Monthly Archives: August 2013

IRS Concedes: Innocent Spouse denial subject to full judicial review

In a major victory for those whose claims for innocent spouse relief are denied by the IRS, it has conceded that the denial is subject to judicial review by the Tax Court, and that the review is not limited to the record that had been developed at the administrative level.

Under the Internal Revenue Code, each person who joins in signing a joint federal income tax return is jointly and severally liable for any income tax liabilities related to the year for which the return is filed. Spouses who become subject to claims for tax related to income earned by a spouse (or ex-spouse) may qualify for relief under certain circumstances under the “innocent spouse” rules.

Because the requirements needed to qualify for innocent spouse relief are rigid, in many cases the IRS will deny relief, forcing the party who is facing tax liability for income earned by the other party to turn to the Tax Court for judicial review. The nature of this review was the subject of litigation in Wilson v. Commissioner, in which the Ninth Circuit affirmed the Tax Court’s holding that its review was de novo, enabling the Court to consider evidence outside the administrative record that had been developed in the case.

In AOD 2012-007, the IRS acquiesced in the Ninth Circuit decision, conceding the greater role of the court in reviewing the determinations of the IRS. This acquiescence gives those claiming innocent spouse relief greater assurance that their specific circumstances can be reviewed by the judicial system, and will not be limited to a cursory review of the IRS’ decision.

Tax planning opportunities for LLCs and S Corps that restructure their debt?

Two recent developments impact the tax consequences of debt restructuring for insolvent entities that are pass-through entities for tax purposes, such as LLCs or S Corps.

When debt is restructured or paid back at less than its face amount, income can be triggered from the cancellation of the debt. This can have adverse tax consequences for entities that have borrowed money, and now must renegotiate its debts. There is an exception for debtors that are insolvent, but the practical application of the insolvency exception to pass-through entities has not always been clear.

The Treasury Department recently finalized Regulations explaining how the insolvency exception applies in this situation, which clarify that the insolvency exception applies if the owner of the entity is insolvent, not just the entity itself. This can cause the owner of an insolvent entity to trigger a personal tax liability when the entities debt is re-negotiated.

Although the newly-issued regulations make it more likely that individuals may become subject to tax, a recent court decision may help them avoid this result. In Majestic Star Casino, the Third Circuit concluded that a shareholder of a bankrupt corporation had the right to revoke a Subchapter S election retroactively, reversing the holding of the Bankruptcy Court that the revocation constituted an unlawful transfer of the property of the bankrupt entity. This revocation had the effect of trapping the tax impact of the cancellation of debt at the entity level, effectively shifting the adverse tax consequences from the shareholder to the creditors.