T.C. Memo. 1996-393
UNITED STATES TAX COURT
SHERBURNE M. EDMONDSON, JR. AND DIANE L. EDMONDSON, Petitioners
v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 22405-93. Filed August 22, 1996.
Sherburne M. Edmondson, Jr., and Diane L. Edmondson, pro
sese.
Matthew R. Kretzer, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
JACOBS, Judge: Respondent determined a $9,629 deficiency in
petitioners' 1988 Federal income tax, and additions to tax pursuant
to sections 6651(a)(1), 6653(a), and 6661 in the respective amounts
of $1,802, $653, and $2,407. Pursuant to an amended answer,
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respondent increased the deficiency to $19,269, and the additions
to tax pursuant to sections 6651(a)(1), 6653(a), and 6661 to
$4,212, $1,135, and $4,817, respectively.
Respondent and Sherburne M. Edmondson, Jr. (Mr. Edmondson),
entered into a Stipulation of Settled Issues (the settlement
stipulation) resolving all items in dispute except whether Diane L.
Edmondson (Ms. Edmondson), Mr. Edmondson's ex-wife, qualifies for
tax relief as an innocent spouse pursuant to section 6013(e). Ms.
Edmondson did not contest any of the compromised items, which would
have resulted in a deficiency in tax, including additions to tax,
being assessed jointly against her and Mr. Edmondson (but for
innocent spouse relief), but she refused to sign the settlement
stipulation because she felt "uncomfortable" doing so. In response
to the Court's inquiry, respondent's counsel agreed that should the
Court deny innocent spouse relief to Ms. Edmondson, respondent
would seek against her only the amount of taxes and additions to
tax computed under the settlement stipulation signed by Mr.
Edmondson and respondent.
In general, respondent's determinations are presumed correct.
Thus, except for a matter pleaded in respondent's amended answer
(discussed below), Ms. Edmondson bears the burden of proving
respondent's determinations erroneous. Rule 142(a); Welch v.
Helvering, 290 U.S. 111, 115 (1933). Since Ms. Edmondson failed to
introduce any evidence with regard to any item in dispute,
respondent's determinations with respect to those items where Ms.
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Edmondson bears the burden of proof are sustained. Thus, the
principal issue to be resolved is whether Diane L. Edmondson
qualifies for tax relief as an innocent spouse.
We also must consider an issue raised by respondent's amended
answer, even though the matter was covered by the settlement
stipulation. The issue so presented is whether gain from the sale
of a house in Seattle, Washington, which was owned by Mr. Edmondson
and his first wife, qualifies for deferred recognition pursuant to
section 1034.
All section references are to the Internal Revenue Code for
the year in issue; all Rule references are to the Tax Court Rules
of Practice and Procedure.
FINDINGS OF FACT
Background
At the time they filed their petition, Sherburne M. Edmondson,
Jr., and Diane L. Edmondson (hereinafter sometimes referred to as
the Edmondsons) resided in Sunnyvale, California. Ms. Edmondson
(hereinafter referred to as petitioner) filed an amendment to
petition on April 12, 1995, asserting that she is an innocent
spouse. Petitioner and Mr. Edmondson untimely filed their 1988
joint Federal income tax return on February 11, 1991.
The Edmondsons' Marriage
Petitioner and Mr. Edmondson met in Seattle in 1981. The
next year they married. At that time, petitioner was 21 years old,
and Mr. Edmondson was approximately 10 years older. Mr. Edmondson
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has a medical technology degree and worked in the research
department of the University of Washington, performing medical
research on cardiovascular disease. Petitioner failed to complete
high school and was not employed at that time. Both petitioner and
Mr. Edmondson had children from previous marriages.
Shortly after they married, the Edmondsons moved to San Diego.
Mr. Edmondson began working at Scripps Clinic and Research
Foundation. In 1983, he acquired Glass Onion Records, a San Diego
record store.1 Petitioner worked in the store but was not paid.
The business failed sometime before 1988.
During the year in issue, petitioner attended the Fashion
Institute of Design and Merchandising, where she took an accounting
course.
Mr. Edmondson provided all monetary support for the family,
and was responsible for the household finances and payment of all
expenses. Although Mr. Edmondson did not hide any assets or income
from petitioner, petitioner did not attempt to ascertain the
details of their finances. The Edmondsons maintained joint bank
accounts. Toward the end of their marriage, petitioner maintained
a separate bank account.
Throughout their marriage, the Edmondsons' lifestyle was
modest. They did, however, fly to Mexico during the year in issue
1
Petitioner believes that she owned Glass Onion Records
jointly with Mr. Edmondson.
