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’Til Taxes Do Us Part - Recent Developments in the Innocent Spouse Rule

Married couples typically file joint tax returns. The husband and wife are responsible jointly and individually for payment of correct taxes on their taxable income. One spouse may contribute little or no income but will still be liable if the other spouse understates or makes an underpayment of the amount of income tax due. (Any reference to "tax" includes interest and penalties, if applicable.)

Upon separation or divorce one spouse, presumably the wife for the purposes of this article, may not be aware of the incorrect tax reporting or underpayment of tax by the other spouse. For example, tax may be due on the husband's self-employment income. Yet in many settlement agreements the wife is required to file a joint return for the, relevant calendar year. Filing a joint tax return, rather than a separate return usually results in a lower tax liability. Often, the agreement provides for a tax indemnification between the spouses with respect to any tax liability, and the husband/income-producing spouse is often required to indemnify and hold his wife harmless from any tax liability. This indemnification may also apply to joint returns in prior years. Unfortunately, the Internal Revenue Service, not surprisingly, insists on full payment of taxes due. If the spouse responsible for the incorrect reporting or nonpayment of tax has insufficient assets to pay the tax bill, the IRS collectors likely will demand the balance from the other spouse, whether the parties are still together, separated, or divorced.

In 1971, Congress enacted the first "innocent spouse" provision of the Internal Revenue Code in order to protect spouses with no knowledge of the incorrect tax reporting by the other spouse. The provision was modified in 1984, but it still offered limited relief. It provided no escape clause for a spouse who "innocently" signed a joint tax return as an accommodation and was then confronted with collection efforts by the IRS because there was an underpayment of taxes as opposed to an understatement of income or overcalculation of deductions creating further tax liability. In other words, in those cases where the parties' tax return accurately reflected the parties, joint taxable income but the spouses failed to remit the full taxes due, the so-called innocent spouse had no redress if the Internal Revenue Service sought collection from her rather than the now debt-ridden asset-depleted former husband.

New Tax Options

Congress, by enacting the IRS Restructuring and Reform Act of 1998 signed by President Clinton on July 22, 1998, gave further relief to innocent spouses by making the old rules more flexible; and it enabled a spouse to claim one or more types of relief, to wit: (i) innocent spouse, (ii) separation of liability, and (iii) equitable relief.

Briefly, the recently enacted amendments provide for relief to spouses in certain circumstances from joint liability for tax due on a jointly filed tax return, plus interest and penalties. The burden of proof is on the individual making the election to establish the deficiency allocable to him or her.

Innocent Spouse Option

The recently amended innocent spouse rule or option makes such status easier to obtain in several ways. Under prior law there were certain minimum understatement requirements which have been eliminated. Also, the understatement of tax must have been deemed grossly erroneous in order to qualify. A spouse can now elect to seek innocent spouse status if he or she meets all of the following five criteria:

  • A joint return was made;
  • There was an understatement of tax attributable to erroneous items of the individual's spouse;
  • In signing the return the individual did not know, and had no reason to know, that there was an understatement of tax;
  • Taking into account all of the facts and circumstances, it is inequitable to hold the individual liable for the, deficiency in tax; and
  • The individual files an innocent spouse election with the IRS and elects to apply for relief no later than two years after the date of the Service's first collection activity after July 22, 1998, with respect to the individual

Separation of Liability Option

Of particular interest to are the new separate rules for divorced and separated taxpayers. The tax code now has separate elective rules for taxpayers who are no longer married, legally separated, or not living together. If a spouse qualifies for such an election, the divorced or separated spouse's liability for any assessed deficiency cannot exceed the portion of such deficiency considered allocable to the individual spouse. Relief from the other spouse's liability is barred to the extent the electing tax payer had actual knowledge of the understated tax.

The electing taxpayer carries the burden of proof to establish the allocatable deficiency. The I.R.S., however, has the burden of proof to show that any assets that were transferred between individuals were part of a plan to defraud the I.R.S. The I.R.S. also has the burden to show that at the time the joint return was signed, an individual had actual knowledge of an item creating a deficiency that was not allowable to such individual. If the taxpayer can show that the return was signed under duress, actual knowledge is permissible.

A divorced or separated individual seeking separation of liability status with regard to a previously filed joint return must meet the following criteria:

  • A joint return was made;
  • At the time relief is elected the individual is no longer married to, is legally separated from, or has been living apart at all times for at least 12 months from his or her spouse or former spouse; or the spouse died.
  • The individual elects to apply for relief no later than two years after the date of the Service's first collection activity after July 22, 1998, with respect to the individual; and
  • The liability remains unpaid at the time relief is elected.

A spouse entitled to "separation of liability status" thus avoids tax created by the other spouse understating his or her tax (income and/or deductions).

Equitable Relief Option

Neither the innocent spouse nor the separation of liability option authorizes relief from tax liabilities that were properly reported on the return but not paid. However, such relief is now available as an "equitable relief" option. Congress enacted this catch-all provision with the intention that the I.R.S. exercise equitable relief when a spouse "does not know and has no reason to know that funds intended for the payment of tax were instead taken by the other spouse for such other spouse's benefit." The exercise of equitable relief by the I.R.S. would also be appropriate if "taking into account all the facts and circumstances it is inequitable to hold an individual liable for all or part of any unpaid tax or deficiency arising from a joint return.

As of December 1998, the Internal Revenue Service revised its form 8857 entitled "Request for Innocent Spouse Relief (And Separation of Liability and Equitable Relief)," which is not filed with the joint tax return but mailed separately to the IRS Center in Cincinnati, Ohio or directed to a specific IRS agent in the event of an examination or notice of deficiency. In electing any of the three options available, the requesting spouse attaches a detailed explanation as to why he or she believes it would be unfair to hold him or her, instead of the spouse (or former spouse), liable for the understatement or underpayment of tax. The favorable I.R.S. determination may also result in the local or state taxing authorities granting a spouse similar relief. However, most states have only the innocent spouse or separation of liability elections. As of yet, the equitable relief option has not been adopted by state law.

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