Reser v. CIR ( 1997 )

IN THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT
________________________________
No. 96-60393
________________________________
REBECCA JO RESER,
Petitioner-Appellant,
versus
COMMISSIONER OF INTERNAL REVENUE,
Respondent-Appellee.
_________________________________________________
Appeal from the United States Tax Court
_________________________________________________
May 12, 1997
Before JOLLY, JONES and WIENER, Circuit Judges.
WIENER, Circuit Judge:
Petitioner-Appellant Rebecca Jo Reser (Reser) appeals
the Tax Court’s decision disallowing certain deductions
that she and her former husband, Don C. Reser (Don),
claimed on their 1987 and 1988 joint income tax returns.
The deductions represented losses incurred by Don’s
subchapter S corporation for those years. Reser asserts,
in the alternative, that she is not liable for any
deficiency determined by the Tax Court on the 1987 joint
return, as she is an innocent spouse, as defined in 26
U.S.C. §6013(e). Although we affirm the Tax Court’s
disallowance of the questioned deductions, we conclude
that Reser is entitled to innocent spouse relief for the
1987 joint return. We therefore reverse the judgment of
the Tax Court insofar as it holds her liable for any
deficiency in tax, including interest, penalties, or
other amounts, attributable to the substantial
understatement of tax on that return. In addition, we
hold, for essentially the same reasons, that she is not
liable for negligence and substantial understatement
penalties attributable to the deficiency on the 1988
joint return.
I.
FACTS AND PROCEEDINGS
Reser is a personal injury defense lawyer who
obtained an undergraduate degree in history from Stanford
University and a law degree from the University of Texas.
Don has an undergraduate degree in economics from
Stanford University, a law degree from the University of
Houston, and a Masters in Business Administration from
the University of Texas. The Resers were married from
2
1974 until 1991 when they divorced.
In 1984, Don created a professional corporation, Don
C. Reser, P.C. (DRPC), to broker large real estate
projects. He made an initial capital contribution of
$6,000 and named himself the sole shareholder.1 That same
year, DRPC elected to be taxed under subchapter S of the
Internal Revenue Code (the Code).2
During the years in question, DRPC’s main business
activity was the offering for sale of Central Park Mall,
a large shopping center in San Antonio, Texas. As a new
corporation, DRPC needed operating capital, so Don and
DRPC together obtained a line of credit from North Frost
Bank of San Antonio, Texas (Frost Bank). The line of
credit was documented by fourteen promissory notes
executed jointly by Don and DRPC in favor of Frost Bank.
The notes were dated from 1985 to 1989, and each was
payable ninety days after its execution. The final note
stated a cumulative principal loan balance of
1
The Resers were subject to Texas’ community property regime,
which classifies DRPC as their community property. See Tex. Fam.
Code §5.01 et seq. (West 1993). Pursuant to these rules, Reser is
considered to be the one-half owner of DRPC even though Don is the
only registered shareholder.
2
See 26 U.S.C. §1362 (1994).
3
$467,508.54. Don and DRPC were jointly and severally
liable to Frost Bank for repayment, but the loan was not
collateralized with any property belonging to Don or
DRPC.
Whenever DRPC needed to draw on the line of credit,
Don would call Frost Bank and request that funds be
deposited directly into DRPC’s account.3 Don had total
discretion with respect to these funds, and he used them
for DRPC’s operating capital as well as for personal
expenses. When Don needed funds for his personal use, he
withdrew them from DRPC’s account.
In 1986, Don and DRPC executed a guaranty agreement
with an individual, Don Test, pursuant to which Test
guaranteed the Frost Bank line of credit and provided
collateral (shares of stock in Genuine Auto Parts
Company) for the loan. In exchange, Don agreed to pay
Test a fee of $14,998.50 for each ninety day period that
his guaranty was outstanding. DRPC’s ledgers for 1987
and 1988 together reflected approximately $82,000 in
guaranty fee payments made to Test. In 1989, Test paid
the balance of the notes to Frost Bank.
3
Don customarily spoke to the secretary for the
senior vice president who approved the line of credit.
4
For each tax year of its corporate existence, DRPC
filed a Form 1120S, the federal tax return for an S
corporation. DRPC reported $257,354 in losses for 1987
and $333,581 in losses for 1988. None dispute that DRPC
actually incurred these losses.
For the 1987 and 1988 tax years, the Resers filed
joint income tax returns on which they claimed as
deductions the losses that DRPC had reported. The IRS
conducted an audit of those returns, questioning
specifically the deductibility of DRPC’s losses. IRS
Agent Kesha Lange attempted to ascertain Don’s adjusted
basis in DRPC, which, in turn, would determine any
limitation on the Resers’ deductibility of DRPC’s losses.
Don provided Lange with the promissory notes executed in
favor of Frost Bank, the guaranty agreement with Test,
and DRPC’s ledgers. Lange determined that (1) the Frost
Bank loan was made to DRPC, (2) Don could not increase
his basis in DRPC by the amount of the loan proceeds, and
(3) Don had insufficient basis in DRPC to deduct the
losses.
When Lange informed Don of her conclusions, he
asserted for the first time that Frost Bank had loaned
5
the money to him individually and that he, in turn, had
loaned the money to DRPC. Despite Don’s assertions, he
provided no documentation in support of the purported
arrangement. DRPC’s corporate tax returns did not
indicate any indebtedness from DRPC to Don in amounts
corresponding to the Frost Bank loan proceeds, and its
ledgers did not reflect any payments of principal or
interest to Don during 1987 or 1988.4 Neither was there
any evidence that Don had made any principal or interest
repayments to Frost Bank on the loan personally.
In 1991, the IRS issued a notice of deficiency,
disallowing all of the deductions that the Resers had
claimed as DRPC’s losses on their 1987 and 1988 joint
returns.5 Curiously, after the IRS issued the notice of
deficiency, Don produced copies of a series of promissory
notes, allegedly executed by him on behalf of DRPC and
purporting to reflect DRPC’s indebtedness to him in the
amount of the Frost Bank loan.
The Resers filed a petition in the United States Tax
4
DRPC’s ledgers for 1987 and 1988 reflected one
principal payment and five interest payments to Frost
Bank.
