Epstein v. Commissioner

T.C. Memo. 1996-239

UNITED STATES TAX COURT

HARVEY I. EPSTEIN AND ARLENE B. EPSTEIN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 3530-95. Filed May 23, 1996.

On the facts, Held: P wife is an innocent spouse
within the meaning of sec. 6013(e), I.R.C., as to that
part of the deficiencies in income tax determined by
the Commissioner for 1976, 1977, and 1978, attributable
to the grossly erroneous items of P husband in those
years.

Richard S. Kestenbaum and Bernard S. Mark, for petitioners.

William J. Gregg and Thomas J. Kerrigan, for respondent.
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MEMORANDUM FINDINGS OF FACT AND OPINION

NIMS, Judge: Respondent determined the following

deficiencies in petitioners' Federal income tax and additions to

tax:

Additions to Tax
Year Deficiency Sec. 6653(a)
1976 $49,828 $2,491
1977 21,612 1,091
1978 12,453 623

Respondent also determined additional interest under section

6621(c) for each year as a result of substantial underpayments of

income tax attributable to tax motivated transactions.

After concessions, the only remaining issue for decision is

whether petitioner Arlene B. Epstein (petitioner or Arlene) is

entitled to claim innocent spouse status under the provisions of

section 6013(e) for each of the 3 years in issue (the relevant

years).

All section references, unless otherwise specified, are to

sections of the Internal Revenue Code in effect for the relevant

years, and all Rule references are to the Tax Court Rules of

Practice and Procedure.

Some of the facts have been stipulated and are so found.

The stipulation of facts and attached exhibits are incorporated

herein by this reference. Petitioners resided in Atlantic Beach,

New York, when they filed their petition.
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FINDINGS OF FACT

Petitioners were married in 1959 and were still married at

the time of trial. Throughout the relevant years, they resided

in a house they bought in 1972 or 1973 for approximately $118,000

located at 109 Piermont Avenue, Hewlett Bay Park, New York.

Petitioner Harvey I. Epstein (Harvey) is a graduate of

Dartmouth College. After graduation, he held several jobs, and

was President of Dreyfus Sales Corporation for a period of time

until 1970 or 1971, when he left Dreyfus and became a consultant.

During the relevant years, Harvey was a general partner and

investor in certain limited partnerships which generated

substantial putative losses, which petitioners claimed as

deductions on their return for the relevant years.

Harvey earned a salary from Harvey I. Epstein, Ltd., which

was reflected on W-2 forms and reported on petitioners' tax

returns for the relevant years. In 1978 Harvey also received a

$21,867 salary from Pace Funding Corp., also reflected on a Form

W-2, and duly reported on petitioners' 1978 return.

Arlene is a graduate of Barnard College. She also received

a Master's degree in Education from Columbia, and a Master's

degree in Humanities from Hofstra University. Arlene was

employed as a teacher for 5 or 6 months shortly after her

marriage, but stopped teaching when she became pregnant, and

never returned to teaching. When her daughter attained age 10,
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Arlene reentered the work force on a part-time basis. Beginning

in 1974, and thereafter, she sold advertising space in the South

Shore Record, a local newspaper, for which she was paid

commissions. She also wrote a weekly drama review column for the

same paper, for which she was paid nominal amounts.

At the end of each year, petitioners' accountant, Paul

Kreindler (Kreindler), would ask Arlene to prepare and submit to

him handwritten statements reflecting her travel and other

business expenses, as well as Forms 1099 and/or Forms W-2 that

she received from her employers (including, in 1978, Atl. Beach

Tennis), for the purpose of preparing Schedule C to reflect

Arlene's commissions, fees from writing, and any other income-

earning activities.

Petitioners reported Schedule C income from Arlene's

activities as follows:

Year Gross Receipts Net Profit
1976 $5,715 $3,017
1977 7,663 4,880
1978 7,724 4,941

Petitioner used the money she earned to purchase art works--

mostly works on paper--and a fur jacket, because Harvey refused

to give her money for these purposes. Arlene also used money she

received from her father to buy one or two things. Arlene never

received any large, unusual, or lavish gifts from her husband.
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From the time Harvey was with Dreyfus, and throughout the

relevant years, petitioners took an annual vacation at Dorado

Beach in Puerto Rico. During the years Harvey was with Dreyfus

Sales he traveled all over the world and Arlene often went with

him, but they took only one vacation a year (the vacation at

Dorado Beach) after that.

