Family Court Orders are No Excuse for Unpaid Taxes – Houston Tax Attorneys

Financial ups and downs are a normal part of life, and many of us will face a time when our finances take a hit. This can be challenging, especially when we have to juggle different financial needs and demands.

Divorce and marital problems often lead to major financial troubles. During a divorce, it’s common for people to focus on immediate financial needs, which can sometimes mean neglecting tax payments. In these situations, the IRS essentially becomes an unexpected creditor for the divorcing couple due to unpaid taxes.

This kind of issue can lead to extra costs in the form of interest and penalties. The IRS is known to enforce penalties for failing to file taxes, but it can also choose to waive these penalties. The Shapiro v. Commissioner, T.C. Memo 2023-261, case considers this issue in the context of a taxpayer who was under a family court order about how to manage his funds.

Facts & Procedural History

The taxpayer worked as an orthopedic surgeon in New York. For tax years 2012-2015, the IRS assessed failure to pay tax penalties against the taxpayer.

The taxpayer submitted a Collection Due Process (“CDP”) hearing request and asked the IRS for an abatement of the failure to pay penalties. The IRS denied the taxpayer’s requests. The taxpayer then filed a petition to the Tax Court challenging the denials.

The court had to consider whether the penalties should be imposed given the taxpayer’s financial struggles from a contentious divorce, reduced income from his medical practice, and a disabling condition that developed in 2015 after his divorce.

The Failure to Pay Tax Penalty

The failure to pay tax penalty is set out in Section 6651(a)(2). It is imposed when a taxpayer fails to pay the tax shown on a return by the payment due date, unless the failure is due to reasonable cause.

The penalty amount equals 0.5% of the unpaid tax for each month or fraction thereof that the tax remains unpaid, up to a maximum of 25% of the unpaid tax. Thus, the failure to pay penalty is calculated as a percentage of the unpaid tax at an increasing rate over time that the tax goes unpaid.

The tax owed by the taxpayer constitutes the basis for computing the penalty. And interest is assessed on the unpaid tax and penalties as time goes by.

Reasonable Cause for Nonpayment

The failure to pay tax penalty may be abated if the taxpayer can demonstrate the failure was due to reasonable cause and not willful neglect.

Reasonable cause for nonpayment exists if the taxpayer exercised ordinary business care and prudence but was nevertheless unable to pay the tax or would endure undue hardship if paying by the due date.

Relevant facts and circumstances determining reasonable cause include the taxpayer’s finances, assets available, and expenditures in light of income that could reasonably be expected to pay the tax timely.

Personal hardships like divorce or disability may constitute reasonable cause if a sufficient nexus exists between the hardship and nonpayment. The taxpayer bears the burden to substantiate reasonable cause based on inability to pay despite prudent efforts.

What About the Family Court Orders?

The taxpayer argued that the restrictions imposed by the family court during the divorce proceedings, along with his declining income and a disability developed in 2015, constituted reasonable cause for his failure to timely pay taxes.

The facts as set out in the tax court opinion do suggest that the family court entered various orders that severely restricted the taxpayer’s ability to make voluntary payments. This included the following:

Automatic Orders Upon Divorce Filing: When the taxpayer filed for divorce in April 2011, a series of automatic orders became effective. These orders prohibited the liquidation, sale, or transfer of any assets, including retirement funds, by either party without consent from the other or further order of the family court. These orders remained in effect throughout the divorce proceedings, which concluded in February 2014.

Restrictions on Asset Liquidation: Throughout the divorce, neither the taxpayer nor his wife consented to the liquidation or sale of any assets by the other.

Court Ordered Payments: In an interim order dated April 30, 2012, the family court ordered the taxpayer to make various payments, including monthly maintenance, child support, and carrying charges for the marital residence.

The family court considered the taxpayer’s substantial state and federal tax payment obligations in setting the amount of interim maintenance. But this was not until 2012. The tax court did not note the timing of this or the continuing nature of the family law court orders, concluding that the family law court fixed the issue after the fact and that this was sufficient. This seems to be at odds with the language in the court opinion that says that the facts at the time of non-payment are to be considered, and facts after that are relevant, but not controlling.

The taxpayer stressed that the family court’s orders restricted his ability to liquidate assets to cover his tax liabilities. This is similar to other cases where the courts have considered cash on hand to determine whether there was an ability to pay. However, the tax court found that the taxpayer did not take sufficient actions that a prudent person facing financial difficulties would have taken to ensure timely tax payment. The tax court also noted that there was no evidence that he sought permission from the family court to liquidate assets to pay his tax debts.

Steps Showing Reasonable Cause

As noted above, the tax court noted that the record did not show steps that the taxpayer took that a reasonably prudent person would. This is the reasonable cause defense to penalties. The tax court provided the following examples of steps a prudent person would have taken:

requested an extension of time for the payment of tax, see § 6161;

submitted an installment agreement request to the IRS, see § 6159;

was in the practice of setting amounts aside for the payment of his tax besides making sporadic estimated tax payments;

sought out legitimate borrowing sources, such as banks, credit card companies, or others who might have been willing to lend to him, before failing to pay his tax timely or even within a reasonable time thereafter;

petitioned the family court for permission to liquidate assets to pay delinquent tax liabilities;

explored whether he could have supplemented his income from sources in addition to, or in lieu of, OCOA; or

explored whether bankruptcy could have provided a restructuring of his tax or other obligations.

The reference to Section 6161 does not apply to the income taxes in this case and the request for an installment agreement would not seem likely given the swings in the taxpayer’s finances. However, the other examples listed by the tax court may have been applicable. The tax court emphasized the third factor of asking the family court for permission to sell assets to pay the IRS. Given this case, similarly situated taxpayers may want to consider making this type of request to the family court, even if they know that the family court is not likely to grant the request.

The Takeaway

Although one may empathize with taxpayer hardships, the taxpayer had significant income and assets. Even though his money was moving around and he was subject to the family law court’s scrutiny and direction, this was not enough to justify not paying the IRS. This ultimately is what seems to have driven the outcome in this case. This case helps in that it provides steps one can consider taking if they find themselves in this situation to help build a record to show that the penalties should be removed.