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to explore the possibility of investing in an import/export
business.
On February 11, 1991, Mr. Edmondson asked petitioner to sign
a joint 1988 tax return. She signed the return voluntarily,
without any force or threat from Mr. Edmondson. Because she
trusted Mr. Edmondson to prepare the return correctly, she signed
the return without reviewing it. Indeed, throughout petitioner's
marriage to Mr. Edmondson, she consistently signed joint tax
returns without reviewing them.
In April 1992, petitioner and Mr. Edmondson separated. Mr.
Edmondson agreed to give petitioner $500 a month for 36 months and
took responsibility to repay one of her two student loans. The
Edmondsons divorced in November 1993.
On October 25, 1994, Mr. Edmondson signed a notarized document
(an indemnity), whereby he agreed to be solely responsible for the
payment of all taxes incurred during his marriage with petitioner.
Seattle House
Prior to marrying petitioner, Mr. Edmondson owned a house in
Seattle with his first wife.2 Mr. Edmondson lived in the house
through 1981. Thereafter, the house was rented until its sale on
July 29, 1988. The sale resulted in a $30,948.64 gain to Mr.
Edmondson. The proceeds from the sale were used to pay the
Edmondsons' living expenses as well as debts of their failed record
2
Petitioner was aware that Mr. Edmondson had owned the
Seattle house.
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business. Neither petitioner nor Mr. Edmondson purchased a house
within 2 years after the date of sale.
Floyd Avenue House
Sometime in 1988, Mr. Edmondson entered into an oral "equity
share" agreement with Wieland and Helen Emery von Behrens (friends
of the Edmondsons). Pursuant to that agreement, the von Behrenses
purchased a house at 1393 Floyd Avenue, in Sunnyvale, California
(the Floyd Avenue house). The von Behrenses held title to the
house, and were the only borrowers on a deed of trust. Mr.
Edmondson agreed to renovate the house in exchange for an eventual
equity interest in the property.3 This arrangement was made
because Mr. Edmondson could not qualify for a mortgage. Petitioner,
Mr. Edmondson, and their respective children lived in the house
during the year in issue.
Petitioner's Present Circumstances
At the time of trial, petitioner supported herself and her
daughter, working as an administrative assistant for a
semiconductor firm. She earned approximately $35,000 a year, and
paid yearly tuition of $5,000 for her daughter to attend private
school. Petitioner also attended night school.
The Edmondsons' 1988 Federal Income Tax Return
The Edmondsons reported an adjusted gross income of $37,611.70
on their 1988 Federal income tax return. Two Schedules C were
3
There is no additional evidence in the record regarding
this arrangement.
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attached to the return, one listing petitioner as the proprietor of
Glass Onion Records ("Businesswoman, Retail Sales, Marketing"), and
the other listing Mr. Edmondson as proprietor of S.M.E. Contracting
Co.4 ("General Contractor"). On the Schedule C relating to Glass
Onion Records, $18,188.01 of expenses was claimed; among other
things, the expenses were with respect to: Debts of Glass Onion
Records prior to its failure; a 1988 trip to Mexico; and
petitioner's education. On the Schedule C relating to S.M.E.
Contracting Co., $19,406.13 of expenses was claimed; among other
things, the expenses were with respect to renovations to the Floyd
Avenue house.
Attached to the Edmondsons' 1988 return was a Form 2119 (Sale
of Principal Residence), wherein $30,948.64 of gain from the sale
of Mr. Edmondson's Seattle house was deferred.
Notice of Deficiency and Amended Answer
Respondent disallowed all deductions claimed on the two
Schedules C on the basis that the Edmondsons failed to establish
that the expenses were deductible under section 162(a). In the
amended answer, respondent asserted that the deferral of the
$30,948.64 gain from the sale of Mr. Edmondson's Seattle house was
erroneous.
4
Except for the 1988 tax return, there is no evidence in
the record with regard to S.M.E. Contracting Co.
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OPINION
Issue 1. Innocent Spouse
Spouses who file a joint income tax return generally are
jointly and severally liable for its accuracy and the tax due,
including any additional taxes, interest, or penalties determined
on audit of the return. Sec. 6013(d)(3); Ness v. Commissioner, 954
F.2d 1495, 1497 (9th Cir. 1992), revg. 94 T.C. 784 (1990); Guth v.
Commissioner, 897 F.2d 441, 442 (9th Cir. 1990), affg. T.C. Memo.
1987-522; Price v. Commissioner, 887 F.2d 959, 961 n.3 (9th Cir.