Petitioners did not maintain a joint checking account, and

Harvey took most of the responsibility for paying bills, although

he was often delinquent in doing so and, as a result, Arlene had

to confront unpaid tradesmen from time to time. Arlene had one

or two savings accounts where she deposited her earnings, but at

no time had a checking account until 1978, when Harvey gave her

one from which she could pay household expenses. Other than

this, Arlene never maintained any of the family's banking or

business records. Any time Arlene asked Harvey a question about

their family's financial affairs, his stock reply was "not now".

Arlene knew that Harvey sold tax shelters but during the

relevant years she was not privy to Harvey's business, which

Harvey refused to discuss with her, and she never went to his

office, where she was not welcome. In general, she thought a tax

shelter was something like an IRA, and therefore legitimate.

Petitioner's tax returns for many years, including the

relevant years, have been prepared by Kreindler, a C.P.A., who

was at Dartmouth College with Harvey. Kreindler is also a social
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friend of Harvey and Arlene. Arlene liked Kreindler and trusted

him.

Harvey did not explain petitioners' tax returns to Arlene

when he brought the returns for her to sign, which occurred

sometimes early in the morning, when Arlene was not at her best

due to a chronic illness, and sometimes late at night when she

came in after reviewing a theater performance. Arlene would

therefore call Kreindler when she had questions. Kreindler would

assure Arlene that since he himself had signed the returns,

Arlene could be assured that they were all right.

In 1986, petitioners sold their Hewlett Bay Park house for

$725,000. It was Arlene's understanding that petitioners had to

sell the house to "pay off taxes to the IRS". Of the proceeds,

$305,000 were used to buy a house in Atlantic Beach, title to

which Arlene insisted be placed in her name alone because she

didn't know what Harvey's obligations were and she wanted to be

protected against claims of his creditors. The increase in the

value of the Hewlett Bay Park house from approximately $118,000,

when purchased in 1973, to approximately $725,000, when sold in

1986, was unrelated to petitioners' putative tax savings from tax

shelter deductions in the relevant years.

Arlene received the proceeds from the sale of certain

property which her father had owned, and on which she had paid

approximately $800 per year nominal real estate taxes for a
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number of years, but of the amount she received she gave Harvey

$34,000 "to pay IRS taxes". She also used most of the money to

pay her father's nursing home expenses, and kept $30,000 which

she used to rehab the Atlantic Beach house.

The art work which Arlene bought with her own earnings had a

total cost over the years of less than $10,000. When Arlene

applied for a home improvement loan on the Atlantic Beach house

on August 5, 1987, the balance sheet supporting her application

for a variable rate $70,000 loan reflected a $100,000 value for

her art collection. The balance sheet also reflected a $150,000

value for personal property. Petitioners' household furnishings,

including furniture, silverware, and china, were all items which

Arlene received from her parents and grandparents (who were

antique dealers), or which petitioners received as wedding

presents.

OPINION

Section 6013(e)(1) provides:

(e) Spouse Relieved of Liability in Certain Cases.--

(1) In general. Under regulations prescribed by
the Secretary, if--

(A) a joint return has been made under
this section for a taxable year,

(B) on such return there is a
substantial understatement of tax
attributable to grossly erroneous items of
one spouse,
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(C) the other spouse establishes that
in signing the return he or she did not know,
and had no reason to know, that there was
such substantial understatement, and

(D) taking into account all the facts
and circumstances, it is inequitable to hold
the other spouse liable for the deficiency in
tax for such taxable year attributable to
such substantial understatement,

then the other spouse shall be relieved of liability
for tax (including interest, penalties, and other
amounts) for such taxable year to the extent such
liability is attributable to such substantial
understatement.

(In 1984, section 424(a) of Pub. L. 98-369, 98 Stat. 801,

803, amended the Code to provide that current section 6013(e) is

applicable to all taxable years to which the Internal Revenue

Code of 1954 applies, which includes 1976, 1977, and 1978.)

Respondent concedes that petitioner satisfies the section

6013(e)(1)(A) and (B) and 6013(e)(4) elements of the innocent

spouse requirements for the relevant years. (Section 6013(e)(4)

relates to understatements exceeding a specified percentage of

the putative innocent spouse's income.) Therefore, the two

elements of the innocent spouse requirements remaining in dispute

are whether petitioner had the kind of knowledge referred to in

subparagraph (C), and whether under the facts of this case there

would be the type of inequity referred to in subparagraph (D).

In reaching our conclusions as to Arlene's liability we are

substantially aided by guidelines provided by the recent

decisions of the U.S. Court of Appeals for the Second Circuit
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(the court to which this case would ordinarily be appealed) in

Friedman v. Commissioner, 53 F.3d 523 (2d Cir. 1995), affg. in

part, revg. in part and remanding in part T.C. Memo. 1993-549;

and Hayman v. Commissioner, 992 F.2d 1256 (2d Cir. 1993), affg.

