive a Form 1099-MISC does not necessarily constitute reasonable cause for failure to report income. See Goode v. Commissioner, T.C. Memo. 2006-48.



We find that petitioner's termination from employment, his eviction resulting in temporary homelessness, his health issues, and the technical nature of the law as to the exclusion of income under section 104 are factors that weigh in his favor. Viewing all the facts and circumstances, including the experience, knowledge, and education of the taxpayer, we conclude that petitioner has demonstrated reasonable cause for failing to report the settlement proceeds as income and that he acted in good faith. See sec. 6664(c). Accordingly, he is not liable for the accuracy-related penalty under section 6662(a).



To reflect the foregoing,



Decision will be entered under Rule 155.


1 Respondent concedes that petitioner is not liable for self-employment tax. Additionally, respondent introduced a Form 4340, Certificate of Assessments, Payments, and Other Specified Matters, showing an assessment of tax on July 24, 2006, 2 months after petitioner timely filed a petition with this Court. Respondent was uncertain as to the basis for the assessment. We presume that respondent has abated or will abate the assessment and will make no further assessments until the decision of the Court is final. See sec. 6213(a).

2 The 81-cent difference between the amount paid and listed in the notice of deficiency is presumably due to rounding by respondent.

3 The parties stipulated that petitioner received the settlement proceeds, and that Onyx issued a Form 1099-MISC, which was submitted as an exhibit. The record does not state that petitioner actually received the Form 1099-MISC.