5
The Commissioner later allowed $36,855 of the loss
deduction for 1987.
6
Court seeking a redetermination of the deficiencies
assessed by the Commissioner. Reser asserted, in the
alternative, that she was an innocent spouse for purposes
of the 1987 joint return, as defined in 26 U.S.C.
§6013(e), and was not liable for any deficiency
determined by the Tax Court.6
The Tax Court (1) concluded that Don did not have
sufficient basis in DRPC to claim its losses as
deductions on the 1987 and 1988 joint returns, (2)
assessed penalties for negligence, substantial
understatements of tax, and failure to file timely, and
(3) denied Reser’s alternative request for innocent
spouse relief.7
Reser alone appealed,8 asserting that the Tax Court
6
Prior to trial, the parties entered into a
stipulation of facts which contained certain computations
relating to Don’s basis in DRPC. The computations were
made by IRS Agent Judith A. Lopez who, in auditing the
Resers’ 1989 and 1990 joint income tax returns,
determined that Don’s basis in DRPC was greater than that
determined by Lange in her audit of the 1987 and 1988
joint tax returns.
7
The Tax Court concluded also that Don was not liable
for any self-employment tax on a $15,000 payment that
Reser had received in 1987 as a referral fee.
8
In June 1996, Don filed a notice of appeal, which we
dismissed in August 1996 for lack of prosecution.
7
erred in (1) disallowing the deductions, (2) holding her
liable for negligence and substantial understatement
penalties,9 and (3) denying her innocent spouse relief on
the 1987 joint return.
II.
ANALYSIS
A. The Innocent Spouse Defense
We address first whether Reser qualifies for relief
as an innocent spouse for purposes of the 1987 joint
return, recognizing that a ruling in her favor relieves
her of all liability attributable to the substantial
understatement of tax on that return10 and pretermits our
determination of the other alleged errors concerning that
return. Reser concedes that, for technical reasons, she
is not eligible for innocent spouse relief from the
9
Reser maintains also that the Tax Court erroneously
calculated the 1987 negligence penalty. She did not
appeal the penalty for failure to file timely.
10
See 26 U.S.C. §6013(e)(1)(flush language)(1994).
The phrase “flush language” is a fairly well-understood
term of statutory construction which is used to refer to
language that is written from margin to margin and that
applies to an entire statutory section as opposed to
language that is indented to designate applicability
limited to a particular subsection or sub-subsection.
8
deficiency on the 1988 joint return.11
1. Standard of review
We review the Tax Court’s determination that a spouse
is not entitled to relief as an innocent spouse under the
clearly erroneous standard.12
2. Applicable law
The Code permits married persons to make “a single
return jointly of income taxes.”13 Spouses who file a
joint return are generally liable jointly and severally
for the tax due on their aggregate income, including
interest and penalties.14 Congress, however, has
statutorily mitigated the harshness of this rule by
enacting the innocent spouse defense. Accordingly, a
taxpayer who qualifies as an innocent spouse is relieved
of liability for the tax, including interest, penalties,
and other amounts, attributable to a deficiency on the
11
For the 1988 joint return, Reser failed to meet the
requirement that the liability be greater than 25% of the
adjusted gross income for the preadjustment year. See 26
U.S.C. §6013(e)(4)(B)(1994).
12
Park v. Commissioner, 25 F.3d 1289, 1291 (5th
Cir.), cert. denied, -- U.S.--, 115 S. Ct. 673 (1994).
13
26 U.S.C. §6013(a)(1994).
14
26 U.S.C. §6013(d)(3)(1994); Park, 25 F.3d at 1292.
9
joint return.15
To assert the innocent spouse defense successfully,
a spouse must establish that (1) a joint return was made
for the taxable year; (2) on that return there is a
substantial understatement of tax attributable to grossly
erroneous items of the other spouse; (3) in signing the
return, the spouse did not know, and had no reason to
know, of such substantial understatement; and, (4) taking
into account all the facts and circumstances, it would be
inequitable to hold the spouse liable for the
deficiency.16 The burden of proof lies with the spouse
seeking relief.17 Stated differently, a spouse’s failure
to prove any one of the statutory elements precludes
relief.
In the instant case, the parties stipulated to the
Tax Court that the Resers filed a joint return for the
1987 tax year on which there is a substantial
understatement of tax. At issue, however, are whether
15
26 U.S.C. §6013(e)(1)(flush language)(1994).
16
26 U.S.C. §6013(e)(1)(1994); See also Park, 25 F.3d
at 1292; Buchine, 20 F.3d at 180.
17
Park, 25 F.3d at 1292; Bokum v. Commissioner, 94
T.C. 126, 138 (1990), aff’d on other grounds, 992 F.2d
1132 (11th Cir. 1993).
10
(1) the substantial understatement is attributable to
grossly erroneous items, (2) Reser knew or had reason to
know of the substantial understatement, and (3) it would
be inequitable to hold Reser liable.18 We shall consider
each contested element seriatim.
3. Grossly erroneous item
Reser must establish first that the substantial
understatement of tax on the 1987 joint return is
attributable to grossly erroneous items.19 The Code
defines grossly erroneous items, with respect to any
spouse, as:
(A) any item of gross income attributable to
such spouse which is omitted from gross income,
and
(B) any claim of a deduction, credit, or basis
by such spouse in an amount for which there is
18
The grossly erroneous items must be attributable to
the other spouse. See 26 U.S.C. §6013(e)(1)(B)(1994).
As the Commissioner does not contest that the grossly
erroneous items were Don’s, we will assume that this is
not an issue.
19
The Tax Court did not address whether the
substantial understatement of tax was attributable to
grossly erroneous items,
and Reser’s appellate brief makes no specific argument on
this point. Reser’s assertion of the innocent spouse
defense in the inconsistent alternative, however,
necessarily assumes a ruling disallowing the Resers’
deductions of DRPC’s losses, thereby establishing this
element of the defense.
