Taxpayer alert: After clawing back more than $1 billion in back taxes last year, a more assertive IRS has pledged to raise tax-return audit rates by more than 50% on wealthy individuals by 2026. Many ongoing disputes with taxpayers will wind up in US Tax Court, an independent judicial authority created by Congress for taxpayers fighting IRS determinations. The Tax Court’s judgments often provide valuable insight about tax matters that you can use to avoid unnecessary penalties, deficiencies and mistakes…
Bottom Line Personal asked leading accountants Edward Mendlowitz, CPA, ABV, PFS, and Maryann Reyes, CPA, PFS, to highlight four recent cases and lessons that will help you keep more of your money…
The Not-So-Innocent Spouse
Case study: Sydney Ann Chaney Thomas lived with her husband, Tracy Thomas, and two daughters in an affluent suburb of San Francisco. After the 2007–2009 recession, the marriage began to break down and the couple became mired in credit card and mortgage debt. To help pay that debt, they took early withdrawals from retirement accounts totaling about $263,000 during 2012, 2013 and 2014—but they didn’t pay the IRS the full amount of taxes due on their joint tax return for those years. Tracy Thomas assured his wife in texts that the “taxes and mortgages have been dealt with.” When he died suddenly in 2016, that proved to be false. The IRS mailed Sydney Thomas a Notice of Deficiency (NOD) for $60,633 plus accrued interest. She petitioned for tax relief as an “innocent spouse,” claiming she shouldn’t be responsible for the deficiency and penalty because her husband had been verbally and physically abusive to her, preventing her from questioning or challenging payment of the liability.
IRS position: When married couples sign a joint federal income tax return computed on their aggregate incomes, each spouse is fully liable for the accuracy of the return and for the entire amount of tax found to be owing.
Tax Court ruling: Ms. Thomas was liable for all back taxes and penalties. The judge found her lacking in two criteria necessary to qualify for innocent-spouse relief. First—was Ms. Thomas’s lack of knowledge about the unpaid taxes credible? Given the couple’s troubled financial history, the judge found there was little reason for her to believe that her late husband had actually paid the taxes or trust his word. Second—did economic hardship make her unable to pay the back taxes? Following Mr. Thomas’s death and receipt of the IRS NOD, Ms. Thomas had spent lavishly, traveling to Rome, Paris and Florence. She bought a Jaguar Land Rover and paid for her daughters’ cell phones and car insurances.
Lesson: Many spouses let their partners take care of the taxes and money without realizing they are personally responsible for liabilities. If something goes wrong, innocent-spouse cases are very difficult to win in court. Before you sign a joint return, at the very least, study the first two pages of the return, and understand what your joint income and your deductible expenses are, as well as the taxes you both owe. If you’re worried about a spouse’s tax misdeeds, you have the option to switch to a “married, filing separately” return. This severs joint liability, although it can reduce some tax breaks.
Sydney Ann Chaney Thomas v. Commissioner, 162 T.C. NO. 2
Taxes on Legal Settlements and Jury Awards
Case study: In 2005, the Indiana State Police investigated the death of a 14-year-old girl. Her stepfather Roman Finnegan and his wife, Lynnette, were arrested on charges of medical neglect, and two other children were removed from the home and placed in foster care. Ultimately, all criminal charges against the Finnegans were dismissed. They then sued for violations of their civil rights. Roman Finnegan dramatically testified to a jury, “There were days that I could not get out of bed. I had attacks in which I couldn’t breathe. I thought they were heart attacks, but they were diagnosed as post-traumatic stress syndrome (PTSD).” The Finnegans won their court case, and in 2017, accepted a $25 million settlement. They did not include the proceeds in their gross income on their tax returns because they maintained the PTSD was caused by the actions of the lawsuit’s defendants, making the settlement money excludable from taxation.
IRS position: The settlement proceeds were includable in gross income and subject to tax. Under federal law, damage awards or settlements are excludable from taxation only if they were received “on account of personal physical injuries or physical sickness.”
