Taxing Lessons From Court Decisions

Decisions – Weighing the factors

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One problem with assuming all factors are equal is that they generally are not.

In T.C. Memo. 2018-93 (Hale), the taxpayer was requesting relief from tax owed on returns she filed jointly with her now-deceased spouse.

The taxpayer’s spouse was an attorney who handled the family’s financial matters. The taxpayer and her spouse filed joint federal income returns for 2004 through 2009. Each return reported tax due but the tax was not paid when the return was filed.

In 2010, the IRS filed a lien regarding the joint income tax liabilities for tax years 2004 through 2008. The IRS sent the lien notice to the taxpayer’s spouse at his law firm office.

The taxpayer was not aware her spouse had not paid the federal income tax until 2011, when her spouse suicided.

While the taxpayer’s spouse was alive, he was the family’s sole income earner. He funded life insurance policies that provided the taxpayer with almost $8 million of benefits upon his death. The taxpayer was unaware of these policies until after her spouse’s death.

In June 2011, the taxpayer received $3,229,971 in life insurance proceeds. In December 2011, the taxpayer received $4,721,415 from another policy. The amounts were placed in a bank account in the taxpayer’s name.

Because the taxpayer was overwhelmed by her husband’s death, her father handled the investment of the life insurance proceeds, based on advice from the taxpayer’s financial advisor.

A few weeks after the death of the taxpayer’s husband, an IRS revenue officer was assigned to collect the unpaid income taxes. The revenue officer believed that mortgages on the taxpayer’s residence had been paid off with insurance proceeds. She asked one of the estate attorneys about life insurance policy proceeds.

About a week after the revenue officer’s inquiry, the taxpayer signed checks drawn on the bank account into which the life insurance proceeds had been deposited. The checks were for the purchase of certificates of deposit in the name of her father and mother, with the certificates payable on their death to the taxpayer. Five of the eight certificates of deposit were over the $250,000.

When the state inheritance tax return was filed, the taxpayer reported her husband’s gross estate of $17,092,954. The bulk of the assets consisted of $15,707,860 of life insurance and the taxpayers’ residence, valued at $1,187,650. The beneficiaries of the insurance policies were the taxpayer, their children, and the taxpayer’s husband’s law firm. The estate was not named a beneficiary of any of the insurance policies.

The inheritance tax return reported a marital deduction for bequests to the taxpayer of $8,152,414, which included life insurance proceeds of $7,954,970. The inheritance tax return also reported funeral and administration expenses of $332,719, debts of $5,889,052, and mortgages of $3,106,288.

The probate assets of the estate were not enough to satisfy what the estate owed.

In 2012, the taxpayer requested innocent spouse relief for tax years 2004 through 2009. She did not disclose the life insurance proceeds in her request.

After making the request for innocent spouse relief, the federal income tax due for tax years 2004 through 2009 was paid in full. In her request for relief, the taxpayer asked for a refund of those taxes.

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When married couples file joint federal income tax returns, both spouses, together and individually, are liable for the federal income tax owed. (Filing status doesn’t have to be joint for the rule to apply to married couples who live in community property states and have community income.)

One way to obtain relief from the tax due on a jointly filed federal income tax return is to request innocent spouse relief. Internal revenue code section 6015 lists three avenues for relief.

In this case, the court considered seven nonexclusive factors to determine whether the taxpayer qualified for innocent spouse relief. (Note that the taxpayer is the requesting spouse, that is, she is the one asking for relief.)

1. Marital status

The rule from revenue procedure 2013-34, section 4.03(2)(a): If the requesting spouse is no longer married to the nonrequesting spouse, this factor will weigh in favor of relief. A widow or widower is treated as no longer married to the nonrequesting spouse only if the surviving spouse is not an heir to the nonrequesting spouse’s estate that would have sufficient assets to pay the tax liability.

The taxpayer says this factor is neutral. She was her husband’s heir. While the probate estate was insufficient to pay the income tax liability, the gross estate was sufficient.

The IRS agrees that the marital status factor is neutral.

The court ruled that the marital status factor was neutral.

 

2. Economic hardship

The rule from revenue procedure 2013-34, section 4.03(2)(b): If denying relief from the joint and several liability will cause the requesting spouse to suffer economic hardship, this factor will weigh in favor of relief.