11
no basis in fact or law.20
There is no question that the substantial understatement
is attributable to deductions claimed on the joint return
and not to omissions of income. Thus the relevant
inquiry is whether those deductions have “no basis in
fact or law.” The Code does not define the phrase, “no
basis in fact or law,” but the Tax Court has stated that:
a deduction has no basis in fact when the
expense for which the deduction is claimed was
never, in fact, made. A deduction has no basis
in law when the expense, even if made, does not
qualify as a deductible expense under well-
settled legal principles or when no substantial
legal argument can be made to support its
deductibility. Ordinarily, a deduction having
no basis in fact or in law can be described as
frivolous, fraudulent, or ... phony.21
The deductions clearly have a basis in fact, as it is
undisputed that DRPC actually incurred the losses, that
DRPC is an S corporation, and that Don owned all issued
and outstanding stock in DRPC. Thus Reser must show that
20
26 U.S.C. §6013(e)(2)(1994) (emphasis added).
21
Bokum, 94 T.C. at 142 (quoting Belk v.
Commissioner, 93 T.C. 434, 442 (1989)); Douglas v.
Commissioner, 86 T.C. 758, 762-63 (1986); Purcell v.
Commissioner, 826 F.2d 470, 475-76 (6th Cir. 1983), cert.
denied, 485 U.S. 987, 108 S. Ct. 1290 (1988).
12
the deductions have no basis in law.22
a. Applicable law
The income of a corporation that has made a
subchapter S election is not subject to the corporate
income tax; rather, it is taxed pro rata to its
shareholders —— a method commonly known as flow-through
taxation.23 Similarly, any net operating loss incurred by
an S corporation passes through to its shareholders, each
of whom may deduct from his personal gross income his pro
rata share of the corporation’s loss.24 There are,
however, statutory limitations on the deductibility of
losses at the shareholder level. Section 1366(d) of the
Code provides in pertinent part:
The aggregate amount of losses and deductions
taken into account by a shareholder ... for any
taxable year shall not exceed the sum of
(A) the adjusted basis of the shareholder’s
stock in the S corporation ..., and
(B) the shareholder’s adjusted basis of any
indebtedness of the S corporation to the
22
See Bokum, 94 T.C. at 144 (finding grossly
erroneous items where there was no basis in law for the
deductions).
23
26 U.S.C. §1366(a)(1994); Underwood v.
Commissioner, 535 F.2d 309, 310 (5th Cir. 1976).
24
26 U.S.C. §1366(a)(1994); Underwood, 535 F.2d at
310.
13
shareholder.25
It is well established that a shareholder cannot increase
his basis in his S corporation stock without making a
corresponding economic outlay.26 Furthermore, courts have
consistently held that when a shareholder personally
guarantees a debt of his S corporation, he may not
increase his adjusted basis in the corporation’s
indebtedness to him unless he makes an economic outlay by
satisfying at least a portion of the guaranteed debt.27
b. No basis in law
In the instant case, Don argued to the Tax Court that
25
26 U.S.C. §1366(d)(1994).
26
Harris v. United States, 902 F.2d 439, 443 (5th
Cir. 1990); Underwood, 535 F.2d at 311-12; Leavitt v.
Commissioner, 875 F.2d 420, 422 (4th Cir.), aff’g, 90
T.C. 206 (1988), cert. denied, 493 U.S. 958, 110 S. Ct.
376 (1989); Selfe v. United States, 778 F.2d 769, 772
(11th Cir. 1985).
27
See e.g. Underwood, 535 F.2d at 312; Harris, 902
F.2d at 445; Leavitt, 875 F.2d at 422; Brown v.
Commissioner, 706 F.2d 755, 756 (6th Cir. 1983); Uri v.
Commissioner, 949 F.2d 371 (10th Cir. 1991); Roesch v.
Commissioner, 57 T.C.M. (CCH) 64, 65 (1989), aff’d, 911
F.2d 724 (4th Cir. 1990). But see Selfe, 778 F.2d at
772-75 (shareholder’s guarantee is sufficient to increase
basis in S corporation if the facts demonstrate that, in
substance, shareholder borrowed funds and subsequently
advanced them to corporation; remanding to Tax Court to
determine whether loan from bank to S corporation was in
reality a loan to shareholder). We are not bound by the
Eleventh Circuit’s decision.
14
he had made the requisite economic outlay to increase his
basis in DRPC by the amount of the Frost Bank loan
proceeds. Specifically, he contended that Frost Bank
loaned the money to him individually and that he, in
turn, loaned the money to DRPC. As evidence of the
purported arrangement, Don produced copies of a series of
promissory notes payable to him by DRPC. Rejecting Don’s
argument and implicitly discrediting the notes, the Tax
Court found that (1) there was no evidence of a
legitimate debt between Don and DRPC, (2) Don could not
increase his basis in DRPC by the amount of the Frost
Bank loan proceeds, and (3) Don had insufficient basis in
DRPC to claim its losses as deductions on the joint
returns. We review the factual findings of the Tax Court
for clear error.28
We agree with the Tax Court’s conclusion that there
was no legitimate debt between DRPC and Don corresponding
to the amount of the Frost Bank loan proceeds. First,
the promissory notes payable to Frost Bank were executed
by Don and DRPC together, indicating on their face that
28
Park v. Commissioner, 25 F.3d 1289, 1291 (5th Cir.
1994); McKnight v. Commissioner, 7 F.3d 447, 450 (5th
Cir. 1993).
15
Frost Bank did not lend the money to Don alone.29 Second,
Frost Bank always deposited the loan proceeds directly
into DRPC’s account. Third, Don, individually, did not
make any repayments on the loan to Frost Bank, but DRPC
made both principal and interest payments to Frost Bank.
Finally, DRPC’s corporate tax returns reflected the notes
as payable to Frost Bank, not to Don, even though the
returns listed other notes payable to Don.
The only evidence of a debt between Don and DRPC was
a series of promissory notes, purporting to represent
indebtedness from DRPC to Don, which Don produced after
the IRS issued its notice of deficiency. The delayed
appearance of these notes caused the Tax Court to
question their authenticity; and we find no clear error
in the court’s decision to disregard them entirely.
Neither DRPC’s 1987 nor 1988 corporate return reflected
the alleged indebtedness to Don. Furthermore, there is
no evidence that (1) Don ever received or that DRPC ever
paid any interest or principal on these notes or (2) DRPC
made any “loan” repayments to Don.
29
None dispute that Frost Bank would not have made a
loan to DRPC without a guaranty from Don or another
guarantor, as neither Don nor DRPC provided the bank with
collateral, and DRPC had no assets.
