Federal Taxation Developments Blog : Federal Taxation Lawyer & Attorney : Fox Rothschild Law Firm : Federal Income Taxation & Tax Litigation

In a move designed to thwart efforts to have offshore loan originators and purchases of U.S. debt portfolios, such as consumer debt or subprime mortgages, from avoiding effectively connected income per §864(b), the Office of Chief Counsel addressed the question of whether interest income earned by a foreign corporation with respect to loans originated by an agent, whether dependent or independent, operating in the United States is attributable to "the U.S. office" through which the foreign corporation’s banking, financing or similar business activity is carried on, such that the interest income is "effectively connected income"?

The CCO Memorandum concludes that received by a foreign corporation with respect to loans that it originated to U.S. borrowers constitutes income effectively connected with such foreign corporation’s banking, financing or similar business when an agent, whether dependent or independent, performs origination activities described in the facts below on the foreign corporation’s behalf with respect to such loans in the United States.

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As previously reported, the IRS published in June, 2009, temporary and proposed regulations to §7874 which modified an example contained in former Temp.Reg. §1.7874-2T(e)(5), Ex.3 that may have created an unintended or unforeseen method of avoiding the 80% stock ownership test under §7874(b).

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The Tax Court in Ocumulgee Fields stated it was not ruling, as a matter of law, that a finding of basis shifting precludes the absence of a principal purpose of tax avoidance, but, in the case at hand, the immediate tax consequences resulting from petitioner's deemed exchange resulted in a $1.8 million reduction in taxable gain and the substitution of a 15% tax rate for a 34% tax rate. Still, the Ocumulgee Fields and Teruya Bros. decisions make it difficult to find a more likely than not basis to qualify a related party exchange through a QI particularly in instances where the related party already owned the replacement property.

The Tax Court’s recent decision in Ocumulgee Fields v. Commissioner, places great stress on the ability of a taxpayer to successfully structure a related party exchange under §1031(f) where the related party transfers the replacement property to the taxpayer through a qualified intermediary. The hurdle is the non-tax avoidance prohibition set forth in §1031(f)(4). Ocmulgee Fields is an important development because it highlights the potential tax risk in acquiring replacement property from a related party. After the Tax Court’s prior decision to the same effect in Teruya Brothers, it was not necessarily clear that the acquisition of replacement property from a related party would, in general, be viewed as "abusive" within the meaning of section 1031(f)(4) .The judicial analysis set forth in Ocmulgee Fields confirms what some had suspected that most acquisitions of replacement property from a related party may be "bad" exchanges and will not qualify for tax free treatment.

As many tax advisors know, §1031(a)(1) provides that no gain or loss is recognized with respect to an "exchange" of property of like-kind. Certain properties described in a parenthetical clause to §1031(a), such as interests in a partnership, stocks or securities, inventory, choses in action, etc., are ineligible for tax-free exchange treatment under this provision. Frequently §1031 is used to exchange real property held for productive use in a trade or business or for investment for property of like kind, i.e., replacement property to be held either for productive use in a trade or business or for investment. The cost for avoiding gain (or loss) recognition under §1031(a) is that the owner of the relinquished property uses the same basis in the replacement property decreased by any money receive and increase by any gain recognized. §1031(d). Other special rules are set forth in the regulations, including rules pertaining to a deferred exchange of property. §1031(a)(3). A deferred exchange will that otherwise qualifies under §1031(a) will in fact qualify where the replacement property: (i) is identified within 45 days of the transfer of the relinquished property; and (ii) such replacement is received by the earlier of 180 days after the transfer of the relinquished property or the due date (including extensions) of the transferor's tax return for the taxable year in which the relinquished property is transferred.

Treas. Reg. §1.1031(k)-1(g)(4) permits a taxpayer to use a qualified intermediary (other than the taxpayer, the taxpayer’s agent or a "disqualified person"), to facilitate a like-kind exchange. Treas. Reg. §1.1031(k)-1(g)(4)(i). If the various requirements in inserting a qualified intermediary as well as the identification (45 days) and replacement period (180 days) requirements are met, etc., the taxpayer's transfer of the relinquished property to a qualified intermediary and subsequent receipt of like-kind replacement property from the qualified intermediary through a third party acquired with the sales proceeds from the relinquished property, is treated as an exchange with the qualified intermediary.