1989), revg. an Oral Opinion of this Court. However, pursuant to
section 6013(e), a spouse (commonly referred to as an innocent
spouse) can be relieved of tax liability if that spouse proves: (1)
A joint return was filed; (2) the return contained a substantial
understatement of tax attributable to grossly erroneous items of
the other spouse; (3) in signing the return, the spouse seeking
relief did not know, and had no reason to know, of the substantial
understatement; and (4) it would be inequitable to hold the spouse
seeking relief liable for the understatement. Sec. 6013(e)(1);
Guth v. Commissioner, supra at 443; Price v. Commissioner, supra at
961-962. The spouse seeking relief bears the burden of proving
that each of the four section 6013(e) requirements has been
satisfied. Purcell v. Commissioner, 826 F.2d 470, 473 (6th Cir.
1987), affg. 86 T.C. 228 (1986). Failure to meet any one of the
statutory requirements will disqualify an individual from innocent
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spouse relief. Bokum v. Commissioner, 94 T.C. 126, 138-139 (1990),
affd. 992 F.2d 1132 (11th Cir. 1993).
In the case before us, respondent concedes that the Edmondsons
filed a 1988 joint income tax return and that a substantial
understatement of tax exists. As a result, the controversy herein
focuses on the aforementioned second, third, and fourth
requirements, namely: Whether the substantial understatement was
attributable to Mr. Edmondson's grossly erroneous items; whether
petitioner did not know, and had no reason to know, of the
substantial understatement; and whether it would be inequitable to
hold petitioner liable for the income tax deficiency attributable
to such substantial understatement.
A. Grossly Erroneous Items of the Other Spouse
The phrase "grossly erroneous items" statutorily is defined to
mean with respect to any spouse (a) any item of gross income
attributable to that spouse which is omitted from gross income, and
(b) any claim of a deduction, credit, or basis by that spouse in an
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amount for which there is no basis in fact or law.5 Sec.
6013(e)(2).
To prove that the disallowed deductions have no basis in fact
or law, an individual seeking innocent spouse status is not entitled
to rely on the Commissioner's disallowance of deductions contained
in the notice of deficiency, without introducing further evidence
to establish that a deduction has no basis in fact or law. Douglas
v. Commissioner, 86 T.C. 758, 762-763 (1986).
Petitioner presented no evidence to show that the items
disallowed by respondent were grossly erroneous or that the
deduction claimed for those items had no basis in fact or law. See,
e.g., Douglas v. Commissioner, supra; Neary v. Commissioner, T.C.
Memo. 1985-261.
Further, the items disallowed were not solely attributable to
Mr. Edmondson. Some relate primarily to Glass Onion Records, a
business in which petitioner participated with Mr. Edmondson.
5
The phrase "no basis in fact or law," is not defined in
sec. 6013. The courts, however, have held that a deduction has
no basis in fact when the expense for which the deduction is
claimed was never made, and 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. Ness v. Commissioner, 954 F.2d 1495, 1498 (9th
Cir. 1992), revg. 94 T.C. 784 (1990); Douglas v. Commissioner, 86
T.C. 758, 762 (1986). "Ordinarily, a deduction having no basis
in fact or in law can be described as frivolous, fraudulent, or,
* * * phony." Douglas v. Commissioner, supra at 763. A portion
of a deduction may be "grossly erroneous" even if another portion
of the same deduction is allowed. Ness v. Commissioner, supra at
1498-1499.
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Moreover, some of the disallowed items are attributable to
petitioner.
We have observed that respondent's agreement to a compromise
settlement may suggest that the deductions claimed on a return were
less than grossly erroneous. See, e.g., Crowley v. Commissioner,
T.C. Memo. 1993-503; Anthony v. Commissioner, T.C. Memo. 1992-133;
Neary v. Commissioner, supra. Here, respondent agreed in the
settlement stipulation to allow a portion of the Edmondsons' 1988
Schedule C deductions. Further, respondent conceded the
inapplicability of the section 6653(a)(1) addition to tax, and
although the settlement stipulation denies the deferral of gain on
the sale of the Seattle house in its entirety, we do not believe the
mischaracterization of this item constitutes a grossly erroneous
item within the purview of section 6013(e)(2). See Winnett v.
Commissioner, 96 T.C. 802, 810-811 (1991). Thus, we reject
petitioner's argument that the substantial understatement of tax was
attributable solely to Mr. Edmondson's grossly erroneous items.
Petitioner did not satisfy this second requirement.
B. Knowledge of the Substantial Understatement
Assuming however, arguendo, that petitioner satisfied the
second requirement, she still is not entitled to innocent spouse
status because she failed to prove that she did not know, and had
no reason to know, of the substantial understatement of tax.
