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Innocent Spouse Relief
By Scott Kauffman, A California Tax Attorney.
The New [Less] Innocent Spousal Relief
As we pass into the new millennium, Congress, a little more than a year ago, decided to correct an imbalance of justice and eased the burden of those taxpayers afflicted with tax liabilities left to them by their former spouses.
A true problem exits when one spouse runs a business and other spouse is ignorant about the particulars. A business that a spouse is running which fails to account for all of its receipts or inflates its deductions, creates major difficulties. When a joint return is filed, a party and their spouse are jointly and severally liable for all income taxes due. Section 6013(d). ( All references to sections are to the Internal Revenue Code unless otherwise stated.)
If your client and their spouse have split and the spouse cannot be found, the client is, scatologically speaking, out of luck. Even if the divorce decree specifies that the spouse was financially responsible for the mess caused, the client is still liable because the Internal Revenue Service (the “Service”) is not bound by the state decree. Theoretically speaking, prior to the 1998 Restructuring and Reform Act (the “RRA”), the client might have had a right to petition the Service for innocent spousal relief, but the chances of actually getting off the hook were, as the saying goes, slim and none.
Before reviewing the new innocent spousal provision of the RRA, a little history of the old innocent spousal provisions will put the recent revisions into perspective.
Most married taxpayers do not comprehend the legal consequences of executing a joint return. Each taxpayer who files a joint return is fully responsible for the accuracy of the return and fully liable for any tax payable pursuant to the return. Joint and several liability applies even though only one spouse may have earned all of the income appearing on the return. Married taxpayers who wished to avoid joint and several liability prior to the RRA, could either file as a married person filing separately (which would not provide much protection in a community property state) or petition for relief as an innocent spouse, Section 6013(e). (For the balance of this article, the term “innocent spouse” refers to the spouse seeking relief pursuant to any of the three bases of relief provided for in §6015 and the term “non-innocent spouse” refers to the spouse of the innocent spouse).
A typical pre-RRA innocent spouse case would often arise subsequent to a divorce. One of the spouses would leave the area and would be difficult for the Service to locate, but it would be able to locate the custodial parent (who was often more accessible) and who would then be responsible for 100% of the tax deficiency that was the result of a return filed during the marriage. The spouse who the Service was able to locate would be jointly and severally liable for the income omitted or erroneous deductions of the other spouse even if those items were concealed from the innocent spouse.
Prior to the RRA, §6013(e) provided conditional relief to the innocent spouse if all of the following conditions are met:
- A joint return had been filed for the tax year at issue;
- In the tax year for which the joint return had been filed, there was a substantial understatement of tax. A substantial understatement was an understatement exceeding $500. For any understatement attributable to an unfounded claim for deduction, credit or basis, there was an additional requirement that the understatement had to be greater than 10% of the innocent spouse’s adjusted gross income in the most recent tax year ending before the date that the deficiency notice was mailed, if the innocent spouse’s adjusted gross income was $20,000 or less. If the innocent spouse’s adjusted gross income exceeded $20,000, the understatement had to have exceeded 25% of the innocent spouse’s adjusted gross income.
- The substantial understatement of tax had to have been attributable to a grossly erroneous item of the non-innocent spouse. A grossly erroneous item was an item of gross income omitted from the return or a claim for deduction, credit or basis in an amount for which there was no basis in fact or law. Merely because a claim for deduction, credit or basis was disallowed, however, did not mean that the item had no basis in fact or law. This often led to the anomalous situation where the Service argued that a claim for a deduction, credit of basis that it had disallowed did in fact have a basis in fact or law.
- The innocent spouse established that the innocent spouse did not know (or have reason to know) of the substantial understatement. The courts did not apply a consistent standard in determining whether an innocent spouse knew or had reason to know of a substantial understatement. Some courts held that knowledge of the facts of a transaction giving rise to an understatement prohibited innocent spousal relief. R.D. Bokum v. Commissioner, 94 T.C. (1991), aff’d on another issue, 992 F.2d 1132 (11 th Cir. 1993). Other courts looked at the business experience and education of the innocent spouse. P.A. Price v. Commissioner. 887 F2d 959 (9 th Cir. 1989). No partial relief was available based upon the limited knowledge of the innocent spouse under the statue, but at least one court did permit partial relief. Wiksell v. Commissioner, 90 F3d 1459 (9 th Cir. 1997).
