Ness v. C.I.R., 90-70393

• Decision Date: 24 January 1992
• Docket Number: No. 90-70393,90-70393
• Citation: 954 F.2d 1495
• Parties: -537, 92-1 USTC P 50,084 Yvonne E. NESS, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE SERVICE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

Page 1495

954 F.2d 1495

69 A.F.T.R.2d 92-537, 92-1 USTC P 50,084

Yvonne E. NESS, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE SERVICE, Respondent-Appellee.

No. 90-70393.

United States Court of Appeals Ninth Circuit.

Argued and Submitted Oct. 8, 1991.

Decided Jan. 24, 1992.

Curtis W. Berner, Buell & Berner, San Francisco, Cal., for petitioner-appellant.

Shirley D. Peterson, Gary R. Allen, David English Carmack, and Teresa T. Milton, Tax Div., U.S. Dept. of Justice, Washington, D.C., for respondent-appellee.

Appeal from a Decision of the United States Tax Court.

Before TANG, REINHARDT and TROTT, Circuit Judges.

TROTT, Circuit Judge:

Gordon Ness ("Mr. Ness") claimed a federal income tax deduction of $103,331 in 1981. Of this amount, $67,806 was determined to be nondeductible because it was not considered to be "at risk," as required by 26 U.S.C. § 465 (1988). Yvonne Ness ("Mrs. Ness") sought relief under the innocent-spouse provision, which, in certain situations, relieves a spouse of tax liability for the understatement of taxes on joint forms. The Tax Commissioner concluded Mrs. Ness met all the criteria of the innocent-spouse provision except the requirement that the deduction be "grossly erroneous." The tax court agreed and denied Mrs. Ness relief. Ness v. Comm'r, 94 T.C. 784 (1990). We reverse.

I

In 1981, Mr. Ness contributed $106,541 to a limited-partnership interest in Research Investors Group ("RIG")--$35,525 in cash and $71,016 in promissory notes signed by Mr. Ness and made payable to Menlo Research Corp. ("MRC"). MRC was wholly owned by Mr. Ness. Mr. Ness formed RIG as a way to enable certain employees of Stanford Scientific, Inc. ("SSI") and his personal friends and relatives to invest in one or more of his research-and-development partnerships. Mr. Ness' investment was allocated among four research-and-development limited partnerships: (1) Custom PCB Chemicals; (2) Earthquake Command System; (3) Automated Blood Pressure; and (4) Princess Heart Watch. ¹ The general partner in each partnership was SSI, also wholly-owned by Mr. Ness.

In 1981, the Nesses claimed a deduction of $103,331 for their share of losses from RIG. After an audit, the Tax Commissioner determined that some of the losses were not allowable as deductions because they exceeded the amount of the Nesses' investment that was "at risk" as defined by 26 U.S.C. § 465. ²

The Nesses agreed with that finding and the parties here stipulate that $67,806 of the deduction did not constitute an amount "at risk" within the meaning of 26 U.S.C. § 465(b); thus only $35,525 was tax deductible. After recomputing their tax liability, the Nesses owed $24,497.37.

Mrs. Ness seeks to avoid liability for this tax deficiency under the innocent-spouse provision, 26 U.S.C. § 6013(e) (1988). To qualify for innocent-spouse relief, the amount of tax owing must be attributable to a "grossly erroneous item" within the meaning of section 6013(e)(2). Although section 6013(e) contains several criteria, the Tax Commissioner concedes that only the "grossly-erroneous-item" requirement of section 6013 was not satisfied.

Mrs. Ness' argument in tax court distinguished the permissible amount of the RIG partnership deduction--the cash investment--from the impermissible amount--the promissory notes. She claimed the latter amount was not deductible in 1981 because any such deduction lacked a basis in law in view of the section 465 "at risk" limitation. Thus, that portion of the deduction was "grossly erroneous."

The tax court rejected this distinction and found that because part of the RIG partnership deduction was allowable, the rest could not be considered a "grossly erroneous" item. Limiting the deduction, therefore, did not make it baseless in fact or law.

Mrs. Ness appeals the tax court's holding.

II

"We review decisions of the Tax Court on the same basis as decisions in civil bench trials in the district courts." Sliwa v. Comm'r, 839 F.2d 602, 605 (9th Cir.1988). The only issues before the court are questions of law that are to be reviewed de novo. See United States v. McConney, 728 F.2d 1195, 1201 (9th Cir.) (en banc), cert. denied, 469 U.S. 824, 105 S.Ct. 101, 83 L.Ed.2d 46 (1984); see also United States v. Silverman, 861 F.2d 571, 576 (9th Cir.1988) (the appeals court should consider the matter anew, the same as if it had not been heard before, and no decision was previously rendered).