Whether a spouse knew or had reason to know of a substantial
understatement depends on whether "a reasonably prudent taxpayer
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under the circumstances of the spouse [here, petitioner] at the time
of signing the return could be expected to know that the tax
liability stated was erroneous or that further investigation was
warranted." Stevens v. Commissioner, 872 F.2d 1499, 1505 (11th Cir.
1989), affg. T.C. Memo. 1988-63; see Bokum v. Commissioner, 94 T.C.
at 148; Griner v. Commissioner, T.C. Memo. 1990-301, affd. without
published opinion 951 F.2d 360 (9th Cir. 1991).
The test for constructive knowledge of an understatement is a
subjective one, focusing on the following factors: (1) The spouse's
level of education; (2) the spouse's involvement in the business and
financial affairs of the marriage and in the transactions that gave
rise to the understatement; (3) the presence of expenditures that
appear lavish or unusual when compared to the taxpayers' accustomed
standard of living and spending patterns; and (4) the culpable
spouse's evasiveness and deceit concerning family finances. Price
v. Commissioner, 887 F.2d at 965.
Petitioner had little knowledge of financial matters and was
only tangentially involved in family finances. However, Mr.
Edmondson did not hide any assets or transactions from her;
petitioner refused to inquire into the details of the family's
finances and income taxes. She neither reviewed the 1988 return,
took any steps to verify the accuracy of its contents, nor made any
inquiries about it. A taxpayer cannot simply turn a blind eye to
what is disclosed on the tax return. The innocent spouse provision
is "designed to protect the innocent, not the intentionally
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ignorant." Cohen v. Commissioner, T.C. Memo. 1987-537. Had
petitioner reviewed the return, she would have seen that it clearly
disclosed the deductions on the Schedules C and the deferment of
gain on Form 2119.6 Nearly half the deductions related to Glass
Onion Records, a business in which she participated. These items
were of such magnitude compared to the Edmondsons' income that a
reasonable person of petitioner's educational level and background
would have been put on notice that further inquiry should have been
made. See Stevens v. Commissioner, supra at 1507; Bokum v.
Commissioner, 94 T.C. at 148. Moreover, petitioner went on the
Mexican trip for which a deduction was taken. Thus, petitioner knew
or had reason to know of the substantial understatement on the
return. She therefore has not satisfied the third requirement (lack
of knowledge).
C. Inequity of Holding Petitioner Liable
Again assuming, arguendo, that petitioner had satisfied the
knowledge requirement, she still is not entitled to innocent spouse
status because she failed to prove that it would be inequitable to
hold her liable (the fourth requirement). This factor focuses on
whether petitioner benefited from the understatement of tax. Purcell
v. Commissioner, 86 T.C. at 242. "Normal support" is not considered
a significant benefit. Terzian v. Commissioner, 72 T.C. 1164, 1170-
6
The Form 2119 lists the $30,948.64 of deferred gain.
Petitioner was aware that Mr. Edmondson had sold the Seattle
house, and indeed she signed the Form 2119 on which the sale was
reported.
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1171 (1979). Petitioner bears the burden of proving that she
received no significant benefit from the understatement other than
normal support, and this burden must be satisfied with specific
facts regarding lifestyle, expenditures, asset acquisitions, and the
disposition of the benefits of the understatement. See Estate of
Krock v. Commissioner, 93 T.C. 672 (1989).
It is also relevant to consider whether the spouse claiming
relief has been deserted, divorced, or separated. Kistner v.
Commissioner, T.C. Memo. 1995-66; sec. 1.6013-5(b), Income Tax Regs.
We also examine the probable future hardships that would be imposed
on the spouse seeking relief, if such relief were denied. Sanders
v. United States, 509 F.2d 162, 171 (5th Cir. 1975).
While petitioner's standard of living did not increase in 1988
in comparison to prior years, the Edmondsons continued living
together from 1988 until 1992. Thus, they shared equally in the tax
savings generated by the understatement. In this regard, part of
the disallowed deductions (from which tax savings were derived)
related to: A failed business that both Mr. Edmondson and
petitioner operated; the Floyd Avenue house in which they both
lived; and a Mexican trip that benefited petitioner as well as Mr.
Edmondson.
The proceeds from the gain on the sale of the Seattle house
went to pay living expenses for the entire Edmondson household, as
well as the debts of the failed business. Moreover, Mr. Edmondson
gave petitioner $500 a month for 36 months following the end of
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their marriage. In addition, Mr. Edmondson signed an indemnity
promising to pay all tax liabilities resulting from the filing of
their joint tax returns. The effect of such a promise has been
considered by this Court on several occasions with regard to
granting innocent spouse relief. See, e.g., Foley v. Commissioner,
T.C. Memo. 1995-16; Buchine v. Commissioner, T.C. Memo. 1992-36,
affd. 20 F.3d 173 (5th Cir. 1994); Henninger v. Commissioner, T.C.