Section 1031(f) provides special rules for property exchanged between related persons intended to qualify under §1031(a). In pertinent part, it provides that if a taxpayer exchanges property with a "related person", that otherwise qualifies as a tax-free exchange under §1031(a), and within 2 years after the date of the last transfer which was part of such exchange the related person disposes or the property or the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer, the prior exchange will be fully taxable. As an exception, §1031(f)(2) provides that the related party recognition rule which overrides §1031(a) will not apply where it is established by the taxpayer (transferor of the relinquished property) to the satisfaction of the Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax, and provided that the exchange was not part of a transaction or series of transactions structure to avoid the related party rule in §1031(f).

In Ocumulgee Fields, taxpayer transferred appreciated property to a qualified intermediary (QI) under an exchange agreement in conformity with the requirements under Treas. Reg. §1.1031(k)-1(g)(4), whereupon the QI sold the same property to an unrelated third party and used the sales proceeds to purchase from a "related person" like-kind property that was transferred back to taxpayer to complete the exchange.

The IRS, in assessing a deficiency for the income tax on the gain realized from the taxpayer’s receipt of the replacement property, argued that the exchange was part of a transaction structured to avoid §1031(f) and did not make the "lack of tax avoidance" exception under §1031(f)(2)(C) absent credible proof. The Service viewed the interposition of the QI was to reflect a significant basis shifting in the taxpayer’s holding and an immediate cash out that resulted in substantial tax savings.

The Tax Court agreed with the Service and found taxpayer's claim of "no tax avoidance" purpose unpersuasive and concluded that the end result of actual exchange involving QI was the same as if the taxpayer had made the exchange directly with the related person followed by the related person’s making an outside sale to a third party. In essence the taxpayer failed to carry its burden of proof of the absence of a principal purpose of tax avoidance. In Teruya Bros., Ltd.. & Subs, 124 T.C. 45 (2005), aff’d 104 AFTR 2d 2009 (9th Cir. 9/8/09)

Note: the taxpayer negotiated the sale of relatively low basis real property to an unrelated person through a QI structure, same as in the Ocumulgee Fields case. In anticipation of the sale, the taxpayer arranged to purchase relatively high basis replacement property from a related person. To carry out the transaction, the taxpayer arranged for a qualified intermediary to acquire the property the taxpayer had agreed to sell and to sell it to the unrelated person, to use the proceeds to purchase the replacement property from the related person, and then to transfer that replacement property to the taxpayer. On a related note, Teruya Bros. was just affirmed by the 9th Circuit in upholding the Tax Court’s denial of §1031(a) treatment.

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With baseball season in full swing this Spring, many following America’s favorite pastime may have overlooked the issue of important and final regulations on the taxation of corporate inversions under §7874. The IRS issued final regulations on May 19, 2008 on the taxation of corporate inversions in which U.S. companies effectively reincorporate offshore by merging into a foreign surrogate.

As background, during the 1990s and early 2000s, several large, public, domestic corporations, reincorporated as foreign corporations, i.e., by establishing a foreign parent holding company over the U.S. subsidiary group, without changing the mode of their business operations or management oversight conducted primarily within the U.S. Inversion transactions can be effectuate several ways, including asset inversions, stock inversions or a combination of the two. Thus, for example, a stock inversion is effectuated by a U.S. corporation forming a foreign (parent) corporation, which then organizes a domestic merger subsidiary. The U.S. merger subsidiary then merges into the U.S. corporation with the U.S. corporation surviving (reverse triangular merger). The U.S. shareholders exchange stock of the foreign corporation for their U.S. shares. As part of the inversion planning, the U.S. corporation may transfer some or all of its foreign subsidiaries directly into the new foreign parent corporation or other related foreign corporations. Additional features of the well-designed inversion included earnings stripping exercises such as payments of interest, rents, fees or royalties to the new foreign parent or other foreign affiliates.