- Under all of the facts and circumstances, it was not equitable to hold the innocent spouse liable for the deficiency in tax resulting from the substantial understatement.
Analogous to §6013(c) provided a form of innocent spousal relief to married taxpayers in community property states who had filed separate returns.
As you can see, the prior provisions for innocent spousal relief were themselves a contradiction in terms. If there was a substantial understatement of tax attributable to a grossly erroneous item, should not the spouse seeking relief have had reason to know of the understatement? Relief under the prior innocent spousal provisions was, in fact, so infrequently granted that it was, in the words of the Senate Finance committee merely theoretical.
In the Senate Finance Committee hearings preceding the passage of the RRA, the American Bar Association suggested that Congress adopt more of an accounting approach which would assign individual responsibility instead of imposing joint and several liability. For example, if the husband was responsible for 60% of the income entering a return and the wife for 40%, those percentages would define the responsibly in any subsequent deficiency. It was this accounting approach that was ultimately adopted by Congress.
First Basis of Relief
Under the RRA, there are now three bases for relief as well as the possibility of partial relief. The First Basis for Relief: §6015(b). Under the new innocent spouse provisions, a spouse will be relieved from joint and several tax liability to the extent that the deficiency assessment is attributable to an understatement of tax if:
- A joint return has been filed for the tax year at issue.
- In the tax year for which a joint return was filed, there was an understatement of tax (the understatement of tax no longer need be substantial).
- The understatement of tax is attributable to an erroneous item of the non-innocent spouse (the erroneous item no longer need be grossly erroneous and the innocent spouse is no longer required to show that the understatement of tax had no factual or legal basis).
- The innocent spouse established that the innocent spouse did not know (or have reason to know) of the substantial understatement. Query: Your spouse finds this article and points it out to you. A few days later your spouse presents you with a joint return for signature and asks if you had an opportunity to read this article and you reply that you did. Your spouse then says something like: “Well ignorance is bliss they say” and walks off. You sign the return without questioning your spouse as to the details of your spouse’s contributions of income to the return. Did you have reason to know of the understatement at the time that you signed the return? This is more than just a rhetorical question and might in fact constitute good tax planning. If one spouse wishes to take a particularly aggressive return position concerning an item of income or a deduction of that spouse, it may behoove that spouse to explain to the other spouse, not the aggressive position, but the subsequent advantages of not receiving an explanation of the aggressive position should that position be rejected by the Service. Could it be better to lie to your spouse concerning a return position to put him or her into a protected position?
- Under all of the facts and circumstances, it is not equitable to hold the innocent spouse liable for the deficiency in tax resulting from the understatement.
- The innocent spouse elects the benefits of innocent spousal relief not later than two years subsequent to the date that the Service initiates collection activities after the enactment date (all references herein to the “enactment date” are to July 22, 1998) with respect to the innocent spouse.
Note that unlike the separate liability election, there is no need for the spouse seeking relief to be divorced, legally separated or not living with the non-innocent spouse for more than twelve months. Consequently, relief from joint and several liability may be particularly pertinent where one spouse is employed in a high tax audit risk profession in which the tax assessed results in a levy upon the wages or separate property of the innocent spouse.
Note also that, as under prior law, community property laws are not taken into account for purposes of determining liability. Query, however, as to whether an innocent spouse who the Service determines is entitled to relief from joint and several liability would also be successful in requesting a removal of a levy or lien from one-half of the community property of the innocent spouse.
Unlike pre-RRA law, if an innocent spouse in signing the return did not know (or have reason to know) of the extent of the understatement, the innocent spouse is relieved of liability to the extent attributable to the portion of the understatement that the innocent spouse did not know or have reason to know. Section 6015(d).
