Kathryn Cheshire v. Commissioner of Internal Revenue
2002 U.S. App. LEXIS 2012, 282 F.3d 326, 27 Employee Benefits Cas. (BNA) 2133 (2002)
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Rule of Law:
For the purpose of denying innocent spouse relief under I.R.C. § 6015(c), a spouse has "actual knowledge of any item giving rise to a deficiency" if they are aware of the underlying income-producing transaction, even if they are unaware of its incorrect tax treatment. A spouse's ignorance of tax law is not a defense and does not satisfy the "no reason to know" requirement under § 6015(b) when they are aware of all the material facts of the transaction.
Facts:
- In 1992, Kathryn Cheshire's husband, David Cheshire, received $229,924 in retirement distributions from his former employer.
- Kathryn Cheshire was aware of her husband's receipt of these funds, which were deposited into the couple's joint checking account.
- With Kathryn's knowledge, the couple used $99,425 of the retirement funds to pay off the mortgage on their marital home and an additional $20,189 to purchase a new family car.
- On their 1992 joint federal income tax return, prepared by David, only $56,150 of the retirement distribution was reported as taxable income.
- Before signing the return, Kathryn questioned the low taxable amount, and David falsely informed her that a certified public accountant had advised him that funds used to pay off a mortgage were non-taxable.
- Kathryn accepted her husband's explanation without making any further inquiries and signed the joint return.
- The couple separated in 1993 and later divorced, with the divorce decree awarding Kathryn unencumbered title to the marital residence and the new car.
Procedural Posture:
- The Commissioner of Internal Revenue audited the Cheshires' 1992 joint tax return, determined a tax deficiency, and imposed an accuracy-related penalty.
- Kathryn Cheshire filed a petition in the United States Tax Court, seeking relief from the deficiency and penalties as an innocent spouse under I.R.C. § 6015(b), (c), and (f).
- Prior to trial, the Commissioner conceded that Cheshire was entitled to relief for certain smaller items, but the parties proceeded to trial on the deficiency related to the primary retirement distributions.
- The Tax Court, in a majority opinion of twelve judges, denied Cheshire's requests for relief under all three subsections.
- Kathryn Cheshire (Appellant) appealed the Tax Court's decision to the U.S. Court of Appeals for the Fifth Circuit, with the Commissioner of Internal Revenue as the Appellee.
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Issue:
Does a spouse have "actual knowledge of any item giving rise to a deficiency" under I.R.C. § 6015(c)(3)(C), thus barring innocent spouse relief, if she knows of the underlying income-producing transaction but is unaware that its reporting on a joint tax return is legally incorrect?
Opinions:
Majority - King, Chief Judge
Yes. A spouse has "actual knowledge of an item giving rise to a deficiency" under § 6015(c)(3)(C) if she has actual knowledge of the income-producing transaction itself, regardless of whether she knew the tax reporting of that transaction was improper. The court held that the term "item" in the statute refers to the source of income or the basis for a deduction, not the incorrect tax treatment of that item. Based on the plain language of the statute and its usage elsewhere in the Internal Revenue Code, the court concluded that since Kathryn Cheshire had actual knowledge of the retirement distributions, she was barred from relief under § 6015(c). Furthermore, the court found she was ineligible for relief under § 6015(b) because, knowing all the facts of the transaction, her defense was based solely on ignorance of the law, which as a matter of law means she had "reason to know" of the understatement. Finally, the court held that the Commissioner did not abuse his discretion in denying equitable relief under § 6015(f), as Cheshire significantly benefitted from the tax understatement by receiving the mortgage-free home and a new car in the divorce.
Analysis:
This decision significantly clarifies the "actual knowledge" standard for innocent spouse relief under I.R.C. § 6015(c), making it more difficult for a spouse who is aware of family finances to obtain relief. By defining "item" as the underlying transaction rather than the incorrect tax reporting, the court reinforced the long-standing principle that ignorance of the law is not a defense to tax liability. The ruling effectively places a higher due diligence burden on spouses signing joint returns, preventing them from avoiding liability by merely accepting a partner's incorrect legal explanation when they are aware of all the underlying facts. This precedent narrows the path to relief for spouses who are not completely ignorant of the financial events leading to a tax deficiency.
