For various reasons that legal historians can drone on about for hours, the United States legal system started out in 1789 as not one system of courts but two systems of courts. One was system was made up of courts of law, staffed by folks with titles like “Judge” or “Justice.” The other system was made up of courts of equity, staffed by folks with titles like “Chancellor” or “Vice Chancellor.” The basic idea was that each system had its own set of powers and you could only get to the equity courts if the law courts lacked the power to give you the relief you sought.
This was a really awkward relationship and a constant source of embarrassment and confusion. The great legal historian F. W. Maitland put it this way in his 1910 Lectures On Equity: “I do not think that any one has expounded or ever will expound equity as a single, consistent system, an articulate body of law. It is a collection of appendixes between which there is no very close connection.” (p. 19) And in this 1913 law review article, Professor Wesley Newcomb Hohfeld discussed the difficulty of teaching equity as a system of rules separate from legal rules.
One awkwardness was that often the same individual would wear both hats. For example, you might file an action at law and have proceedings before the “Judge” sitting as a court of law. The Judge had power to award damages but did not have power to order depositions. So you would need to file a completely separate proceeding in equity, seeking a “Bill of Discovery” from the Vice Chancellor because the Vice Chancellor had the power to order depositions (but had no power to award damages). But you would file that in the same building and be heard by the same individual. So one day the “Judge” would say “I have no power to order discovery” but the next day the very same individual, sitting as “Vice Chancellor,” would suddenly have the power to grant your Bill.
I tell you all this because although the two systems have been merged in federal courts since 1938 (although some states, such as Delaware and Mississippi, keep the two systems separate) federal judges still tend to compartmentalize the two. The Tax Court in particular has wrestled with the role of equity from its inception. Two recent Tax Court cases teach useful lessons about the role of equity in Tax Court proceedings. This week I will look at the innocent spouse case of the Connie L. Minton a.k.a. Connie L. Keeney v. Commissioner, T.C. Memo. 2018-15 (Feb. 5, 2018). Next week I will discuss the very interesting case of Emery Celli Cuti Brinckerhoff & Abady, P.C. v. Commissioner, T.C. Memo 2018-55 (Apr. 24, 2018), a case that will introduce us to the doctrine of equitable recoupment.
The Law Part
Section 6013 provides that spouses are jointly and severally liable for the taxes owed on a jointly filed return. That’s all well and good, until the marriage breaks up and recriminations set in. If there are unpaid tax liabilities after a divorce, one spouse might not want to be jointly liable for those liabilities. Such spouse can seek spousal relief under §6015.
Congress enacted the first spousal relief provisions in 1971 in §6013(e), modified them in 1984, and overhauled them in 1998, putting them in §6105. These relief provisions are a mixture of legal concepts and equitable concepts. For the gory details, you can suffer through this article I wrote about the history of spousal relief provisions, called “The Unhappy Marriage of Law And Equity in Joint Return Liability," 108 Tax Notes 1307 (September 12, 2005).
Basically, §6015 gives taxpayers three ways to obtain relief from unpaid tax liabilities associated with a joint return.
First, §6015(b) applies when the unpaid tax liability is due to an understatement of tax on the return. In other words, there was a deficiency of tax reported on the original return. That might happen, for example, if Mr. and Ms. White file a return that does not report Mr. White’s income from his illegal drug business. Ms. White can obtain relief if she can show (1) they filed a joint return; (2) it had an understatement of tax attributable to the non-requesting spouse (here, Mr. White); (3) the requesting spouse (here, Ms. White) was innocent of knowledge about the understatement (she must show she did not know and did not have any reason to know about it); and (4) it would be inequitable to hold her liable for the liability (she must show she did not benefit from the cause of the understatement).
Second, §6015(c) also applies only to understatements. It basically allows one spouse to simply “unwind” a joint return if (1) the requesting spouse had no actual knowledge that there were erroneous items on the return (that can simply be asserted and it’s up to the IRS to prove otherwise); and (2) the requesting spouse is now divorced or separated under the applicable rules.
Third, §6015(f), applies to both understatements and underpayments. That is, it can apply even if there is no deficiency but simply an unpaid tax liability. It allows a spouse who cannot get relief under either §6105(b) or (c) to be relieved of responsibility for an unpaid liability when “taking into account all the facts and circumstances, it is inequitable to hold” the requesting spouse liable. The IRS has published guidance on what “facts and circumstances” it will consider in Rev. Proc. 2013-34. While the Tax Court repeatedly says it is not bound by the Rev. Proc., as a practical matter it always follows the Rev. Proc.’s structure and approach to evaluating the suitability of relief because the IRS always uses the Rev. Proc. and therefore the case is always framed in terms of the Rev. Proc. when it comes to Tax Court for review.
The Equity Part
Equity is not a free-floating concept but is instead a set of structured doctrines, each with a long body of legal precedent. When Congress put equity into the Tax Court in 1998 in the form of §6015(f), the IRS confronted the difficulty that this was a new idea in tax law. Rev. Proc. 2013-34 is the IRS attempt to provide a structure around which to organize the “facts and circumstances” so enable both the IRS and courts to make consistent determinations and not grant relief to some taxpayers but not others similarly situated.
The basic organizational approach Rev. Pro. 2013-34 takes is to put a taxpayer’s request through three equity screens, each of which asks slightly different questions, all on the variation of “is it fair to allow relief?” The first screen is called “threshold” conditions and most of them are basically a checklist to ensure that the taxpayer requesting relief jumped through the proper procedural hoops. If a taxpayer does not meet the threshold conditions, the IRS rejects the request without further analysis.
