Friday, July 11, 2014

A Ruling on Fraud and Some Innocent Spouse Cases

Originally published on Passive Activities and Other Oxymorons on June 13th, 2011.
Private Letter Ruling 201114005

LLC was qualified investor for purposes of claiming theft loss deduction under Rev. Proc. 2009-20 and discovery year for purposes of claiming deduction was stated year.

Cases and rulings involving fraud have an almost pornographic appeal to me. I always want some detailed descriptions in there. This ruling measured up in that regard:

In Year 4, some of Company's loans began to default. Individual A, President of Company from Year 2 until Date 6, and Individual B, chairman and CEO of Company from Year 1 until Date 6, the lead figures, concealed from investors that loans were not performing and caused Company to continue to pay interest to investors regardless of whether the underlying borrowers had made loan payments to the Account X. As a result, the Account X had insufficient funds to make payments to all of its investors, and Individuals A and B began to look for sources of money to cover the shortage in the Account X. One of the ways Individuals A and B covered the shortage was by not remitting principal payments to investors when borrowers paid off the loans. Individuals A and B made it appear as if the loans were still performing by paying the investors an amount calculated as if the borrowers had made only interest payments on the loans. Individuals A and B also funded the shortage in the Account X with money collected from new investors and by withholding payments from the Account X owed to Taxpayer. By the end of Year 5, Individuals A and B had used more than Amount 1 of Taxpayer's funds to make payments to other Company investors on non-performing loans.

Oh what a tangled web we weave, when first we practice to deceive.  The tax problem you have when dealing with a mess like this  is like unscrambling an egg.  The taxpayers recognized income that wasn't really there. In principle you should amend open returns and to some extent might not have any relief. Rev Proc 2009-20 which was issued in light of the Bernie Madoff mess

allows taxpayers to take a theft loss in the year that the excrement strikes the air moving device in the amount of their unrecovered investment including fictitious income they reported.  It's a lot easier and possibly more favorable for something that went on a long time.  The treatment is an optional safe harbor.  At least according to this ruling you didn't have to have your money stolen by Bernie Madoff to qualify.

(1) Taxpayer is the qualified investor for purposes of claiming a theft loss deduction under Rev. Proc. 2009-20.

(2) The discovery year for purposes of claiming a theft loss deduction under Rev. Proc. 2009-20 is Year 8.

Songie S. Milhouse, et vir., v. Commissioner, TC Summary Opinion 2009-012
Stacey L. Cody, et vir. v. Commissioner, TC Summary Opinion 2011-49

The box on the return where you check "Married Filing Jointly" should have a big warning label maybe something like "Just because many gay people are mad that they aren't supposed to check this box, doesn't mean it's always such a good idea."  I must say I admire the principled civil disobedience approach of the Refuse to Lie campaign.  It happens that my own attitude toward taxes is generally "It is what it is.  Deal with it."  The dark side of Married Filing Jointly is known as "joint and several liability".  It means that the IRS can collect the entire tax deficiency from which ever of the pair they can lay their hands on.  There is a very easy defense against joint and several liability. It is called filing a separate return.  Then there is the much more challenging "innocent spouse" defense which often turns the Tax Court into a soap opera.

The Milhouse case was not particularly dramatic:

Throughout the marriage, petitioner mostly separated herself financially from Mr. Todd because of a "pattern" of "financial mismanagement" which she perceived on the part of Mr. Todd. Wages and child support payments which petitioner received were therefore deposited into her individual bank account. Mr. Todd, however, deposited his wages into a bank account jointly held with petitioner (joint account). Funds deposited into the joint account were used to pay household expenses and make improvements to Mr. Todd's house. While petitioner had access to the joint account, she never in fact accessed it. Instead, petitioner periodically transferred money to the joint account when Mr. Todd requested that she do so.

Petitioner sent to respondent a Form 8857, Request for Innocent Spouse Relief, which respondent received on August 27, 2008. In her request for relief, petitioner stated that she reported "all" of her income and that she was "under the impression" that Mr. Todd had provided her with all yearend tax statements he received for inclusion on the joint return. Before petitioner's entitlement to relief was determined, respondent provided Mr. Todd with the opportunity to oppose relief by filing with respondent a Form 12509, Statement of Disagreement.

