A New York State Administrative Law Judge has held that a husband was entitled to innocent spouse relief in connection with a personal income tax assessment relating to the income from his wife's operation of a restaurant. Matter of Peter Gerace, Sr., DTA No. 826468 (N.Y.S. Div. of Tax App., Sept. 29, 2016).

Mr. Gerace is a retiree whose income was limited to a fixed disability pension, fixed social security disability benefit income, and some gambling winnings. Mr. and Mrs. Gerace had separate bank accounts, and Mr. Gerace paid for the couple's living expenses from his pension income. Mrs. Gerace was a homemaker and had never been employed prior to her opening a restaurant in 2001 with money she received from a personal injury action. Although Mr. Gerace thought that opening a restaurant was "a terrible idea," and tried to discourage Mrs. Gerace from using her settlement money to open a restaurant, her sons encouraged her and she went forward. In May 2001, Mrs. Gerace opened her restaurant, Pietro's Ristorante, in East Amherst, New York. She operated the restaurant as an S corporation, in which she was the sole shareholder and officer.

Mrs. Gerace held a variety of roles in the restaurant, and one of her sons served as a manager while another acted as a bartender. For his part, Mr. Gerace "wanted no part of" Pietro's and did not participate in the management, operations, or any other aspect of the restaurant, other than occasionally unlocking it for the chefs if Mrs. Gerace had had a particularly late night. Mr. Gerace had no ownership interest in the restaurant, did not loan money to the restaurant, and was not a creditor of the restaurant.

The restaurant was profitable in its first few years of operation, but eventually it was unable to keep up with its expenses. In an effort to keep the restaurant afloat, Mrs. Gerace borrowed money from her father and aunts. By early 2011, however, the restaurant did not have enough cash to continue operations and closed its doors.

In May 2011, the Department commenced a sales tax audit of the restaurant. After conducting a purchase mark-up audit, the Department concluded that the restaurant had additional gross taxable sales receipts on which sales tax was due. After Mrs. Gerace decided not to appeal the sales tax assessment beyond a conciliation conference, the sales tax audit led to an income audit in which the Department determined that the additional gross sales receipts constituted additional business income to Mrs. Gerace's S corporation, which Mrs. Gerace should have reported on her joint New York State personal income tax return. The Department subsequently issued an income tax assessment to Mr. and Mrs. Gerace on that basis, which the Geraces failed to timely protest, causing the assessment to become final. However, Mr. Gerace timely petitioned for innocent spouse relief.

Generally, spouses who file a joint personal income tax return are subject to joint and several liability for New York State personal income tax deficiencies. Tax Law 651(b)(2). An innocent spouse may be relieved of joint liability, however, where (i) the innocent spouse establishes that in signing the return he or she did not know and had no reason to know that there was a substantial understatement of income; and (ii) under all of the facts and circumstances, it would be inequitable to hold the innocent spouse liable for the deficiency in tax attributable to such understatement. The regulations further provide that where a joint return contains a substantial understatement of income attributable to grossly erroneous items of one spouse, the other spouse will be relieved of liability by establishing that he or she did not know or have reason to know that there was a substantial understatement of income, and in taking into account all of the facts and circumstances, including whether or not the other spouse benefitted directly or indirectly from the grossly erroneous items, it would be inequitable to hold him or her liable for the deficiency. 20 NYCRR 151.10(e)(1).

The ALJ determined that Mr. Gerace was entitled to innocent spouse relief. The ALJ found that the record clearly demonstrated that Mr. Gerace had no involvement with the restaurant and had no knowledge of, or reason to know of, any understatement of income as a result of the operation of that restaurant. The ALJ noted that, if anything, Mr. Gerace had had reason to believe the restaurant was operating at a loss based on his wife's borrowing of money from her relatives in an attempt to keep the restaurant afloat. The ALJ also found that there was no obvious change in lifestyle that benefitted Mr. Gerace or that would have alerted him to an increase in their income. The ALJ found that, to the contrary, the credible testimony of Mr. and Mrs. Gerace demonstrated that "their lives were consistently rather unremarkable." They took only one vacation during the three-year period at issue, which consisted of two days in Las Vegas and a few days afterwards visiting friends in Arizona, and lived in the same modest house they had lived in for years.

Moreover, the ALJ found that the fact that Mr. Gerace signed the joint tax returns prepared by his and Mrs. Gerace's accountant without making any investigation or raising any questions did not preclude him from receiving innocent spouse relief, since it was "extraordinarily unlikely" that Mr. Gerace could have discovered the possibility that additional income might be attributable to his spouse based on a sales tax audit of his spouse's restaurant even if he had conducted a more thorough review of those joint returns.

Finally, the ALJ concluded that holding Mr. Gerace responsible for the income tax deficiency resulting from the "imputed income" of the restaurant would be inequitable. In reaching this conclusion, the ALJ relied on the fact that Mr. Gerace was disabled, lived on a fixed income, was solely responsible for the Geraces' living expenses, and had not benefited in any way from the additional income that caused the deficiency.

Additional Insights

It is well established that the innocent spouse provision in the Tax Law is not meant to apply to cases where a spouse remains willfully ignorant of the contents of a joint tax return. Indeed, the Appellate Division has held that "an innocent spouse is one who despite having made reasonable efforts to investigate the accuracy of the joint return remains ignorant of its illegitimacy." Matter of Revere v. Comm'r of Taxation & Fin., 75 A.D.3d 860, 863 (3d Dep't 2010). The instant decision, although not precedential, is notable because the ALJ held that innocent spouse relief was appropriate even though Mr. Gerace admitted that he did not investigate or question the joint returns that he signed. The ALJ distinguished this case from Revere on the grounds that Revere stood for the principle that innocent spouse relief was not designed to protect willful blindness or intentional ignorance, neither of which was at issue in this case, and that Mr. Gerace's failure to investigate the returns could not be said to negate his innocence since he was never in a position to discover their inaccuracy.