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Innocent Spouse Relief Under Internal Revenue Code Section 6013(E)(1)
Most family practitioners are aware that if a spouse involved in a divorce is self-employed, a corporate officer with a controlling interest in a small corporation or a partner in a professional partnership, income may not be accurately disclosed on his or her financial affidavit. This situation requires extensive discovery via written interrogatories, depositions, an examination of corporate and partnership books and records and consultation with an accountant. Although this extensive discovery often unearths additional income for purposes of the divorce, it can jeopardize the divorce settlement if the attorney fails to consider joint Federal Income Tax Returns. In many cases, the spouse under-reporting income on a Financial Affidavit is also under-reporting for Federal Income Tax purposes. All joint Federal Income Tax Returns are signed under penalty of perjury and all taxes due are the joint and several obligation of both husband and wife.
In numerous cases the spouse receiving the family home in the divorce settlement earns substantially less than the other party. However, ownership of the family home makes that individual an easy target for tax liens and possible foreclosure in the event a tax audit reveals a deficiency on any of the previously filed joint returns. Section 6013(e)(1) (Innocent Spouse Rule) of the Internal Revenue Code provides that where:
Pursuant to Internal Revenue Code Section 6013(e)(3), a substantial understatement is any understatement exceeding $500.00. The definition of "grossly erroneous" is more complex and often difficult to prove.
There are two forms of grossly erroneous items. The first consists of any item of gross income which is omitted on the tax return. The second consists of any deduction, credit or basis by the spouse in an amount for which there is no basis in fact or law.
The claim of a deduction or credit is available if the innocent spouse's adjusted gross income for the "pre-adjustment year" is $20,000.00 or less, and if the liability is greater than 10% of the gross income. If the innocent spouse adjusted gross income is more than $20,000.00, pursuant to Section 6013Oe)(4) relief is available only if the tax liability is greater than 25% of adjusted gross income for the pre-adjustment year.
In the case of a deduction, credit or basis, the item is grossly erroneous only if it is both erroneous and in an amount for which there is no basis in fact or law. In the case of a deduction, Courts have held the deduction has no basis in fact when the expense for which the deduction is claimed was never made.
A deduction has no basis in law in "(W)hen the expense, even if made, does not qualify as a deductible expense under well settled legal principles or when no substantial legal argument can be made to support its deductibility. Ordinarily, a deduction having no basis in fact or law can be described as frivolous, fraudulent or ... phony". Douglas v. Commissioner, 86 T.C. 758 (1986).
The Internal Revenue Service will attempt to determine whether the innocent spouse knew or had reason to know of the understatement of income or false deduction. The factors the Internal Revenue Service and Tax Court consider in applying innocent spouse relief are:
Despite the above criteria used by the Internal Revenue Service, it is possible to claim innocent spouse relief when the couple is leading a lavish lifestyle. In one case argued successfully by this writer, the guilty spouse was a real estate developer and the innocent spouse led and expensive and very luxurious life. However, I was able to prove that the innocent spouse had inherited several hundred thousand dollars from her parents who lived in a foreign country. The Internal Revenue Service was persuaded that it was reasonable for the innocent spouse to believe her mink coat and Jaguar were a result of her inheritance rather than her husband's under-reporting of income. In that case, the guilty spouse reported approximately $7,000.00 of income in a year in which the wife had made several trips to her home country, lived in an expensive home, drove a luxury car and wore expensive jewelry and furs.
In similar case, the Tax Court agreed with this writer that the former wife of an accountant, leading a modest lifestyle, qualified for innocent spouse relief because the guilty spouse was an accountant and had engaged in numerous tax shelter transactions. The accountant, ex-husband, had been convicted of criminal tax fraud and was serving a prison term. The Internal Revenue Service found that it was unreasonable to expect a college educated woman with no background in finance, accounting or economics to understand the complex tax shelter deductions taken by her former husband.
District Counsel permitted the application of innocent spouse relief even though the wife filled out the tax return in her handwriting. In that case, I was able to prove that the innocent spouse was a physically abused woman and was psychologically unable to confront her husband about the truthfulness of the tax figures that he gave her.
In Belk v. Commissioner, 93 T.C. No. 35 (1989), the Tax Court held that the spouse was entitled to innocent spouse relief because she was unsophisticated in tax and financial matters and physically had nothing to do with the preparation of the couple's joint Federal Income Tax Returns. The Belk Court also found that the primary factor for determining whether relief should be granted is whether the innocent spouse significantly benefitted, either directly or indirectly, from the understatement.
