Change In Innocent Spouse Tax Relief

You may have read or seen that the IRS has ‘changed” the rules for innocent spouse relief. 

While this is not wrong, it is incomplete. How? Because there are three ways to request innocent spouse status, and the IRS has changed one of them. The other two remain as they were before.

Being married and filing a joint tax return with your spouse is what creates this issue. You later divorce or separate from your spouse. You and your (now ex) spouse are audited by the IRS. Remember, the IRS lags a year or two before they select returns for audit. The IRS finds unreported income and assesses additional tax.  The income triggering the tax belongs to your ex-spouse.

Let’s return to the joint tax return you filed. A joint return means that you are “jointly and severally liable.”  The IRS can proceed against you alone, against your spouse alone or against the two of you.  The IRS can, and likely will, proceed against you (for at least 50%) even if it wasn’t your fault. From their perspective, why not? They have nothing to lose, and it doubles their chance of getting someone to pay.

This is the point of innocent spouse relief. You want to separate your tax from that of your ex-spouse. Ideally, you want to completely separate your tax, so that the IRS leaves you alone for any additional tax, penalties and interest.

There are three types of innocent spouse relief.

Type I is “general” relief:

(1)   You filed a joint return.

(2)   The return has an “understatement of tax” due to “erroneous” items of your spouse (or ex-spouse).

(3)   You can show that at the time you signed the joint return you did not know, and had no reason to know, that there was an understatement of tax.

(4)   Considering all the “facts and circumstances,” it would be unfair to hold you liable for the understatement of tax.

An “erroneous” item is IRS-speak for not reporting income or for overstating deductions.

The third requirement can be a tough to meet.  It is possible that you did not know, but that is not enough. The IRS wants to be sure that you had no reason to know. For example, you and your spouse reported $60,000 of income. That year you and your spouse bought a Colorado chalet and a Bugatti Veyron. Unless you had savings to tap into or one of you inherited, expect the IRS to be very skeptical of you denying any “knowledge.” They will figure that you should have known.  And it doesn’t have to be as dramatic as a Swiss chalet. Perhaps you and your ex moved to a nicer neighborhood. Or enrolled the kids in a private school. Or started showing horses.  A quick review of your income and savings would prompt one to wonder how you paid for everything. Expect the IRS to argue that you had “constructive” knowledge. That is, you “had reason to know.”

Type II is “separation of liability.”

Under this method, you separate your income and deductions from your (ex) spouse’s income and deductions. You then calculate your separate tax on such separate income. You are trying to get the IRS to agree that your share of the joint tax is that amount and not more.

It does have the advantage of appearing “fair.”

Oh, the IRS requires that you be divorced, legally separated or at least living apart for the 12-month period preceding the innocent spouse filing. Don’t be surprised if your tax planning includes advice to get divorced.

What is going to sour the IRS on this deal, other than their general reluctance to let anyone off the hook?  Well, that “knowledge” requirement we discussed previously will derail you, with one important distinction: you must have actually known of the tax understatement. The “you should have known” argument is not good enough to deny you the second type of innocent spouse relief.

A second thing that will sink the separation of liabilities is transferring assets for the main purpose of avoiding payment of tax. You can expect the IRS to want to review every significant asset move between you and your ex.

You must request Type I and Type II innocent spouse relief within 2 years after the date on which the IRS first begins collection activity against you. This is not the same as the date you filed the return. Rather it is the date that the IRS sends you a letter or asks you to go downtown for a meeting.

Type III is “equitable relief.”

Equitable relief is only available if you meet the following conditions:

• You do not qualify for innocent spouse relief or separation of liability.
• The IRS determines that it is unfair to hold you liable for the understatement of tax taking into account all the facts and circumstances.

Well, unfair is in the eye of the beholder, isn’t it? What facts and circumstances will the IRS consider as they ponder whether to be fair or unfair?

·        

• Current marital status
• Abuse
• Reasonable belief of the spouse requesting innocent spouse, at the time he or she signed the return, that the tax was going to be paid; or in the case of an understatement, whether that  spouse had knowledge or reason to know of the understatement
• Current financial hardship or inability to pay basic living expenses
• Legal obligation to pay the tax liability pursuant to a divorce decree or other agreement to pay the liability
• To whom the liability is attributable
• Significant benefit received by the spouse asking for innocent spouse
• Mental or physical health of the spouse requesting innocent spouse on the date that spouse signed the return or requested relief
• Compliance with income tax laws following the taxable year or years to which the request for relief relates

The IRS had previously held Type III relief to the same time limit as Types I and II. While not in the Code itself, the IRS inserted the time limit into its Regulations and battled hard to have the courts accept its position.

