Defining the revised innocent-spouse provisions.

To address widely perceived injustices arising from joint and several liability for spouses who fried joint returns, Congress, as part of the Internal Revenue Service Restructuring and Reform Act of 1998 (IRSRRA), expanded the possibilities for relief from joint liability. In enacting Sec. 6015, Congress provided three separate statutory bases for innocent-spouse relief. Two of these arise only when a taxpayer's tax increases.

Relief from Tax Increases

Sec. 6015(b) provides relief from joint liability if five conditions are met:

1. A joint return was filed;

2. On the return, an understatement of tax was attributable to erroneous item(s) of the spouse (i.e., the non-requesting spouse) with whom the spouse requesting relief (i.e., the requesting spouse) filed the return;

3. The requesting spouse established that at the time that the return was signed, he had no knowledge or reason to know of a tax understatement;

4. Taking into account all the facts and circumstances, holding the requesting spouse liable for the understatement would be inequitable; and

5. The requesting spouse elected the benefits of Sec. 6013(b) no later than two years after the date collection activities began as to him.

Sec. 6013(b) is analogous to pre-IRSRRA Sec. 6013(e), but was expanded to include all items adjusted (but not limited to those that were "grossly erroneous").

Relief is not available to a spouse whose income or deductions or both are the cause of the tax increase.

The third requirement of Sec. 6015(b), that the requesting spouse had no knowledge or reason to know of a tax understatement at the time the taxpayers filed the joint return, was considered by the Tax Court in Butler, 114 TC 276 (2000). In Butler, the court adopted its precedents on pre-IRSRRA Sec. 6013(e). It stated:

... if a reasonably prudent taxpayer in his or her position, at the time he or she signed the return, could be expected to know that the return contained an understatement or that further investigation was warranted. The spouse seeking relief has a "duty of inquiry" ... In deciding whether a spouse "has reason to know" of an understatement, we undertake a subjective inquiry, and we recognize several factors that are relevant to our analysis, including: (1) The alleged innocent spouse's level of education; (2) the spouse's involvement in the family's business and financial affairs; (3) the presence of expenditures that appear lavish or unusual when compared to the family's past income levels, income standards, and spending patterns; and (4) the culpable spouse's evasiveness and deceit concerning the couple's finances.

In Braden, TC Memo 2001-69, the court compared two of its prior holdings--Cheshire, 115 TC 15 (2000) and Varney, TC Memo 1991-14 --as illustrative of the facts that distinguish between a requesting spouse having reason to know and meeting his duty to inquire.

In Cheshire, the, requesting spouse knew that her husband had received a large sum from his retirement plan. The retirement proceeds were incorrectly reported as partially nontaxable on the taxpayers' joint return. The court concluded the requesting spouse had knowledge of the amount of the retirement distribution and that she "knew or had reason to know of the understatement."

In Varney, distributions from an IRA belonging to the requesting spouse's deceased wife were not reported. Before dying, the wife withdrew the funds from her IRA and deposited them into a joint account. When the requesting spouse inquired about the large deposit into the couple's joint account, his wife told him that the funds were from accumulated savings. The Braden court concluded that "the taxpayer had satisfied his duty of inquiry and did not know that the funds received were the result of a distribution from his spouse's IRA." Accordingly, the requesting spouse qualified for relief.

Under prior law, a conflict existed between the circuits as to the appropriate test for determining if a spouse had knowledge of adjusted deductions. The Tax Court in Bokum, 94 TC 126 (1990), aff'd, 992 F2d 1132 (11th Cir. 1993), found that the same tests were to be applied for deductions as for income. The Eleventh Circuit adopted the Tax Court's standard.

The Bokum standard was rejected by the Second and Ninth Circuits: In both Friedman, 53 F3d 523 (2d Cir. 1995), and Price, 887 F2d 959 (9th Cir. 1989), the courts held that applying the omission-of-income test to cases involving the disallowance of deductions would eviscerate the innocent-spouse defense, because merely looking at the return informs the spouse of the transaction that gave rise to the deduction. Instead, the Second and Ninth Circuits require a taxpayer to establish that "she [or he] did not know and did not have reason to know that the deduction would give rise to a substantial understatement"

There are still no precedents that provide any guidance as to whether the courts will harmonize their opinions consistent with congressional intent that innocent-spouse relief be viewed more expansively.

Allocation of Increased Tax

Sec. 6015(c) allows a requesting spouse to elect to allocate a tax deficiency if (1) a joint return was filed and (2) at the time of the election, the requesting spouse was no longer married to, was legally separated from or had not been a member of the same household as the nonrequesting spouse at any time during the 12-month period ending on the date the election was filed. For Sec. 6015(c) purposes (unlike for Sec. 6015(b) and (f)), whether the election is equitable or inequitable is irrelevant.