Memo. 1991-574.
Considering all the facts and circumstance involved herein,
we conclude that it would not be inequitable to hold petitioner
liable for the determined understatement.
In sum, we hold that petitioner is not entitled to innocent
spouse relief. She has failed to prove: That the substantial
understatement was attributable to Mr. Edmondson's grossly erroneous
items; that she did not know or have reason to know of the
substantial understatement; or that it would be inequitable to hold
her liable for the deficiency as determined in the settlement
stipulation.
Issue 2. Section 1034 Deferral
A taxpayer must include in gross income gains derived from
dealings in property. Sec. 61(a)(3). A taxpayer is generally
required to recognize the entire amount of gain or loss realized on
the sale or exchange of property. With respect to gain realized on
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the sale of a principal residence,7 section 1034(a) provides the
following exception to that general rule:
If property (in this section called "old
residence") used by the taxpayer as his
principal residence is sold by him, and, within
a period beginning 2 years before the date of
such sale and ending 2 years after such date,
property (in this section called "new
residence") is purchased and used by the
taxpayer as his principal residence, gain (if
any) from such sale shall be recognized only to
the extent that the taxpayer's adjusted sales
price (as defined in subsection (b)) of the old
residence exceeds the taxpayer's cost of
purchasing the new residence.[8]
Mr. Edmondson converted the Seattle house (old residence) to
a rental property in 1982 and never lived in it again.9 Although
7
The Internal Revenue Code does not define the phrase
"principal residence". Nevertheless, sec. 1.1034-1(c)(3), Income
Tax Regs., provides that the determination of whether or not
property is used by the taxpayer as his principal residence
"depends upon all the facts and circumstances in each case,
including the good faith of the taxpayer." For property to be
"used by the taxpayer as his principal residence" within the
meaning of sec. 1034(a), the taxpayer ordinarily must physically
occupy and live in the dwelling. Perry v. Commissioner, F.3d
(9th Cir., July 31, 1996), affg. T.C. Memo. 1994-247;
Houlette v. Commissioner, 48 T.C. 350 (1967); Stolk v.
Commissioner, 40 T.C. 345 (1963), affd. 326 F.2d 760 (2d Cir.
1964). Certain property has been considered as the principal
residence of taxpayers despite the fact that the taxpayers were
not living there at the time of its sale, e.g., where adverse
economic conditions required the taxpayers to lease the old
residence while trying to sell it. Bolaris v. Commissioner, 776
F.2d 1428, 1431 (9th Cir. 1985), affg. in part and revg. in part
81 T.C. 840 (1983); Clapham v. Commissioner, 63 T.C. 505, 509-512
(1975).
8
Any gain that is not recognized under sec. 1034 reduces
the taxpayer's basis in the "new residence". Sec. 1034(e).
9
We note that petitioner never lived in the Seattle
(continued...)
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the "temporary" rental of an old residence prior to its sale does
not preclude the nonrecognition of gain realized on the sale of the
old home, here the old residence ceased to be Mr. Edmondson's
principal residence well before it was sold in 1988. See Perry v.
Commissioner, F.3d (9th Cir., July 31, 1996), affg. T.C.
Memo. 1994-247; Clapham v. Commissioner, 63 T.C. 505, 511-512 (1975)
(the definition of "temporary" depends on the facts and
circumstances of each case).
Moreover, the Edmondsons never purchased a new principal
residence. Mr. Edmondson entered into an oral agreement intended
to give him some type of an interest in the Floyd Avenue house. The
exact details of such arrangement are not clear from the record.
What is clear, however, is that the Edmondsons never purchased the
Floyd Avenue house; the von Behrenses did. See Marcello v.
Commissioner, 380 F.2d 499, 502 (5th Cir. 1967) ("If a third party
owns the residence, the purchase requirements are not met"), affg.
on this issue and remanding T.C. Memo. 1968-268.
Based on the record before us, we conclude that Mr. Edmondson
did not purchase a new principal residence within the period
beginning 2 years before and ending 2 years after the sale of the
Seattle house. Thus, we sustain respondent's position that the gain
on the Seattle house does not qualify for deferred recognition
pursuant to section 1034.
9
(...continued)
house.
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To reflect concessions made by respondent in the settlement
stipulation,
Decision will be entered
under Rule 155.