If denying relief from the joint and several liability will not cause the requesting spouse to suffer economic hardship, this factor will be neutral.

The taxpayer says the economic hardship factor is neutral. She concedes that she had sufficient funds to pay the tax liabilities for the years in issue and acknowledges that she did not suffer economic hardship as a result of paying the tax liabilities.

The IRS argues that the economic hardship factor weighs against granting relief because the taxpayer received over $8 million from her husband’s estate and her monthly income exceeds expenses by approximately $6,300. The IRS says the taxpayer will not suffer an economic hardship by having to pay the tax.

The court: Despite the plain language of the revenue procedure, the court sided with the IRS on this factor.

 

 

3. Knowledge or reason to know

The rule from revenue procedure 2013-34, section 4.03(2)(c): In the case of an income tax liability that was properly reported but not paid, “the knowledge or reason to know” factor will weigh in favor of relief if the requesting spouse reasonably expected the nonrequesting spouse to pay the tax liability reported on the return.

This factor will weigh against relief if, based on the facts and circumstances of the case, it was not reasonable for the requesting spouse to believe that the nonrequesting spouse would or could pay the tax liability shown on the return. For example, if prior to the return being filed, or the date the requesting spouse reasonably believed the return was filed, the requesting spouse knew of the nonrequesting spouse’s prior bankruptcies, financial difficulties, or other issues with the internal revenue service or other creditors, or was otherwise aware of difficulties in timely paying bills, then this factor will generally weigh against relief.

Depending on the facts and circumstances, if the nonrequesting spouse maintained control of the household finances by restricting the requesting spouse’s access to financial information, and because of the financial control, the requesting spouse was not able to question the payment of the taxes reported as due on the return or challenge the nonrequesting spouse’s assurance regarding payment of the taxes for fear of the nonrequesting spouse’s retaliation, this factor will weigh in favor of relief even if the requesting spouse knew or had reason to know about the nonrequesting spouse’s intent or ability to pay the taxes due.

The facts and circumstances that are considered in determining whether the requesting spouse had reason to know whether the nonrequesting spouse could or would pay the reported tax liability include, but are not limited to, the requesting spouse’s level of education, any deceit or evasiveness of the nonrequesting spouse, the requesting spouse’s degree of involvement in the activity generating the income tax liability, the requesting spouse’s involvement in business or household financial matters, the requesting spouse’s business or financial expertise, and any lavish or unusual expenditures compared with past spending levels.

The taxpayer says that the “knowledge or reason to know” factor weighs in her favor because she reasonably expected her husband to pay the tax liabilities shown on their returns for the years in issue.

She says she was a stay-at-home mother with no financial background. She was not involved in household financial decisions and did not contribute to the preparation of the tax returns, and mail relating to tax and financial matters was sent to her husband at his law firm. Her husband kept the checkbook, had all bills sent to his office, and paid the bills from there. She did not have access to their joint accounts. She says her husband controlled the household finances and deceived her by keeping her unaware of the financial difficulties and tax problems.

After her husband’s death, though the taxpayer was named executor of her husband’s estate, she didn’t feel she could do what needed to be done and she declined to serve as executor. Her father was named as successor executor in the will and served in that capacity by paying bills and investing the insurance proceeds. The taxpayer also relied on her father and professional advisers to help her deal with her finances.

The IRS claims that after her husband’s death, the taxpayer structured her assets in various nominee accounts to avoid collection of income tax by dividing the insurance proceeds among multiple certificates of deposit in different names at different banks. The IRS says the ability to engage in these maneuvers means the taxpayer would not have let herself be excluded from family financial decisions.

In addition, the IRS says the taxpayer and her husband accumulated significant assets during the years in issue and that the accumulation should have given the taxpayer reason to suspect her husband had not paid the tax liabilities. Because the taxpayer filed a joint tax return for six successive years that reported unpaid liabilities, the IRS argues that at some point she should have asked if, and how, her joint tax liabilities would be paid.

Finally, the IRS argues that the lien notice filed in 2010 would have put the taxpayer on notice regarding the underpayments of tax.