Inversion transactions are typically not tax-free to all participants. U.S. shareholders generally must recognize gain (but not loss) under §367(a), upon exchanging stock of a domestic corporation for shares of the new foreign parent. A domestic corporation may also recognize gain on transferring stock of a foreign subsidiary or other assets to a foreign member of the newly constituted group. For example, a domestic corporation recognizes gain under § 367(b) on the exchange of stock of a controlled foreign corporation (“CFC”) for stock of another foreign corporation which is not a CFC.

What §7874 attacks, which generally applies to inversions occurring after March 4, 2003, is by providing that the foreign corporation following an inversion will still be considered as “domestic” corporation for U.S. tax purposes, even though it is organized under the laws of a foreign country, if at least 80% of its stock is owned by former shareholders of the inverted domestic corporation. Where ownership by former shareholders of the inverted corporation is less than 80% but 60% or more, special rules apply to ensure that the corporation pays U.S. tax on gains recognized in transactions carried out to effectuate the inversion. Recognizing that the U.S. shareholders were required to pay capital gains taxes on the exchange, Congress also decided to imposed a 15% excise tax on the value of options and other stock-based compensation outstanding when a corporation inverts. The statute sets forth a set of complex definitions and applicable rules pertaining to a so-called “expatriated entity” which includes a domestic corporation or partnership to which a foreign corporation is a “surrogate foreign corporation.”

The IRS issued final regulations (T.D. 9399) maintain much of the provisions set forth under the temporary regulations in determining the scope of the inverted company’s expanded affiliate group of subsidiaries. Many tax practitioners have been reported by the tax press to be concerned about the overbreadth of the final regulations, in particular, the failure for the Service to provide an exception for the issuance of plain vanilla preferred stock in apply the stock percentage tests. Yet, on the other hand, certain rules pertaining to ownership by affiliates seems to make it easier to avoid the inversion provision. The final regulations add that Treasury is aware some taxpayers may be attempting to avoid the application of §7874 by structuring the inversion of a U.S. entity into a foreign entity through the use of intervening partnerships, resulting in an ownership fraction of zero. The IRS announced it was considering publishing additional regulations to address end around inversion strategies that in substance fall within Congress intent as what would constitute an inversion transaction for purposes of §7874.

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Tax practitioners, and particularly tax lawyers drafting, reviewing and/or negotiating partnership or limited liability company agreements for clients engaged in a business or investment joint venture, know the importance of meeting the substantial economic effect test under the regulations to §704(b), which is a form of safe harbor contained in federal income tax regulations. But capital accounts, as determined for book purposes as compared to for tax purposes, are critically important in understanding the economics of the particular business venture or “deal” as many are prone to say. Clients may think percentage of ownership in the deal or cash flow preferences are critical to set forth in the document. Of course they are. But added to the mix is the idea that for liquidations or other asset bailout strategies, the joint venturers, be it as partners in a partnership, or as members in a limited liability company, must understand capital accounts and the requirement under the regulations that liquidating distributions must be made in accordance with positive capital account balances. Where a partner has a deficit capital account on liquidation, strict capital account rules require that the partner must be obligated to restore its deficit balance, etc., to meet the safe harbor test.

The safe harbor “substantial economic effect” test, set forth in substantial detail in the regulations, permits the partners to allocate tax items among the participants so that the allocations have a corresponding substantial economic effect. Otherwise, allocations of tax items which do not meet the requirements of the safe harbor are respected only if in accordance with the partner’s interest in the partnership. Treas. Reg. §1.704-1(b)(1)(i) . Where the applicable standards are left unsatisfied, i.e., where the partners are reluctant to put in deficit capital account restoration provision, the Service may reallocate tax items to reflect each partner’s economic interest in the partnership. Treas. Reg. §1.704-1(b)(3)(i). This analysis generally has the Service (or a court in review) looking at how would the sales proceeds be divided among the members if all of the partnership’s assets were sold and the partnership liquidated. While both tests essentially are evaluating the allocation of tax items within the context of their economic interests, the partner’s interest in the partnership method for testing allocations is certainly unpredictable.

