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Lessons from the Tax Court: Guilty until proven innocent

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in Small Business Tax,Small Business Tax Deduction Strategies

A taxpayer who qualifies as an “innocent spouse” may be entitled to relief from tax liability on a joint return. But the IRS often questions claims of innocence. To qualify for relief, it has imposed the following requirements:

  • You must have filed a joint return that has an understatement of tax.
  • The understatement of tax is due to erroneous items of your spouse.
  • You have established that at the time the joint return was signed, you did not know (or have reason to know) there was an understatement of tax.
  • Taking into account all of the facts and circumstances, it would be unfair to hold you liable for the understatement.
  • The relief is requested within two years after the IRS started its collection activities.

Note: This last requirement has now been eliminated by the IRS. It is expected to further liberalize the rules in the near future.

In a new case decided by the Tax Court, a taxpayer tried to avoid liability stemming from a small business operation. (Bell, TC Memo 201-142)

Key facts: In 2002, Mr. Bell incorporated an Internet-based sales company under Indiana law.  At all relevant times, the corporation was treated as an S corporation for federal income tax purposes. From 2002 to 2004, Mr. Bell owned 51% of the S corp and Mrs. Bell owned 49%. During this time, Mr. Bell maintained total control over the operations and activities of the company.

Mrs. Bell sought innocent spouse relief with respect to her tax liability from the corporation. She noted that the corporation’s K-1 reported her husband’s ownership interest as 100%. But the IRS established a rebuttable presumption that Mrs. Bell owned 49% of the company. Mrs. Bell also acted as an owner when she sold her stock to her ex-husband for $1 million.

Tax resolution: The Tax Court ruled that Mrs. Bell failed to meet the innocent spouse rules, so 49% of the corporation’s income was attributable to her.

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