16
We find that the parties’ treatment of the Frost Bank
loan, from the time it was entered into until the IRS
issued its notice of deficiency, was wholly consistent
with the unambiguous, credible documentation of the
transaction and entirely inconsistent with the way in
which Don attempted post hoc to recast the transaction to
the Tax Court. Again, the only evidence to the contrary
is a series of promissory notes to which the Tax Court
attributed no probative value. As structured and
otherwise documented, the transaction did not lack
adequate reality or substance. Regrettably for Don,
taxpayers are bound by the form that they have chosen for
the transaction and may not in hindsight recast the
transaction as one that they might have made to obtain
tax advantages.30 We therefore conclude that Don may not
30
Harris, 902 F.2d at 443 (citing Don E. Williams Co.
v. Commissioner, 429 U.S. 569, 97 S. Ct. 856-57 (1977);
Commissioner v. Nat’l Alfalfa Dehydrating & Milling Co.,
417 U.S. 134, 149, 94 S. Ct. 2129, 2137 (1974)). In some
circumstances, however, the IRS may disregard form and
recharacterize a transaction by looking to its substance.
Harris, 902 F.2d at 443 (citing Higgins v. Smith, 308
U.S. 473, 60 S. Ct. 355 (1940)). See also Uri v.
Commissioner, 949 F.2d 371, 373 n.4 (10th Cir. 1991).
For example, in Blum v. Commissioner, 59 T.C. 436, 440
(1972), the Tax Court recognized an exception that
permits a shareholder to question a transaction’s form
when he argues that his guaranty of a corporate debt
should be recast as an equity investment on his part.
17
increase his basis in DRPC by the amount of the Frost
Bank loan proceeds; consequently, the Resers are not
entitled to deduct DRPC’s losses on their 1987 and 1988
joint returns.
More pertinent to Reser, however, is the favorable
impact of this ruling on the innocent spouse issue. As
we have disallowed the deductions, the conclusion is
inescapable that the substantial understatement of tax on
the 1987 joint return is attributable to grossly
erroneous items.
4. Know or reason to know
a. Background
Reser must prove next that, in signing the 1987 joint
The Tax Court later clarified its decision, however,
noting that the Blum court never reached the debt/equity
issue because the taxpayer failed to carry his burden of
proving that the loan, in substance, was made to him and
not to the corporation. Leavitt v. Commissioner, 90 T.C.
206, 215 (1988). In affirming the Tax Court, the Fourth
Circuit stated that the Code’s provisions limiting the
basis of a subchapter S shareholder to his corporate
investment or outlay could not be circumvented through
the use of debt/equity principles. Leavitt v.
Commissioner, 875 F.2d 420 (4th Cir.), cert. denied, 493
U.S. 958, 110 S. Ct. 376 (1989). In the instant case, in
which Don failed to prove that the bank, in substance,
loaned the money to him and not to DRPC, we will not look
behind the form and structure of the transaction in an
attempt to recharacterize it as an economic outlay. See
Harris, 902 F.2d at 443.
18
return, she did not know, and had no reason to know, of
the substantial understatement of tax.31
Courts have generally agreed that when the
substantial understatement of tax liability is
attributable to an omission of income from the joint
return, the relevant inquiry is whether the spouse
seeking relief knew or should have known of an income-
producing transaction that the other spouse failed to
report.32 In short, in omission of income cases, the
spouse’s knowledge of the underlying transaction which
produced the omitted income is alone sufficient to
preclude innocent spouse relief.
When the substantial understatement is traceable to
erroneous deductions, however, the Tax Court is in
disagreement with some of the circuits as to whether the
“knowledge of the transaction” test is appropriate.
Although we have not addressed this issue in the past, at
31
26 U.S.C. §6013(e)(1)(C)(1994).
32
Park v. Commissioner, 25 F.3d 1289, 1294 (5th
Cir.), cert. denied, -- U.S.--, 115 S. Ct. 673 (1994);
Sanders v. United States, 509 F.2d 162, 169 (5th Cir.
1975); Hayman v. Commissioner, 992 F.2d 1256, 1261 (2d
Cir. 1993); Erdahl v. Commissioner, 930 F.2d 585, 589
(5th Cir. 1991); Guth v. Commissioner, 897 F.2d 441, 444
(9th Cir. 1990); Quinn v. Commissioner, 524 F.2d 617, 626
(7th Cir. 1975).
19
least four circuits have expressly rejected application
of the knowledge-of-the-transaction test in erroneous
deductions cases. They have concluded instead that the
proper inquiry is whether the spouse seeking relief knew
or had reason to know that the deduction would give rise
to a substantial understatement.33 The leading case in
this camp is the Ninth Circuit’s decision in Price v.
Commissioner.34 The Tax Court, however, in Bokum v.
Commissioner,35 explicitly refused to acquiesce in Price
and continues to apply the knowledge-of-the-transaction
test in omission of income cases and erroneous deduction
cases alike.36 In Bokum, the Tax Court found support for
33
See Bliss v. Commissioner, 59 F.3d 374, 378 n.1 (2d
Cir. 1995); Hayman v. Commissioner, 992 F.2d 1256, 1261
(2d Cir. 1993); Friedman v. Commissioner, 53 F.3d 523,
530 (2d Cir. 1995); Resser v. Commissioner, 74 F.3d 1528,
1535-36 (7th Cir. 1996); Erdhal v. Commissioner, 930 F.2d
585, 589 (8th Cir. 1991); See also Kistner v.
Commissioner, 18 F.3d 1521, 1527 (11th Cir. 1994)(citing
Price and Erdhal with approval).
34
887 F.2d 959 (9th Cir. 1989).
35
94 T.C. 126 (1990), aff’d on other grounds, 992
F.2d 1132 (11th Cir. 1993).
36
The Tax Court recently adhered to its position in
Bellour v. Commissioner, 69 T.C.M. (CCH) 3010 (1995)
(denying innocent spouse relief to a wife who knew of the
transaction for which a grossly erroneous tax deduction
was taken on her joint return but not of the tax
consequences of that transaction). The Tax Court
20
its position in the Sixth and Seventh Circuits.37
Significantly, however, since the Tax Court’s decision in
Bokum, the Seventh Circuit has changed its position and
followed Price,38 and the Sixth Circuit has not had the
opportunity to revisit the issue.
