Innocent spouse relief.

There are four requirements that must be met under Sec. 6013(e)(1) for a spouse to obtain relief from the joint and several liability imposed by the filing of a joint return. 1. A joint income tax return must be filed. 2. There must be a substantial understatement of tax (i.e., in excess of $500) attributable to grossly erroneous items of one spouse. Grossly erroneous items are: (a) any item of gross income attributable to the other spouse that is omitted from gross income, or (b) any claim of a deduction, credit or basis in an amount for which there is no basis in fact or law. Note: If the understatement of tax results from an erroneous deduction, the understatement, interest and penalties must be more than: (a) 10% of the taxpayer's adjusted gross income (AGI) for the pre-adjustment year, if his AGI was $20,000 or less, or (b) 25% of the taxpayer's AGI for the pre-adjustment year, if his AGI was more than $20,000. 3. The spouse claiming relief must establish that in signing the return he did not know, and had no reason to know, of the substantial understatement -- the most litigated issue in this area. 4. Taking into account all of the facts and circumstances, it would be inequitable to hold the spouse seeking relief liable for the deficiency.

Omission of Income

In cases involving an omission of income, if the taxpayer merely knew or should have known of an income-producing item, there will generally be no relief.

Erroneous Deductions

Taxpayers have a more difficult time proving that they did not have knowledge of an erroneous deduction that gave rise to a substantial understatement of tax. Logic automatically denies innocent spouse relief, as just seeing the deduction on the return is "knowledge of the transaction."

Five circuits now reject the "knowledge of the transaction" standard in erroneous deduction cases; only the Sixth Circuit and the Tax Court apply it. The five circuits have looked at what a reasonably prudent person in the taxpayer's position had reason to know or would be expected to know about a substantial understatement.

In Stevens, 872 F2d 1499 (11th Cir. 1989), four criteria were listed for making this assessment: 1. Level of education. 2. Involvement in the family's finances. 3. Presence of expenditures that are lavish or extravagant in comparison with past circumstances. 4. The guilty spouse's evasiveness and deceit concerning the family finances.

In Reser, 112 F3d 1258 (1997), the Fifth Circuit used precisely these factors in evaluating whether the spouse had reason to know that a deduction would give rise to a substantial understatement of tax on the joint return. The Court of Appeals reversed the Tax Court, based on the argument that "mere knowledge" of the transaction in and of itself did not preclude innocent spouse relief.

A joint return was filed by the Resers for 1987, reflecting large S corporation losses ($250,000) from the husband's start-up business as a real estate developer. The taxpayers were later divorced and the 1987 return was subsequently audited. On audit, it was found that the husband had borrowed money on a credit line from his bank and was jointly liable with his corporation for the loan.

Both the Tax Court and the Fifth Circuit held that the loans were made to the corporation and not to the taxpayer. Sec. 1366(d) provides that taxpayers/shareholders are only allowed to deduct such losses from an S corporation to the extent that they have basis in the stock. Because the loans were made to the corporation and not to the shareholder, Mr. Reser's basis was not increased by these loans and the losses were not deductible on the joint return.

Mrs. Reser sought innocent spouse relief for the resulting understatement of tax. Mrs. Reser was an educated woman; in fact, she was a personal injury attorney. She did have knowledge of the transaction; she was aware of the loans and knew that most of the joint income was being invested in the S corporation. However, the appearance of the losses on the tax return did not alert her to the problem of a substantial understatement of tax on its face.

The key fact in this case is that Mrs. Reser did not have the requisite knowledge of Sec. 1366(d), which would have caused her to know that the losses claimed on the tax return were not proper and would give rise to a substantial understatement of tax for that year.

In looking at the four factors in Stevens, the Fifth Circuit determined that, although Mrs. Reser's level of education was high, it was not the specific education necessary to know that the deduction would give rise to a substantial understatement of tax; she was not involved on a daily basis in the S corporation finances; her standard of living did not change during this period; and she could not be penalized for her husband's efforts to recast a bank loan in a favorable light.