The key equitable concept in these threshold conditions is an attribution rule: the unpaid tax liability must be due to the other spouses’ behavior. If it is attributable to the actions of the requesting spouse, relief is not appropriate. Since this is an equitable determination, however, the attribution rule has exceptions, all grounded in various reasons why it may be unfair to enforce that rule. For example, if a requesting spouse can show that the other spouse was so abusive that the requesting spouse had no ability to challenge the item, or if the requesting spouse can show the non-requesting spouse fraudulently induced the behavior giving rise to the liability, then the IRS will ignore the attribution rule.
The IRS applies a second equity screen when a taxpayer satisfies the threshold requirements. This second screen applies just three additional conditions. If all three apply, then the IRS will grant relief without the need for further analysis. So this second screen is called the “streamlined determination.” Basically, the three conditions are: the requesting spouse is properly divorced or separated; paying the tax would cause the requesting spouse suffer economic hardship; and (in underpayment situations) the requesting spouse reasonably believed the other spouse was supposed to have paid the tax.
If a taxpayer passes the threshold requirements but does not qualify for the streamlined determination, then the Rev. Proc. lays out seven non-exclusive factors to evaluate to see if it would be fair to grant relief. Some of them repeat the above equitable considerations.
Ms. Minton was married to Mr. Keeney in 2009 and 2010 and divorced in 2013. He ran an air conditioning business but it did not do well. According to Judge Pugh’s opinion, Ms. Minton “was aware of Mr. Keeney’s financial difficulties, which included insufficient funds to pay bills.” During 2009 Mr. Keeney convinced Ms. Minton that he had found a great money-making opportunity, and just needed some capital. He promised her that a “big contract” was about to come through for his A/C business so repayment would not be a problem. So Ms. Minton did an early withdrawal of $30,000 from her 401(k) retirement savings account and gave it to him. He lost it.
On their 2009 joint return, the taxpayers properly reported a total tax of $5,335. That included $1,177 in self employment tax for Mr. Keeney’s business and $3,000 in tax on the early 401(k) withdrawal. You can tell from those numbers that they did not have a lot of income that year and it is not surprising they were only able to pay $480 of the tax they reported due. That left about $4,800 in unpaid tax, accruing interest and penalties.
In 2014, Ms. Minton asked for relief under §6015(f). Relief under §6105(b) and (c) were not available to her because the unpaid tax was not due to an understatement of tax, just an underpayment.
The IRS denied the requested relief using the structure and factors in Rev. Proc. 2013-34. Ms. Minton petitioned for Tax Court review. Meanwhile she needed to sell the home. That basically forced her to pay off the balance due for 2009, which had grown to $6,677. Fortunately, §6015(g) gives the Tax Court authority to order a refund for §6015(f) petitions, so that did not affect her ability to seek Tax Court review of the IRS denial. She drew Judge Pugh.
Judge Pugh also followed the structure and factors in Rev. Proc. 2013-34 to review de novo the IRS determination. Judge Pugh separated the analysis into relief from the tax created by the early 401(k) withdrawal and the tax associated with Mr. Keeney’s air-conditioning business.
As to the tax associated with the 401(k) withdrawal, Judge Pugh noted that Ms. Minton’s request for relief failed the threshold attribution rule. The tax was undeniably caused by her withdrawing the money. Judge Pugh looked at the abuse exception and the fraud exception and concluded that neither applied because “Mr. Keeney’s duplicity” as to why he wanted the money “does not constitute the type of abuse that warrants excusing [Ms. Minton] from the responsibility for tax on income from her own retirement account.” Judge Pugh wrote that “while we recognize...the difficulties of the marriage, they are insufficient to overcome the fact that the liability relates to a withdrawal petitioner made freely (even if she was misled about the quality of the investment). Unfortunately, the tax laws cannot right that wrong.”
Judge Pugh came to a different conclusion, however, regarding the tax associated with Mr. Keeney’s business. There, Ms. Minton satisfied the threshold tests. She did not qualify for the streamlined determination, however, because she had already paid the tax (and so could not claim that paying it would cause her future economic hardship). That took Judge Pugh to the third equity screen.
The IRS had decided to deny relief because Ms. Minton knew about the unpaid tax and did not have a reasonable expectation that Mr. Keeney would pay it. So Judge Pugh focuses her opinion on that factor. Ms. Minton testified that Mr. Keeney’s promise of a “big contract” coming through is what made her believe he would be able to pay the tax resulting from the pre-mature 401(k) withdrawal. Judge Pugh believed her and so concluded “it would be inequitable to hold [Ms. Minton] liable for any of the tax liability associated with Mr. Keeney’s business.... Here, we take into account petitioner’s credible testimony that Mr. Keeney had convinced her about his business prospects, his duplicity throughout their marriage, and his verbal abuse. On this record it would not be equitable to require her to pay his liability.”
Spousal relief under §6105 is an example of how the Tax Court can exercise equity because of the explicit introduction of equity in the Tax Code. Note, however, that here the idea of equity comes from the statute and is highly influenced by the IRS's decision on how to structure its administrative process. That means, as Judge Pugh so aptly put it, tax law cannot right every wrong. Absent statutory authority, the Tax Court must have some other source of authority to apply equity. Is there any other source of authority? That’s next week’s lesson.
Coda: It appears that Mr. Keeney is still in the air conditioning business. At least I found this entry in the BBB website that suggests he may be.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.