 

WHAT WOULD YOU DECIDE?

 

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4. Legal obligation

The rule from revenue procedure 2013-34, section 4.03(2)(d): The legal obligation factor weighs in favor of relief if a divorce decree or other legally binding agreement imposes on the nonrequesting spouse the sole legal obligation to pay the outstanding tax liability.

The factor is neutral, however, if the requesting spouse knew or had reason to know, when entering into the divorce decree or agreement, that the nonrequesting spouse would not pay the income tax liability.”

The factor is also neutral if the spouses are not separated or divorced, and it weighs against relief if the requesting spouse has the sole legal obligation to pay the tax.

The taxpayer and the IRS agree that the legal obligation factor is neutral.

 

5. Significant benefit

The rule from revenue procedure 2013-34, section 4.03(2)(e): A significant benefit is any benefit in excess of normal support. For example, if the requesting spouse enjoyed the benefits of a lavish lifestyle, such as owning luxury assets and taking expensive vacations, this factor will weigh against relief.

If, however, the nonrequesting spouse controlled the household and business finances such that the nonrequesting spouse made the decision on spending funds for a lavish lifestyle, then this mitigates this factor so that it is neutral.

If only the nonrequesting spouse significantly benefitted from the unpaid tax and the requesting spouse had little or no benefit, or the nonrequesting spouse enjoyed the benefit to the requesting spouse’s detriment, this factor will weigh in favor of relief.

The taxpayer says the “significant benefit” rule is neutral. She claims that the only benefit she received from her husband’s income was normal support. She says that the family’s lifestyle did not change during the tax years in issue relative to the prior years. She claims not to have had any unusual or lavish expenses. She acknowledges they owned a Cancun timeshare but claims that the timeshare was their only vacation property.

The IRS says the significant benefit rule weighs against relief. The IRS says the taxpayer did receive a significant benefit because at least $8 million of life insurance proceeds was paid to her. According to the IRS, it stands to reason that these policies were funded, at least in part, by the failure of the responsible parties to pay the income tax liabilities for the years at issue in this case.

The IRS claims that the taxpayer and her husband accumulated other assets during the years at issue, including a real property interest in Cancun, Mexico and their personal residence which included two rental apartments.

The taxpayer argues that, because the claims against her husband’s estate exceeded the life insurance proceeds she received, it does not stand to reason that the life insurance is traceable to the tax liability.

She also claims that, even if her husband’s failure to pay their tax liabilities allowed him to fund the policies that provided her with about $8 million after his death, the benefit she received should nonetheless be a neutral factor because her husband made the decision to invest in the policies.

 

WHAT WOULD YOU DECIDE?

 

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6. Compliance with income tax laws

The rule from revenue procedure 2013-34, section 4.03(2)(f): Provides no guidelines specifically applicable to a requesting spouse who is a widow or widower.

Note: The court said that for purposes of applying the “compliance with income tax laws” factor, the circumstances of a widowed spouse were sufficiently analogous to those of a divorced spouse. The court applied the guidelines provided in revenue procedure 2013-34, section 4.03(2)(f)(i), with appropriate modifications. In particular, the court considered the taxpayer’s compliance with the income tax laws for the taxable years after her husband’s death.

The taxpayer claims that she has filed all required income tax returns and has no balance owing for the tax years subsequent to 2009. She acknowledges that her requests for innocent spouse relief did not list among her assets the proceeds she received from insurance on her husband’s life but attributes that omission to a lack of communication among her advisors.

She also attributes to reliance on advice of others (her father and financial advisor) her transfer of insurance proceeds to family members. She claims that those transfers were not intended to purposefully conceal funds from the IRS, but instead to obtain greater Federal Deposit Insurance Corporation coverage and avoid harassment from (unspecified) creditors.

Because her omission of the insurance proceeds from her request for innocent spouse relief does not establish a lack of good faith compliance on her part, the taxpayer claims that the “compliance with income tax laws” factor weighs in favor of granting her the refund she requests.

The IRS does not dispute that the taxpayer complied with the requirements for filing income tax returns and paying income tax for years after her husband’s death.