The lack of client understanding or acceptance of the role of maintaining and distribution out assets (in liquidation) in accordance with capital accounts has, in certain instances, given thought to more creative methods for determining a partner’s interest in the venture. The thought is that the percentage of ownership in the venture, by analogy to corporate law concepts, should be paramount. Indeed, there may be various instances where clients sign a partnership type agreement and really do not understand the capital account concept and its impact on the rights and interests of the partners. Some have, in response to the criticisms leveled at the complex capital account maintenance rules, permit distributions of cash and other assets to lead the allocation of income and loss. If the draftsmen is not sufficiently sophisticated in drafting legal agreements of this type, it would be best to avoid using this architecture. Those who prefer such other formulas, including corporate type proportionate ownership formulas, run the risk that the Service will have a great degree of flexibility in reallocating tax items among the parties in the event of an audit which predictably would require a fair degree of involvement by tax counsel for the partnership and perhaps counsel for the partners in avoiding an adverse impact for their clients.

The overriding point to be made here is that lawyers drafting partnership and LLC agreements must clearly understand the terms of the deal, whether there are distributional preferences for net cash flow from operations, refinancings, sales and liquidating distributions and how income or loss allocations will be made and to what extent such allocations will effect the partners’ rights in the deal. In many instances a business lawyer may trust the language used in a form from another deal with differing economic formulas and allocations, and assume it will work in the current deal she or he is involved with as well as pass IRS muster. The suggestion here, go over the cash flow, allocation of tax items and distribution provisions, including liquidating distributions, so that clients understand the economics and sign off on the deal. It helps for the client to recognize that normal corporate share ownership norms can frequently vary from capital account rules and principles. Clients and their legal counsel must carefully evaluate whether or not to apply strict capital account based principals in entering into partnership and LLC agreements.

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The Fifth Circuit Court of Appeals, in a per curiam decision, affirmed the findings and holding of the Tax Court and upheld the imposition of an accuracy related penalty on a husband and wife based on the record before the court. The testimony proferred by each side was conflicting, which is frequently if not generally true in tax litigation proceedings, but the Tax Court found that the taxpayer had not met its burden of production that it acted in good faith and reasonable cause in relying on their accountant who prepared their returns. See §6664(c)(1). Tax Court held that the Prudhommes did not meet this standard because they provided their accountants with insufficient information to prepare the tax return accurately and did not make a reasonable effort to assess their proper tax liability.

After operating a family business for a period of years, the taxpayers sold the business for approximately $11M with approximately one half or $5.5M received in cash, the acquiring company’s stock, valued at $2M and a promissory note for $3.5M. The sale took place in 2003 and the Prudhommes long-standing accounting firm prepared the return which was timely filed after extensions were applied for. The tax return omitted substantial amount of the sales proceeds resulting in additional taxes that were assessed by the Service in the amount of $576,728 which was paid in November, 2005. The accounting firm admitted during the audit that the error was its error. The taxpayers challenged a 20 percent underpayment (accuracy related) penalty and small penalty for failure to pay the correct amount of estimate taxes. The IRS contended that the taxpayers failed to properly notify the accounting firm of the total amount of sales proceeds it received in the transaction, including a $3.2M dividend they received from the sale. A Tax Court petition subsequently followed on the issue of the penalties.

On appeal to the Fifth Circuit, the Prudhommes asserted that the lower court’s findings of a lack of reasonable cause or acting in good faith on the part of the taxpayers was clearly erroneous. The Fifth Circuit was faced, under its applicable standard of review under §7482(a)(1), as to whether the Tax Court’s fact findings were clearly erroneous.