In rejecting the knowledge-of-the-transaction test in
erroneous deduction cases, the Price court was careful
not to discount entirely a spouse’s knowledge of the
underlying transaction. That court stated,
we do not mean to say that a spouse’s knowledge
of the transaction underlying the deduction is
irrelevant. Obviously, the more a spouse knows
about a transaction, ceteris paribus, the more
likely it is that she will know or have reason
to know that the deduction arising from the
acknowledges, however, that it will follow Price in cases
appealable to the Ninth Circuit. See Bokum, 94 T.C. at
151 (citing Golsen v. Commissioner, 54 T.C. 742, 756-57
(1970), aff’d, 445 F.2d 985 (10th Cir.), cert. denied,
404 U.S. 940, 92 S. Ct. 284 (1971)). Presumably, the
Golsen rule applies to Tax Court cases appealable to the
other circuits that have followed Price.
37
“As the Seventh Circuit stated: ‘[t]he knowledge
contemplated by [section 6013(e)] is not knowledge of the
tax consequences of a transaction but rather knowledge of
the transaction itself.’” Bokum, 94 T.C. at 152-53
(quoting Purcell v. Commissioner, 826 F.2d 470, 474 (6th
Cir. 1987), cert. denied, 485 U.S. 987, 108 S. Ct. 1290(1988)(quoting Quinn v. Commissioner, 524 F.2d 617, 626
(7th Cir. 1975))).
38
See Resser v. Commissioner, 74 F.3d 1528 (7th Cir.
1996).
21
transaction may not be valid. We merely
conclude that standing by itself, such knowledge
does not preclude relief.39
In addition, the court enumerated several factors to
consider in determining whether a spouse had reason to
know of the substantial understatement.40
b. Applicable standard in this circuit
The Price and Bokum approaches intersected for the
first time in this circuit in Park v. Commissioner,41 an
erroneous deduction case in which the taxpayer argued
that her knowledge of the underlying transactions did not
give her reason to know of the erroneous deductions so as
to destroy the availability of innocent spouse relief.
39
Price, 887 F.2d at 963 n.9.
40
These include (1) the spouse’s level of education,
(2) the spouse’s involvement in the family’s business and
financial affairs, (3) the presence of expenditures that
appear lavish or unusual when compared to the family’s
past levels of income, standard of living, and spending
patterns; and (4) the culpable spouse’s evasiveness and
deceit concerning the couple’s finances.
Id. at 965 (citing Stevens v. Commissioner, 872 F.2d
1499, 1505 (11th Cir. 1989)).
41
25 F.3d 1289 (5th Cir.), cert. denied, -- U.S. --,
115 S. Ct. 673 (1994). In Park, we did not address
whether the two approaches actually espoused different
principles. Id. at 1299 n.3. See also Price, 887 F.2d
at 963 n.9, n.10 (noting the functional similarity
between the two tests). Again we leave that question for
another day.
22
Declining to rule specifically on the applicable standard
in this circuit, we concluded that the taxpayer had
reason to know of the substantial understatement under
either approach.42 But we recognized, and the Tax Court
agrees, that the general standard of inquiry concerning
a spouse’s reason to know in both omission of income and
erroneous deduction cases is whether a reasonably prudent
taxpayer in the spouse’s position at the time she signed
the return could be expected to know that the stated
liability was erroneous or that further investigation was
warranted.43
The facts before us today present the issue, and we
neither can nor care to duck it: We must decide whether
to join the growing number of circuits that have adopted
the Price approach or to follow the Tax Court. But we do
not find this choice problematical —— we conclude that
the Price approach is clearly the better. Thus we hold
that the proper test of a spouse’s knowledge in an
erroneous deduction case is whether the spouse seeking
42
Park, 25 F.3d at 1298.
43
Park, 25 F.3d at 1298 (citing Sanders v.
Commissioner, 509 F.2d 162, 167 (5th Cir. 1975)). See
also Price, 887 F.2d at 965 and Bokum, 94 T.C. at 148.
23
relief knew or had reason to know that the deduction in
question would give rise to a substantial understatement
of tax on the joint return. We hasten to add, lest there
be doubt, that our decision today does not disturb the
unquestioned application of the knowledge-of-the-
transaction test in omission and understatement of income
cases.
If we had chosen instead to apply the knowledge-of-
the-transaction test in erroneous deduction cases, we
would have made it virtually impossible for a spouse ever
to obtain innocent spouse relief in such cases. As the
Price court noted, deductions are conspicuously recorded
on the face of the tax return; therefore, any spouse who,
at a minimum, reads the return will be put on notice that
some transaction gave rise to the deduction.
Furthermore, in the 1980's, it was common knowledge that
investors could legally obtain large tax benefits through
clever investment strategies.44 Thus mere knowledge that
a spouse had invested in a tax shelter would establish
constructive knowledge of a substantial understatement.
Such a result would undermine the objective of the
44
Friedman v. Commissioner, 53 F.3d 523, 531 (2d Cir.
1995).
24
innocent spouse defense, which is intended to provide
relief in both erroneous deduction and omission of income
cases.45
In determining a spouse’s reason to know under our
newly adopted standard, the relevant factors to consider
include: (1) the spouse’s level of education; (2) the
spouse’s involvement in the family’s business and
financial affairs; (3) the presence of expenditures that
appear lavish or unusual when compared to the family’s
past levels of income, standard of living, and spending
patterns; and (4) the culpable spouse’s evasiveness and
deceit concerning the couple’s finances.46
Nevertheless, when the spouse seeking relief knows
sufficient facts such that a reasonably prudent taxpayer
in his position would be led to question the legitimacy
45
When the innocent spouse defense was enacted
initially, it provided relief from substantial
understatements attributable to omissions of income only.
In 1984, however, Congress expanded the protection of the
innocent spouse defense, expressly making relief
available for erroneously claimed deductions and credits
also. See Park, 25 F.3d 1289, 1292 (1994).
46
See Price, 887 F.2d at 965; Stevens v.