The IRS lost a high profile case (Lantz) on this issue in 2010. Lantz was the former wife of an Indiana dentist. In 2000 her then-husband was arrested for Medicaid fraud. Shortly thereafter came a $900,000 IRS bill. She didn’t file for innocent spouse because he told her that he had taken care of it. He did not, of course. Shortly thereafter he died.

And of course more than two years had gone by…

Mrs. Lantz filed for Type III innocent spouse. In 2009 the Tax Court sided with her. In 2010, however, the Appeals Court sided with the IRS.

The IRS Taxpayer Advocate howled at what was happening to Mrs. Lantz. Forty-nine members of the House of Representatives sent a letter to the IRS Commissioner demanding a stop to such behavior.  

The IRS did, and in 2011 it announced that it was backing-off the two-year requirement for Type III innocent spouse claims. 

The IRS has now published Regulations formalizing what it announced back in 2011.   

So how long do you have now to file a Type III innocent spouse claim? You have ten years – the same period as the IRS has to collect taxes from you.

Note though that Type I and Type II still have the two-year requirement. It is only Type III that has changed. Why the difference? Because for Types I and II, the two-year requirement is written into the law.

My Thoughts: To hold an innocent spouse to a two-year window – when the law passed by Congress said nothing about a two-year window for Type III relief – was a clubfooted mistake by the IRS. It is a bit late, but the IRS finally got it right.

By the way, if you have been turned down for innocent spouse – and you are still within the ten-year window – please consider filing again under the new rules.

Changes In Ohio Taxes Beginning In 2013

Ohio Governor John Kasich on June 30, 2013 signed Ohio House Bill 59, which made significant changes to Ohio taxes.  

Individual Income Tax Decrease

 Individual income tax rates will be cut 10% over three years.

The $20 personal exemption credit will be available only to taxpayers with Ohio taxable income under $30,000.

Sales Tax Increase

Effective September 1, 2013 Ohio’s sales and use tax rate will increase to 5.75% (from 5.5%)

Minimum Commercial Activities Tax (CAT) Increase

The Commercial Activity Tax (CAT) was previously $150 on the first $1 million in annual gross receipts, regardless of total annual gross receipts. The CAT tax on the first $1 million will now vary depending on the taxpayer’s total annual gross receipts. The new minimums are as follows:

• $1 million or less in annual gross receipts – $150
• From  $1 million to $2 million in annual gross receipts – $800
• From $2 million to $4 million in annual gross receipts – $2,100
• More than $4 million in annual gross receipts – $2,600

Please note that the above apply only to first $1 million in annual gross receipts. Receipts over $1 million will continue to be taxed at a 0.26 percent rate.

 Small Business Income Deduction

There is a new tax deduction for small business income starting in 2013. The deduction will be the lesser of $125,000 ($62,500 per spouse if filing separately) or 50% of the small business income includable in federal adjusted gross income.

 The deduction will apply to sole proprietors as well as to investors in passthrough entities.

The deduction will not be available to trusts and restates.

 New Ohio Earned Income Tax Credit

New for 2013, the new credit will be equal to 5% of the federal tax credit.

New Sales Tax on Downloads

Beginning in 2014, sales tax will apply on downloads of music, books and videos.

The Houdini of Manufacturing

How would you define “manufacturing?”

There is a tax deduction tied-in with manufacturing activity. It is called the “domestic production activity deduction,” abbreviated “DPAD” and pronounced “Dee Pad.” 

An accountant calculates the DPAD by putting all revenues and expenses in one of two columns: domestic manufacturing and everything else. We want to know the profit from domestic manufacturing only. There is a bee’s nest of rules and sub-rules in here, but in general the deduction is 9% of the profit from domestic manufacturing. If your tax rate is 35%, then the DPAD translates into a 3.15% reduction in your tax rate.

Not bad for doing what you were going to do anyway.

The key thing is to define manufacturing. The IRS has provided the following:

·        The manufacture, production, growth or extraction of tangible personal property

·        Film production

·        Production of electricity, natural gas or water

·        Construction or renovation of real property

·        Engineering and architectural services in relation to the construction of real property

Many accountants have wondered about that last one. Good lobbying, I guess.

What is not manufacturing? The IRS did not consider food preparation at a retail establishment to be manufacturing, as one example. There actually is a “Starbucks Footnote” in the House-Senate conference committee report explaining that roasting the coffee beans would qualify but brewing and serving the coffee to customers would not.  

Let us introduce Houdini Inc. Here is some text from their website:

Since 1984, Houdini Inc. has been the leading supplier of upscale food and wine gifts to re-seller's throughout the U.S. Our trend-right gift assortments are found at America's foremost warehouse clubs, mass merchandisers, liquor retailers, specialty stores, catalog companies and internet sites.

We know you'll find these baskets represent a remarkable value: comparable products at these prices will not be found anywhere. Come in and shop around to find out why Houdini is the premier supplier of food gifts throughout the United States.