T.C. Memo. 1992-228.

In Friedman v. Commissioner, 53 F.3d at 525, the Court of

Appeals stated the issue in that case in a way that also

succinctly states the issue in this case, to wit: whether an

individual is entitled to assert the innocent spouse defense to

avoid joint tax liability for tax transactions of which he or she

was aware but did not thoroughly understand. We take the liberty

of quoting at some length from the Friedman case because we

believe it appropriately points the way to a resolution of our

case:

The "innocent spouse" exemption was not designed to
protect willful blindness or to encourage the
deliberate cultivation of ignorance. Extravagant tax
savings may alert even a financially unsophisticated
spouse to the possible improprieties of a tax scheme.

Nevertheless, we recognize that in the bewildering
world of tax shelter deductions, few experts, let alone
laypersons, easily discern the difference between a
fraudulent scheme and an exceptionally advantageous
legal loophole in the tax code. There is a common
sense limit we think to a spouse's duty of
investigation in those circumstances where the more
financially sophisticated spouse invokes the support of
tax experts and accountants in asserting an improper
deduction. The wife claiming status as an innocent
spouse under such circumstances must persuade the fact-
finder that she had no reason to suspect that what her
more financially sophisticated husband did was wrong.
In short, an innocent spouse is one who despite having
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made reasonable efforts to investigate the accuracy of
the joint return remains ignorant of its illegitimacy.
[Id.]

In Friedman v. Commissioner, supra, the husband was a

financially successful mortgage broker, and the wife was a

widowed mother of two who, prior to the couple's marriage, had

been the future husband's secretary. The Court of Appeals

considered the couple's lifestyle as one which could be

characterized as "lavish", made possible by the husband's

business success. The substantial understatements of tax on the

returns in question resulted from the husband's participation in

a computer-leasing transaction that the Court described as a

"complex international tax shelter". Friedman v. Commissioner,

supra at 530. The wife was aware of the transaction, but did not

understand it and because of her husband's business acumen

assumed it to be legitimate.

The Court of Appeals in the Friedman case applied the test

enunciated in Hayman v. Commissioner, supra, that required a

taxpayer to establish that she or he did not know and did not

have reason to know that the deduction would give rise to a

substantial understatement. Friedman v. Commissioner, supra at

530.

The Court of Appeals in Hayman listed four factors to

consider in deciding whether a reasonably prudent person in the

"innocent" spouse's position at the time she signed a return
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should have known that the return contained a substantial

understatement. Hayman v. Commissioner, 992 F.2d at 1261.

According to Hayman, a court should look at (1) The level of

education and (2) the knowledge and experience in the family's

business and financial affairs attained by the spouse claiming to

be innocent; (3) whether the family's current standard of living

was lavish compared to past levels of income and expenditures;

and (4) the conduct of the culpable spouse in concealing the true

state of the family's finances from the "innocent" spouse.

Friedman v. Commissioner, supra at 531-532.

We have made detailed findings of fact, many of which

encompass the Hayman case factors, and no useful purpose is

served by rehashing these facts in detail. But in our view, when

the Hayman four factors are applied in our case, petitioner

satisfies the requirement of subparagraph (C) that in signing the

return she did not know, and had no reason to know, that there

were substantial understatements.

(1) Petitioner, while well educated, devoted most of her

time to her interest in the arts--graphic arts and the theater--

and her work experience as a space salesman for a small, local

newspaper did nothing to fit her for an understanding of business

matters on anything like a sophisticated level.

(2) Petitioner had no role whatever in the family's

financial affairs beyond, at most, making cash payments for
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household expenses. Harvey simply refused to discuss finances

with petitioner, and systematically excluded her from his

business affairs, at least the business affairs which he

conducted after he left Dreyfus in 1971, well before the relevant

years. Whatever petitioner spent to indulge her own taste for

art and afford herself a few small luxuries, she paid for out of

her own meager earnings. She in fact gave Harvey money to pay

"IRS taxes" out of money she received from her father, and used

additional funds from that source to rehab the smaller house into

which petitioners were forced to move after tax deficiencies

required them to sell their larger, more comfortable house in

Hewlett Park.

(3) Nothing in the record would lead one to believe that

petitioners' lifestyle was lavish either before, during, or after

the relevant years. While petitioner conceded that Hewlett Bay

Park is considered to be a wealthy area, she also testified that

the couples' house on Piermont Avenue was at the "low end". We

perceive no reason to question the truthfulness of her testimony

on this point, and respondent's counsel did not challenge it.