Mr. Todd sent to respondent his statement of disagreement, which respondent received on February 26, 2009. In that statement Mr. Todd asserted that petitioner "knew" about the retirement income because she had access to the joint account both online and through statements that were mailed to their residence. Mr. Todd also stated that he gave petitioner all year-end tax statements to be reported on the joint return. Respondent subsequently forwarded petitioner's request for relief to respondent's Office of Appeals for further consideration.

The Tax Court resolved the "He said. She Said" in favor of Ms. Milhouse:

Petitioner testified credibly that she transferred money to the joint account but did not access the account or have any knowledge regarding the funds being deposited into that account. This testimony supports petitioner's claim that she did not have actual knowledge of the items giving rise to the deficiency at the time she signed the return. We generally reject Mr. Todd's contradictory testimony as self- serving and incredible. See Tokarski v. Commissioner, 87 T.C. 74, 77 (1986). Such is especially appropriate given that Mr. Todd did not offer any corroborating evidence to support his allegations of actual knowledge on the part of petitioner.

The Cody case has more drama to it:

Petitioner and intervenor's marriage was not stable. Petitioner moved out of the marital home with the children on more than one occasion. After each departure petitioner and the children returned to the marital home. At some point during the marriage intervenor was charged with misdemeanor domestic assault. Near the end of the marriage petitioner and intervenor began to experience financial difficulty. Petitioner became aware that the amount of intervenor's income was decreasing. They received foreclosure documents for the marital home dated October 26, 2007. On November 18, 2007, petitioner permanently separated from intervenor. Petitioner and intervenor eventually divorced on September 17, 2008.

As of the time of trial, petitioner, as the custodial parent, supported herself and the three children on her Social Security income. Petitioner received $916 a month for herself and $152 a month for each child. Petitioner's expenses exceeded her income by approximately $800 a month. When petitioner ran out of money each month, she visited a food bank to provide meals for her children.

Here is my advice to IRS collections.  You will probably do better chasing people who are eating at high end restaurants rather than lining up at the food pantries.  Just an opinion.  Don't want to tell you how to do your job.

Petitioner and intervenor initially did not file Federal income tax returns for the years 2002, 2003, 2004, and 2005. Respondent prepared substitutes for returns (SFRs)  for each of the tax years at issue for intervenor, and intervenor was sent a notice of deficiency. Intervenor did not respond to the notice, and taxes and additions to tax of $370, $5,242, $13,959, and $11,517 for 2002 through 2005, respectively, were assessed against intervenor.

Note that Mrs. Cody probably was not required to file a return.  I would have advised her to file one anyway, married filing separate, because in some situations taxpayers have been deemed to have consented to a joint return.  What Mrs. Cody ended up doing was, I must say, less than smart :

After the assessments, intervenor prepared joint Federal income tax returns for all of the years at issue. Intervenor contacted petitioner and asked that she execute those joint returns. Because she was afraid to meet intervenor alone, petitioner, accompanied by her adult niece, met with intervenor in a parking lot to sign the returns. Petitioner signed the returns without reviewing them on November 26, 2007. The returns reported tax liabilities due of $332, $2,713, $9,793, and $6,927 for 2002 through 2005, respectively.

Above we see the allure of the joint return.  By getting his estranged spouse to sign joint returns Mr. Cody reduced the liability for four years from slightly over 30,000 to slightly less than 20,000. What was Mrs. Cody getting out of this other than an opportunity to demonstrate to Mr. Cody what a formidable niece she had ? Further what did Mr. Cody get out of it ultimately other giving the IRS somebody else to chase ?  I suppose he got the satisfaction of seeing his ex-spouse have some more aggravation.

The Court then went into the various factors considered in innocent spouse cases

I. Marital Status

II. Economic Hardship

III. Knowledge or Reason To Know

IV. Nonrequesting Spouse's Legal Obligation

V. Significant Benefit

VI. Compliance With Federal Tax Laws

VII. Abuse and Mental or Physical Health

The only thing that was clearly against her was that the divorce decree had called for the parties to split the income tax liability.  The parking lot incident, in the analysis, kind of split.  All the surrounding circumstances of her signing the return indicate that she knew that the tax was not going to be paid.  On the other hand the fact that she brought her, presumably formidable, adult niece along helped support her abuse contention.

Of course if she had been my aunt, I would have prepared married filing separate returns for her driven her to the post office to mail them and then taken her for ice cream at a Friendly's on the opposite side of the city from where she was supposed to meet my ex-uncle. That would probably have been a better result.  It's exciting to have a niece in special ops, but sometimes a CPA nephew is what you really need.

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