The Treasury regulations provide that "[t]he determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances." Treas. Reg. § 1.6664-4(b). "Generally, the most important factor is the extent of the taxpayer's effort to assess the taxpayer's proper tax liability." Id. The regulations also state that a court must consider whether the taxpayer made "an honest misunderstanding of fact or law that is reasonable in light of all of the facts and circumstances, including the experience, knowledge, and education of the taxpayer." Id. That is, even if a taxpayer relies on an expert, the court still must take into account "[a]ll facts and circumstances" regarding whether that reliance was reasonable and in good faith, including the "taxpayer's education, sophistication and business experience."Treas. Reg. § 1.6664-4(c)(1). Case law reveals that the most important factor is "'the extent of the taxpayer's effort to assess [his] proper tax liability' is '[g]enerally[] the most important factor' in determining reasonable cause and good faith." Stanford v. Comm'r, 152 F.3d 450, 460-61 (5th Cir. 1998) (quoting Treas. Reg. § 1.6664-4(b)). In other words, reliance on a tax professional, however, must be reasonable, and simply relying on a professional is not dispositive. While a taxpayer in avoiding the penalty based on reliance on a tax professional does not require obtaining a second opinion, there is no good faith reliance wheref the taxpayer fails to disclose a fact that it knows, or reasonably should know, to be relevant to the proper tax treatment of an item." Treas. Reg. § 1.6664-4(c)(i); see Srivastava v. Comm'r, 220 F.3d 353, 367 (5th Cir. 2000) (rejecting argument that the taxpayers reasonably relied upon a professional because, inter alia, they never gave their accountant a copy of the settlement agreement subject to the tax).

The record established at trial, in the view of the Fifth Circuit, supported the Tax Court’s holding on the imposition of the penalties. First, the taxpayers did not fully reveal the details of the sale to the accounting firm. This included bank records, a large dividend distribution and other documents of the sale. Second, the court concluded that the Prudhommes did not make a good faith effort to assess their correct tax liability. The court noted that Richard Prudhomme did not even read or sign the return, that Cathy Prudhomme did not verify that all income from the sale of the company was on the return, and that both Prudhommes were not unsophisticated taxpayers but were successful business people.

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In SEC v. Microtune, Inc. (N.D. Tex. 6/4/09), the District Court for the Northern District of Texas held that documents, notes, memos and other material produced and maintained by a law firm and its agents for the purpose of conducting an internal investigation of alleged improper practices with respect to reporting stock options was discoverable by the SEC through the issuance of its subpoena over the company’s claims (motion to quash) of attorney client privilege and the work product doctrine.

The case involved an enforcement action by the Securities and Exchange Commission against the former Chairman and CEO, Bartek, and the former CFO, Richardson, for their role in an alleged backdating scheme involving stock options of Microtune.

In June 2006, Microtune hired outside counsel, Andrews Kurth law firm, to conduct an internal investigation into the company’s stock option practices. Such legal counsel hired an outside accounting, Grant Thornton LLP, to assist in its efforts. In February and July 2007, Andrews Kurth presented its findings to the SEC, in the process turning over hundreds of pages of documents and other information gathered during the internal investigation. Approximately one year later, the SEC filed civil charges against Microtune, Bartek and Richardson allegeding the perpetration of a fraudulent stock option backdating scheme that had as its intended effect the improper awarding the defendants and other employees of millions of dollars in undisclosed compensation. Bartek and Richardson caused Microtune to grant backdated options, cancelling those options after the company's stock price dropped precipitously, and subsequently re-granting the same options at a substantially lower exercise price. According to the SEC's complaint, the re-grants were not, as required, accounted for using variable accounting, in part because Richardson and Bartek allegedly concealed the nature of the re-grants from Microtune's outside auditors and others.