Second Basis for Relief
Section 6015(c) provides a separate liability election. An innocent spouse may elect separate liability if: 1) a joint return was filed; and 2) at the time of the filing of the election, the innocent spouse is no longer married or is legally separated from the person with whom the innocent spouse filed the joint return or the innocent spouse has not lived in the same household as the person with whom the innocent spouse filed the joint return during the prior twelve months.
As is true under §6015(b) request for relief from joint and several liability, taxpayers may elect separate liability up to two years after the Service initiates collection activities with respect to the electing taxpayer. Section 6015(c)(3)(B). The Senate Committee Report provides that the two year period begins with the collection activities that have the effect of notifying the electing taxpayer of the Service to collect the wages of the taxpayer and the notice of levy against the property of the electing taxpayer, but not a notice of deficiency or demand for payment addressed to both spouses. This two-year period will not expire before two years after the date of the first collection activity that occurs after the date of enactment. RRA §3201(c).
The liability of the innocent spouse will generally be limited to the amount of the deficiency arising from items that would have been allocated to the innocent spouse if the innocent spouse had filed a separate tax return for the tax year. Income from a jointly owned business or investment will be allocated equally between the spouses unless a different allocation is supported by clear and convincing evidence. Items of income, however, will be allocated to the spouse who earned the wage or separately owned business or investment that produced the income. If a deficiency is attributable to the denial of a deduction, credit or basis, the deficiency will be allocated to the spouse to whom the deduction, credit or basis will be allocated. Business deductions will be allocated according to ownership of the business. Personal deductions will be allocated equally between each spouse unless a different allocation is appropriate.
A separate liability election will be invalid if:
- The Service demonstrates that, at the time that the innocent spouse signed the return, the innocent spouse possessed actual knowledge of any item giving rise to the deficiency, unless the electing spouse establishes that the return was signed under duress. If an innocent spouse did in fact possess actual knowledge of an item, that item is allocated between both spouses. Actual knowledge must be established by the evidence and may not be inferred by indications that the innocent spouse had merely a reason to know of the understatement.
- The tax liability of an innocent spouse is increased by the value of any “disqualified asset,” i.e., an asset that is transferred by the other joint filer to the innocent spouse for the principal purpose of avoiding tax or the payment of tax. Any transfer between spouses within one year preceding the date upon which the first letter of proposed deficiency is mailed is presumed to have tax avoidance as its principal purpose unless the transfer is pursuant to a decree of divorce or separate maintenance.
Burden of Proof
While an innocent spouse has the burden of proof with respect to making a separate liability election, the Service has the burden of proof with respect to establishing that relief is not available on the basis of a fraudulent transfer of assets or the possession by the innocent spouse, at the time of signing the return, of actual knowledge of an item giving rise to a deficiency that is not allowable to the innocent spouse. Section 6015(c).
Note that relief under the separate liability election may be less burdensome for an innocent spouse to obtain than relief from joint and several liability because the Service, in order to defeat the separate liability election, has the burden of proving that the innocent spouse possessed actual knowledge of the item giving rise to a deficiency that is not allowable to the innocent spouse whereas an innocent spouse claiming relief from joint and several liability has the burden of showing that the innocent spouse did not know or have reason to know of the understatement.
Note that if the innocent spouse remains married to the non-innocent spouse, only the separate liability election (and equitable relief discussed below) is available to the innocent spouse. If the innocent spouse and the non-innocent spouse are divorced, legally separated or have not cohabited within the same household for the prior twelve months, relief from joint and several liability, the separate property election and equitable relief are available to the innocent spouse.
The tax liability of an innocent spouse is generally limited to the portion of the deficiency that is attributable to items allocable to the innocent spouse. An item giving rise to a deficiency generally is allocated in the manner it would have been allocated if the taxpayers had filed separate returns. Section 6015(d)(1) and 6015 (d)(3)(A).
Items of income, in general, are to be allocated according to the spouse who earned the wages or owned the business or investment that produced the income. Income from a jointly owned business or investment will be allocated equally between each spouse unless there is clear and convincing evidence that supports a different allocation. Senate Committee Report (S.Rep.No. 105-174).