Relief under Sec. 6015(c) is limited. First, a Sec. 6015(c) election would be invalid if the assets were transferred between the requesting spouse and the nonrequesting spouse as part of a fraudulent scheme. Second, relief is not available to the extent that the requesting spouse had actual knowledge of an item giving rise to a deficiency at the time he signed the return. Third, relief is available only to the extent that the liability exceeds the value of any disqualified assets (as defined in Sec. 6015(c)(4)(B)) transferred to the requesting spouse by the nonrequesting spouse.

Of these limits, the only one discussed is the preclusion of relief when the requesting spouse had actual knowledge of the item giving rise to the deficiency.

In Cheshire, the Tax Court found that relief would be precluded if a requesting spouse knew of the item that led to the deficiency, but was unaware of the proper reporting requirements. The nonrequesting spouse received a pension distribution that the requesting spouse believed included nontaxable portions.

The court stated:

We believe the knowledge standard for purposes of section 6015(c)(3)(C) is an actual and clear awareness (as opposed to reason to know) of the existence of an item which gives rise to the deficiency (or portion thereof). In the case of omitted income (such as the situation involved herein), the electing spouse must have an actual and clear awareness of the omitted income. Section 6015(c)(3)(C) does not require actual knowledge on the part of the electing spouse as to whether the entry on the return is or is not correct. (Emphasis in original.)

The court further held that "generally, ignorance of the tax law is not a defense to a deficiency."

In King, 116 TC 16 (2001), the Tax Court established its test for determining whether a taxpayer had actual knowledge of a deduction. The requesting and nonrequesting spouses had filed a joint return in which they claimed a loss from the nonrequesting spouse's cattle-raising activity. The Service disallowed the loss under Sec. 183 as an activity not engaged in for profit.

The court held that when the item giving rise to the deficiency is a disallowed deduction, actual knowledge must include knowledge of the facts that caused the disallowance of the deduction. In King, the fact that gave rise to the adjustment was the nonrequesting spouse's lack of a profit objective. The requesting spouse knew of the loss but expected the activity to become profitable. For this reason, the Service did not meet its burden of proving that the requesting spouse had actual knowledge of the nonrequesting spouse's lack of a profit motive, and, therefore, the court granted relief.

Relief Due to Inequity Sec. 6015 (f) provides:

Under procedures prescribed by the Secretary, if--(1) taking into account all the facts and circumstances, it is inequitable to hold the individual liable for any unpaid tax or, any deficiency (or any portion of either); and (2) relief is not available to such individual under subsection (b) or (c), the Secretary may relieve such individual of such liability.

Pre-IRSRRA Sec. 6013(e) required a consideration of whether it was inequitable to grant relief. In Braden, the court stated:

"[s]ince section 6015(b)(1)(D) is substantially identical to former section 6013(e)(1)(D), we may look to cases applying former section 6013(e)(1)(D) to inform our analysis under section 6015 (b) (1) (D). See Butler v. Commissioner, 114 T.C. 276 (2000).

As Sec. 6015(f)(1) is a duplicate of Sec. 6015 ( b) (1) (D) , it is highly likely that the court will make a similar interpretation.

In Silverman, 116 F3d 172 (1997), in overturning the Tax Court's more restrictive view of former Sec. 6013(e), the Sixth Circuit stated, "The innocent spouse provision should be construed and applied liberally in favor of those for whom it was designed to protect"; see Friedman, 53 F3d 523 (2d Cir. 1995), aff'g in part and rev'g in part, TC Memo 1993-549; Perry, TC Memo 1992-258; and Allen, 514 F2d 908 (5th Cir. 1975), aff'g in part and rev'g in part, 61 TC 125 (1973).

In Makalintal TC Memo 1996-9, the Tax Court recapitulated its holdings on the issue of inequity under the former section:

In light of all of the facts and circumstances, it would be inequitable to hold petitioner liable for the alleged understatement ... This issue turns largely on the question of whether petitioner benefitted directly or indirectly from the understatements of tax. Flynn v. Commissioner, supra at 367; Bell v. Commissioner, T.C. Memo. 1989-107; sec. 1.6013-5(b), Income Tax Regs. Normal support of a spouse and children is not regarded as a significant benefit and is to be considered in light of the circumstances of the parties. Sanders v. United States, 509 F.2d 162, 168 (5th Cir. 1975); Flynn v. Commissioner, supra at 367; Bell v. Commissioner, supra. Also to be considered is whether the spouse claiming relief has been deserted, divorced, or separated. Kistner v. Commissioner, T.C. Memo. 1995-66; sec. 1.6013-5 (b), Income Tax Regs.

Significantly, the Tax Court also stated:

Further, in deciding whether it would be inequitable to hold a spouse liable for understatements of tax, it is relevant to consider the probable future hardships that would be imposed on the spouse seeking relief, if such relief were denied.