There were SEC financial disclosure violations caused by the scheme as the backdated options resulted in the filing of false and misleading financial statements with the SEC. In particular, the SEC alleged that “Bartek directed others to backdate employment records, including offer letters, to establish falsified start dates and grant dates that preceded the actual dates when the new hires began working for Microtune.” The SEC sought penalties and other relief under Section 304 of the 2002 Sarbanes-Oxley Act, in order to prevent corporate executives to profit from money wrongfully earned while their companies mislead investors with false financial statements. Microtune, without admitting or denying wrongdoing, agreed to a permanent injunction against violations of the antifraud, financial reporting, books and records, internal controls, and proxy provisions of the federal securities laws. The SEC sought injunctive relief, disgorgement of wrongful profits, civil monetary penalties, officer and director bars, and reimbursement of profits from stock sales pursuant to Section 304 of the Sarbanes-Oxley Act against Bartek and Richardson. The company settled its liability out separately with the SEC, which presumably is proceeding against Bartek and Richardson.

Now for the production request made by the SEC. During discovery, the SEC subpoenaed internal investigation documents from Microtune, Andrews Kurth, Grant Thornton, and other law firms that had provided services to Microtune. Microtune moved to quash the subpoena on grounds of attorney-client and work product privileges. The District Court ruled in favor of the SEC in its June 4, 2009 decision. The attorney-client privilege was waived by Microtune’s voluntarily disclosing the internal investigation documents to the SEC and others.

The work product argument was also rejected because the evidence did not suggest that litigation concerns were the “primary motivating purpose” behind the documents' creation. The work product doctrine, sourced from the Supreme Court’s decision in Hickman v. Taylor, 329 U.S. 495 (1947) and now settled in FRCP 26(b)(3), holds that the work of preparing for trial demands insulation from opposing counsel's inquiries on a lawyer's research, analysis, legal theories, and mental impressions. The courts have used two tests in determining what is work product, which does not necessarily have to be prepared by a lawyer. The broader test is the “because of” test, which widens substantially the scope of what is work product. See United States v. Textron Inc. & Subsidiaries, 103 AFTR2d 2009-509, 520-23 (1st Cir. 2009), pending rehearing en banc. The other standard is that announced in the El Paso decision rendered by the 5th Cir., 682 F2d 530 (5th Cir. 1982), cert. denied, (1984) which asks if the primary purpose or motivation for engaging in the analysis, here the internal investigation, was in anticipation of litigation. If not, the work product doctrine does not apply. In is obviously of great difference whether the court applies the “because of……litigation” test versus the “primary purpose of …..litigation” test.

The decision in Microtune is presumably one of the first cases to extend such an analysis to internal investigation documents such that the documents are not protected unless the primary motivation behind their creation was the anticipation of litigation. This case should stand as a sharp reminder to counsel engaged in internal investigations to earmark that their work, memos, e-mails, power points, etc., are documented as primarily engaged in anticipation of litigation. For further background and analysis see, August, the Attorney-Client Privilege and Work-Product Doctrine in Federal Tax Matters, Business Entities (WG&L), Jul/Aug 2008.

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On June 25, the U.S. Bankruptcy Court for the Southern District of New York, Bankr. S.D. N.Y. No. 09-50026 (REG) June 25, 2009, issued a final order under §§105(a) and 362 of the Bankruptcy Act setting forth notification procedures and transfer restrictions pertaining to the transfer of GM stock retroactive to the filing of the petition before the court. It also scheduled a final hearing on open issues under the Chapter 11 proceeding.

As part of its final order the Court held: (i) that the Debtors’ net operating loss carryforwards "NOLs", foreign tax credits and other excess credit carryforwards, inotherwords the Debtors’ aggregate tax attributes, were property of the Debtors’ estates and are protected by section 362(a) of the Bankruptcy Code; (ii) unrestricted trading in GM stock could, before the Debtors' emergence from chapter 11 could severely limit the Debtors' ability to use the tax attributes for purposes of the Internal Revenue Code of 1986, as amended (i.e., by application of section 382 ownership change of the Code and related provisions); and (iii) with a view to preserving the maximium benefit or use of such tax attributes, set out detailed share transfer notification procedures and restrictions viewed as necessary and proper to preserve the tax attributes and in the best interests of the Debtors, their estates, and their creditors.

