Trial court isn't bound by IRS and FTB determinations re innocent spouse status . . .
In affirmance, Fourth District holds that trial court did not err by characterizing parties' capital gains tax liability as a community property debt (despite wife's alleged innocent spouse status) or by concluding that post-separation income received by husband from disability policy was his separate property (intended to replace lost income and not a retirement asset)
In re Marriage of Marshall
April 18, 2018; ordered published May 17, 2018)
California Court of Appeal 4 Civil G053897 (Div 3) 23 Cal.App.5 th 477, 232 Cal.Rptr.3d 819, 2018 FA 1839, per Ikola, J (Moore, Acting PJ and Goethals, J, concurring). Orange County: Vogl, Temporary Judge, Affirmed. For appellant: Todd Coulston, CFLS, (949) 502-4400. For respondent: Brian Saylin, CFLS, (949) 577-9240. CFLP §§L.41.1.7, N.29.2.15.
Linda, a registered nurse, married Bryan Marshall, a dentist, in 1984. She continued her nursing career until 1987, when she became a stay-at-home Mom and their three children's primary caregiver. In 1989, the couple applied for a loan to pay for the refurbishing of Bryan's dental office. The lender agreed to the loan provided that Bryan take out a disability insurance policy and a life insurance policy. At the time, Bryan already had a retirement policy, and both parties had IRAs and 401(k) accounts.
In 2002, Bryan became disabled by a degenerative autoimmune disease, and began receiving disability benefits of $10,000 a month from the disability insurance policy. He had to sell his dental practice, but he and Linda retained ownership of the office building where it was located. After they sold that building in 2006, they invested the sale proceeds in a limited partnership called Orange Tree Lane (OTL), which was formed to buy land and develop it into an office-condo complex. However, according to Bryan, he intended to use the sale proceeds to buy another property in an IRC 1031 exchange in order to defer the capital gains tax. Unfortunately, Bryan and his accountant were not on the same page as to the procedure for filing such an exchange. When he and Linda belatedly filed their federal income tax return for 2006, the return "reflected capital gains of $1,735,615." Later, both the IRS and the FTB assessed capital gains taxes ($300,000 from the IRS and $265,000 from the FTB).
Linda and Bryan separated in July 2011 and began disso proceedings. In her trial brief, Linda asserted that the capital gains liability should be allocated to Bryan in total and that the disability insurance benefits were community property. At their disso trial, she testified that she applied for and received innocent spouse status regarding the capital gains taxes from the IRS and the FTB, with the latter granting her that status "'in part.'" Linda argued that her status as an innocent spouse precluded the FTB from imposing any liability on her for the capital gains taxes. She also contended that the parties intended the disability insurance policy to be another item in their retirement program and not as income replacement. Bryan, on the other hand, testified that the disability insurance policy was intended as income replacement, and pointed out that they had other retirement assets. He claimed that the post-separation payments to him were his separate property.
When the trial concluded, the trial court issued a lengthy statement of decision, finding, among other things, that the parties took out the disability insurance policy at the request of their lender and they intended the policy to be for income replacement, not for their retirement. Accordingly, the trial court concluded that the post-separation disability payments were Bryan's separate property. As to the capital gains liability, the trial court noted that an innocent spouse determination by the IRS is not res judicata on the issue because that determination does not adjudicate rights between spouses, does not treat the non-requesting spouse as a party to the proceeding, and is not made by a "'court of competent jurisdiction.'" Therefore, the trial court characterized the capital gains tax liability as a community property debt.
Linda appealed, but the Fourth District affirmed.
Ties that bind, or not . . .
Linda first contended that although the trial court was not bound by the decisions of the IRS and the FTB re her innocent spouse status, it had discretion to follow them and should have done so when it allocated the capital gains liability. The justices found several reasons why her analysis was flawed. They pointed out that the trial court has no discretion in applying res judicata; a prior decision "is either binding in the successive action, or it is not." And, since Linda had conceded that those decisions were not binding, there was no remaining issue as to res judicata. Moreover, her contention that Bryan lacked standing to challenge the IRS or FTB ruling, but had the right to be heard and contest the rulings was "internally inconsistent" given that Bryan's lack of standing would preclude him from having a right to be heard and contest the IRS and FTB proceedings. Moreover, per In re Marriage of Hargrave (Hargrave II) (1995) 36 Cal.App.4 th 1313, 43 Cal.Rptr.2d 474, 1995 CFLR 6805, 1995 FA 183, an innocent spouse proceeding does not adjudicate rights between the spouses; therefore, its decision can't be preclusive on the issue of the spouses' rights. The panel found that Linda's attempts to distinguish Hargrave were unpersuasive, and her contentions re Bryan's having breached his fiduciary duty in his "management and control of the commercial building" and his failing to file the parties' 2006 tax return did not convince them that the lower court should have made a different allocation of the capital gains tax burden.
Nice try, but no sale . . .
Linda next argued that the proceeds of the disability insurance were not Bryan's separate property because the policy was acquired during marriage. The panel reasoned that per In re Marriage of Elfmont (1995) 9 Cal.4 th 1026, 39 Cal.Rptr.2d 590, 1995 CFLR 6709, 1995 FA 696, disability payments are intended to replace lost earnings and are characterized according to the character of the disabled person's earnings. If the payments are received during marriage, they are community property, but if they are received after separation, they are the separate property of the disabled person. The justices didn't buy Linda's contention that the payments here were intended to be for retirement income. They noted that the parties bought the disability policy at the behest of their lender and was intended to replace lost earnings, not to be part of their retirement plans. In addition, the panel saw no reason to apportion the payments as retirement benefits from the time that Bryan reached retirement age, as the courts had done in In re Marriage of Samuels (1979) 96 Cal.App.3d 122, 158 Cal.Rptr. 38, 1979 CFLR 1192, and In re Marriage of Briltz (1983) 141 Cal.App.3d 17, 189 Cal.Rptr. 893, 1983 CFLR 2244, 1983 FA 51. Those cases, the justices found, were inapposite since Bryan had not made a choice to receive disability payments instead of retirement benefits and it was clear that there were no retirement benefits at issue here. They were similarly unpersuaded that the trial court should have inferred an intent that the payments were retirement benefits, since Bryan's testimony and evidence concerning the purchase of the disability policy made it clear that they were not. Summing up, the justices held that the trial court had not erred in either its characterization of the disability benefits or in its treatment of the tax liability, and they affirmed the lower court's judgment.
This is a nice little case that gives a detailed explanation of why an innocent spouse ruling by the IRS or FTB is not binding on state courts faced with the question of allocating unpaid tax debt. It is also important for its discussion of the disability payments issue. Keep this one bookmarked for reference in future cases.