However, the IRS says that in 2011 and 2012, the taxpayer actively tried to conceal assets from the IRS when the IRS tried to collect the tax liabilities for the years at issue. The IRS says the taxpayer did this by withdrawing $4.7 million and opening certificates of deposit in the names of nominees.

The taxpayer also failed to disclose all of her assets in her request for innocent spouse relief, which she signed under penalties of perjury.

Therefore, the IRS says the “compliance with income tax laws” factor weighs against relief.

 

WHAT WOULD YOU DECIDE?

 

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7. Mental or Physical Health

The rule from revenue procedure 2013-34, section 4.03(2)(g): This factor will weigh in favor of relief if the requesting spouse was in poor mental or physical health at the time the return or returns for which the request for relief relates were filed (or at the time the requesting spouse reasonably believed the return or returns were filed), or at the time the requesting spouse requested relief.
The IRS will consider the nature, extent, and duration of the condition, including the ongoing economic impact of the illness. If the requesting spouse was neither in poor physical nor poor mental health, this factor is neutral.

The taxpayer claims that the mental or physical health factor weighs in her favor. She argues that she suffered severely from shock, anxiety, and other mental struggles following her husband’s suicide. She claims that testimony from her advisor and attorney vouched for her poor mental state after her husband’s death, and that because of her concern about the impact of her husband’s death on their children, she and the two oldest boys went to counseling for about a year to a year and a half.

The IRS claims that the taxpayer was both physically and mentally healthy when the returns for the tax years at issue were filed. The IRS says any health issues that the taxpayer faced after her husband’s death did not prevent her from engaging in a complicated scheme in an attempt to evade collection of her 2004 through 2009 unpaid income tax liabilities by, among other actions, shifting money from life insurance accounts to certificates of deposit in the names of nominees.

The IRS concedes that the death of her husband caused the taxpayer significant emotional distress. Nonetheless the IRS concludes that based on the dearth of evidence regarding the taxpayer’s mental and physical state and other actions taken contemporaneously with the filing of the request for innocent spouse relief, this factor is neutral.

 

WHAT WOULD YOU DECIDE?

 

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Wrap up

Per the court: The factors listed are not to be applied by simply toting up favorable and unfavorable factors, giving equal weight to each: In determining whether it is inequitable to hold the requesting spouse liable for all or part of the unpaid income tax liability or deficiency, and whether full or partial equitable relief should be granted, all the facts and circumstances of the case are to be taken into account.

The factors are designed as guides and not intended to comprise an exclusive list. Other factors relevant to a specific claim for relief may also be taken into account in making the determination. In evaluating a claim for relief, no one factor or a majority of factors necessarily determines the outcome. The degree of importance of each factor varies depending on the requesting spouse’s facts and circumstances.

Our charge under the statute is to determine, taking into account all of the facts and circumstances, whether it would be inequitable to deny the taxpayer a refund of any taxes she can establish that she paid for the taxable years 2004 through 2009.

 

WHAT WOULD YOU DECIDE?

 

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Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided in the post to read the entire case.

This information should not be considered legal, investment, or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment, or tax advice. Always consult your legal, investment, and/or tax advisor regarding your personal situation.

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The parties agree that the taxpayer did not suffer economic hardship as a result of her payment of the tax liabilities in issue. Their dispute centers on the import of her lack of economic hardship.

Under revenue procedure 2013-34 (currently in effect), the absence of economic hardship is a neutral factor.

The IRS does not explain the departure from the standards announced in the service’s own revenue procedure.

Although we might properly hold the IRS to the standards of revenue procedure 2013-34, we are not bound by those standards.

It does not strike us as manifestly unfair to require the tax to be paid out of the proceeds from insurance policies funded during the years in issue using amounts that would otherwise have been available to pay the tax–particularly given the IRS’s likely inability to collect the tax from any other source if the amounts the taxpayer paid are refunded.

We conclude that, under the circumstances of the present case, the taxpayer’s ability to pay the tax liabilities in issue (to the extent that she in fact paid them) out of the proceeds of insurance purchased by her husband weighs against her claim for relief.

Right answer!

The dispersal of insurance proceeds among multiple certificates of deposit in different names at different banks need not be viewed as evidence of financial acumen on the taxpayer’s part. The taxpayer relied on her father to invest the insurance proceeds, which he did, at least in part, on the basis of her financial advisor’s advice.

