Are tax indemnity payments to an ex-spouse taxable?

Tax indemnity payments are common features of many transactions, such as litigation settlement agreements, merger documents, purchase and sale agreements, leases, etc. Regardless of the context, they generally provide that if one party is taxed as a result of the transaction, the other party will reimburse the tax paid. Sometimes, indemnity provisions are part of a divorce settlement.

Why include a tax indemnity provision in a divorce settlement? Because filing a joint return results in joint and several liability (i.e., each spouse is potentially liable for the entire amount of any tax deficiencies, interest and penalties); see Sec. 6013(d)(3); Hayman, 992 F2d 1256 (2d Cir. 1993), aff'g TC Memo 1992-228; Osborn, TC Memo 1993-312.

Innocent Spouse Relief?

While a tax indemnity agreement might help an ex-spouse recover unexpected tax liabilities from the other ex-spouse, will it help the former avoid joint and several liability in the first place? No; see, e.g., Buchine, TC Memo 1992-36. While there are other ways to avoid it, the most popular method is Sec. 6015(b) innocent spouse relief.

Qualifying as an innocent spouse is not easy, however. The spouse requesting such relief must prove all of the following: (1) there is an understatement of tax attributable to erroneous income items that belong to the other spouse (or former spouse); (2) he or she was unaware of this understatement when signing the return; (3) based on all the facts and circumstances, it would be inequitable to hold the requesting spouse liable for the deficiency; and (4) he or she sought relief within two years of the IRS's commencement of collection activities; see Bokum, 94 TC 126 (1990), aff'd, 992 F2d 1132 (11th Cir. 1993).

A requesting spouse who fails to fulfill any of the above requirements is barred from qualifying as an innocent spouse under Sec. 6015(b); see Shea, 780 F2d 561 (6th Cir. 1986), aff'g in part and rev'g in part TC Memo 1984-310; Est. of Jackson, 72 TC 356 (1979). The Tax Court has frequently been unsympathetic to the plight of alleged innocent spouses; see, e.g., Stiteler, TC Memo 1995-279, aff'd w/o pub. op., 108 F3d 339 (9th Cir. 1997); Knapp, TC Memo 1988-109.

Tax on Tax?

What if an ex-spouse receives a tax bill from the IRS and the other ex-spouse indemnifies him or her for it? How is the indemnity payment treated for tax purposes? Can the reimbursing ex-spouse just write the taxed spouse a check for the gross amount? Does the check have to be "grossed up" to account for taxes the taxed spouse may recur on receipt of the indemnity payment?

Taxpayers have generally cited Clark (40 BTA 33 (1939), nonacq., 1939-2 CB 45 (withdrawn), acq. 1957-2 CB 4) for the proposition that tax indemnity payments are excludible from gross income. The IRS has made no secret of the fact that, notwithstanding Clark, it generally considers tax indemnity payments to be fully taxable. It has frequently attacked tax indemnity payments under Sec. 61 (gross income is income from whatever source derived) and Regs. Sec. 1.61-14(a) (the payment of another person's income tax (directly or indirectly) results in gross income to that person (unless otherwise excluded by law)); see, e.g., IRS Letter Rulings 9833007, 9743035, 9743034, 9728052 and 9226033; see also Old Colony Trust Co., 279 US 716 (1929).

Nonetheless, one can argue that tax indemnity payments are not gross income. These types of payments are distinguishable from those in Old Colony Trust Co., as well as those contemplated by Regs. Sec. 1.61-14(a). In the typical divorce, the recipient spouse would clearly end up paying additional taxes as a result of his or her association with the other spouse. Old Colony Trust Co. and Regs. Sec. 1.61-14(a) contemplate the payment of another's taxes when the payer is not doing so, to make the recipient whole.

As noted in Centex Corp., 55 Fed. Cl. 381 (2003), a common thread in recent letter rulings dealing with tax indemnification is to distinguish Clark. In Centex, the court held that the tax-payer was not ultimately paying any more in Federal income tax than it otherwise would have, but for the negligence of another; thus, the tax indemnity payment it received was includible in gross income. If the recipient spouse can prove that he or she paid more in Federal income taxes than he or she would have had a joint return not been filed, there should be a credible argument under Centex that any indemnification received is nontaxable.

FROM ROBERT W. WOOD, J.D., AND DOMINIC L. DAHER, J.D., LL.M., ROBERT W. WOOD, P.C., SAN FRANCISCO, CA (NEITHER AFFILIATED WITH GRANT THORNTON LLP)