US Tax Court ruling: The Court sided with the IRS. For damages to be excludable, there must be a direct causal link between the legal action and the physical injury or sickness. Emotional distress typically does not qualify for exclusion. Moreover, the Finnegans’ original lawsuit did not seek damages for PTSD, and the subsequent settlement clearly established that the payment was compensation for violations of the plaintiffs’ constitutional rights stemming from the defendants’ conduct and the emotional pain caused therefrom.
Lesson: Many people are awarded legal settlements for mental, emotional and physical injuries they have suffered. You and your attorney should deliberate over potential damages and craft the wording of the settlement document with an eye toward tax implications.
Estate of Roman J. Finnegan and Lynnette Finnegan v. Commissioner, T.C. Summary Op. 2024-2
Careless Recordkeeping
Case study: Patricia Chappell had worked as a tax-return preparer since 1996. During tax year 2015, she operated a sole proprietorship called Quik Tax in Ohio. On Schedule C of her federal tax return Ms. Chappell reported gross receipts of $152,521 and expenses totaling $140,768, which included (among other things) vehicle expenses of $15,385 for the Toyota Prius that she used for business and personal driving. At the end of March 2015, she started tracking her mileage using a cell phone GPS app. Of the roughly 15,000 miles she drove, she reported about 13,500 for business and 1,500 for personal use. The IRS disallowed all her business expenses related to her vehicle and assessed her an accuracy-related penalty of 20% of the underpayment of her taxes. Ms. Chappell disputed the penalty and claimed any inaccuracies were, in part, caused by having to care for her elderly disabled mother that year and suffering herself from a painful tumor.
IRS position: Ms. Chappell’s recordkeeping of her deductions was careless and inaccurate. The 20% penalty was applied because her negligence caused a substantial underpayment of taxes, which is typically defined as an amount greater than $5,000, or 10% of the tax that was required to be shown on the taxpayer’s return.
US Tax Court ruling: The Court reduced Ms. Chapell’s vehicle expense deduction to $6,669. The judge noted that Ms. Chapell kept no driving mileage records for the first three months of the year, and her receipts for fuel, insurance, interest on a car loan, repairs, licensing fees and depreciation were flawed. While the Court sympathized with Ms. Chappell’s personal difficulties in 2015, it also refused to wave the accuracy-related penalty. As a professional tax preparer, she should have been well-acquainted with the substantiation requirements for business deductions.
Lesson: You must be especially vigilant about documentation when taking business deductions for property that also is used for personal reasons. The IRS may waive this penalty if it’s your first time underpaying or if you acted in good faith and there was a reasonable cause for the underpayment.
Patricia S. Chappell v. Commissioner, T.C. Memo 26309-18S
Safe Harbor from Early-Distribution Penalties
Case study: In 2018, Caren Kohl, who was in her early 50s and lived in New York, found herself in dire financial straits. To pay past rent and avoid eviction, she took a distribution of $10,342 from her retirement plan. She did not report that amount as income on her tax return, nor did she report or pay the 10% penalty required for the early withdrawal. The IRS caught the error and sent her a Notice of Deficiency (NOD). Ms. Kohl conceded she did owe taxes on the distribution, but she should not have to pay the 10% penalty because the SECURE 2.0 Retirement Act allows an exemption for taxpayers suffering financial emergencies.
IRS position: Ms. Kohl was subject to the penalty because she took a distribution before the age of age 59½. The cause for exemption that she provided— “unforeseeable or immediate financial needs relating to personal or family emergency expenses”—was not available in 2018.
US Tax Court ruling: Ms. Kohl was liable for the 10% penalty on her early distribution. The penalty exemption for financial emergencies granted by Congress did not go into effect until tax year 2024. Even if the exemption had applied, Ms. Kohl would been allowed a maximum penalty-free distribution of only $1,000.
Lesson: There now are more than 20 legitimate reasons you can avoid a 10% early-distribution penalty from the IRS, including being a survivor of domestic abuse or a terminally ill patient. For the full exemption list: Go to IRS.gov and search “early withdrawal exceptions”…then choose “Retirement Topics—Exceptions to tax on early distributions.” Important: Exemptions from penalties do not exempt you from any taxes you may owe on early distributions.
Caren Kohl v. Commissioner, T.C. Memo 2024-4