Commissioner, 872 F.2d 1499, 1505 (11th Cir. 1989);
Erdahl v. Commissioner, 930 F.2d 585, 590-91 (8th Cir.
1991); Friedman, 53 F.3d at 531; Resser v. Commissioner,
74 F.3d 1528, 1536 (7th Cir. 1996); Bliss v.
Commissioner, 59 F.3d 374, 378 (2d Cir. 1995).
25
of the deductions, he has a duty to make further inquiry.
Tax returns setting forth “dramatic deductions” will
generally put a reasonable taxpayer on notice that
further investigation is warranted.47 A spouse who has
a duty to inquire but fails to do so may be charged with
constructive knowledge of the substantial understatement
and thus precluded from obtaining innocent spouse relief.
c. Did Reser have reason to know?
The Tax Court denied Reser’s claim for innocent
spouse relief on the sole ground that she had either
reason to know that the stated liability was erroneous or
a duty to make further investigation. When we consider
Reser’s actual knowledge and the four relevant factors,
we are convinced that the Tax Court’s conclusion was
clearly erroneous. Reser had no reason to know that the
deductions in question would give rise to a substantial
understatement. Neither did she have a duty to inquire
as to the propriety of the deductions.
i. Actual knowledge
When Reser signed the joint returns, she thought that
47
Hayman v. Commissioner, 992 F.2d 1256, 1262 (2d
Cir. 1993); Stevens, 872 F.2d at 1506; Levin v.
Commissioner, 53 T.C.M. (CCH) 6 (1987); Cohen v.
Commissioner, 54 T.C.M. (CCH) 944 (1987).
26
she and Don together had invested sufficient funds in
DRPC to cover the losses claimed as deductions.
Specifically, she (1) had advanced significant amounts of
her personal funds for the operating expenses of DRPC;
(2) knew that Don had obtained a line of credit from
Frost Bank and had invested the funds in DRPC; and (3)
knew that Don had written checks on their joint account
to DRPC that totaled approximately $135,000.48 In
addition, she was the sole producer of income reported by
the Resers in 1987 and 1988. And, importantly, she
legitimately anticipated substantial start-up losses,
which are typical in such a corporation’s initial years
of operation and which did in fact occur. Reser
testified at trial:
Well, I understood that Don was starting up his
business in these years, and that these were
losses incurred in the start-up of the business,
and I believed in his abilities with his
background in economics from Stanford, a
master’s in accounting, and a law degree, and
his business acumen, that this was a business --
this was normal starting up a business, that
there would be losses, and eventually hopefully
profits.
48
In 1988, she and Don borrowed jointly $50,000 from
Fidelity Bank and invested these funds in DRPC. That
same year she allowed Don to withdraw (on penalty for
early withdrawal) over $13,000 from two of her IRA’s and
invest those funds in DRPC.
27
ii. Relevant factors
The relevant factors that we are to consider indicate
that Reser did not know and did not have reason to know
that the deductions in question would give rise to a
substantial understatement on the 1987 joint return.
First, Reser’s education, albeit advanced, provided her
with no special knowledge of complex tax issues such as
basis computation. She had a background in history and
practiced personal injury law. Second, Reser was not
personally involved with DRPC’s business and financial
affairs to any significant degree; rather, she was
engaged full-time in her law practice and was the
family’s sole source of financial support.49 In addition,
she gave birth to their second child in 1987. Third, the
record is devoid of evidence of lavish or unusual
expenditures compared to the Resers’ normal standard of
living and spending patterns, which exhibits no notable
changes during the years in question. To the contrary,
they invested most of Reser’s income into DRPC and
consumed the rest on the family’s living expenses. In
49
Reser reported income from her full-time law
practice of $194,000 in 1987 (but testified that she did
not “take home” that much) and $114,000 in 1988.
28
addition, they incurred substantial debt when borrowing
money to invest in DRPC. And ultimately, the Resers
divorced, and Don filed for bankruptcy. Finally, Reser
cannot be penalized for Don’s discredited efforts to
recast the Frost Bank loan in a tax-favorable light.
Indeed, Reser was not even aware of the second set of
“promissory notes” until 1991, several years after she
had signed the 1987 joint return.
d. Duty to inquire
We are equally convinced that the Tax Court clearly
erred in determining under the instant circumstances that
Reser had a duty to inquire as to the propriety of the
deductions. This is not the typical “dramatic
deductions” case in which a cursory review of the return
should have alerted Reser that the deductions might not
be legitimate. Given Reser’s personal knowledge that she
and Don had made large infusions of capital into DRPC and
that DRPC had generated no income, nothing about the
deductions would have put Reser on notice that further
inquiry was necessary.
In addition, the Commissioner and the Tax Court both
concede that the losses were legitimate deductions at the
29
corporate level; that they produced net losses at the
corporate level for tax purposes; that generally S
corporation losses pass through to the shareholders; and
that the only question is whether the losses are
deductible at the level of these particular shareholders
due to the basis limitation, which, in turn, rests on the
hypertechnical determination whether Don borrowed funds
from Frost Bank and loaned them to his corporation (in
which case his basis would increase dollar for dollar) or
the corporation was the borrower (in which case Don’s
basis would not be increased). This case demonstrates
that the determination of basis, which limits the
deductibility of the losses, is an extremely difficult
and technical process. The issue has been hotly
contested and vigorously fought throughout, and even two
of the IRS’s own agents arrived at different calculations
of Don’s basis in DRPC for 1987. We would not expect
Reser to question such arguably legitimate, close-call
deductions. Moreover, there can be no doubt that,
even if Reser had conducted further inquiry, she would
have gotten responses that corresponded exactly to the
information as reported on the 1987 joint return. The
30
Resers’ 1987 joint tax return was prepared by CPA Duane
DuLong, who concluded that the Resers were entitled to
deduct DRPC’s losses.50 Don testified at trial that when
he filed the 1987 and 1988 joint returns, he believed
that he had treated DRPC’s losses correctly in claiming
them as deductions. And John Gwaltney, DRPC’s
comptroller-accountant, instructed the CPA who prepared
the 1988 joint return that the Frost Bank loans were
payable to Don individually.
Had Reser asked Don, Gwaltney, or DuLong about the
deductions, they would have told her what they believed
—— that DRPC’s losses were properly deductible in full.