III

The facts in this case are stipulated. The two legal issues are (a) whether a deduction can be bifurcated and one part of it be deemed "grossly erroneous" when another part of the deduction is allowable; and, if so, (b) whether in Mrs. Ness' case, the $67,806 not "at risk" had a basis in law, and was not "grossly erroneous."

A

Generally, "marital partners are jointly and severally liable for income tax owed when they sign a joint return." Guth v. Comm'r, 897 F.2d 441, 442 (9th Cir.1990); 26 U.S.C. § 6013(d)(3). However, to avoid inequity, Congress created an "innocent-spouse exception." See 26 U.S.C. § 6013(e). In 1984, Congress extended that protection to " 'substantial understatement[s] of tax ... attributable to grossly erroneous items ... including claims for deductions or credits, as well as omitted income.' " Id. at 443 (quoting H.R.Rep. No. 432, 98th Cong., 2d Sess., pt. 2, at 1502, reprinted in 1984 U.S.Code Cong. & Admin.News 697, 1143).

It is stipulated that Mrs. Ness meets all but one of the criteria for the innocent-spouse exception. The Commissioner contends that the deduction fails to satisfy the "grossly erroneous" section of the statute. Section 6013 reads in relevant part:

Sec. 6013. Joint returns of income tax by husband and wife

....

(e) Spouse relieved of liability in certain cases.

....

(2) Grossly erroneous items.--For purposes of this subsection, the term "grossly erroneous items" means, with respect to any spouse--

(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 no basis in fact or law.

26 U.S.C. § 6013(e).

Not all disallowances of deductions are "grossly erroneous." Douglas v. Comm'r, 86 T.C. 758, 762 (1986). The innocent spouse statute itself does not define what constitutes "no basis in fact or law," but a

clue to its meaning ... is found in the reference in the ... committee report to 'phony business deductions.' As we read the statute as a whole and its legislative history, 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.

Id. at 762-63. See also Ness, 94 T.C. at 786.

In the instant case, only $35,525 of the $103,331 could be claimed as a deduction. The Commissioner argues, and the tax court held, that any claimed deduction must be viewed as an indivisible whole for the purposes of determining whether it was "grossly erroneous." It then follows that any item which is partly allowed cannot be wholly without legal basis. Therefore, if part of the deduction is based in fact or law, the rest cannot be "grossly erroneous." ³

However, here the $67,806 portion of the deduction is "grossly erroneous." The basis for the disallowance was legal, not factual, because the plain language of section 465 prohibits the deduction. See Meade Emory, Is Tax Court Right in Narrow Reading of "Grossly Erroneous" for Innocent Spouse Relief?, 1990 Fed. Taxes (P-H) p 85,226 (PHINet citation: 94.47PHTC) [hereinafter Emory]. "In construing a statute, we look first to its plain meaning." Price v. Comm'r, 887 F.2d 959, 963 (9th Cir.1989) (citation omitted). The statute bars deductions "if such amounts are borrowed from any person who has an interest in such activity or from a related person to a person (other than the taxpayer) having such an interest." 26 U.S.C. § 465(b)(3). This clearly applies to Mr. Ness' $67,806 of promissory notes from interested parties. No deduction explicitly excluded by the plain words of the statute could qualify as a deductible expense under "well-settled legal principles."

The Commissioner's argument that the single deduction of $103,331 is indivisible in the instant case appears to be pure sophistry. The Commissioner may have been misled because on the Nesses' tax form, their wrongly claimed deductions for funds not "at risk" were combined with legitimate deductions (thus, there was only one deduction). However, under Code section 465, there are two kinds of losses. There are those for which the investor is "at risk" and those for which he is not "at risk." There is no basis in law to take a deduction on those funds not "at risk."

A rule such as the tax court's would give the Commissioner carte blanche to by-pass the innocent-spouse exception in virtually every case. Theoretically, even if only one dollar of a deduction were allowed and one million dollars were not allowed, the entire deduction would be disqualified under the innocent-spouse exception, because one could not fragment a deduction into two parts. Moreover, "[i]t is not rare ... for the IRS, during the examination process, to concede part of an item (for example, on a 'hazards of litigation' basis); but, this should not mean that it would be impossible to classify the disallowed part as 'grossly erroneous.' " Emory, supra, at p 85,226. Why should the allowance of part of a deduction mean that the rest of the deduction was not "grossly erroneous"? We find that a spouse should be able to claim that part of a lump sum deduction is "grossly erroneous." ⁴

B

The Commissioner's most persuasive argument is that the deduction had a basis in law because the entire $103,331 sum was a proper partnership deduction. ⁵ The "at risk" rules do...