As background, where a corporation possessed with carryovers, i.e., NOLs, excess business or foreign tax losses, etc., undergoes an ownership change, section 382(a) imposes prospective use of such tax attributes. More specifically, an ownership change occurs if, for example, the percentage of stock owned by one or more of the corporation's 5% shareholders increases by more than 50% points over 3 year "testing period" on the day of any owner shift involving a "5% shareholder" as defined. As is true with public companies, section 382(g)(4) provides that stock owned by all shareholders who are not 5% shareholders is generally treated as owned by one 5% shareholder group n determining whether an ownership change has occurred. However, unless the corporation elects otherwise, the section 382(a) limitation does not apply to an ownership change if the old loss corporation is under the jurisdiction of a court in a Title 11 or similar case and the shareholders and qualified creditors, as defined, of the old loss corporation (determined immediately before the ownership change) own, as a result of being shareholders or creditors immediately before the change, stock of the new loss corporation constituting at least 50% of the total voting power and 50% of the total value of stock of the new loss corporation. See also Treas. Reg. §1.382-9(d)(3)(i)(debt "as always" equity rule). This paragraph is an oversimplification of the breadth and depth of section 382 to a corporation with tax attributes both in bankruptcy and non-bankrupcty contexts.

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Chief Counsel’s Office Announces Standard of Review for Litigating Cases Involving Innocent Spouse Relief Under Section 6015(f). (CC-2009-021)(June 30, 2009), supplementing CC-2004-26 (July 12, 2004).

The subject of "innocent spouse" relief is not new to tax practitioners and to many individuals who have had to endure the situation where signing a joint income tax return exposed the "non-liable" spouse, so to speak, with the spectre of joint and several liability. Section 6015(a) provides three avenues for a spouse filing a joint return to obtain relief. Under § 6015(b) , innocent spouse relief is available if the understatement of tax is attributable to erroneous items of one individual and the other individual did not know, or have reason to know, of the understatement and, taking into account all the facts and circumstances, it would be inequitable to hold that spouse liable. Section 6015(c) provides, for taxpayers who are no longer married, are legally separated, or not living together, for the liability of each spouse to be computed separately as if the spouses had filed separate returns for the taxable year if certain pre-requisites can be met. Finally, § 6015(f) is a general equity or "catch-all" rule that taking into account all the facts and circumstances, it would be inequitable to hold the spouse claiming innocent spouse status liable.

Chief Counsel’s Office sets forth a short history of recent case law under the general equitable relief rule, §6015(f). In Porter v. Comm’r, 130 T.C. 115 (2008) ("Porter I"), the Tax Court, following its prior opinion in Ewing, 122 T.C. 32 (2004), vacated, 439 F.3d 1009 (9th Cir. 2006), held that in determining whether the Commissioner abused his discretion in denying the petitioner relief under section 6015(f), the court conducts a trial de novo and may consider evidence introduced at trial that was not included in the administrative record developed during the administrative consideration of the claim. In Porter v. Commissioner, 132 T.C. No. 11 (April 23, 2009) ("Porter II"), the court reconsidered the standard of review in section 6015(f) cases and concluded that a de novo standard of review is proper. Thus, the Tax Court now will make its own de novo determination regarding whether a requesting spouse is entitled to relief under §6015(f) and will not be limited to evidence in the administrative record. The proper standard for review if that of "abuse of discretion". The Chief Counsel’s Advisory directs that attorneys should, therefore, continue to argue that, under an abuse of discretion standard of review, the scope of the Tax Court's review is limited to issues and evidence presented before Appeals or Examination. Attorneys should raise the scope and standard of review arguments whenever appropriate (e.g., in the pre-trial memo, at trial, and on brief), noting the Service's disagreement with the holding in the Porter I and II opinions.

To preserve the Porter issues for appeal, attorneys should continue to work with the petitioner to stipulate to the administrative record and should continue to raise a continuing evidentiary objection if the petitioner attempts to testify or otherwise enter evidence into the record that was not made available to the Service's examiner or Appeals Officer. If the court denies the evidentiary motion, additional evidence outside of the administrative record that may strengthen the Commissioner's case should be introduced into evidence . Other information and guidance is set forth in the Advisory.

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