Neither the court nor the law will penalize Reser for
50
Burnside & Reshebarger, the firm that prepared
DRPC’s 1987 corporate return, refused at the last minute
to prepare the 1987 joint return because of a fee
dispute. The record is unclear as to the cause of the
fee dispute. The Resers’ 1988 joint income tax return
was prepared by CPA Stewart Goodson, senior manager in
the tax department at Ernst & Young, L.L.P., and signed
by CPA Houston Bryan, a partner at that firm. Goodson
obtained the necessary information concerning DRPC from
John Gwaltney, the comptroller-accountant for DRPC. In
the course of two conversations and one meeting with
Goodson, Gwaltney provided Goodson with DRPC’s financial
statements which listed various loans payable by DRPC.
Gwaltney instructed Goodson that the loans were actually
payable to Don individually. Gwaltney also provided
Goodson with DRPC’s tax returns for 1987 and 1988 and
asked Goodson to determine the Resers’ basis in DRPC for
purposes of claiming DRPC’s losses as deductions.
31
failing to perform the hollow act of asking questions,
the answers to which would have provided no new or
different information.
5. Inequity
Reser must establish last that it would be
inequitable to hold her liable for the tax deficiency on
the 1987 joint return.51 The inequity question is one of
fact,52 and even though we do not ordinarily determine
questions of fact for the first time on appeal, both
parties expressly conceded at oral argument that we could
decide the issue based on the information in the record.
With the parties’ acquiescence and in the interest of
judicial economy, we undertake this task.
The Code and the regulations instruct that inequity
is to be determined on the basis of all of the facts and
circumstances.53 The most important factor in determining
inequity is whether the spouse seeking relief
“significantly benefitted” from the understatement of
51
26 U.S.C. §6013(e)(1)(D)(1994).
52
Buchine v. Commissioner, 20 F.3d 173, 181 (5th Cir.
1994).
53
26 C.F.R. §1.6013-5(b) (1996).
32
tax.54 The regulations provide that the benefit may be
direct or indirect but caution that normal support is not
a benefit.55
A direct or indirect benefit may be evidenced by (1)
a transfer of property,56 (2) a spouse’s receipt of more
than she otherwise would as part of a divorce
settlement,57 or (3) an accumulation of savings or other
assets in lieu of present consumption.58 This list,
however, is not exclusive.
Other factors to consider in determining inequity
include (1) whether the spouse seeking relief has been
deserted or divorced or separated from the other spouse59
54
Buchine, 20 F.3d at 181 (citing Belk v.
Commissioner, 93 T.C. 434, 440 (1989)).
55
26 C.F.R. §1.6013-5(b)(1996).
56
Id. A transfer of property not traceable to items
omitted from income does not constitute a benefit.
Ferrarese v. Commissioner, 66 T.C.M. (CCH) 596 (1993),
aff’d, 43 F.3d 679 (11th Cir. 1994).
57
Stiteler v. Commissioner, 69 T.C.M. (CCH) 2975(1995), aff’d, 108 F.3d 339 (9th Cir. 1997).
58
Purificato v. Commissioner, 64 T.C.M. (CCH) 942(1992), aff’d, 9 F.3d 290 (3d Cir. 1993), cert. denied,
511 U.S. 1018, 114 S. Ct. 1398 (1994).
59
26 C.F.R. §1.6013-5(b); Flynn v. Commissioner, 93
T.C. 355, 367 (1989).
33
and (2) the probable hardships that would befall the
spouse seeking relief if she were not relieved.60
The record reveals that Reser did not significantly
benefit from the substantial understatement in tax.
During the marriage, the Resers did not accumulate any
savings or other assets. They invested their sole source
of income, Reser’s earnings from her legal practice, in
DRPC and became indebted to various sources in their
efforts to keep DRPC afloat. Instead of experiencing a
benefit, their standard of living actually fell.61
Furthermore, the Resers are now divorced, and there is no
record evidence that Reser received more than she
otherwise would have as part of the divorce settlement.
Taking into account all of the facts and circumstances,
we find that it would be inequitable to hold Reser liable
for the deficiency.
Reser has borne her burden of establishing every
element of the innocent spouse defense. We therefore
hold that she is entitled to innocent spouse relief for
purposes of the 1987 joint return.
60
Sanders v. Commissioner, 509 F.2d 162, 167 n.16
(5th Cir. 1975).
61
Belk v. Commissioner, 93 T.C. 434 (1989).
34
B. Negligence Penalty
We turn now to the 1988 joint return, which contains
a substantial understatement of tax for which Reser
concedes —— on the basis of a technicality —— she is not
entitled to relief as an innocent spouse. As we have
already concluded that the Tax Court properly disallowed
Don and Reser’s deductions of DRPC’s losses, we shall
address only whether Reser should be held liable for the
negligence and substantial understatement penalties
attributable to the deficiency on the 1988 joint return.62
We consider the negligence penalty first.
The Tax Court’s determination of negligence is a
factual finding which we review for clear error.63
Section 6653(a)(1) of the Code imposes an addition to
62
As we have concluded that Reser is an innocent
spouse for purposes of the 1987 joint return, she is
automatically relieved of liability for the 1987
negligence penalty. Therefore, we need not address
whether the Tax Court erroneously calculated that
penalty. In addition, we note that the Tax Court’s
decision did not charge Reser with liability for the 50%
interest penalty for the 1988 joint return. See 26
U.S.C. §6653(a)(1)(B)(1994). Thus for the
1988 joint return only the 5% negligence penalty is
before us.
63
Westbrook v. Commissioner, 68 F.3d 868, 880 (5th
Cir. 1995); Portillo v. Commissioner, 932 F.2d 1128, 1135
(5th Cir. 1991), rev’d on other grounds, 988 F.2d 27 (5th
Cir. 1993).
35
tax equal to 5% of the entire underpayment if any portion
of such underpayment is due to negligence.64
“‘Negligence’ includes any failure to make a reasonable
attempt to comply with the tax code, including the lack
of due care or the failure to do what a reasonable or
ordinarily prudent person would do under the
circumstances.”65 The taxpayer bears the burden of
establishing the absence of negligence.66
The relevant inquiry for the imposition of a
negligence penalty is whether the taxpayer acted
reasonably in claiming the loss.67 The Tax Court found
that Reser’s reliance on Stewart Goodson, the CPA who
prepared the 1988 joint return, was not reasonable, as
based on inaccurate information, in light of its decision
that there was no separate loan from Don to DRPC. We
find clear error in this conclusion of the Tax Court.