Houdini makes gift baskets. Odds are we have either given or received gift baskets over the years, so we have a grasp of the “activity” involved.

Houdini makes lots of baskets. They employ around 300 people, bring on approximately 4,000 temporaries during their busy period and can crank up to 80,000 baskets in a day. Most of their business is retail, and a good portion of that goes through their website using the business name Wine Country Gift Baskets. Houdini orders the baskets from China, and it fills the baskets with chocolate, cookies, candy, cheeses, crackers, wine or alcohol. They use inserts and spacers to make the baskets merry and festive.

What do you think? Does Houdini have a DPAD here?

Houdini filed its 2005 and 2006 tax returns without claiming the DPAD. They apparently met a smart tax practitioner and filed amended returns claiming a deduction. The numbers were as follows:

·        2005 DPAD of $206,987 and tax refund of $74,618

·        2006 DPAD of $394,770 and tax refund of $140,933 

The IRS issued the refunds.

Then the IRS wanted its money back. Houdini said no, and the IRS filed suit in December 2011. The case went to a District Court in California.

COMMENT: Tax cases from California can be entertaining to read.

The Court starts off addressing the Code section allowing the DPAD:

Section 199 … allows a taxpayer to deduct a specified percentage of ‘qualified production activities income’ for the taxable year.”

The IRS had published the following Regulation: 

If a taxpayer packages, repackages, labels or performs minor assembling … and the taxpayer engages in no other … activity …, the taxpayer’s packaging, repackaging, labeling or minor assembly does not qualify ….”

The IRS argued that Houdini merely packaged and repackaged the cookies, crackers, and wine. Per Regulation (which the IRS itself conveniently wrote), Houdini failed to have a manufacturing activity. No manufacturing activity means no deduction.

Houdini of course disagreed, arguing that the packaging and repackaging would disallow the deduction only if there is no other manufacturing activity. Houdini argued that there was other production activity.

How can Houdini show a manufacturing or production activity?

It helps to have a friendly judge.

The Court notes that Congress did not provide definitions. The IRS had not provided definitions either.  The Court explains that statutory interpretation “begins with the statutory text, and ends there as well if the text is unambiguous.”

The Court sees the following words and goes to the Merriam Webster Dictionary to determine what they mean:

·        Manufacture

o   To make into a product suitable for use

o   To make from raw materials by hand or by machinery

o   To produce according to an organized plan and with division of labor

·        Package

o   To make into a package

o   To present in such a way as to heighten appeal to the public

·        Produce

·        Repackage

The Court determines that Houdini makes products using machinery, according to an organized plan and with division of labor.

            SCORE: One for Houdini.

On the other hand, Houdini takes various items and puts them together in a more attractive form that appeals to the public.

            SCORE: One for the IRS.

We are tied. The Court must keep going.

Defendants [Houdini] argue that Houdini’s production process “changes the form of an article” within the meaning of Treasury Regulation 1.199-3(e)(1).

Houdini first selects various items – chocolates, cookies, candy, cheeses, crackers, wine or alcohol, packaging materials, and a basket or boxes – for its final products. Next the individual items are assembled in a gift basket or gift tower based on one of many detailed plans. This complex production process relies on both assembly line workers and machines. The final products, gift baskets and gift towers, are distinct in form and purpose from the individual items inside. The individual items would typically be purchased by consumers as ordinary groceries. But after Houdini’s production process, they are transformed into a gift that is usually given during the holiday season.”

SCORE: I see two for Houdini.

The IRS raises its hand and reminds the Court of the example in Regulation 1.199-3(e):

X purchases automobiles from unrelated persons and customizes them by adding ground effects, spoilers, custom wheels, specialized paint and decals, sunroofs, roof racks, and similar accessories. X does not manufacture any of the accessories. X’s activity is minor assembly …., which is not ….[a production] activity.

Houdini’s activity is not distinguishable from the example, argues the IRS. Its activity is a service – packaging and repackaging – that adds final value to a product but does not rise to the level of production. 

The Court then decides:

Unlike X, which does not change the form or function of the car by adding accessories to it, Houdini changes the form and function of the individual items by creating distinct gifts. Furthermore, the Court considers Houdini’s complex production process as more similar to purchasing various automobile parts from suppliers – such as the frame, engine, wheels, etc – and assembling them to create the car itself, which is undoubtedly manufacturing.

Can you believe it? Houdini won!

My thoughts? If you have read my posts, you know that I am usually pro-taxpayer. That said, I believe this is an ill-reasoned decision and lacking in common sense. A key concept to manufacturing is transformation. The final product is similar, but different. Whether we are discussing smelting ore to make engine blocks or planting seeds for a crop – what follows is different from what went before. Quite frankly, using the Court’s reasoning I would find a meal prepared by Iron Chef Morimoto to be closer to manufacturing than putting candy bars and wine bottles into baskets.