Third Basis for Relief
Section 6015(f) provides equitable relief. An innocent spouse may be relieved of joint and several liability when: 1) It would not be equitable to hold the innocent spouse liable for any unpaid tax or deficiency; and 2) Relief is not available to the innocent spouse under a claim for relief from joint and several liability or separate liability election. Note that equitable relief is applicable to understatements of tax liability and under payments of tax. Equitable relief should be available to the innocent spouse who did not know or have reason to know that funds were purloined for the benefit of the innocent spouse instead of applied to the payment of tax.
Equitable relief is also available for certain individuals not filing joint returns in order to avoid the community property implication of Poe v. Seaborn, 282 U.S. 101 (1930), which held that each spouse in a community property state is liable for the tax upon one-half of the community income. Consequently, relief is available to a spouse who would otherwise be liable for income tax on items of income that were not known to the innocent spouse and no joint return had been filed.
Tax Court Petition for Review
The Tax Court has jurisdiction to determine the appropriate relief available for a request for relief from joint and several liability or separate liability election, but not equitable relief, if a petition is filed within the later of six months after the date on which the election is field with the Service or ninety days after the date upon which the Service mails a notice to the innocent spouse of the determination by the Service of relief available to the taxpayer. Note also that the Service is required to provide the non-innocent spouse with notice and with an opportunity to participate in any administrative proceeding with respect to a claim for relief by the innocent spouse. Section 6015(d)(4).
Suspension of Collection
The Service is prohibited from pursuing enforced collection activity until the expiration of the ninety-day period discussed above or until the Tax Court decision becomes final. The Tax Court may enjoin enforced collection action if a petition has been timely filed.
If your client is the non-innocent spouse and comes to you for advice and representation before the Service in a tax audit, should you represent the innocent spouse also or suggest that the innocent spouse obtain her own counsel? Or may you represent the couple on all of the tax issues other than the claim for innocent spouse relief and suggest that the innocent spouse retain separate legal counsel upon only that issue?
Dual representation of both spouses where one spouse may have a claim as an innocent spouse, raises many of the same problems estate planners face when they represent both spouses.
The California Rules of Professional Conduct provide that, unless all of the clients give their informed written consent, an attorney may not represent an interested party if the attorney has or had a relationship with another matter. The attorney may also not represent, except with the consent of the client or former client, a client whose interests are adverse to those of another client or former client if the attorney has confidential information material to the employment. Rule 3-310(E). Informed written consent is also required if the attorney concurrently represents (or intends to represent) clients whose interests conflict. Rule 3-310(C).
Because of the fiduciary relationship between a lawyer and the client, the problems arising from a conflict of interest become more severe. Courts have frequently applied form ABA Model Code of Professional Responsibility Canon 9 as a rule of construction, resolving any doubt against the lawyer when a conflict of interest issue arises. The lawyer is to avoid even the appearance of impropriety, which can be as damaging as any actual misconduct committed by the lawyer. Multiple representation where on spouse may have a claim as an innocent spouse may lead to the appearance of impropriety.
When approached by a couple, one of whom may have a claim for relief from tax liability as an innocent spouse, the lawyer should assume that there will be a conflict of interest. In a breach of fiduciary obligation, the lawyer’s honesty and good faith are not relevant. An error committed in good faith is nevertheless an error. Hammett v. McIntyre, 114 Cal.App.2d 148, 249 P.2d 885 (1952).
The changes to the innocent spousal provisions, with three forms of relief and partial relief now available, should make relief much more easy to obtain for those who have been taken advantage of in a martial relationship. Section 6015(b) relief from joint and several liability applies to all understatements of tax attributable to erroneous items of the other spouse. No longer is it necessary that the understatement of tax be “substantial” which removes the $500 minimum tax deficiency and the minimums based upon the adjusted gross income of the innocent spouse under the prior innocent spousal provisions.
While a request for innocent spousal relief is pending, the Service is prohibited from enforced collection activity. The opportunity to appeal an adverse decision to the Tax Court should make the decisions by the Service less arbitrary. The risk to the practitioner is in failing to spot an innocent spousal claim or spotting it and not thinking through the potential conflicts of interest.