Reser v. C.I.R., 96-60393

• Decision Date: 12 May 1997
• Docket Number: No. 96-60393,96-60393
• Parties: -2743, 65 USLW 2756, 97-1 USTC P 50,416 Rebecca Jo RESER, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Fifth Circuit

Page 1258

112 F.3d 1258

79 A.F.T.R.2d 97-2743, 65 USLW 2756,

97-1 USTC P 50,416

Rebecca Jo RESER, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 96-60393.

United States Court of Appeals, Fifth Circuit.

May 12, 1997.

O. Jan Tyler, William M. Boyd, Boyd & Veigel, McKinney, TX, for Petitioner-Appellant.

Teresa T. Milton, Richard Bradshaw Farber, Gary William Allen, Department of Justice, Tax Division, Appellate Section, Washington, DC, Stuart L. Brown, Chief Counsel, Internal Revenue Service, Washington, DC, for Respondent-Appellee.

Appeal from the United States Tax Court.

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 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 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.

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 $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.

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.

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 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 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 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 return ¹⁰ 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 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 joint return. ¹⁵

To assert the innocent spouse defense successfully, a spouse must establish that (1) 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 (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.

                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.
                

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...