Under pre-IRSRRA Sec. 6013(e) (as will assuredly be required under current law), taxpayers bore the burden of proving that they did not receive a significant benefit from the understatement, other than normal support. This burden must be met with specific facts on lifestyle, expenditures, asset acquisitions and the disposition of the benefits of the understatement.

In considering the facts and circumstances that favor a finding of inequity, the courts have considered the departure of a spouse, whether the spouse had to pursue further education to support the spouse and family, a reduction in living standard, the lack of accumulated liquid assets, a reduction of income and physical or mental abuse.

The courts have not found that the requesting spouse's retention of the family home or automobile weigh against relief.

In Rev. Proc. 2000-15, the Service established the threshold conditions that taxpayers must satisfy before it will consider a request for equitable relief under Sec. 6015(f), as well as the circumstances under which the IRS will ordinarily grant Sec. 6015(f) relief and the factors weighing in favor and against that relief.

Rev. Proc. 2000-15 does not provide relief when the requesting spouse knowingly filed a fraudulent return or took part in the fraudulent transfer of assets. Relief is also limited by the disqualified-asset-transfer limits under Sec. 6015(c)(4)(B).

The Service lists those circumstances under which it will ordinarily grant equitable relief under Sec. 6015(f).When the tax is unpaid at the time the taxpayers file a request:

* The requesting spouse can no longer be married to (or has to be legally separated from) the nonrequesting spouse or cannot have been a member of the same household as the nonrequesting spouse at any time during the 12-month period ending on the date relief was requested;

* At the time the return was signed, the requesting spouse had no knowledge or reason to know that the tax would not be paid. The requesting spouse must establish that it was reasonable for the requesting spouse to believe that the nonrequesting spouse would pay the reported liability.

* The requesting spouse will suffer economic hardship, as defined under Regs. Sec. 301.6343-1(b)(4), which limits relief to taxpayers unable to pay reasonable basic living expenses. It appears that under Rev. Proc. 2001-15, the Service adopted a far more stringent definition of hardship than had been applied previously.

The procedure also includes a list of circumstances under which the IRS will grant equitable relief. No single circumstance is determinative; the Service considers and weighs whether:

* The requesting spouse was separated (whether legally separated or living apart) or divorced from the nonrequesting spouse.

* The requesting spouse would suffer economic hardship.

* The requesting spouse was abused by the nonrequesting spouse.

* The requesting spouse did not know and had no reason to know that the liability would not be paid. For a liability that arose from a deficiency, whether the requesting spouse did not know and had no reason to know of the items giving rise to the deficiency.

* The nonrequesting spouse had a legal obligation pursuant to a divorce decree or an agreement to pay the outstanding liability. This would not be a circumstance weighing in favor of relief if the requesting spouse knew or had reason to know (at the time the divorce decree or agreement was entered into) that the nonrequesting spouse would not pay the liability.

* The liability for which relief was sought was solely attributable to the nonrequesting spouse.

Circumstances weighing against relief include:

* The unpaid liability or item that gave rise to the deficiency was attributed to the requesting spouse.

* The requesting spouse knew or had reason to know of the item that gave rise to a deficiency or that the reported liability would be unpaid when the return was signed. This is an extremely strong factor weighing against relief.

* The requesting spouse had significantly benefited (beyond normal support) from the unpaid liability or items that gave rise to the deficiency; see Regs. Sec. 1.6013-5(b).

* The requesting spouse would not experience economic hardship.

* The requesting spouse had not made a good-faith effort to comply with Federal income tax laws in the tax years following the tax year(s) to which the request for relief relates.

* The requesting spouse had a legal obligation pursuant to a divorce decree or agreement to pay the liability.

Procedure for Requesting Innocent-Spouse Relief

To request innocent-spouse relief, a spouse must file Form 8857, Request for Innocent Spouse Relief, within two years of the first collection activity against the requesting spouse after July 22,1998.

If the IRS denies the request, the requesting spouse must file a petition with the Tax Court during the 90-day period beginning on the date on which the Service mailed (by certified or registered mail) a determination notice denying relief.

If the IRS fails to issue a valid notice of determination within six months of filing a relief request, the spouse could file a petition with the court during the 90-day period beginning after the expiration of the six-month period (Sec. 6015 (e) (1) (A)).

In Heit, Docket No. 5503-00 (2001), a determination notice issued by the Service included a series of errors, including a misstatement of the date for filing a Tax Court petition. The taxpayer filed her petition by the date stated in the notice. The Service moved the court to dismiss the taxpayer's petition, claiming that the petition was not timely. The Tax Court held that the notice was invalid and allowed the taxpayer's petition to stand as being filed within six months after her request for relief.

FROM TIMOTHY BURKE, CPA, J.D., BURKE AND ASSOCIATES, BRAINTREE, MA