64
26 U.S.C. §6653(a)(1)(1994).
65
See 26 U.S.C. §6653(a)(3)(1994); Durrett v.
Commissioner, 71 F.3d 515, 518 (5th Cir. 1996);
Westbrook, 68 F.3d at 880 (quoting Heasley v.
Commissioner, 902 F.2d 380, 383 (5th Cir. 1990)).
66
Westbrook, 68 F.3d at 880; Portillo, 932 F.2d at
1135.
67
Chamberlain v. Commissioner, 66 F.3d 729, 733 (5th
Cir. 1992).
36
For the same reasons that we concluded that Reser did not
have reason to know of the substantial understatement on
the 1987 joint return,68 we conclude that she acted
reasonably in relying on the professionals who prepared
the 1988 joint return. In fact, but for her failure to
meet a technical requirement, she would have been an
innocent spouse for purposes of the 1988 joint return.
Goodson and Bryan, two CPA’s at a national accounting
firm, both agreed that the Resers’ basis in DRPC was
sufficient to claim the losses as deductions. As we
stated in Chamberlain v. Commissioner,69 “[t]o require the
taxpayer to challenge the [expert], to seek a ‘second
opinion,’ or try to monitor [the expert] on the
provisions of the Code himself would nullify the very
purpose of seeking the advice of a presumed expert in the
first place.”70 Furthermore, Reser was wholly unaware of
Don’s belated attempt to recast the Frost Bank loan to
his tax advantage.
We conclude that Reser was not negligent with respect
68
See supra at Part II (A)(4).
69
Id.
70
Id. at 732 (quoting United States v. Boyle, 469
U.S. 241, 251 105 S. Ct. 687, 692-93 (1985)).
37
to the 1988 joint return and, therefore, is not liable
for the negligence penalty.
C. Substantial Understatement Penalty
Finally, we address the substantial understatement
penalty. Section 6661 provides for an addition to tax
equal to 25% of the amount of any underpayment
attributable to a substantial understatement of tax.71
A taxpayer may be granted relief from all or any
part of the addition to tax, however, if he shows that
there was reasonable cause for the understatement (or
part thereof) and that he acted in good faith.72 The
regulations provide that reliance on the advice of a
71
26 U.S.C. §6661(a)(1994). That section also
provides for a reduction of the understatement if there
was substantial authority for the taxpayer’s treatment of
the item causing the understatement. 26 U.S.C.
§6661(b)(2)(B)(I)(1994). The Tax Court concluded that
there was no substantial authority for Don to increase
his basis in DRPC by the amount of the Frost Bank loan
proceeds, and we find no error in this determination.
The only authority for allowing a shareholder to increase
his basis in a corporation when he guarantees a debt of
the corporation is the Eleventh Circuit’s decision in
Selfe v. Commissioner, 778 F.2d 769 (11th Cir. 1985).
But we are not bound by another circuit’s decision.
Furthermore, the Tax Court rejected that case in Leavitt
v. Commissioner, 90 T.C. 206 (1988)(decided February
1988), aff’d, 875 F.2d 420 (1989)(decided May 1989), well
over a year before the Resers filed their 1988 joint
return (filed October 1989).
72
26 U.S.C. §6661(c)(1994).
38
professional, such as an accountant, or on other facts
may constitute a showing of reasonable cause and good
faith if, under all of the circumstances, such reliance
was reasonable and the taxpayer acted in good faith.73 We
have just concluded that Reser acted reasonably in
relying on the professionals who prepared the 1988 joint
return and would have been an innocent spouse for
purposes of that return but for her failure to meet a
technical requirement. As relief from the substantial
understatement penalty does not depend on the taxpayer’s
ability to meet the technical requirement that was fatal
to Reser’s innocent spouse defense for the 1988 joint
return, we exonerate her from liability for this penalty.
Any other conclusion would be absurdly inconsistent with
our earlier holdings.
III.
CONCLUSION
As there was no legitimate debt between Don and DRPC,
we conclude that Don was not entitled to increase his
basis in DRPC by the amount of the Frost Bank loan
proceeds. Consequently, we affirm the Tax Court’s
73
26 C.F.R. §1.666-6(b); Heasley, 902 F.2d at 385.
39
holding that the Resers could not properly deduct DRPC’s
losses on their 1987 and 1988 joint tax returns.
We conclude also that Reser is entitled to relief as
an innocent spouse for the 1987 joint return and,
therefore, reverse the Tax Court’s contrary holding.
First, the disallowed deductions are grossly erroneous
items and create the substantial understatement of tax on
the 1987 joint return. Second, Reser neither knew nor
had reason to know that the deductions claimed on the
1987 joint return would give rise to a substantial
understatement of tax. Neither did she have a duty to
inquire as to the propriety of the deductions, as any
further inquiry would have been informatively futile
under the discrete facts of this case. Finally, it would
be inequitable to hold Reser liable for the tax
deficiency.
Significantly, we hold that henceforth in erroneous
deduction cases in this circuit, the proper inquiry
concerning a spouse’s knowledge is whether the spouse
seeking relief knew or had reason to know that the
deductions in question would give rise to a substantial
understatement, not whether he knew or had reason to know
40
of the existence of the underlying transaction.
Lastly, we hold that Reser is not liable for the
negligence and substantial understatement penalties
attributable to the deficiency on the 1988 joint return.
For the foregoing reasons, we affirm the Tax Court’s
decision disallowing the Resers’ deductions of DRPC’s
losses on the 1987 and 1988 joint returns, but we reverse
the judgment of the Tax Court insofar as it holds Reser
liable for (1) the deficiency in tax, including
penalties, interest, and other amounts, attributable to
the substantial understatement of tax on the 1987 joint
return and (2) the negligence and substantial
understatement penalties attributable to the deficiency
on the 1988 joint return; and we hold that she is not
liable for the same.
AFFIRMED in part; REVERSED and RENDERED in part.
41