(4) Harvey and his friend, Kreindler, repeatedly kept from

Arlene the truth about the tax shelter deductions that were being

claimed on the couple's returns for the relevant years, and

systematically refused to explain the returns to Arlene or give
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any meaningful answers to any questions she from time to time

asked.

As stated in Friedman, the fact that the innocent spouse-

taxpayer knows of the existence of a tax shelter, and the

deductions it hopefully gives rise to, does not itself establish

that she cannot meet the lack of knowledge requirement of section

6013(e)(1)(C). Friedman v. Commissioner, supra at 530. In the

case before us, petitioner testified that she knew that Harvey

was in the business of selling tax shelters, but was unaware that

he was investing in them himself. While this profession of lack

of knowledge is of course self-serving, petitioner's additional

testimony rings true, namely, that she was led to believe, at

least during the relevant years, that tax shelters were on the up

and up and were, like IRAs, a legitimate way to save taxes. In

the era that encompassed the years 1976-1978, individuals far

more financially sophisticated than petitioner let themselves

believe that the tooth fairy in the guise of a tax shelter would

bring them substantial wealth, at little or no cost to

themselves, which would be entirely paid for out of the National

fisc as tax savings. We, therefore, hold that petitioner had no

reason to know that the returns for the relevant years contained

substantial understatements of tax.

To meet the fourth requirement imposed by section 6013(e) to

validate an innocent spouse claim, the taxpayer must establish
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that it would be inequitable to hold her liable for the

substantial understatement-related deficiency. Sec.

6013(e)(1)(D). One of the factors to be considered is whether

the "innocent" spouse received significant benefits as a result

of the understatements. Friedman v. Commissioner, 53 F.3d at

532; sec. 1.6013-5(b), Income Tax Regs. Normal support, measured

by the circumstances of the parties, is not considered a

significant benefit for purposes of this determination. Id.,

Flynn v. Commissioner, 93 T.C. 355, 367 (1989). There is no

evidence that petitioner received any unusual benefit from the

tax shelter deduction. Harvey controlled the family finances,

and did not allow petitioner to have access to the couple's money

beyond that which he, Harvey, chose to give her. Even if part of

the understatements did inure to petitioner's benefit, such

benefit did not exceed normal support.

At the trial respondent attempted to attach significance to

the fact that in 1986 petitioners sold their Hewlett Bay Park

house for $725,000, which they had purchased in 1973 for

approximately $118,000. Since the record contains no indication

that the house was in any way enhanced by the money generated by

tax savings in the relevant years, we cannot attribute a tax

generated benefit to Arlene in connection with the increased

value of the house. Increases in values merely through

inflation, which in this case would also include not only the
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house but also the house furnishings and the art collection, have

no apparent significance in the determination of whether

petitioner received any benefit from the understatement.

Another factor to be considered is whether the spouses have

been divorced. Flynn v. Commissioner, supra at 367; sec. 1.6013-

5(b), Income Tax Regs. Given the couple's uneasy relationship

throughout their marriage, we do not attach particular

significance to the fact that they have remained together.

Petitioner characterized her marriage as not one "made in

heaven", and testified that because of her chronic health

problem, which appears to have persisted throughout most of her

adult life, she "couldn't think of leaving, because how was I

going to take care of myself?" Petitioner first discovered in

1984 that Harvey had been "sheltering" his income in the relevant

years. Other recent cases have considered the impact and

reliability of a spouse's promise to pay any tax deficiencies

resulting from grossly erroneous items. See, e.g., Friedman v.

Commissioner, T.C. Memo. 1995-576 (on remand from 53 F.3d 523);

Stiteler v. Commissioner, T.C. Memo. 1995-279; Foley v.

Commissioner, T.C. Memo. 1995-16. But in the instant case the

record only reveals a struggle by both spouses to pay

unidentified Federal tax bills, with Arlene contributing $34,000

at one point from money received from her father, and the couple

selling their comfortable home to raise cash with which to pay
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other income tax bills. Thus, the fact that the couple was not

divorced or separated appears at best to be a neutral factor in

determining the inequity question, and we afford it no negative

significance.

Taking into account all the facts and circumstances, we

conclude and hold that it would be inequitable to hold petitioner

liable for the substantial understatements in the relevant years.

For the foregoing reasons, we hold that petitioner Arlene

Epstein is an innocent spouse within the meaning of section

6013(e) as to that part of the deficiencies in income tax for the

relevant years attributable to the grossly erroneous items of her

spouse, petitioner Harvey Epstein.

Decision will be entered

under Rule 155.