Whatever the motivations underlying the investment of the insurance proceeds–whether or not the dispersal of those funds among multiple CDs was done to hide assets from the IRS–the actions in question were carried out by the taxpayer’s father. The record provides no evidence of the extent to which the taxpayer herself participated in the implementation of that plan, beyond endorsing checks to her father, or even knew about it. Therefore, we cannot treat the investment of insurance proceeds as rebutting her disavowals of financial expertise.

Contrary to the IRS’s claim, the assets referred to were not accumulated during the years in issue. Even if those assets had been purchased during the years in issue, the taxpayer would have had no reason to suspect that the purchases were made with funds that could otherwise have been used to satisfy unpaid tax liabilities if, as she claims, her husband had kept to himself information about the family’s financial circumstances. The IRS offered no evidence to refute the taxpayer’s claimed lack of involvement in family financial matters.

Finally, the IRS’s claim about the 2010 lien notice is both incorrect and irrelevant. The lien notice–apparently like other tax and financial information–was sent to the taxpayer’s husband at his law firm. Moreover, even if the lien notice had been sent to the taxpayer’s residence, thus potentially alerting the taxpayer to the unpaid tax liabilities, her awareness of those liabilities at that time would have been irrelevant under the applicable guidelines. Revenue procedure 2013-34, section 4.03(2)(c)(ii), asks what the requesting spouse knew or should have known when the returns for the years in issue were filed.

In short, the IRS has given us no reason to question the taxpayer’s testimony regarding her lack of involvement in family financial matters.

We conclude that the taxpayer has established that she expected her husband to make appropriate arrangements to pay the tax liabilities shown on the couple’s returns for the years in issue and that, under the circumstances, her expectation was reasonable.

Sorry, wrong answer :(
Right answer!

The evidence does not establish that the taxpayer received no benefit other than normal support from her husband’s failure to pay their income tax liabilities for the years in issue.

First, an annual one-week stay in Cancun could well be viewed as an “expensive vacation,” even if the trip involved no lodging costs because it involved the use of a timeshare interest owned by the vacationers.
Of course, we do not know that the funds the taxpayer’s husband might otherwise have used to pay the couple’s income tax liabilities were used instead to pay costs of the family’s annual Cancun vacations. In fact, given money’s fungibility, it would be unrealistic in most cases to expect to trace unpaid liabilities to specific expenditures. The husband’s struggling business ventures apparently made considerable demands on his resources.

But at the same time that he sought, unsuccessfully, to sustain those ventures, he also purchased or continued to fund a substantial amount of insurance on his life. That some policies eventually lapsed for nonpayment of premiums suggests that, had he fully paid the couple’s income tax liabilities when due, he might have been forced to allow other policies to lapse, including some or all of the policies that provided the taxpayer with about $8 million in benefits upon his death.

The taxpayer thus has not established that her husband was the only one who benefited from the unpaid tax liabilities.

But the extent to which the “significant benefit” factor would otherwise weigh against the taxpayer is mitigated by the evidence that her husband controlled the family’s finances and decided to make the expenditures that benefited her.

Thus, despite the prospect that the taxpayer significantly benefited from the unpaid tax liabilities, this factor, at least under the revenue procedure guidelines, is neutral.

Sorry, wrong answer :(
Sorry, wrong answer :(
Right answer!

Strictly speaking, the compliance factor, as articulated in revenue procedure 2013-34, may weigh in the taxpayer’s favor.

There seems to be no dispute that the taxpayer filed the income tax returns required of her for taxable years after her husband’s death and paid any tax shown as due on those returns. The actions of which IRS complains may not have clearly violated any income tax laws.

Whether a requesting spouse must disclose a contingent interest in a financial account payable upon the death of the named account holder may be an open question. And the taxpayer’s failure to pay gift tax on any taxable gifts she made to her parents would not violate income tax laws.

Notwithstanding the specific terms of revenue procedure 2013-34, section 4.03(2)(f), however, we are unwilling to disregard the transfer of insurance proceeds to accounts in the name of the taxpayer’s parents and the (perhaps consequent) failure to mention her interests in the insurance proceeds on her request for innocent spouse relief.