In Foster v. Commissioner, T.C. Memo 1989-276, the Tax Court held that the spouse was not entitled to innocent spouse relief in a case where the guilty spouse embezzled funds and treated them as loan proceeds on a joint Federal Income Tax Return. The Tax Court found although the wife did not know of the substantial understatement of income, the facts should have put her on notice that the embezzlement proceeds were reportable income. In Foster, the wife signed the return knowing the increase in income was not the result of her husband's moonlighting because her husband had been convicted of embezzlement. Therefore, at the time she signed the return, she possessed sufficient knowledge to know it was not accurate.
In Douglas v. Commissioner, 86 T.C. 75, the Tax Court held that the innocent spouse was not entitled to relief under Section 6013(e) because she failed to show that disallowed deductions had "no basis in fact or law" within the meaning of Section 6013(e)(2) and (b), I.R.C.
In Douglas, Mr. Douglas participated in a business that manufactured and sold windows. He received additional income in the amount of $15,128.00 which he failed to report on his 1979 Federal Income Tax Return. The Internal Revenue Service agreed that under Section 6013(e) the spouse was relieved of liability for that portion of tax attributable to the omitted gross income.
However, the Internal Revenue Service disallowed innocent spouse relief for alimony and transportation deductions for 1979 and 1980. The wife argued she was entitled to innocent spouse relief because there was substantial understatement of tax attributable to erroneous items of one spouse and she did not know her husband had made such substantial understatement.
The Douglas Court held that for purposes of Section 6013(e), grossly erroneous items are defined as "any item of gross income attributable to such spouse which is omitted from gross income" and "any claim of deduction, credit or basis by such spouse in an amount for which there is no basis in fact or law". I.R.C. Section 6013(e)(2). "Substantial understatement of tax...means any understatement...which exceeds $500.00". I.R.C. Section 6013(e)(3). The Court agreed with the Internal Revenue Service position that the claimed employee business expense and alimony deduction did not fulfill two of the statutes requirements. Namely, Mrs. Douglas failed to establish that the understatement of tax was attributable to grossly erroneous items of Mr. Douglas and the understatement of tax was not greater than 10% of her adjusted gross income for the pre-adjustment year as required by 6013(e)(4). The Tax Court considered the legislative history of the innocent spouse statute and found that "the statute does not defined 'no basis in fact or law'". However, the Court found a clue to its meaning in the reference to a Committee report citing "phony business deductions". The Douglas Court read the statute and legislative history together and concluded that "a deduction has no basis in fact when the expense for which the deduction is claimed was never in fact made. A deduction has no basis in law when the expense, if made, does not qualify as a deductible expense under well settled legal principles or when no substantial legal argument can be made to support its deductibility. Ordinarily a deduction having no basis in fact or in law can be described as frivolous, fraudulent, or, to use the word of the Committee report, phony." Douglas v. Commissioner, 86 T.C. 745, p. 763, Shenker v. Commissioner, T.C. Memo 1985-301. The Douglas Court found that the guilty spouse was entitled to some employee deductions and some alimony deductions. The fact that Mrs. Douglas could not prove them did not mean the deduction had no basis in fact or law.
The most difficult time for a taxpayer to prove in obtaining innocent spouse relief is that the claimed deductions are not only properly no allowable, but they have no basis in fact or law.
In Purcell v. Commissioner, 86 T.C. 22 (1986) the Tax Court held that the deductions in issue were not "grossly erroneous" from the standpoint of being phony deductions. The Purcell Court clearly felt that for deductions to be clearly erroneous, they had to be completely false. In Purcell, the deductions did have some basis in fact and therefore, innocent spouse relief on those deductions was denied.
In conclusion, innocent spouse relief is available under Internal Revenue Code Section 6013 in appropriate cases. The family law practitioner should be aware of the innocent spouse rule and be ready to make the claim at the Audit, Appeals, District Counsel or Tax Court level. Generally, the earlier the claim for innocent spouse relief is made, the legal fees to the innocent spouse taxpayer are reduced.
Finally, family law practitioners should be aware of the potential liability they are subjecting their clients to when they agree to file a joint Federal Income Tax Return. If there is any basis for the attorney to believe the tax return is not correct and accurate, the client should be advised to file separately, thereby eliminating the potential exposure for omission of income or erroneous deductions taken by an ex-spouse.
If the court refuses to award alimony at the final hearing, and if alimony is not included in the final judgment, neither spouse can return to court in the future and request alimony due to a change in circumstance. Many final divorce judgments in Connecticut award $1 a year in alimony because this preserves the right to revisit the alimony issue if circumstances change.
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