By offering explanations for those actions, the taxpayer seems to concede that they can be considered in applying the compliance factor. And those actions tend to undercut her claim that it would be inequitable not to grant her the refund she seeks.

The taxpayer walks a fine–if not evanescent–line in attempting to distinguish the IRS from other creditors. She admits that the reinvestment of her insurance proceeds had as at least one of its purposes avoiding harassment from creditors. But she denied any effort to purposefully conceal funds from the IRS. She would thus have us believe that she was not trying to hide assets from the IRS but instead to hide them from other, perhaps spurious, creditors.

Her claims that the reinvestment was also motivated by a desire to obtain greater Federal Deposit Insurance Corporation protection is belied by the fact that most of the certificates of deposit (five out of eight) were over the $250,000 limit on Federal Deposit Insurance Corporation insured deposits in effect since 2008.

The timing of the transfers, about one week after the revenue agent inquired about receipt of life insurance proceeds may also be viewed with suspicion.

We find it difficult to attribute the omission of assets from the taxpayer’s request for innocent spouse relief entirely to her advisers’ failure to communicate. We sympathize with her situation as a grieving widow dealing with the shock of her husband’s suicide and her discovery of financial problems that included unpaid income tax.

In those circumstances, she understandably turned to family members and professional advisers for help. But her reliance on others to prepare her requests for innocent spouse relief does not excuse her apparent failure to notice and inquire about the omission of the insurance proceeds–an omission that should have been obvious to her (had she read the forms before signing them).

Right answer!

We are also sympathetic to the taxpayer’s condition in the aftermath of her husband’s death. She was understandably in shock and under stress.

For those reasons, she felt she would be unable to fulfill her duties as executor of her husband’s estate. But other than her reference to counseling for up to a year and a half following the death, we have no evidence of the severity or duration of her condition. And the counseling appears to have been at least as much for her two older boys as for her.

On the other hand, the IRS has offered no evidence to rebut the taxpayer’s testimony. Contrary to the IRS’s argument, the alleged scheme to evade the collection of tax does not refute the taxpayer’s claim of mental health problems. Her distraught mental state following her husband’s death is one of the reasons she relied on others to handle her financial affairs. Any scheme to evade the collection of tax was implemented not by the taxpayer but by her father. The record does not demonstrate the extent to which the taxpayer was involved with or even aware of any such scheme. On balance, we view the mental or physical health factor as weighing slightly in the taxpayer’s favor.

Sorry, wrong answer :(
Sorry, wrong answer :(
Right answer!

Our charge under the statute is to determine, taking into account all of the facts and circumstances, whether it would be inequitable to deny the taxpayer a refund of any taxes she can establish that she paid for the taxable years 2004 through 2009.

We are not convinced it would be.

Because the claims against her husband’s estate exceeded its probate assets, allowing the taxpayer the refund she seeks would most likely prevent the IRS from collecting the tax in issue. For two principal reasons, we see no inequity in requiring the taxpayer to bear the burden of that tax.

First, by her own admission, payment of the tax did not cause her economic hardship. And second, the payments were necessarily funded with the proceeds of insurance policies on her husband’s life, the premiums for which were paid out of his income–policies that he might have been forced to allow to lapse had he paid the couple’s tax liabilities.

Thus, giving the taxpayer the benefit of every doubt–that she reasonably relied on her husband to pay the tax due and did not realize that he had not, that the only benefits she received from his failure to pay the tax were the result of his decisions, and that, in her understandable shock and grief, she reasonably relied on family members and advisers to reinvest the insurance proceeds she received and determine what assets needed to be reported on the Forms 8857 she submitted–we are not convinced that equity justifies granting her the relief she seeks.

Even under those circumstances, it does not strike us as manifestly unfair to require the tax to be paid out of the proceeds from insurance policies funded during the years in issue using amounts that would otherwise have been available to pay the tax–particularly given the IRS’s likely inability to collect the tax from any other source if the amounts the taxpayer paid are refunded.

The taxpayer is not entitled to a refund of any amounts she paid in satisfaction of her and her husband’s federal income tax liabilities for the years in issue.

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